Question

Required: Ignoring capital gains tax, discuss whether any part of the $4m constitutes ordinary income.

Steve runs a business that manufactures a specialised type of extra strong glass. This business has a number of customers. Steve buys the essential raw materials to make the glass from the only known supplier of such materials, Rare Ltd. If Steve was unable to purchase the materials from Rare, the factory would only be able to produce regular glass. Steve’s contract with Rare is of 8 years duration and has 6 years to run.

During February 2020, Rare Ltd informs Steve that it is cancelling the contract. As a result, Steve will not be able to sell the specialised glass to his customers. As compensation, Rare Ltd gives Steve $4 million. Rare Ltd’s internal documents indicate that $3 million of this was calculated on the basis of how much profit Steve’s business will lose due to being unable to sell such specialised glass to its buyers. The remaining $1 million is based on the loss of Steven’s reputation.

Answer 1

Here in this case, $4m comprises of,

1) Compensation for loss of profit

2) Compensation for loss of reputation.

Under US internal revenue code, ordinary income is an income excluding long term capital gains.

Compensation in couse if employment is covered in Ordinary income.

Here the compensation is NOT FROM THE EMPLOYER. Hence as per literal interpretation of law these are covered under Long Term CG.

But since it is due to loss in Ordinary course of business, alternative assumption can be taken to include $3m in Ordinary Income as well.