                          T.C. Memo. 2009-191



                        UNITED STATES TAX COURT



           JOSEPH A. AND JUDITH FREDA, ET AL.,1 Petitioners v.
              COMMISSIONER OF INTERNAL REVENUE, Respondent



       Docket Nos. 12874-07,   16255-07,   Filed August 25, 2009.
                   16256-07,   16257-07,
                   16258-07,   16259-07,
                   16260-07,   16261-07,
                   16262-07.



       Jenny L. Johnson and Ziemowit T. Smulkowski, for petition-

ers.

       John J. Comeau and Kathleen C. Schlenzig, for respondent.



       1
      Cases of the following petitioners are consolidated here-
with: Mark N. Freda, docket No. 16255-07; Joseph M. and Victoria
A. Freda, docket No. 16256-07; Michael F. Maude, Jr., and Maria
E. Maude, docket No. 16257-07; Michael R. and Kathryn A. Newcome,
docket No. 16258-07; Dennis J. and Mary Ann Olson, docket No.
16259-07; Matthew J. Olson, docket No. 16260-07; Michael and Lynn
Slaboch Olson, docket No. 16261-07; and Michael P. and Christine
Stock, docket No. 16262-07.
                                 - 2 -

                MEMORANDUM FINDINGS OF FACT AND OPINION


     CHIECHI, Judge:     Respondent determined for taxable year 2002

deficiencies in Federal income tax (tax) as follows:

                Petitioner(s)                        Deficiency
         Joseph A. and Judith Freda                   $754,606
         Mark N. Freda                                  23,983
         Joseph M. and Victoria A. Freda                33,246
         Michael F. Maude, Jr., and Maria E. Maude         373
         Michael R. and Kathryn A. Newcome              68,084
         Dennis J. and Mary Ann Olson                  666,099
         Matthew J. Olson                               54,425
         Michael and Lynn Slaboch Olson                 53,601
         Michael P. and Christine Stock                 28,226

     The issue remaining for decision for taxable year 2002 is

whether the amount that Pizza Hut, Inc. (Pizza Hut), paid to C&F

Packing Co., Inc. (C&F), during 2002 in settlement of certain

claims of C&F against Pizza Hut is long-term capital gain or

ordinary income to C&F.2    We hold that that amount is ordinary

income.

                           FINDINGS OF FACT

     Some of the facts have been stipulated and are so found.

     At the time petitioners, except Mark N. Freda, filed their

respective petitions, they resided in Illinois.      At the time

petitioner Mark N. Freda filed his petition, he resided in

Washington.


     2
      As discussed below, for taxable year 2002 C&F was an S
corporation, the income of which flowed through to its stockhold-
ers, certain petitioners herein (stockholder petitioners).
                               - 3 -

     At all relevant times, including during 2002, petitioners

Joseph A. Freda, Mark N. Freda, Joseph M. Freda, Maria E. Maude,

Kathryn A. Newcome, Mary Ann Olson, Matthew J. Olson, Michael

Olson, and Christine Stock were stockholders of C&F.3

     At all relevant times, C&F, a corporation organized in

Illinois that maintained its principal place of business in that

State, made and sold a variety of meats, including sausage.    At

those times, C&F was an S corporation.

     Since the early 1970s, C&F supplied uncooked sausage to

pizza vendors, including Pizza Hut.    In 1984, after several years

of work, C&F succeeded in developing a process (C&F process) for

making precooked sausage that had the appearance and taste of

home-cooked sausage.   In 1985, C&F applied for, and later ob-

tained, a patent (C&F process patent) on the C&F process.4

Thereafter, C&F continued to improve the C&F process.   C&F

treated as a trade secret (C&F trade secret) the information

relating to (1) the C&F process and (2) the improvements made to

that process after obtaining the C&F process patent.




     3
      Petitioners Judith Freda, Victoria A. Freda, Michael F.
Maude, Jr., Michael R. Newcome, Dennis J. Olson, Lynn Slaboch
Olson, and Michael P. Stock are petitioners in their respective
cases solely because each filed a joint tax return with his or
her spouse, who was a stockholder of C&F during 2002.
     4
      C&F also obtained a separate patent on an apparatus that
was specially designed for use in the C&F process.
                                - 4 -

       Around 1985, Pizza Hut expressed an interest in using

nationwide sausage made with the C&F process.    On July 18, 1985,

certain executives of Pizza Hut (Pizza Hut executives) and

certain executives of C&F (C&F executives) met to discuss Pizza

Hut’s interest in the C&F process (July 18, 1985 meeting).

During that meeting, the Pizza Hut executives informed the C&F

executives that Pizza Hut was willing to enter into a contract

with C&F under which Pizza Hut was to purchase from C&F sausage

made using the C&F process only if C&F was willing to share the

C&F process with other Pizza Hut suppliers.    During the July 18,

1985 meeting, the C&F executives countered that C&F was willing

to share the C&F process with other Pizza Hut suppliers only if

C&F was to receive a royalty on all sales of sausage made with

that process.    The Pizza Hut executives rejected that counterpro-

posal with an offer that Pizza Hut and C&F enter into a long-term

supply contract under which Pizza Hut was to purchase from C&F

one-half of its total sausage needs, with a guaranteed floor of

at least 200,000 pounds of sausage per week.    During the July 18,

1985 meeting, the Pizza Hut executives also insisted that any

such supply contract between Pizza Hut and C&F include an agree-

ment by C&F not to license the C&F process, or to sell sausage

made with that process, to certain major competitors of Pizza

Hut.
                               - 5 -

     On August 5, 1985, Pizza Hut and C&F executed a document

entitled “CONFIDENTIAL DISCLOSURE AGREEMENT” (Pizza Hut confiden-

tiality agreement).   That document required, inter alia, C&F to

disclose to Pizza Hut “confidential information relating to the

meat product, process and apparatus invention as we [C&F] believe

will be required to enable you [Pizza Hut] to evaluate the same.”

The Pizza Hut confidentiality agreement further required, inter

alia, Pizza Hut (1) to keep confidential the information that C&F

disclosed to Pizza Hut, (2) not to disclose that information to

any person not employed by Pizza Hut without the written consent

of C&F, and (3) not to use that information for the benefit of

any person or entity except Pizza Hut without the written consent

of C&F.   Pursuant to the Pizza Hut confidentiality agreement, C&F

disclosed to Pizza Hut the C&F process and all improvements made

to that process after C&F obtained the C&F process patent.

     Around late 1985, C&F also entered into certain agreements

(third-party confidentiality agreements) with the following four

suppliers of Pizza Hut (Pizza Hut’s third-party suppliers):   H&M

Food Systems Co., Standard Meat Co., Doskocil Cos., Inc., and

Parks Sausage.   Each of those agreements required C&F to disclose

“confidential information relating to the meat product, process

and apparatus invention as C and F believes will be required to

enable * * * [Pizza Hut’s third-party supplier] to operate the

same and to make patented and know-how product.”   Pursuant to the
                                - 6 -

third-party confidentiality agreements, Pizza Hut’s third-party

suppliers were (1) to maintain confidentiality with respect to

the information that C&F disclosed to them and (2) not to dis-

close that information to, or use it for the benefit of, anyone

else without the written consent of C&F.

       Pursuant to the third-party confidentiality agreements, C&F

shared the C&F trade secret with Pizza Hut’s third-party suppli-

ers.    By at least early 1986 all of those suppliers had dupli-

cated the C&F process and were selling sausage made with that

process to Pizza Hut.    Thereafter, Pizza Hut extracted from C&F

certain price reductions for the sausage that it was purchasing

from C&F and pressured C&F into incurring substantial expendi-

tures on its behalf.    In reliance on the discussions at the July

18, 1985 meeting and the prospect of a significant supply con-

tract with Pizza Hut, C&F (1) purchased and refurbished at

substantial cost a new production facility, (2) incurred the cost

of correcting the deficiencies in certain substandard products

that other companies produced for Pizza Hut, and (3) incurred the

cost of operating a C&F production facility to assist Pizza Hut

in the development of new products, such as a bacon pizza top-

ping.

       Although C&F undertook certain actions in reliance on the

discussions at the July 18, 1985 meeting, including those de-

scribed above, Pizza Hut did not enter into a long-term supply
                                 - 7 -

contract with C&F, as the Pizza Hut executives had promised to do

at that meeting.    Nor did Pizza Hut’s weekly purchases of sausage

from C&F after the July 18, 1985 meeting through early 1993 reach

200,000 pounds, as those executives had also promised at that

meeting.

     Starting around 1989, when IBP, Inc. (IBP), was one of Pizza

Hut’s largest suppliers of meat products other than sausage,

Pizza Hut disclosed the C&F trade secret to that company without

having informed C&F or acquired its consent.    Thereafter, IBP

replicated the C&F process and began to sell to Pizza Hut sausage

made with that process, and Pizza Hut began to buy less sausage

from C&F.

     Around late 1992 or early 1993, C&F began to suspect that

IBP was using the C&F process.    In early 1993, C&F confirmed its

suspicions when IBP allowed C&F’s attorneys to inspect IBP’s

manufacturing facility.

     On March 17, 1993, C&F filed a complaint against IBP in the

U.S. District Court for the Northern District of Illinois (Dis-

trict Court) in which it alleged that IBP had infringed the C&F

process patent.    (We shall refer to the proceeding that C&F

initiated in the District Court as the C&F lawsuit.)    On the same

date, C&F sent Pizza Hut a letter in which it informed Pizza Hut

about the C&F lawsuit.    Shortly thereafter, Pizza Hut stopped

purchasing sausage from C&F and terminated C&F as a supplier.     On
                               - 8 -

March 22, 1993, C&F amended its complaint in the C&F lawsuit and

added a claim against Pizza Hut for inducement of patent in-

fringement.

     On May 14, 1993, C&F filed a second amended complaint in the

C&F lawsuit (second amended complaint).   In that complaint, C&F

alleged (1) fraud against Pizza Hut (Pizza Hut fraud count),

(2) breach of fiduciary duty against Pizza Hut (Pizza Hut breach

of fiduciary duty count), (3) unfair competition against Pizza

Hut (Pizza Hut unfair competition count), (4) unjust enrichment

against Pizza Hut (Pizza Hut unjust enrichment count), (5) patent

infringement against both Pizza Hut and IBP (Pizza Hut and IBP

patent infringement count), (6) tortious interference with

business expectancy against IBP (IBP tortious interference

count), (7) unfair competition against IBP (IBP unfair competi-

tion count), and (8) misappropriation of trade secrets against

Pizza Hut in violation of the Illinois Trade Secrets Act (Pizza

Hut misappropriation count).   As part of the Pizza Hut misappro-

priation count, C&F alleged:

          1-54. C&F restates Paragraphs 1 through 54 of
     Count I as Paragraphs 1 through 54 of Count VIII.

          55. The confidential information which C&F en-
     trusted to Pizza Hut included trade secrets protected
     by the Illinois Trade Secrets Act, 75 ILCS 1065/1, et
     seq.

          56. Pizza Hut misappropriated such trade secrets
     by, among other things: (a) acquiring the trade se-
     crets through fraudulent misrepresentations and omis-
     sions, and (b) disclosing and using such trade secrets,
                               - 9 -

     after notice, without express or implied consent of
     C&F.

          57. As a result, C&F has been damaged, and has
     suffered, among other things, lost profits, lost oppor-
     tunities, operating losses and expenditures.

          58. Pizza Hut’s misappropriation was willful and
     malicious.[5]

                         Prayer For Relief

          WHEREFORE, C&F asks this Court to enter judgment
     against Pizza Hut for the following relief:

               (a)   An award of compensatory damages in an
                     amount to be determined at trial;

               (b)   An award of punitive damages in an
                     amount to be determined at trial;

               (c)   An injunction prohibiting Pizza Hut’s
                     future use and disclosure of C&F’s trade
                     secrets;

               (d)   An award of C&F’s reasonable attorney’s
                     fees; and

               (e)   Such other and further relief as this
                     Court and/or jury may deem proper and
                     just.

     In a memorandum opinion and order filed on February 1, 1994

(February 1, 1994 opinion and order), the District Court granted

Pizza Hut’s motion to dismiss the following counts in the second

amended complaint:   The Pizza Hut fraud count, the Pizza Hut

breach of fiduciary duty count, the Pizza Hut unfair competition


     5
      Paragraph Nos. 1-54, 55, 56, 57, and 58 in the Pizza Hut
misappropriation count are also used in the Pizza Hut breach of
fiduciary duty count. Any reference hereinafter to paragraph 1-
54, 55, 56, 57, or 58 of the second amended complaint is to the
paragraph number in the Pizza Hut misappropriation count.
                              - 10 -

count, the Pizza Hut unjust enrichment count, and the Pizza Hut

misappropriation count.

     On February 28, 1997, pursuant to a document entitled

“SHAREHOLDER REDEMPTION AGREEMENT” (redemption agreement), C&F

redeemed the C&F stock held by Gerald Freda (redeemed stock-

holder).   The redemption agreement provided that the redeemed

stockholder was to tender to C&F all of his C&F stock in exchange

for certain consideration that C&F was to provide to him, includ-

ing a one-third interest in the C&F lawsuit.

     In a report and recommendation filed on March 16, 1998

(March 16, 1998 report), a U.S. magistrate judge of the District

Court (magistrate judge) recommended that that court grant IBP’s

motion for summary judgment with respect to the IBP tortious

interference count and the IBP unfair competition count.     In the

March 16, 1998 report, the magistrate judge also recommended that

the District Court deny IBP’s motion for summary judgment with

respect to a claim against IBP for misappropriation of trade

secrets (IBP misappropriation count).   On a date not disclosed by

the record, the District Court accepted the magistrate judge’s

recommendations and dismissed the IBP tortious interference count

and the IBP unfair competition count and denied IBP’s motion for

summary judgment with respect to the IBP misappropriation count.
                              - 11 -

     In an opinion filed on March 31, 1998, the District Court

held that the C&F process patent was invalid.   As a result, that

court granted the respective motions for summary judgment that

IBP and Pizza Hut had filed with respect to the Pizza Hut and IBP

patent infringement count.

     In December 1998, the District Court conducted a jury trial

with respect to the IBP misappropriation count.   On December 9,

1998, the jury returned a verdict in favor of C&F on that count

and awarded it $10,939,391 in damages based on a theory of unjust

enrichment.   Thereafter, the District Court (1) awarded to C&F

prejudgment interest on the jury’s damages award and (2) denied

IBP’s posttrial motions for (a) judgment as a matter of law,

(b) a new trial, and (c) remittitur (posttrial motions).

     IBP appealed the District Court’s judgment awarding C&F

prejudgment interest and denying its posttrial motions.    C&F

appealed the District Court’s judgment reflecting its February 1,

1994 opinion and order dismissing the Pizza Hut fraud count, the

Pizza Hut breach of fiduciary duty count, the Pizza Hut unfair

competition count, the Pizza Hut unjust enrichment count, and the

Pizza Hut misappropriation count.

     In an opinion filed on August 25, 2000 (Court of Appeals

opinion), the U.S. Court of Appeals for the Federal Circuit

(Court of Appeals) affirmed the District Court’s denial of IBP’s

posttrial motions and affirmed that court’s award of $10,939,391
                              - 12 -

in damages with respect to the IBP misappropriation count.     The

Court of Appeals also affirmed the District Court’s dismissal of

the Pizza Hut fraud count, the Pizza Hut breach of fiduciary duty

count, the Pizza Hut unfair competition count, and the Pizza Hut

unjust enrichment count. However, the Court of Appeals reversed

the District Court’s award of prejudgment interest to C&F.     The

Court of Appeals also reversed the District Court’s dismissal of

the Pizza Hut misappropriation count, reinstated that count, and

remanded the case to the District Court for further proceedings.

After the Court of Appeals opinion, the only unsettled claim in

the C&F lawsuit was the Pizza Hut misappropriation count.

     At a time during 2000 after the Court of Appeals affirmed

the District Court’s award with respect to the IBP misappropria-

tion count, IBP paid to C&F $10,939,391 (IBP payment), which

equaled the damages that the District Court awarded to C&F

consistent with the jury’s verdict on the IBP misappropriation

count.   Of that $10,939,391, C&F (1) paid $4,922,726 to its

attorneys Niro, Scavone, Haller & Niro (Niro law firm), (2) paid

$2,005,555, or one-third of the balance after its payment to the

Niro law firm, to the redeemed stockholder, and (3) retained
                             - 13 -

$4,011,110, or two-thirds of the balance after its payment to the

Niro law firm.6

     At a time not disclosed by the record after August 25, 2000,

and before January 12, 2001, Pizza Hut filed a motion for summary

judgment with respect to the Pizza Hut misappropriation count.

In a memorandum opinion and order filed on January 12, 2001, the

District Court denied that motion.

     On January 28, 2002, C&F, petitioner Joseph A. Freda,

petitioner Dennis J. Olson, the redeemed stockholder, and Pizza

Hut entered into an agreement entitled “SETTLEMENT AGREEMENT AND

RELEASE” (settlement agreement).7    That agreement provided in

pertinent part:




     6
      C&F filed Form 1120S, U.S. Income Tax Return for an S
Corporation (Form 1120S), for taxable year 2000 (2000 S corpora-
tion return). In that return, C&F reported the following with
respect to the IBP payment: (1) $2,936,936 as “Net section 1231
gain (loss)” and (2) $1,047,279 as “Net gain (loss) from Form
4797, Part II, line 18”. C&F included with the 2000 S corpora-
tion return Form 4797, Sales of Business Property. In Form 4797,
Part I, Sales or Exchanges of Property Used in a Trade or Busi-
ness and Involuntary Conversions From Other Than Casualty or
Theft - Most Property Held More Than 1 Year, C&F reported
$2,963,831 as a gain from a “TRADE SECRET SALE”. In that part of
that form, C&F also reported $26,895 as a loss from the sale of
“MACHINERY & EQUIPMENT”, resulting in a net gain of $2,936,936.
In Form 4797, Part II, Ordinary Gains and Losses, C&F reported
$1,047,279 as a gain from a “LOST PROFIT SETTLEMENT”.
     7
      We shall refer collectively to C&F, petitioner Joseph A.
Freda, petitioner Dennis J. Olson, and the redeemed stockholder,
all of whom entered into the settlement agreement with Pizza Hut,
as the C&F parties.
                          - 14 -

                     I.    RECITALS

     1.1 C&F has asserted claims against Pizza Hut for
damages as set forth in an Amended Complaint, Second
Amended Complaint and subsequent pleadings filed in the
action entitled C&F Packing Co., Inc. v. Pizza Hut,
Inc., No. 93 C 1601, United States District Court for
the Northern District of Illinois (hereinafter referred
to as “the Lawsuit”).

     1.2 The C&F Parties and Pizza Hut desire to enter
into this Agreement in order to provide for a lump-sum
payment in full and complete discharge and settlement
of the Lawsuit and all other past, present and future
claims that could be asserted now or in the future by
the C&F Parties and Pizza Hut related to the events and
circumstances described in the Lawsuit, upon the terms
and conditions set forth herein, without the necessity
of proceeding with a trial on the merits, and all
without admission of liability or wrongdoing on the
part of Pizza Hut.

                     II.    PAYMENT

     In consideration of the dismissal with prejudice
of the Lawsuit, and the release, representations,
warranties and the remaining promises set forth in this
Agreement, Pizza Hut agrees to make a cash payment in
the amount of $15,300,000.00 (fifteen million three
hundred thousand dollars and zero cents) payable to
“C&F Packing Co., Inc. and its attorneys, Niro,
Scavone, Haller & Niro” on or before February 6, 2002
by wire transfer * * *

              III. AGREEMENTS RESPECTING
    PRESENT AND FUTURE CLAIMS AND CAUSES OF ACTION

     In consideration of the above payment, and release
and dismissal, the parties agree to the following:

     3.1 Dismissal with Prejudice. Within two (2)
days of receipt of the payment required by this Agree-
ment, C&F’s attorneys shall file with the Court an
agreed-to order dismissing the Lawsuit with prejudice
in the form attached hereto as Exhibit A.

     3.2 Release. The C&F Parties and Pizza Hut
mutually release and forever discharge one another,
                        - 15 -

their predecessors and successors in interest, assign-
ees, nominees, and their past, present and future
parents, subsidiaries, affiliates, divisions, officers,
directors, employees, stockholders, attorneys, ser-
vants, representatives, partners and agents, as well as
all of the subsidiaries, divisions, affiliates, direc-
tors, officers, agents, employees, attorneys, heirs,
executors administrators and assignees of all those
persons and entities (hereinafter all collectively
referred to as the “Released Parties”), of and from any
and all past, present or future claims, obligations,
actions, or causes of action (however denominated) for
any injury, damage or loss arising directly or indi-
rectly from Pizza Hut’s relationship with C&F as a
Pizza Hut product supplier, including, but not in any
sense limited to, all claims and allegations that were
or that could have been asserted in the Lawsuit. The
C&F Parties and Pizza Hut intend for the Released
Parties that are not parties to this Agreement to be
third-party beneficiaries of the release provided for
by this paragraph.

     3.3 Covenant Not to Sue. The C&F Parties and
Pizza Hut agree not to, at any time, sue, institute or
assist in instituting a proceeding in any court or
forum, alleging any claim that is covered by the re-
lease in Paragraph 3.2 of this Agreement.

     3.4 The C&F Parties and Pizza Hut acknowledge
that the payment called for by this Agreement is being
made to compromise and settle claims disputed as to
both liability and amount, and is being made to C&F in
settlement and release of all past, present and/or
future claims against any of the Pizza Hut Released
Parties. Neither payment of the sum reflected herein
nor any statements or communications made by Pizza Hut
or its agents during the negotiations leading to this
Agreement shall be considered admissions of liability
by or on behalf of any of them.

     3.5 The C&F Parties and Pizza Hut acknowledge
that this Agreement is intended to terminate any claims
by them against the Released Parties and to bar any
future litigation between the parties hereto and that
there is no agreement by Pizza Hut to make any payment
or to do any act or thing other than as expressly
stated herein.
                               - 16 -

     Pursuant to section II of the settlement agreement, Pizza

Hut issued a check for $15,300,000 (Pizza Hut payment) that was

payable to C&F and the Niro law firm and sent that check to that

firm.   The Niro law firm (1) retained $6,120,000 of the Pizza Hut

payment as legal fees and expenses and (2) distributed on Febru-

ary 5, 2002, (a) one-third of the balance, or $3,060,000, to the

redeemed stockholder and (b) two-thirds of the balance, or

$6,120,000, to C&F.

     C&F filed Form 1120S for taxable year 2002 (2002 S corpora-

tion return).   In that return, C&F reported a net long-term

capital gain of $6,112,347 (C&F’s net long-term capital gain).

C&F included with the 2002 S corporation return Schedule D,

Capital Gains and Losses and Built-In Gains (2002 S corporation

Schedule D).    In that schedule, C&F’s net long-term capital gain

included a gain of $6,120,000 from a “TRADE SECRET SALE” and a

loss of $7,653 from a “LONG TERM STOCK SALE”.   The $6,120,000

that C&F reported as a “TRADE SECRET SALE” in the 2002 S corpora-

tion Schedule D is equal to the amount of the Pizza Hut payment

that the Niro law firm distributed to C&F on February 5, 2002.

In the 2002 S corporation return, C&F also reported an ordinary

loss from trade or business activities of $3,367,961 (C&F’s

ordinary loss).

     C&F issued to each stockholder petitioner Schedule K-1,

Shareholder’s Share of Income, Credits, Deductions, etc. (2002
                              - 17 -

Schedule K-1), for taxable year 2002.   In each of those Schedules

K-1, C&F reported as net long-term capital gain the stockholder

petitioner’s proportionate share of C&F’s net long-term capital

gain, which included the $6,120,000 that C&F reported as gain

from a “TRADE SECRET SALE” in the 2002 S corporation Schedule D.

In each 2002 Schedule K-1, C&F also reported as an ordinary loss

from trade or business activities the stockholder petitioner’s

proportionate share of C&F’s ordinary loss.

     Petitioners or petitioner, as the case may be, in each of

these cases filed Form 1040, U.S. Individual Income Tax Return,

for taxable year 2002 that included Schedule D, Capital Gains and

Losses (2002 Schedule D), and Schedule E, Supplemental Income and

Loss (2002 Schedule E).   Those respective 2002 Schedules D showed

as net long-term gain the stockholder petitioners’ respective

proportionate shares of C&F’s net long-term capital gain, as

reported in the respective 2002 Schedules K-1 that C&F issued to

them.8   The respective 2002 Schedules E showed as nonpassive



     8
      In their respective 2002 Schedules D, stockholder petition-
ers Maria E. Maude, Kathryn Newcome, and Michael Olson reported
amounts of net long-term capital gain that flowed through to them
that were different from the amounts of net long-term capital
gain that C&F reported in the respective 2002 Schedules K-1 that
it issued to them. The record does not explain those differ-
ences. In any event, the amounts of net long-term capital gain
that C&F reported in the respective 2002 Schedules K-1 that it
issued to stockholder petitioners Maria E. Maude, Kathryn
Newcome, and Michael Olson reflected their respective proportion-
ate shares of C&F’s net long-term capital gain reported in the
2002 S corporation Schedule D.
                                - 18 -

losses from C&F the stockholder petitioners’ respective propor-

tionate shares of C&F’s ordinary loss, as reported in the respec-

tive 2002 Schedules K-1 that C&F issued to them.9

     Respondent issued respective notices of deficiency for

taxable year 2002 to petitioners in these cases (2002 notices).

In the 2002 notices, respondent determined that the amount that

Pizza Hut paid to C&F during 2002 pursuant to the settlement

agreement is ordinary income, and not long-term capital gain, to

C&F for that year.    In those notices, respondent also determined

that the $3,060,000 that the Niro law firm distributed to the

redeemed stockholder on February 5, 2002, is ordinary income to

C&F.10    As a result of those determinations, respondent further

determined to (1) decrease the amount of long-term capital gain

reported in the 2002 Schedules D and (2) increase the amount of

ordinary income reported in the 2002 Schedules E.


     9
      In their respective 2002 Schedules E, stockholder petition-
ers Joseph M. Freda and Maria E. Maude reported amounts of
ordinary loss that flowed through to them that were different
from the amounts of ordinary loss that C&F reported in the
respective 2002 Schedules K-1 that it issued to them. The record
does not explain those differences. In any event, the amounts of
ordinary loss that C&F reported in the respective 2002 Schedules
K-1 that it issued to stockholder petitioners Joseph M. Freda and
Maria E. Maude reflected their respective proportionate shares of
C&F’s ordinary loss reported in the 2002 S corporation return.
     10
      Respondent concedes the issue involving the redeemed
stockholder. That is because in the event the Court were to hold
that the $3,060,000 that the Niro law firm distributed to that
stockholder is includible in C&F’s income for 2002, respondent
would concede that C&F is entitled to a deduction in an equal
amount for that year.
                               - 19 -

                               OPINION

     Petitioners bear the burden of establishing that the amount

that Pizza Hut paid to C&F pursuant to the settlement agreement

(amount at issue) is long-term capital gain, and not ordinary

income, to C&F for taxable year 2002 that flows through propor-

tionately to its respective stockholder petitioners for that

year.11   See Rule 142(a);12 Welch v. Helvering, 290 U.S. 111, 115

(1933).

     It is petitioners’ position that the amount at issue is

long-term capital gain to C&F for taxable year 2002.    In support

of that position, petitioners advance three alternative argu-

ments.    According to petitioners, Pizza Hut paid the amount at

issue for:    (1) Damage to the C&F trade secret, a capital asset

in C&F’s hands (petitioners’ principal argument); (2) C&F’s sale

or exchange of the C&F trade secret to Pizza Hut; or (3) the

termination of C&F’s rights under the Pizza Hut confidentiality

agreement with respect to the C&F trade secret.

     We turn first to petitioners’ principal argument.    In

support of that argument, petitioners assert, and respondent does

not dispute, that “The taxability of the proceeds of a lawsuit,



     11
      Petitioners do not claim that the burden of proof shifts
to respondent under sec. 7491(a).
     12
      All Rule references are to the Tax Court Rules of Practice
and Procedure. All section references are to the Internal
Revenue Code (Code) in effect for the year at issue.
                              - 20 -

or of a sum received in settlement thereof, depends upon the

nature of the claim and the actual basis of recovery.”    Sager

Glove Corp. v. Commissioner, 36 T.C. 1173, 1180 (1961), affd. 311

F.2d 210 (7th Cir. 1962); see also Tribune Publg. Co. v. United

States, 836 F.2d 1176, 1178 (9th Cir. 1988); Canal-Randolph Corp.

v. United States, 568 F.2d 28, 33 (7th Cir. 1977).   Where the

recovery represents damages for lost profits or other items taxed

as ordinary income, it is taxable as ordinary income.    See Hort

v. Commissioner, 313 U.S. 28, 31 (1941); State Fish Corp. v.

Commissioner, 48 T.C. 465, 473 (1967).   Where the recovery

represents damages for injury to, or destruction of, a capital

asset, it is taxable as capital gain to the extent that it

exceeds the taxpayer’s basis in the asset.13   See Wheeler v.

Commissioner, 58 T.C. 459, 461 (1972); State Fish Corp. v.

Commissioner, supra at 473.

     The parties do not dispute that the only claim outstanding

against Pizza Hut at the time Pizza Hut and the C&F parties

entered into the settlement agreement was the Pizza Hut misappro-

priation claim.   Nor do they dispute that a trade secret, like

the C&F trade secret, is a capital asset.   See Ofria v. Commis-

sioner, 77 T.C. 524, 541-542 (1981).   The parties’ dispute is


     13
      To the extent that the recovery does not exceed the tax-
payer’s basis in the capital asset, it is a return of capital and
not taxable. See, e.g., State Fish Corp. v. Commissioner, 48
T.C. 465, 473 (1967). Petitioners do not claim that the amount
at issue is not taxable.
                             - 21 -

whether the amount at issue that Pizza Hut paid to C&F

represented damages for injury to, or destruction of, the C&F

trade secret.

     Petitioners maintain that “the value of * * * [the C&F trade

secret] was the right to a competitive advantage by using a

process unknown to others” and that “Pizza Hut destroyed * * *

[the C&F trade secret] when it disclosed * * * [that trade

secret] to IBP and terminated C&F as a supplier.”   From those

premises, petitioners conclude:

     The amount paid by Pizza Hut to settle C&F’s claim for
     misappropriation of trade secrets is, therefore, prop-
     erly treated as capital gain because “amounts received
     for injury or damage to capital assets are taxable as
     capital gain.” Inco [Electroenergy Corp. v. Commis-
     sioner], T.C. Memo[. 1987] * * *-437; State Fish [Corp.
     v. Commissioner], * * * [supra] at 472.

Petitioners’ conclusion does not logically follow from the

premises on which it is based.    It also disregards the fundamen-

tal principle, with which petitioners agree, that the tax treat-

ment of the amount at issue “depends upon the nature of the claim

and the actual basis of recovery.”    Sager Glove Corp. v. Commis-

sioner, supra at 1180.

     In the Pizza Hut misappropriation count, C&F alleged in

pertinent part:

          56. Pizza Hut misappropriated such trade secrets
     by, among other things: (a) acquiring the trade se-
     crets through fraudulent misrepresentations and omis-
     sions, and (b) disclosing and using such trade secrets,
     after notice, without express or implied consent of
     C&F.
                               - 22 -

          57. As a result, C&F has been damaged, and has
     suffered, among other things, lost profits, lost oppor-
     tunities, operating losses and expenditures.

     Petitioners argue that C&F’s allegations in paragraph 57 of

the Pizza Hut misappropriation count specified “lost profits,

lost opportunities, operating losses and expenditures” solely as

a measure of Pizza Hut’s injury to, or destruction of, the C&F

trade secret.14   Those allegations in that paragraph belie that

argument.15   C&F alleged in paragraph 57 of the Pizza Hut misapp-

ropriation count that, as a result of Pizza Hut’s misappropria-

tion of the C&F trade secret alleged in paragraph 56 of that

count, C&F had been damaged and had suffered “among other things,



     14
      Petitioners also argue that C&F could not have recovered,
and did not recover, any lost profits from Pizza Hut because it
recovered lost profits from IBP as a result of the judgment of
the District Court, which was based upon a jury verdict and which
the Court of Appeals affirmed, that IBP was to pay C&F
$10,939,391 in damages with respect to the IBP misappropriation
count. That argument assumes that any profits that C&F may have
lost which were attributable to IBP’s misappropriation of the C&F
trade secret were the same as any profits that C&F may have lost
which were attributable to Pizza Hut’s alleged misappropriation
of that trade secret. On the record before us, we reject peti-
tioners’ argument and the assumption on which it is based. On
that record, we find that petitioners have failed to carry their
burden of establishing that any lost profits of C&F that were
attributable to IBP’s misappropriation of the C&F trade secret
were the same as any lost profits of C&F that were attributable
to Pizza Hut’s alleged misappropriation of that trade secret.
     15
      C&F’s allegations in paragraph 57 of the Pizza Hut misap-
propriation count also belie any suggestion in the uncorroborated
testimony on which we are unwilling to rely of the president of
C&F, petitioners’ only witness at trial, that Pizza Hut did not
pay the amount at issue to C&F as damages for C&F’s lost profits
and the other items specified in that paragraph.
                               - 23 -

lost profits, lost opportunities, operating losses and expendi-

tures.”   On the record before us, we find that petitioners have

failed to carry their burden of establishing that C&F specified

in paragraph 57 of the Pizza Hut misappropriation count “lost

profits, lost opportunities, operating losses and expenditures”

and other unidentified items covered by “among other things”

solely as a measure of Pizza Hut’s injury to, or destruction of,

the C&F trade secret.   On that record, we find that C&F asserted

a claim in paragraph 57 of the Pizza Hut misappropriation count

for the items specified therein as the damage to and the suffer-

ing of C&F resulting from Pizza Hut’s alleged misappropriation of

the C&F trade secret.   On the record before us, we further find

that petitioners have failed to carry their burden of establish-

ing that the damages that C&F claimed in the Pizza Hut misappro-

priation count were for injury to, or destruction of, the C&F

trade secret.   On that record, we find that in settlement of

C&F’s claim in the Pizza Hut misappropriation count, which was

the only claim outstanding against Pizza Hut at the time of the

execution of the settlement agreement, Pizza Hut paid the amount

at issue to C&F for “lost profits, lost opportunities, operating

losses and expenditures”.16   On the record before us, we find


     16
      Pizza Hut and the C&F parties entered into the settlement
agreement


                                                    (continued...)
                                - 24 -

that petitioners have failed to carry their burden of establish-

ing that that amount did not represent damages for lost profits

or other items taxed as ordinary income.17    On that record, we

find that petitioners have failed to carry their burden of

establishing that the amount at issue is long-term capital gain

to C&F for taxable year 2002 under petitioners’ principal argu-

ment.

     We turn next to petitioners’ alternative argument that the

amount at issue is long-term capital gain to C&F for taxable year

2002 because it represents gain from C&F’s sale or exchange

during that year of the C&F trade secret to Pizza Hut.

     Pursuant to section 1222, a “sale or exchange” of a capital

asset is a prerequisite to capital gain treatment.    See Dobson v.


        16
         (...continued)
        in order to provide for a lump-sum payment in full and
        complete discharge and settlement of the [C&F] Lawsuit
        and all other past, present and future claims that
        could be asserted now or in the future by the C&F
        Parties and Pizza Hut related to the events and circum-
        stances described in the [C&F] Lawsuit * * *.
        17
      As discussed above, C&F claimed in paragraph 57 of the
Pizza Hut misappropriation count that C&F had been damaged and
had suffered not only “lost profits” but also “lost opportuni-
ties, operating losses and expenditures.” On the record before
us, we find that petitioners have failed to carry their burden of
establishing what “lost opportunities, operating losses and
expenditures” C&F had suffered that would result in long-term
capital gain, and not ordinary income, to C&F for taxable year
2002. Assuming arguendo that petitioners had carried that
burden, on the record before us, we would find that petitioners
have failed to carry their burden of establishing the portion of
the amount at issue that is long-term capital gain to C&F for
that year.
                                - 25 -

Commissioner, 321 U.S. 231, 231-232 (1944).    Since the Code does

not define the words “sale” and “exchange” for purposes of

section 1222, we shall give those words their ordinary meaning.

See Helvering v. William Flaccus Oak Leather Co., 313 U.S. 247,

249 (1941).    A sale is “‘a transfer of property for a fixed price

in money or its equivalent’”.    Commissioner v. Brown, 380 U.S.

563, 571 (1965) (quoting Iowa v. McFarland, 110 U.S. 471, 478

(1884)).    An exchange occurs when “property is transferred in

return for other property”.     Spalding v. Commissioner, 7 B.T.A.

588, 590 (1927); see also Guest v. Commissioner, 77 T.C. 9, 24

(1981).

     In determining whether a transfer of rights in a trade

secret constitutes a sale of the trade secret, courts generally

have applied the tests developed in the context of a transfer of

a patent.    See Pickren v. United States, 378 F.2d 595, 599 (5th

Cir. 1967); PPG Indus., Inc. v. Commissioner, 55 T.C. 928, 1012

(1970).    Section 1235(a) provides in pertinent part that “A

transfer * * * of property consisting of all substantial rights

to a patent * * * shall be considered the sale or exchange of a

capital asset held for more than 1 year”.    Thus, in order for the

transfer of a trade secret to qualify as a sale or exchange, the

owner of the trade secret must transfer “all substantial rights”

to it.    See Vision Info. Servs., L.L.C. v. Commissioner, 419 F.3d

554, 561 (6th Cir. 2005), affg. T.C. Memo. 2004-53.    For purposes
                              - 26 -

of section 1235, the term “all substantial rights” means “all

rights * * * which are of value at the time the rights * * * are

transferred.”   Sec. 1.1235-2(b)(1), Income Tax Regs.   In the

context of a trade secret, the most significant rights held by

its owner are the rights to prevent the unauthorized use and the

unauthorized disclosure of the secret.   See Ruckelshaus v.

Monsanto Co., 467 U.S. 986, 1011 (1984); E.I. Du Pont De Nemours

& Co. v. United States, 153 Ct. Cl. 274, 288 F.2d 904, 911

(1961); Stalker Corp. v. United States, 209 F. Supp. 30, 34 (E.D.

Mich. 1962).

     On the record before us, we find that under the settlement

agreement C&F did not transfer to Pizza Hut any rights, let alone

the most significant rights, to the C&F trade secret, viz., the

rights to prevent the unauthorized use and the unauthorized

disclosure of that trade secret.   On that record, we further find

Pizza Hut did not pay the amount at issue under the settlement

agreement for C&F’s sale or exchange of the C&F trade secret to

Pizza Hut.   On the record before us, we find that petitioners

have failed to carry their burden of establishing that under

section 1222 the amount at issue is long-term capital gain to C&F

for taxable year 2002.

     We turn finally to petitioners’ alternative argument that

the amount at issue is capital gain to C&F for taxable year 2002

because Pizza Hut paid that amount for the termination of the
                                - 27 -

rights of C&F under the Pizza Hut confidentiality agreement with

respect to the C&F trade secret.       In support of that argument,

petitioners rely on section 1234A.

     Section 1234A provides in pertinent part:

     SEC. 1234A.     GAINS OR LOSSES FROM CERTAIN TERMINATIONS.

          Gain or loss attributable to the cancellation,
     lapse, expiration, or other termination of--

                 (1) a right or obligation * * * with respect
            to property which is * * * a capital asset in the
            hands of the taxpayer, * * *

        *        *         *       *        *       *       *

     shall be treated as gain or loss from the sale of a
     capital asset. * * *

     Petitioners argue that the Pizza Hut confidentiality agree-

ment gave to C&F the rights to require Pizza Hut to (1) keep the

C&F trade secret confidential, (2) refrain from using that trade

secret except for purposes of evaluating the sausage product, and

(3) return all materials relating to the trade secret.       According

to petitioners, the settlement agreement terminated those con-

tractual rights.     In support of that assertion, C&F maintains

that in the settlement agreement

     C&F released Pizza Hut from any claims or obligations
     for “any injury, damage or loss arising directly or
     indirectly from Pizza Hut’s relationship with C&F as a
     Pizza Hut Product Supplier.” * * * After entering into
     the Settlement Agreement, C&F could not pursue any
     claims and Pizza Hut had no obligations arising from
     Pizza Hut’s relationship with C&F as a Pizza Hut Sup-
     plier, which encompasses the contractual rights in the
     [Pizza Hut] Confidentiality Agreement. The payment
     Pizza Hut made in exchange for that release, therefore,
                                - 28 -

     represents a gain attributable to the termination of
     C&F’s rights with respect to its trade secrets.

     Petitioners’ argument ignores the express terms of the

settlement agreement, including the following:

          3.4 The C&F Parties and Pizza Hut acknowledge
     that the payment called for by this Agreement is being
     made to compromise and settle claims disputed as to
     both liability and amount, and is being made to C&F in
     settlement and release of all past, present and/or
     future claims against any of the Pizza Hut Released
     Parties. * * *

          3.5 The C&F Parties and Pizza Hut acknowledge
     that this Agreement is intended to terminate any claims
     by them against the Released Parties and to bar any
     future litigation between the parties hereto and that
     there is no agreement by Pizza Hut to make any payment
     or to do any act or thing other than as expressly
     stated herein.

     On the record before us, we find that petitioners have

failed to carry their burden of establishing that Pizza Hut paid

the amount at issue under the settlement agreement for the

termination of the rights of C&F under the Pizza Hut confidenti-

ality agreement with respect to the C&F trade secret.   On that

record, we find that petitioners have failed to carry their

burden of establishing that under section 1234A the amount at

issue is long-term capital gain to C&F for taxable year 2002.

     Based upon our examination of the entire record before us,

we find that petitioners have failed to carry their burden of

establishing that the amount at issue is long-term capital gain

to C&F for taxable year 2002.    On that record, we sustain respon-
                             - 29 -

dent’s flow-through determinations in the 2002 notices issued to

the respective petitioners that are at issue in these cases.

     We have considered all of the contentions and arguments of

the parties that are not discussed herein, and we find them to be

without merit, irrelevant, and/or moot.

     To reflect the foregoing and the concession by respondent,


                                          Decisions will be entered

                                   under Rule 155.
