Revenue Ruling ADJUSTMENT TO BASIS; RECOVERY FROM CONTRACTOR FOR FAILURE TO PERFORM UNDER CONSTRUCTION CONTRACT Published: November 30, 1981 26 CFR 1.61-1: Gross income (Also Sections 1012, 1016; 1.1012-1, 1.1016-1.) Adjustment to basis; recovery from contractor for failure to perform under construction contract. The payment by a contractor of a sum of money to a buyer in exchange for a release of the buyer's claims against the contractor for failure to fulfill the contract for construction of a plant constitutes a return of capital rather than gross income to the buyer. The cost basis of the plant is adjusted downward to reflect the payment. ISSUE Does payment by a contractor of a sum of money to a buyer in exchange for a release of the buyer's claims against the contractor for failure to fulfill a contract result in income to the buyer or a return of capital? FACTS In 1969 corporation M agreed to construct a nuclear generating plant for corporation P at a price of 250x dollars. The construction contract specified that M would provide, at no additional cost to P, any additional items that later were determined to be necessary to deliver a complete, safe, licensable, fully operational plant. During the construction period regulatory agencies imposed stricter environmental safeguards on nuclear generating plants than were in effect at the time the contract was signed. Disputes arose between M and P over M's obligation to provide for stricter safeguards and to include them as part of the delivered plant at the original contract price. To the date of the dispute, P has paid M 230x dollars of the contract price of 250x dollars. The parties eventually settled their dispute by agreeing that the terms of the 1969 contract must be met by both parties. They also agreed that M was responsible to deliver a plant that met the stricter environmental safeguards and that it would cost an additional 40x dollars. P was
required to forward 20x dollars to M to complete P's payment obligation
under the contract. In light of these agreements, P paid M 20x dollars, the value of the work performed under the contract but unpaid at the time of the settlement agreement. M and P 40x dollars representing the estimated cost to satisfy the stricter environmental standards rather than completing the plant's construction. Both parties then executed general releases to each other and M ceased its construction activities. P then contracted with a third party to finish construction of the nuclear generating plant. P eventually had to pay the third party 50x dollars to obtain a plant that satisfied the regulatory agencies standards. LAW AND ANALYSIS Section 61 of the Internal Revenue Code provides that gross income means all income from whatever source derived, including income realized in any form. Section 1012 of the Code provides that the basis of property is usually its cost. Section 1.1012-1(a) of the Income Tax Regulations provides that cost is the amount paid for property in cash or other property. Section 1016(a) provides that adjustments are made to the basis of property for expenditures, receipts, losses, or other items properly chargeable to the capital account. Inherent in section 61 of the Code is the concept of economic gain. For a taxpayer to have income under section 61, there must be an economic gain that benefits the taxpayer personally. United States v. Gotcher, 401 F.2d 118 (5th Cir. 1968). The determination of whether the proceeds received in a lawsuit or received in settlement of a lawsuit constitute income under section 61 of the Code depends on the nature of the claim and the actual basis for recovery. If the recovery represents damages for lost profits, it is taxed as ordinary income. If, however, the recovery is treated as a replacement of capital, the damages received from the lawsuit are treated as a return of capital and are not taxable as income. Freeman v. Commissioner, 33 T.C. 323 (1959). Payments by the one causing a loss that do not more than restore a taxpayer to the position he or she was in before the loss was incurred are not includible in gross income because there is no economic gain. Clark v. Commissioner, 40 B.T.A. 333 (1939), acq., 1957-1 C.B. 4 and Rev. Rul. 57-47, 1957-1 C.B. 23. In the present situation, the effect of the settlement agreement was that
M would compensate P for M's failure to provide a fully operational and
licensable plant for 250x dollars as agreed upon under the contract. The payment from M to P of 40x dollars represents the estimated present damages P has incurred because of the breach of contract, determined under the settlement agreement as the estimated additional costs needed to satisfy new regulatory standards that were necessary to deliver a complete, safe, licensable, fully operational plant as required under the contract. P has received no economic gain as a result of the 40x dollars payment and is merely being made whole under the contract. P is being restored to the position that it would have been in if M had fulfilled the terms of the contract. HOLDING The 40x dollars payment from M to P represents a return of capital and is not income to P. The basis of the plant in P's hands should be adjusted downward to 210x dollars from its cost basis of 250x dollars (230x dollars plus the 20x dollars payment from P to M) to reflect the 40x collars payments, and adjusted upward to 260x dollars when P incurs expenses of 50x dollars to finish construction of the plant. Rev. Rul. 81-277, 1981-2 C.B. 14, 1981-48 I.R.B. 5.