Breaking up is hard to do, especially when termination fees are imposed on the deal. Earlier this year, the Internal Revenue Service addressed the often-encountered, but surprisingly elusive, question of how “break-up” or termination fees are properly taxed (See Letter 2008823012, issued on March 10, 2008.) To be sure, termination fees indisputably constitute gross income. The fees are clearly “accessions to wealth” over which the recipient has dominion and control. In addition, break-up fees do not fall within any of the statutory exclusions to the definition of gross income.

In the IRS ruling, an example was set up to underscore the tax treatment. The example involves a taxpayer, which we will call Omega Ltd., which enters into an agreement on June 1, to acquire Beta Inc. The proposed acquisition, however, is subject to a number of “substantial conditions,” including the requirement that shareholder approval be obtained.

On June 20, an interloper — Chi Corporation — appears on the scene and makes an unsolicited tender offer to purchase all of the stock of Beta Inc. Beta’s board of directors likes the new deal. In fact, compared to the June 1 agreement, the directors believe that Chi’s offer may amount to a “superior proposal.” So Beta Inc. begins discussions and negotiations with Chi.

On June 30, Omega Ltd. and Beta Inc. terminate their merger deal, and based on the original agreement provisions, Beta pays Omega a termination fee. Then on July 5, Chi acquires control of Beta, and in doing so, triggers break-up provisions included in the original June 1 agreement, as well as the June 30 termination agreement. As a result, Beta pays Omega an additional termination fee.

Soon after, Beta asks the IRS to rule on whether the termination fees received should be treated as ordinary income as opposed to a capital gain. The IRS grants the ruling, focusing its decision on a venerable principle, the so-called origin of the claim.

Origin of the Claim

Under the origin of the claim doctrine, the taxability of a settlement or a judgment depends upon the “nature” of the claim, and the actual basis of recovery. (See United States v. Gilmore, 372 US 39 (1963).) While the Beta case does not involve a lawsuit, and therefore lacks a settlement or judgment, the IRS still concludes that contractual termination fees and settlements are sufficiently similar to lawsuit settlements or judgments. As a result, the agency applies the same principles as if the case included a lawsuit settlement.

Based on the doctrine, if the amount received in the Beta case represents “damages for lost profits,” it is taxable as ordinary income. On the other hand, if the recovery is received as the “replacement of capital” destroyed or injured, the money received is a return of capital, which is taxable only if it exceeds the basis of the destroyed capital. (See Freeman v. Commissioner, 33 T.C. 323 (1959).)

Lost Profits

In the Beta example case, the break-up fees are taxable as ordinary income. Here’s why. The fee provisions that were triggered were silent regarding the allocation of the recovery to either lost profits or damage to capital. In general, however, a termination fee is paid in lieu of damages for failure to consummate the contract. That is, the parties’ “contractual expectations” are protected by awarding what the ruling refers to as expectation damages as the usual remedy for a breach of the contract. Such damages place the injured party in the same position financially as if the contract had been fully performed. Indeed, the IRS ruling notes that the benefits that were expected from the contract, the so-called “expectancy damages, are often equated with lost profits.

Therefore, the ruling observes that it is reasonable to conclude that Omega’s termination fees provided for expectancy damages. As such damages are often equated with lost profits, it can be surmised that Omega’s receipt of the termination fees is for recovery of lost profits. Further, there is “ample authority” to support the IRS position that a recovery for loss of anticipated profits is ordinary income.

Also, because the termination fee provisions in the two agreements is silent as to the allocation of the recovery, the IRS had substantial support for its position. That position is that whenever the status of the payment to be characterized is uncertain — or where, as here, no allocation is made — the recovery will be treated as lost profits. In short, lost profit is the “default option” in this case.

Finally, without explanation, the IRS concluded that Section 124A does not apply to the termination fees received by Omega. Section 124A provides that gain or loss attributable to the cancellation or other termination of a right or obligation — with respect to property which is a capital asset — will be treated as gain or loss from the sale or exchange of a capital asset. Here, a right was terminated and, presumably, the terminated right pertained to property — the stock of Beta —, which is a capital asset.

Accordingly, Section 124A, by its terms, could have been invoked here. But it is disappointing that the IRS did not choose to share its reasoning, with respect to the non-applicability of this provision, with the readers of the ruling.

Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.