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     , 144 F.2d 110, 113 (1st Cir. 1943), cert. denied, 323
U.S. 779 (1944) is a United States income tax case which discusses the tax deductibility of damages for
loss of business good will. It is notable (and thus appears frequently in law school casebooks) for the
following holdings:

Tax law treats business good will not as future profits (which are fully taxable when recovered as
damages), but as present capital. Thus, damages for its destruction (rewarded under the Federal
Anti-Trust Laws) are designed to compensate for the destruction of a capital asset -- they are a
"return" of this capital.
However, tax law does not exempt compensatory damages just because they are a return of
capital -- exemption applies only to the portion of these damages that recovers the cost basis of
that capital; any excess damages serve to realize prior appreciation, and should be taxed as
income.

In this case, the Court treated the basis as zero because Raytheon was unable to establish it. Generally,
goodwill has a basis of zero because the costs that generate it are themselves immediately deductible (as
expenses for advertising, PR, etc). However, goodwill can acquire a basis, e.g. as a portion of the cost of
purchasing another business.


 

Raytheon built up business good will on a rectifier tube that it developed, patented, and licensed to
manufacturers. RCA licensed a competing tube to many of the same manufacturers, with a clause
requiring the licensee to only buy from RCA. These antitrust practices caused a significant decline in
Raytheon¶s market share, eventually leading to the complete destruction of Raytheon¶s business good will
in this product market. RCA paid $410,000 to settle Raytheon's claims under the Federal Anti-Trust Laws,
but in the same transaction also acquired rights to some 30 patents, and declined to state how much of its
payment should be allocated between the patent license rights versus the settlement of the suit.

In its tax return, Raytheon chose to allocate $60,000 of the settlement to the value of the patents, thus
claiming only this amount as income and excluding the remaining $350,000 as damages. The
Commissioner determined that the $350,000 constituted income. It did not immediately argue that any
damage recovery for loss of good will is always taxable as income; rather, it protested that "[t]here exists
no clear evidence of what the amount was paid for so that an accurate apportionment can be made." At
trial, Raytheon gave evidence to support its valuation of the patents; it also assessed the value of its lost
business good will (at $3,000,000) by introducing evidence of its profitability.




First: Are damages for the destruction of business good will taxable income -- or a return of capital, of
which any recovery of basis is non-taxable?

Second: If the recovery is non-taxable, did the Tax Court err in holding that there was insufficient
evidence to enable it to determine what part of the lump sum payment was properly allocable to the
settlement?


 
  

Tax law treats recoveries as "income" when they represent compensation for loss of profits. Thus, the test
for taxability is: What loss were the damages designed to compensate for? -- "In lieu of what were the
damages awarded?"

Tax law treats business good will not as future profits (which are fully taxable when recovered as
damages), but as present capital -- even though evidence of future profitability must be introduced to
evaluate it. Thus, damages for its destruction are designed to compensate for the destruction of a capital
asset -- they are a "return" of this capital.

However, tax law does not exempt compensatory damages just because they are a return of capital --
exemption applies only to the portion that recovers the cost basis of that capital; any excess damages
serve to realize prior appreciation, and should be taxed as income.

In this case, the record is devoid of evidence as to the amount of that basis. This Court agrees with the
Tax Court that "in the absence of evidence of the basis ... the amount of any nontaxable capital recovery
cannot be ascertained." Since Raytheon could not establish the cost basis of its good will, its basis will be
treated as zero. The Court concludes that the $350,000 of the $410,000 attributable to the suit is thus
taxable income. (Thus, the second question as to allocation between this and the ordinary income from
patent licenses is not present.)


 

In this case, the Court treated the basis as zero because Raytheon was unable to establish it. Generally,
the basis of goodwill is zero because it consists of costs that are themselves immediately deductible --
expenses for advertising, PR, etc. However, goodwill can acquire a basis, e.g. as a portion of the cost of
purchasing another business.