Robert W. Wood (Robert W. Wood, P.C., San Francisco) has published Litigation Settlements, Sales and Exchanges, and Section 1234A, also available on the Tax Analysts web site as Doc 2005-22208, 2005 TNT 212-50.  Here is the Conclusion:

Considering the relatively scant authority under section 1234A, I doubt there will be a groundswell of authority dealing with taxpayers’ attempts to apply section 1234A to litigation recoveries. Still, it seems possible that the IRS or a court could apply section 1234A to a lawsuit settlement. For that to occur, at least two requirements will probably have to be met.

First, the IRS or a court would have to find that the underlying lawsuit (or perhaps the chose in action) was a capital asset in the hands of the plaintiff. Although at this point I am not certain whether the underlying suit could be viewed as a capital asset, that determination appears to be a separate issue from whether the ultimate monetary recovery from the suit would produce capital gain. Second, the IRS or a court would also have to find that there was a cancellation, lapse, expiration, or other termination of the contract. With a lawsuit settlement, that second requirement is likely to be met, or perhaps could be met with minimal effort.

If those two requirements are met, and the IRS or a court finds that section 1234A applies to a lawsuit settlement, the consequences could be enormous. The plaintiff could treat the recovery as capital gain. That could statutorily remove the sale or exchange requirement that (depending on whom you listen to or which authorities you read) has sometimes been viewed as one of the prerequisites to achieve capital gain.

I find the sale or exchange requirement in the context of lawsuit settlements less troubling than I used to, perhaps because I see the IRS agreeing (on an informal level at least) that a sale or exchange is often not required. Plus, even apart from that informal experience, I am comforted by the authorities that accord capital gain treatment to lawsuit recoveries even though no one refers to it as a sale or exchange. Yet, a new avenue to redemption is nothing to scoff at. That makes section 1234A intriguing.

Contract cancellations are implicit in many disputes involving capital assets. Further, it would not be difficult for the parties in a settlement agreement to refer to the underlying contract under which the events took place and to agree that the contract was being canceled. All of that may make section 1234A worth exploring. I have no doubt that section 1234A was not intended for that purpose, but it is certainly worth a closer look.