Acqis Technology, Inc. (Acqis) owned a number of patents. Acqis retained a law firm to sue companies that infringed on its patents. The law firm was to receive a contingent fee based on cash paid by the defendant companies to its Lawyer Trust Account. On April 2, 2009, eleven companies were sued for patent infringement.

On November 18, 2018, Acqis restructured its capital, creating Class A common stock and Class B common stock. All existing shareholders were issued Class A common stock. Class A shareholders were entitled to vote, receive dividends and to receive payments in the event of liquidation. Class B shareholders were entitled to none of these rights.

In November 2010, the first defendant company agreed to settle. Pursuant to the settlement, the parties agreed that the litigation would be dismissed if the first defendant purchased Class B shares of Acqis. Acqis further agreed to grant the first defendant a perpetual license to use its intellectual property. The parties signed a Memorandum of Understanding and a Stock Purchase Agreement. On November 24, 2010, the first defendant paid money to the Lawyer Trust Account. In December 2010, three other defendants similarly settled the litigation by purchasing Class B shares and paid funds to the Lawyer Trust Account. The demanded damages exceeded the amount ultimately paid by the defendants.

Acqis did not report the payments from the defendants as gross receipts. Instead, it increased shareholder equity on its balance sheet and reported the contingent legal fees as cost of goods sold. On audit, the IRS determined that the payments from defendants reflected gross income and not contributions to capital.

In Acqis Technology, Inc. v. Commissioner, T.C. Memo 2024-21 (Feb. 13, 2024), the Court ruled that the Stock Purchase Agreements were a sham that lacked economic substance. The Court reasoned that the Class B shares had no economic value and were akin to a ceremonial “Key to the City” as the shares did not receive dividends, had no liquidation rights, had no voting rights and were not transferrable or redeemable. Moreover, the law firm took its contingent fee on money purportedly paid for Class B shares.

The Court further stated that when a taxpayer receives damages from a settlement, the tax consequences of the settlement depend on the nature of the claim that was the basis for the settlement. Here, the Court ruled that the payments were made to settle the patent infringement litigation and accordingly, the payments are taxable gross income under IRC Section 61(a)(6) (gross income means all income from royalties).

In analyzing the tax consequences of a transaction, the Courts look beyond the form of a transaction and look to its substance.