1981-2 C.B. 14, 1981-48 I.R.B. 5.

Internal Revenue Service

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.