21 T.C. 688">*688 The respondent determined a deficiency in the income tax of petitioner for the year 1949 in the amount of $ 18,163.97. ¹

The issue is whether all or any part of $ 62,043.77, the net1954 U.S. Tax Ct. LEXIS 296">*297 proceeds of the settlement of a lawsuit received by the petitioner in 1949, represents taxable income.

FINDINGS OF FACT.

Facts stipulated by the parties are incorporated herein by reference as part of our findings.

Petitioner is a corporation organized under the laws of the State of California on September 19, 1946. Its principal office is in Hollywood, California. Its corporation income tax return for the year 1949 was filed with the collector of internal revenue for the sixth district of California.

Telefilm, Inc. (predecessor of petitioner), was incorporated under the laws of California on January 8, 1940. It took over the business of a partnership organized in 1939. On November 14, 1946, its name was changed to Telefilm Holding Company. Telefilm Holding Company and Telefilm, Inc. (predecessor of petitioner), will hereinafter be referred to as the company. On November 14, 1946, the company transferred all of its assets to the petitioner in exchange for 70,000 shares of petitioner's capital stock. The transaction was treated by the company as a nontaxable exchange. Upon the consummation of the exchange the petitioner and the company had the same stockholders.

The company1954 U.S. Tax Ct. LEXIS 296">*298 and its predecessor partnership had been continuously engaged in the business of taking, developing, and exhibiting motion pictures of events with 16 mm. film from 1939 to 1946. In the early 21 T.C. 688">*689 part of September 1945 the company, at the suggestion of the Hollywood Turf Club, devised and perfected a technique of taking motion pictures of horse races and of developing the film showing such races and projecting the same within a comparative short period after the finish of any race. The objective of the process was to have the film fully developed promptly after the race so that officials at the track could make immediate rulings on disputed matters such as alleged fouls. The company received its first contract to perform this service in September 1945 at the Hollywood race track and thereafter, prior to June 1946, received similar contracts from 2 or 3 other tracks. In order to perform this service it acquired some equipment consisting of 2 developing machines and 8 cameras. The petitioner still has this equipment, and the company and petitioner have been recovering its cost through deductions for depreciation in income tax returns filed for 1945 and subsequent years.

During1954 U.S. Tax Ct. LEXIS 296">*299 the period beginning in the latter part of 1945 and ending in May 1946, the company expended approximately $ 15,000 in a promotional campaign which consisted of advertising and direct contact with race track operators in order to interest them in photography of horse races. Expenditures made for this purpose were charged to expense on the books of the company.

In June 1946 the company filed a complaint in the Superior Court of the State of California in and for the County of Los Angeles, in an action against Harry M. Warner, Thorobred Photo Service, Inc., and others, entitled "Telefilm, Inc., a corporation, plaintiff, v. Harry M. Warner, et al, defendants." Among the assets which the company agreed to transfer to petitioner on November 14, 1946, were the proceeds of any judgment obtained in this action, and the proceeds resulting from any compromise thereof.

In the complaint the company made, among others, the following allegations:

Prior to the opening of the 1945 racing meeting at Hollywood Park, defendant Hollywood Turf Club invited plaintiff, on plaintiff's own time and at its own expense, to discover ways and means of taking motion pictures with 16 mm films, which would show1954 U.S. Tax Ct. LEXIS 296">*300 every foot of a horse race, photographed at points in front of the horses, and projecting the same for examination by the racing stewards sufficiently soon after the finish of a race to permit said stewards to make their rulings, in ordinary course and without delay, in the event fouls were claimed or appeared to have occurred, with the understanding that if the ways and means so discovered should appear practicable to defendant Hollywood Turf Club, it would consider entering into a contract with plaintiff, under the terms of which said defendant would employ plaintiff to render, for hire, the service of photographing the races during the 1945 Hollywood Park racing meeting, developing the films, and projecting the photographs for the examination of the stewards as requested by them.

* * * *

Pursuant to the beforementioned invitation of defendant Hollywood Turf Club, and prior to the opening of the 1945 racing meeting at Hollywood Park, 21 T.C. 688">*690 plaintiff, on its own time and at its own expense, discovered and developed new skills and processes, and new methods and techniques, by which, for the first time in history, it was possible to photograph entire horse races, at points in front1954 U.S. Tax Ct. LEXIS 296">*301 of the horses, showing every foot of such race, and also to develop the film showing such races and project the same within seven minutes after the finish of any race. Such skills and processes, and methods and techniques became, and were, and are, the property of plaintiff, and became, and were, and are, trade and business secrets and confidential information belonging exclusively to plaintiff.

* * * *

By the end of the Hollywood Park 1945 racing meeting, that is to say by October 20, 1945, and particularly by the end of the Santa Anita 1945-46 racing meeting, that is to say by March 15, 1946, there was a large and growing demand for plaintiff's service among the owners and operators of race tracks in all parts of the United States and in other parts of the civilized world, whereby plaintiff became assured of contracts for furnishing said service at profits to it exceeding $ 250,000 annually.

The complaint also alleged that defendants pirated the skills and processes and methods and techniques which were the property of the company and trade and business secrets and confidential information belonging exclusively to it, and that the defendants enticed and hired away from the 1954 U.S. Tax Ct. LEXIS 296">*302 company its employees who had developed these skills, processes, methods, and techniques, and that --

Since April 6, 1946, defendants Warner and Thorobred Photo Service, Inc., have received large sums of money and large profits from the Jamaica Race Track and the Belmont Race Track pursuant to the contract beforementioned, and they, and each of them, will receive further sums of money and profits from said tracks pursuant to said contract, and will also receive large sums of money and profits from Aqueduct Race Track, Empire Race Track, and Saratoga Race Track pursuant to said contract. Said defendants have also received large sums of money and profits from Pimlico Race Track pursuant to the contract with it beforementioned. Said defendants have also received, and will receive, large sums of money and profits from Hollywood Turf Club pursuant to the contract with it beforementioned.

* * * *

Plaintiff has been prevented by the frauds and wrongs of the defendants herein alleged from contracting to furnish its service to the five New York race tracks as aforesaid, and from contracting to furnish its service to the owners and operators of other race tracks in various parts of the United1954 U.S. Tax Ct. LEXIS 296">*303 States, and has been defrauded of the fruits of its contract with Pimlico.

* * * *

As the result of the wrongs and frauds of the defendants above complained of, plaintiff has suffered damage through loss of business, it otherwise would have enjoyed, in excess of $ 250,000.00, and other injury to its business and good will in a sum in excess of $ 250,000.00.

* * * *

The acts and things wrongfully and fraudulently done by defendants, as herein alleged, were oppressively and maliciously, as well as fraudulently, done, and as the result thereof plaintiff is entitled to recover, for the sake of example and by way of punishing defendants, in addition to the actual damages already alleged, the further sum of $ 500,000.00.

* * * *

21 T.C. 688">*691 WHEREFORE, plaintiff prays as follows:

* * * *

4. For a judgment for actual damages in the sum of $ 500,000.00, and for exemplary damages in the further sum of $ 500,000.00.

Thereafter, the company filed a "Supplemental Complaint," adding two new paragraphs to the original complaint. In these new paragraphs it was alleged that since the filing of the complaint the defendants had obtained contracts from most of the major race tracks in the United States1954 U.S. Tax Ct. LEXIS 296">*304 and had performed or were about to perform such contracts by the use of its trade secrets, confidential information, and know-how, and the use of its former employees or persons trained by them, that defendants had destroyed that portion of its business known as Telefilm Control, and the good will thereof, and that as a result of these wrongs and frauds, it suffered damage in excess of $ 500,000.

The case came on for trial on October 22, 1947, before a jury. At the trial the principal claim presented was that the tortious acts of the defendants destroyed that portion of the business of the company involving the taking and developing of pictures of horse races, and that it was entitled to be compensated in damages for the value of the portion of its business destroyed, and also to receive exemplary damages. In the course of the trial evidence was presented to show the conditions of the business, cost of operations, competitive conditions, and earnings and prospects for earnings, and a witness for the company testified, as an expert on valuation, that based upon this evidence his opinion was that the portion of its business involved had a value of $ 509,508 in March 1946.

On December1954 U.S. Tax Ct. LEXIS 296">*305 11, 1947, the jury rendered a verdict for the company for compensatory damages in the amount of $ 250,000 and exemplary damages in the amount of $ 50,000.

Defendants made a motion for a new trial but the judge before whom the case was tried died before he could rule upon it. The matter was argued before another judge, who granted defendants' motion.

The company filed an original proceeding in mandamus directed against the Superior Court of the State of California in and for the County of Los Angeles, to compel that court to issue execution on the judgment entered upon the verdict. This original proceeding was filed in the District Court of Appeal, Second District, of the State of California, and it granted the writ. Telefilm v. Superior Court, 86 A. C. A. 143, .

Thereafter, the Supreme Court of California granted defendants' petition for hearing and reversed the decision of the District Court of Appeal. . The company then petitioned the Supreme Court of the United 21 T.C. 688">*692 States for certiorari. While the petition1954 U.S. Tax Ct. LEXIS 296">*306 was pending, the company and the defendants settled the litigation, caused the complaint filed in the superior court to be dismissed, stipulated that the petition for certiorari should be dismissed, and the company executed a release in favor of Thorobred Photo Service, Inc., in consideration of the payment to the company of $ 100,000. The release read in part as follows:

WHEREAS, the undersigned, TELEFILM, INC., did in the year 1946 bring action in the Superior Court of Los Angeles County, California, against Thorobred Photo Service, Inc., a corporation, and others as the defendants therein, asserting for cause of action, among other things that Thorobred Photo Service, Inc. had appropriated for its own use and benefit certain business and good will of the undersigned, and business secrets, confidential information and skills, methods and techniques of and belonging to the undersigned, whereby the undersigned believed and asserted that it had been wrongfully deprived of large profits by the said Thorobred Photo Service, Inc.,

Now Therefore, Know All Men by These Presents:

That the undersigned, TELEFILM, INC., a corporation, in consideration of the sum of $ 100,000.00 in hand paid1954 U.S. Tax Ct. LEXIS 296">*307 to it, does by these presents hereby release and discharge Thorobred Photo Service, Inc., a California corporation, and its successors, * * * from any and all claims or causes of action whatsoever due to, or growing out of, any act or acts, or asserted act or acts, of the said Thorobred Photo Service, Inc. * * *

Another release, running in favor of the other defendants, was executed in consideration of the payment of $ 10.

The $ 100,000 was received by the petitioner during the year 1949, and it paid counsel fees and costs aggregating $ 37,956.23. The remaining $ 62,043.77 was entered upon its books in its surplus account. This latter amount was also entered as a credit to earned surplus in Schedule M of its corporation income tax return for 1949 with a notation to see schedule attached. The schedule reads as follows:

Net amount received by Telefilm, Inc., in settlement of an action in tort involving unfair competition and injury to company's business:

The petitioner did not include any part of the $ 100,000 in the net income reported in its return1954 U.S. Tax Ct. LEXIS 296">*308 for the year 1949. The respondent determined that $ 62,043.77 of this amount was taxable as ordinary income.

One-sixth of the net amount received by petitioner represented punitive damages, and the other five-sixths represented compensatory damages. One-half of such compensatory damages was for loss of profits and the other one-half for destruction of business, including goodwill.

21 T.C. 688">*693 OPINION.

The question presented is whether all or any part of the net proceeds of the settlement, $ 62,043.77, constitutes taxable income. The respondent contends that the entire amount consisted of taxable compensation for profits which the petitioner otherwise would have received. The petitioner contends that this amount constituted nontaxable compensation for the tortious destruction of the portion of the business of its predecessor devoted to the photography of horse races.

The tax consequences which attach to the lump-sum payment received by petitioner depend upon the nature of the payment. To what extent, if at all, did it represent punitive or exemplary damages, compensation for loss of profits, or compensation for destruction of the company's business? At the time of the settlement1954 U.S. Tax Ct. LEXIS 296">*309 and execution of the release for $ 100,000, the parties did not specify what part of that amount was allocable to any of the foregoing elements, although the "whereas" clause of the release referred to a cause of action for appropriation of the company's business and good will, resulting in alleged loss of profits. In the circumstances, the nature of the recovery will have to be determined from the claims made in the pleadings, the issues presented to the jury, and from such assistance as we are able to obtain from the release itself. Cf. (C. A. 1), certertiorari denied, , affirming .

Although the pleadings are not too clear, we think that, fairly construed, they asserted a claim of $ 250,000 for lost profits, $ 250,000 for injury to business and good will (or in the alternative, in lieu of the two foregoing items, $ 500,000 for destruction of business and good will), and $ 500,000 as exemplary damages. On the other hand, at the trial, the principal claim presented to the jury was one for destruction or pirating1954 U.S. Tax Ct. LEXIS 296">*310 of business and goodwill; evidence as to loss of profits was submitted primarily to show the extent of damage to business and goodwill. Cf. . The jury verdict was in the amount of $ 250,000 as compensatory damages (without specification as to whether such damages were for loss of profits or destruction of business) and $ 50,000 as exemplary damages.

In the circumstances, we are satisfied that the settlement amount includes several different components. It cannot be treated in its entirety as income resulting from the recovery of lost profits, as respondent urges; nor can it be regarded in its entirety as a penalty, cf. (C. A. 3), or as a nontaxable recovery for injury to business, cf. 21 T.C. 688">*694 (C. A. 6), as urged by petitioner.

As already noted, the suit was to recover not only compensatory damages, but also punitive damages, and the reasonable assumption is that the amount paid in settlement was 1954 U.S. Tax Ct. LEXIS 296">*311 intended to satisfy both of these claims. Since the tax consequences attributable to the receipt of amounts in satisfaction of each claim differ, an allocation is necessary and proper. (C. A. 6); ; . Some basis for allocation is found in the verdict of the jury in the original lawsuit awarding the company $ 250,000 as compensatory damages and $ 50,000 as punitive damages. Using this basis as the most reasonable one available we find that one-sixth of the net proceeds of the settlement represented a payment in the nature of punitive damages, and therefore does not constitute taxable income. ; ;; cf.

As to the precise nature of the remaining five-sixths, which must be regarded1954 U.S. Tax Ct. LEXIS 296">*312 as compensatory damages, the record is in an unsatisfactory state. On the one hand, the complaint as originally filed by the company sought compensatory damages in the amount of $ 500,000, relating in part to loss of profits and in part to destruction or injury to business. Those allegations in the original complaint were left unchanged by the supplemental complaint, which added two new paragraphs. However, the two new paragraphs added by the supplemental complaint and the presentation of the case to the jury placed predominant emphasis upon destruction of business and good will as the gist of the action. And to make matters even more confusing, the recitation in the "whereas" clause of the release refers to the pirating of the company's business merely as the cause for the alleged loss of profits.

Exercising our best judgment on the evidence before us we have concluded and found as a fact that one-half of the five-sixths representing compensatory damages consists of damages for loss of profits and the other one-half consists of damages for destruction of business and goodwill. To the extent that the damages are for loss of profits they plainly constitute taxable income. Cf. 1954 U.S. Tax Ct. LEXIS 296">*313 ; (C. A. 5); (C. A. 9); ; ; .

A somewhat more difficult problem is presented as to the remaining 21 T.C. 688">*695 one-half of the compensatory damages allocable to destruction of the company's business. Surely, to the extent that damages for the destruction of property, whether tangible or intangible, do not exceed the cost or other unrecovered basis of such property, they are merely a return of capital and are not taxable at all. But to the extent that such damages exceed the unrecovered basis of the property the excess represents a profit which constitutes taxable income. This was clearly spelled out in the Raytheon case where, after pointing out that an amount received in settlement of a damage suit for the destruction1954 U.S. Tax Ct. LEXIS 296">*314 of business and goodwill represented a return of capital, the Court of Appeals went on to say ():

But, to say that the recovery represents a return of capital in that it takes the place of the business good will is not to conclude that it may not contain a taxable benefit. Although the injured party may not be deriving a profit as a result of the damage suit itself, the conversion thereby of his property into cash is a realization of any gain made over the cost or other basis of the good will prior to the illegal interference. Thus A buys Blackacre for $ 5,000. It appreciates in value to $ 50,000. B tortiously destroys it by fire. A sues and recovers $ 50,000 tort damages from B. Although no gain was derived by A from the suit, his prior gain due to the appreciation in value of Blackacre is realized when it is turned into cash by the money damages.

And in , the Court of Appeals said ():

It is also urged upon us that a sale or conversion into cash of capital assets, which have increased in value over a period of time, is1954 U.S. Tax Ct. LEXIS 296">*315 a realization of the gain in value over the cost or other applicable basis of such assets, and such realized gain becomes taxable income. * * * We agree that the rule is applicable in this case. * * * ²

(C. A. 6), relied upon by petitioner, was an earlier decision by the Court of Appeals for the same circuit that decided the Durkee case and must be read in the light of the Durkee and Raytheon cases.

The burden was on the petitioner to establish the cost or other basis of the business and goodwill for the destruction of which it was compensated. ³ Its president, who was also the president of the predecessor company, testified that the company expended approximately $ 15,000 in a promotional campaign which consisted1954 U.S. Tax Ct. LEXIS 296">*316 of advertising and sending representatives to "contact" race track operators with the object of selling them the idea of photographing horse races. All 21 T.C. 688">*696 such expenditures were charged to expense on the books of the company and claimed as deductions in the year in which they were made.

The foregoing strongly suggests that there is no unrecovered basis for the destroyed1954 U.S. Tax Ct. LEXIS 296">*317 property that must be taken into account in order to determine the amount of taxable profit attributable to the damages in question. Certainly the petitioner, upon whom the burden rests, has not shown any unrecovered basis, and in these circumstances we must hold that the portion of the compensatory damages paid for the destruction of business and goodwill represents taxable income.

Decision will be entered under Rule 50.