Harahan won a lawsuit against
Cole and was awarded $75k. However Cole didn't pay.
Eventually Harahan sold her
interest in the Cole judgment to Hudson and Taylor for $11k. Hudson and
Taylor then negotiated with Cole and settled the judgment for $21k.
When they filed their taxes,
Hudson and Taylor reported their profit on the deal (~$5k each) as a long-term
capital gain. The IRS denied the
claim. Hudson and Taylor appealed.
The IRS argued that it was
not a long-term capital gain but
instead was ordinary income (which was taxed at a higher rate).
Hudson and Taylor argued
that the judgment was a capital asset, and the settlement was a
"sale or judgment of a capital asset" which met the definition
of the relevant section of the tax code (then 26 U.S.C. §117, now 26 U.S.C. §1222).
The Tax Court found for the
IRS.
The Tax Court found that the
judgment was not 'property' but just a debt. Hudson and Taylor did not
recover the money as the result of any sale or exchange but only as a
collection of settlement of the judgment.
The Court found that since
the settlement of a debt is not a "sale or exchange," then the
tax code provisions related to capital gains are inapplicable and the profits are to be
treated as ordinary income.
