MEMORANDUM — PRIVILEGED AND CONFIDENTIAL
ATTORNEY WORK PRODUCT
TO: Francesca Morano, Responsible Partner; Carlos Espinoza, Lead Associate
FROM: Hannah Brinkley, Working Associate
DATE: December 20, 2024
RE: Redstone Gaming Corp. v. Grizzly Peak Research LLC et al. — Tax Treatment and Allocation of Settlement Proceeds (Case No. 24STCV-01892)
CLIENT: Redstone Gaming Corp. (EIN: 88-0412793)
MATTER: Calderwood & Harkness LLP Matter No. 1033-00006
This memorandum is protected by the attorney-client privilege and constitutes attorney work product prepared in anticipation of litigation and in connection with the provision of legal advice. It is intended solely for the use of the addressees identified above and should not be disclosed to any third party without the prior written consent of Calderwood & Harkness LLP and Redstone Gaming Corp.
I. Purpose and Executive Summary
This memorandum analyzes the federal and state income-tax treatment of the $14.75 million settlement payment to be received by Redstone Gaming Corp. ("RGC" or the "Company") under the Settlement Agreement and Mutual Release expected to be executed on January 6, 2025 (the "Settlement Agreement"). The settlement resolves all claims asserted by RGC in Redstone Gaming Corp. v. Grizzly Peak Research LLC, Grizzly Peak Capital Partners LP, and Tobias Fenchurch, Case No. 24STCV-01892, pending in the Superior Court of California, County of Los Angeles.
The settlement arises from trade libel and related claims brought against Grizzly Peak Research LLC (EIN: 85-3291064), Grizzly Peak Capital Partners LP (EIN: 85-3291078), and Tobias Fenchurch (collectively, "GPR" or "Defendants"). These claims stem from a series of three fraudulent short-seller research reports published in February 2024 that falsely accused RGC of fabricating approximately $410 million in fiscal year 2023 revenue, manipulating its proprietary random number generation ("RNG") software platforms, and engaging in undisclosed related-party transactions with an entity described as "Vermilion Holdings LLC." Each of those allegations was subsequently disproven through independent investigation, regulatory clearance, and the closure of a related SEC informal inquiry.
This memorandum addresses three key tax questions raised by the settlement:
(1) Whether and to what extent the $14.75 million settlement payment is includible in RGC's gross income for federal and state income-tax purposes;
(2) How the settlement proceeds should be allocated — or whether the parties should negotiate an allocation — among compensatory damages, reputational recovery, and the injunctive/non-monetary relief components of the settlement; and
(3) Whether and to what extent RGC's litigation costs — including Calderwood & Harkness fees of approximately $3,220,716 plus $187,450 in costs advanced, as well as other professional costs totaling $4,627,000 — are deductible as ordinary and necessary business expenses.
Summary of Conclusions and Recommendation. Based on the analysis set forth below, it is my conclusion that the entire $14.75 million settlement payment is most likely includible in RGC's gross income as ordinary income under Internal Revenue Code ("IRC") § 61 and the well-established "origin of the claim" doctrine. Although a theoretical argument could be advanced that some portion of the proceeds compensates for damage to corporate goodwill — a capital asset — the practical benefit of such an argument is limited for several reasons: (a) RGC's self-created goodwill has a zero tax basis, meaning any amount allocated to goodwill would be fully taxable as capital gain in any event; (b) RGC is a C corporation, and both ordinary income and capital gains are taxed at the same 21% federal corporate rate; and (c) the IRS would likely scrutinize any goodwill allocation absent explicit language in the Settlement Agreement and contemporaneous documentation.
On the deduction side, RGC's total litigation and professional costs of approximately $8,035,166 should be fully deductible as ordinary and necessary business expenses under IRC § 162, partially offsetting the taxable settlement income. The net taxable impact of the settlement, before considering state taxes and apportionment, is therefore approximately $6,715,000, resulting in an estimated federal tax liability of approximately $1,410,000 at the current 21% corporate rate.
I strongly recommend that, before the anticipated Effective Date of January 6, 2025, the firm coordinate with RGC's internal tax team — specifically, CFO Priya Ramaswaran — and with RGC's independent auditors at Pinnacle Audit & Advisory LLP (engagement partner Walter Ng, CPA) to confirm the tax return and financial reporting treatment of the settlement proceeds. In addition, the team should evaluate whether it is advisable and feasible to negotiate an allocation clause with defense counsel at Caldwell, Tseng & Barrow LLP prior to execution, although the marginal benefit for a C corporation taxpayer may not justify the potential delay in closing.
II. Background: The Settlement
A. Litigation Overview
RGC filed its initial Complaint on February 5, 2024, in the Superior Court of California, County of Los Angeles, under Case No. 24STCV-01892. The Complaint was assigned to the Honorable Margaret Soo-Kwan Chen, Department 34, Spring Street Courthouse. RGC subsequently filed a First Amended Complaint on March 18, 2024, adding a claim for negligent misrepresentation against all three Defendants. As amended, the operative pleading asserted the following four causes of action:
(1) Trade Libel (Cal. Civ. Code § 46(3)) — alleging that the Defendants published false statements of fact concerning RGC's financial performance, the integrity of its RNG software systems, and its corporate governance, with the intent to injure RGC's business and induce divestment of RDGM shares;
(2) Intentional Interference with Prospective Economic Advantage — alleging that the Defendants' publication of false research reports interfered with RGC's relationships with existing and prospective investors, gaming regulators, and commercial counterparties;
(3) Unfair Business Practices (Cal. Bus. & Prof. Code § 17200 et seq.) — alleging that the Defendants engaged in unlawful and unfair business practices by publishing false reports for the purpose of profiting from short-sale positions in RDGM securities; and
(4) Negligent Misrepresentation (added in the First Amended Complaint) — alleging that the Defendants failed to exercise reasonable care in verifying the factual bases for their reports before publishing statements that they knew, or should have known, were false.
The False Reports. At the core of the litigation were three research reports published by Grizzly Peak Research LLC under the byline of Tobias Fenchurch, GPR's founder and managing director, on February 7, 14, and 21, 2024, respectively. The reports — titled "Redstone Gaming: A $3 Billion House of Cards" (Part 1), "The Vermilion Connection" (Part 2), and "Rigged from the Inside" (Part 3) — collectively alleged: (a) that RGC had fabricated approximately $410 million in fiscal year 2023 revenue through sham transactions with a purported related party, "Vermilion Holdings LLC"; (b) that RGC's proprietary RNG software platforms deployed across its eleven casino-resort properties had been manipulated to alter gaming outcomes in violation of state gaming regulations; and (c) that RGC's senior management had concealed material related-party dealings from shareholders and regulators. Each report was disseminated through GPR's website (grizzlypeakresearch.com), the social media account @GrizzlyPeakRes, and various financial media distribution channels.
Disproven Allegations. Every material allegation in the three reports was subsequently disproven through independent investigation and regulatory review:
• Pinnacle Audit & Advisory LLP, RGC's independent auditor, confirmed in a supplemental review completed on March 15, 2024, that RGC's FY 2023 revenue figures were accurate and that no entity named "Vermilion Holdings LLC" appeared in RGC's books, records, or counterparty databases;
• The Nevada Gaming Control Board ("NGCB") completed an independent audit of RGC's RNG software systems across all Nevada-licensed properties and issued a clearance letter on March 29, 2024, confirming full compliance with Nevada Gaming Commission Regulation 14.040 and Technical Standard 1.090;
• The New Jersey Division of Gaming Enforcement and the Mississippi Gaming Commission conducted parallel reviews and issued no adverse findings; and
• The U.S. Securities and Exchange Commission ("SEC") opened an informal inquiry in February 2024 following the publication of the GPR reports; that inquiry was closed with no action on August 16, 2024, and the SEC's Division of Enforcement confirmed by letter to RGC's securities counsel that no enforcement proceeding would be recommended.
Market Impact. The GPR reports caused significant and immediate harm to RGC's market capitalization. RDGM common stock, which closed at $92.14 per share on the Nasdaq Global Select Market on February 6, 2024 (the trading day immediately preceding the first report), declined to $72.80 per share by the close of trading on February 21, 2024 (the date of the third report), representing a cumulative decline of 21.0%. Based on 73.8 million shares outstanding, the aggregate market-capitalization loss at the trough was approximately $1.427 billion ($19.34 per share × 73.8 million shares). As of the date of this memorandum, RDGM shares have substantially recovered, trading at approximately $82.70 per share, reflecting a current market capitalization of approximately $6.1 billion.
RGC retained Dr. Elena Vostrikova of Meridian Forensic Economics LLC to perform an event-study analysis isolating the stock-price decline attributable to the false GPR reports from contemporaneous market-wide and sector-specific movements. Dr. Vostrikova's analysis, set forth in her preliminary expert report dated October 14, 2024, calculated event-study-adjusted damages of $327.6 million in shareholder value directly attributable to the Defendants' false statements. While this figure was presented as the principal damages measure for litigation purposes, the parties ultimately agreed to a settlement amount significantly below this figure, reflecting the inherent uncertainties of trial, the Defendants' limited financial capacity, and the availability of insurance proceeds.
Out-of-Pocket Costs. In addition to the market-capitalization decline and shareholder-value losses, RGC incurred substantial out-of-pocket costs in responding to the GPR reports and the resulting regulatory and investor-relations fallout. These costs totaled $4,627,000, comprising the following:
These costs are separate from, and in addition to, the fees and costs incurred for litigation counsel at Calderwood & Harkness, which are discussed in Part IV below.
B. Settlement Terms
The parties participated in a full-day mediation on December 4, 2024, before the Honorable David K. Watanabe (Ret.) of Pinnacle Dispute Resolution. At the conclusion of the mediation, the parties executed a Mediator's Term Sheet reflecting the material terms of the settlement. The definitive Settlement Agreement and Mutual Release has been drafted by Calderwood & Harkness and is currently being reviewed by defense counsel at Caldwell, Tseng & Barrow LLP (attorneys Raymond Caldwell and Natalie Orenstein). Execution is expected on or about January 6, 2025.
The principal terms of the Settlement Agreement are as follows:
Monetary Payment. The Defendants shall pay RGC the aggregate sum of $14,750,000 (the "Settlement Payment"), funded from two sources:
(a) $10,250,000 from Ironclad Surety & Insurance Co. ("Ironclad"), paid on behalf of the Defendants under Directors & Officers / Media Liability Insurance Policy No. ML-2023-07714 (the "Ironclad Policy"); and
(b) $4,500,000 jointly from Grizzly Peak Research LLC and Grizzly Peak Capital Partners LP, payable from their own assets.
The Settlement Payment is to be deposited within thirty (30) calendar days of execution of the Settlement Agreement into an interest-bearing escrow account at Great Basin Trust Company, N.A. (the "Escrow Agent"), with a target deposit date of February 5, 2025. Upon satisfaction of all conditions precedent — including entry of the stipulated permanent injunction by the Court — the Escrow Agent shall disburse the full Settlement Payment to RGC, less any wire-transfer fees.
Non-Monetary Relief. The settlement includes the following non-monetary components, each of which carries significant value to RGC from a reputational and operational standpoint:
• Corrective Publication: Grizzly Peak Research LLC shall publish a corrective statement of not fewer than 1,500 words on its website, grizzlypeakresearch.com, acknowledging that the allegations in the three February 2024 reports were unsupported and that GPR retracts those reports in their entirety. The corrective statement shall remain posted for a minimum of twenty-four (24) months from the date of initial publication.
• Social Media Corrective: Grizzly Peak Research LLC shall post a corrective statement of not fewer than 280 characters on its X (formerly Fenmore Solutions) account, @GrizzlyPeakRes, and shall pin that post to the top of its profile for a period of not fewer than twelve (12) months.
• Permanent Injunction: The parties shall jointly move for entry of a stipulated permanent injunction prohibiting the Defendants from republishing, distributing, or otherwise disseminating any of the three February 2024 reports, or any substantially similar statements, in any medium.
• Trading Bar: Each Defendant, and their respective affiliates, officers, directors, employees, and agents, shall be barred from purchasing, selling, or otherwise trading in RDGM securities — whether directly or through any derivative instrument — for a period of five (5) years through January 6, 2030.
• Mutual Releases: Each party shall deliver a full and complete mutual release of all claims, known and unknown, arising from or related to the subject matter of the litigation, including an express waiver of California Civil Code § 1542.
• Non-Disparagement: Each party agrees to a three (3)-year mutual non-disparagement covenant, subject to customary carve-outs for legally compelled testimony and regulatory filings.
• Confidentiality: The amount of the Settlement Payment shall be confidential and shall not be disclosed by any party except as required by law, regulation, or legal process.
Attorneys' Fees and Costs. Each party shall bear its own attorneys' fees, costs, and expenses. The Settlement Agreement contains no provision for fee-shifting or cost-reimbursement.
III. Federal Income Tax Analysis
A. General Rule: IRC § 61 — Gross Income
The starting point for any analysis of the tax treatment of settlement proceeds is IRC § 61(a), which defines gross income broadly to include "all income from whatever source derived." The statute provides a non-exhaustive list of items included in gross income, among them "compensation for services, including fees, commissions, fringe benefits, and similar items," "gross income derived from business," and "income from . . . dealings in property." Treas. Reg. § 1.61-14(a) further provides that, in addition to the enumerated items, "[g]ross income includes income realized in any form, whether in money, property, or services," and specifically notes that "[t]reasure trove, to the extent of its value in United States currency, . . . punitive damages, and other amounts not enumerated in section 61" are includible.
Settlement proceeds are generally includible in gross income unless they fall within a specific statutory exclusion. The most commonly invoked exclusion is IRC § 104(a)(2), which excludes from gross income "the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness." This exclusion is inapplicable here for multiple independent reasons: (a) RGC is a corporation, not a natural person, and therefore cannot suffer "personal physical injuries or physical sickness"; (b) the claims asserted in the litigation are entirely commercial and economic in nature — trade libel, tortious interference, unfair business practices, and negligent misrepresentation — none of which sound in personal injury; and (c) the Tax Reform Act of 1996 narrowed the § 104(a)(2) exclusion to require "physical" injury or sickness, eliminating the pre-1996 exclusion for nonphysical personal injury claims such as emotional distress and reputational harm.
No other statutory exclusion appears applicable to the facts here. Accordingly, the $14.75 million Settlement Payment is presumptively includible in RGC's gross income under § 61(a).
It bears noting that RGC is a Nevada corporation, publicly traded on the Nasdaq Global Select Market under the ticker symbol RDGM. The Company is a C corporation for federal income-tax purposes and files on a calendar-year basis. The settlement proceeds will therefore be subject to the federal corporate income tax at the rate applicable under IRC § 11, currently 21%.
B. The "Origin of the Claim" Doctrine
The tax treatment of litigation settlement proceeds is governed by the "origin of the claim" doctrine, which was established by the Supreme Court in United States v. Gilmore, 372 U.S. 39 (1963), and further developed in Commissioner v. Schleier, 515 U.S. 323 (1995), and Raytheon Production Corp. v. Commissioner, 144 F.2d 110 (1st Cir. 1944). Under this doctrine, the tax consequences of a settlement payment are determined by reference to the nature and character of the underlying claim that gave rise to the payment — not by the labels that the parties may attach to the payment in their settlement documents. As the First Circuit stated in Raytheon, the critical question is: "In lieu of what were the damages awarded?"
This analysis requires an examination of the substantive claims asserted, the theories of damages pursued, and the nature of the harm for which the settlement proceeds are intended to compensate. Where settlement proceeds are received "in lieu of" lost profits, lost business income, or other forms of ordinary income, they are taxable as ordinary income. See Raytheon, 144 F.2d at 114 (proceeds received as compensation for lost profits are ordinary income because they replace the income that the taxpayer would have earned). Where, by contrast, settlement proceeds are received as compensation for the destruction of, or damage to, a capital asset — such as goodwill — they may be treated as amounts received in exchange for the capital asset and thus eligible for capital-gain treatment under IRC §§ 1001 and 1221, but only to the extent the proceeds exceed the taxpayer's adjusted basis in the asset. Id. at 113-14.
Applying the origin-of-the-claim doctrine to the present case, the four causes of action asserted by RGC all arise from harm to the Company's business reputation, its market capitalization, and its relationships with investors, gaming regulators, and commercial counterparties. Specifically:
• The trade libel claim compensates for the publication of false statements that injured RGC's business reputation and caused the Company to lose revenue, market value, and business opportunities — a quintessentially commercial injury;
• The intentional interference claim compensates for the Defendants' deliberate disruption of RGC's relationships with existing and prospective investors and business partners — again, an injury to ongoing business operations;
• The unfair business practices claim under Section 17200 seeks restitution of profits unfairly obtained by the Defendants through their short-selling scheme — a disgorgement measure that, from RGC's perspective, functions as compensation for the economic harm caused by the scheme; and
• The negligent misrepresentation claim compensates for the harm caused by the Defendants' publication of false statements without exercising reasonable care — another business-injury theory.
In each instance, the damages sought were measured by reference to RGC's lost market capitalization, lost business revenue, and out-of-pocket remediation costs — all of which are inherently ordinary-income items. The primary damages measure presented throughout the litigation — the $327.6 million in event-study-adjusted shareholder-value loss calculated by Dr. Vostrikova — is a market-capitalization measure that, for tax purposes, most naturally represents compensation for lost business value and foregone income. The out-of-pocket costs of $4,627,000 (crisis PR, forensic audit, and regulatory counsel) are direct economic losses that would have been deductible as ordinary business expenses when incurred, further reinforcing their ordinary-income character.
Accordingly, the predominant character of the $14.75 million Settlement Payment, analyzed under the origin-of-the-claim doctrine, is ordinary income.
C. Allocation of the $14.75 Million Among Claim Components
Although the Settlement Agreement as currently drafted does not explicitly allocate the $14.75 million among the four causes of action or among different categories of damages, it is appropriate to consider whether an allocation would be beneficial for tax purposes and, if so, whether such an allocation is supportable on the facts. I address each potential damage category in turn.
1. Compensatory Damages Component (Lost Profits / Market-Cap Recovery). The overwhelming majority of the settlement proceeds is most naturally characterized as compensation for RGC's economic losses — specifically, the decline in market capitalization and the out-of-pocket remediation costs incurred in response to the false GPR reports.
The primary damages theory presented throughout the litigation was the market-capitalization decline. RDGM stock fell from $92.14 per share to $72.80 per share between February 6 and February 21, 2024, representing an aggregate market-capitalization loss at the trough of approximately $1.427 billion. Dr. Vostrikova's event-study analysis isolated $327.6 million of this decline as directly attributable to the Defendants' false statements. In addition, RGC incurred $4,627,000 in documented out-of-pocket costs for crisis communications, supplemental forensic auditing, and gaming regulatory counsel.
The $14.75 million Settlement Payment represents a small fraction — approximately 4.5% — of the event-study-adjusted damages and approximately 1.0% of the aggregate trough market-cap loss. It is most naturally characterized as partial compensation for these economic losses and is therefore taxable as ordinary income.
Notably, the Settlement Payment of $14.75 million is comparable to GPR's estimated short-sale profit of approximately $13.15 million, calculated as the per-share price decline of $19.34 ($92.14 minus $72.80) multiplied by GPR's reported short position of approximately 680,000 shares. This comparability suggests that the settlement amount was influenced in significant part by the Defendants' capacity to pay — essentially their ill-gotten gains — rather than by the full measure of RGC's damages. From a tax perspective, this reinforces the ordinary-income characterization: the settlement compensates RGC for the economic harm inflicted by the Defendants' wrongful conduct, measured by reference to the profits the Defendants extracted from RGC's market-value decline.
2. Reputational / Goodwill Damages Component. RGC could theoretically argue that some portion of the $14.75 million compensates for damage to the Company's corporate goodwill and business reputation — assets that are generally treated as capital assets for federal income-tax purposes. Under Raytheon and its progeny, amounts received as compensation for damage to or destruction of goodwill may receive capital-gain treatment, provided that the taxpayer can demonstrate: (a) the existence of a specific, identifiable capital asset that was injured; and (b) a determinable tax basis in that asset.
However, this argument faces several significant obstacles in RGC's case:
Zero Basis. RGC's goodwill is entirely self-created through decades of operation, brand development, and customer relationships. Self-created goodwill has a zero tax basis for federal income-tax purposes. See IRC § 197(c)(2) (defining "amortizable section 197 intangible" to exclude self-created intangibles in most circumstances); see also Newark Morning Ledger Co. v. United States, 507 U.S. 546, 556 (1993) (discussing the nature of goodwill as an intangible asset). Accordingly, even if a portion of the settlement were allocated to goodwill recovery, the full amount so allocated would be taxable as capital gain — with zero basis to offset — resulting in full taxation regardless of characterization. The only potential benefit would be capital-gain treatment (long-term capital gain, assuming a holding period exceeding one year), but as discussed below, this distinction is of limited value for a C corporation.
IRS Scrutiny. The IRS has historically scrutinized taxpayer-initiated allocations of settlement proceeds to goodwill or other capital assets, particularly where the settlement agreement itself is silent on allocation. See Rev. Rul. 85-98, 1985-2 C.B. 51 (allocation in settlement agreement is not binding on the IRS); Robinson v. Commissioner, 102 T.C. 116 (1994) (taxpayer's intent at the time of filing suit is relevant to the origin-of-the-claim analysis). In the absence of a negotiated allocation in the Settlement Agreement supported by contemporaneous documentation of the parties' intent, the IRS would likely challenge any post hoc allocation to goodwill and treat the entire payment as ordinary income.
Partial Recovery Undermines the Argument. RGC's current market capitalization of approximately $6.1 billion reflects a substantial recovery from the approximately $4.95 billion trough reached in late February 2024 (prior to the regulatory clearances and SEC closure). While the stock has not yet returned to its pre-report level, the partial recovery complicates any argument that the goodwill damage is permanent or that the settlement compensates for a lasting impairment of goodwill value.
For all of these reasons, a goodwill allocation, while theoretically available, is unlikely to withstand IRS scrutiny and would provide minimal tax benefit given RGC's C corporation status.
3. Injunctive / Non-Monetary Relief. The non-monetary components of the settlement — the corrective publication, social media corrective, permanent injunction against republication, and five-year trading bar — have substantial practical and reputational value to RGC but do not have an independently quantifiable monetary value for federal income-tax purposes. The IRS does not generally impute income to a taxpayer based on the receipt of injunctive or declaratory relief in litigation. See Rev. Rul. 75-230, 1975-1 C.B. 93 (injunctive relief obtained in settlement does not give rise to gross income).
These non-monetary components are nonetheless relevant to the overall tax analysis in two respects. First, they support the argument that the monetary payment of $14.75 million does not represent the full value of the settlement to RGC — a point that may be relevant in future discussions with the IRS or in financial reporting contexts. Second, they demonstrate that a meaningful portion of the consideration flowing from the Defendants to RGC is non-monetary in nature, which may be useful in the event the IRS seeks to recharacterize any portion of the payment or challenges the reasonableness of the settlement amount relative to the claimed damages.
However, the non-monetary relief does not directly reduce the amount of taxable income arising from the settlement. The $14.75 million monetary payment remains fully includible in gross income regardless of the existence or value of the non-monetary components.
4. Recommended Allocation. In the absence of a contrary allocation in the Settlement Agreement, the IRS will likely treat the entire $14.75 million as ordinary income to RGC. This result is consistent with the origin-of-the-claim analysis set forth above and represents the most defensible position for RGC's federal income tax return.
The Settlement Agreement as currently drafted does not allocate the $14.75 million among the four causes of action or among different categories of damages. The Mediator's Term Sheet similarly contains no allocation language. Consideration should be given to whether it is advisable — and whether defense counsel at Caldwell, Tseng & Barrow LLP (Raymond Caldwell and Natalie Orenstein) will agree — to include an allocation clause in the Settlement Agreement before execution. However, the parties' interests with respect to allocation may diverge: GPR and Ironclad may prefer to characterize the payments as non-deductible penalties or as punitive in nature (to avoid the deduction on their side under IRC § 162(f)), while RGC would prefer an allocation that maximizes the portion treated as a return of capital or goodwill recovery.
Critically, given that RGC is a C corporation, the distinction between ordinary income and long-term capital gain is less impactful than it would be for an individual taxpayer, a pass-through entity, or a trust. Under current law, both ordinary income and capital gains of C corporations are taxed at the same flat rate of 21% under IRC § 11(b). The primary significance of the ordinary-versus-capital distinction for RGC lies in the potential interplay with: (a) any net operating loss ("NOL") carryforwards that RGC may have (net capital losses can only offset capital gains, not ordinary income, under IRC § 1211(a)); (b) any tax credit limitations that depend on the nature of income; and (c) state income tax treatment, which may differ between ordinary income and capital gains in certain jurisdictions (though this is not currently the case in the states where RGC files). Based on our understanding, RGC does not currently have material NOL carryforwards or capital loss carryforwards, further diminishing the significance of the characterization distinction.
In sum, I recommend that the $14.75 million be reported as ordinary income on RGC's federal income tax return for the taxable year ending December 31, 2025. If the team determines that the marginal benefit of pursuing an allocation is worth the negotiation effort and potential delay, we should engage with Caldwell, Tseng & Barrow promptly, given the January 6 execution target.
D. Insurance Proceeds Component ($10.25 Million from Ironclad)
Of the $14.75 million Settlement Payment, $10.25 million will be funded by Ironclad Surety & Insurance Co. under its Directors & Officers / Media Liability Insurance Policy No. ML-2023-07714, issued to Grizzly Peak Research LLC and Grizzly Peak Capital Partners LP. The remaining $4.50 million will be paid jointly by Grizzly Peak Research LLC and Grizzly Peak Capital Partners LP from their own assets.
From RGC's perspective, the source of the funds — whether from the Defendants' insurer or from the Defendants' own assets — does not alter the tax characterization of the settlement proceeds. The entire $14.75 million is received by RGC as settlement proceeds in satisfaction of its claims against the Defendants, regardless of the funding source. The IRS treats insurance-funded settlement payments identically to payments made directly by the defendant for purposes of the recipient's income-tax analysis. See Treas. Reg. § 1.61-14(a); see also Bankamerica Corp. v. United States, 462 U.S. 122, 130 (1983) (economic substance of the payment, not the identity of the payor, controls tax treatment for the recipient).
It is worth noting, for completeness, that the Ironclad Policy covers GPR — not RGC. RGC's own D&O insurance program is maintained through Atlas National Insurance Group, and RGC's coverage counsel notified Atlas National of the litigation in February 2024. However, no claim was triggered under RGC's own D&O policy, as RGC is the plaintiff, not the defendant, in this action. The Ironclad Policy funds are therefore not insurance proceeds received by RGC under its own policy (which would raise separate tax issues relating to the recovery of previously deducted insurance premiums or the tax-exempt treatment of certain insurance recoveries under IRC § 101), but rather are third-party settlement funds paid on behalf of the Defendants.
IV. Deductibility of RGC's Litigation Costs
A. Calderwood & Harkness Fees and Costs
RGC has incurred the following fees and costs in connection with the Calderwood & Harkness engagement in this matter:
• discounted Hourly Fees: Approximately $2,800,623, representing fees billed at the discounted hourly rates set forth in the December 2023 Engagement Letter (as amended), inclusive of time incurred by partners, associates, paralegals, and litigation support staff through the expected date of settlement execution;
• Success Premium: Approximately $420,093, representing the 15% contingent success premium payable upon execution of a settlement agreement or entry of judgment in RGC's favor, calculated as 15% of the discounted hourly fees incurred ($2,800,623 × 15% = $420,093);
• Costs Advanced: $187,450, comprising expert fees for Dr. Elena Vostrikova and Meridian Forensic Economics LLC ($112,700), deposition transcript costs ($41,200), and e-discovery vendor charges to Evergreen Data Solutions Inc. ($33,550).
Total Calderwood & Harkness fees and costs: approximately $3,408,166.
Under IRC § 162(a), a taxpayer engaged in a trade or business may deduct "all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business." Litigation costs — including attorneys' fees, expert witness fees, deposition costs, and e-discovery expenses — are generally deductible under § 162 when they are incurred in connection with litigation that arises from the taxpayer's trade or business. The origin-of-the-claim doctrine applies to the deductibility analysis in the same manner as it applies to the inclusion analysis: the character of the deduction depends on the nature of the underlying claim.
Here, the underlying litigation arises directly from RGC's trade or business as a gaming company. The GPR reports attacked the integrity of RGC's financial reporting and gaming operations — the core of its business. The litigation was commenced to defend RGC's commercial reputation, protect its regulatory standing, and recover economic losses suffered as a result of the Defendants' tortious conduct. The legal fees incurred by Calderwood & Harkness are therefore ordinary and necessary business expenses deductible under § 162, not capital expenditures that must be capitalized under § 263.
This conclusion is consistent with the treatment of litigation costs in analogous cases. Courts have consistently held that legal fees incurred in defending against attacks on a taxpayer's business reputation, trade practices, or regulatory standing are deductible as ordinary business expenses. See Tellier v. Commissioner, 383 U.S. 687, 689 (1966) ("The federal income tax is a tax on net income, not a sanction against wrongdoing. That principle has been firmly imbedded in the tax statute from the beginning."); Gilmore, 372 U.S. at 49 (litigation costs are deductible under § 162 where the underlying claims arise from the taxpayer's trade or business).
The success premium of $420,093 presents a modest timing question. Under the accrual method of accounting applicable to RGC, an expense is deductible in the taxable year in which "all events have occurred which establish the fact of the liability," the amount of the liability "can be determined with reasonable accuracy," and "economic performance has occurred." IRC § 461(h); Treas. Reg. § 1.461-1(a)(2). The success premium becomes fixed and determinable upon execution of the Settlement Agreement, which is expected to occur on January 6, 2025. Calderwood & Harkness will perform the final billing and issue the success premium invoice shortly after execution. Accordingly, the success premium should be deductible in RGC's FY 2025 tax year, consistent with the timing of the settlement income recognition discussed in Part VII below.
B. Other Professional Costs
In addition to the Calderwood & Harkness fees and costs, RGC incurred $4,627,000 in professional costs from three other service providers in direct response to the GPR reports and the resulting regulatory, investor-relations, and audit challenges. Each category of cost is deductible as an ordinary and necessary business expense under IRC § 162:
Crisis Communications (Crestline Equity Partners Group Inc.): $2,180,000. RGC retained Ashgrove Equity Partners immediately following the publication of the first GPR report on February 7, 2024, to manage investor communications, coordinate media responses, and develop a public relations strategy to mitigate the reputational damage caused by the false reports. Crisis communications and investor relations costs are well-established ordinary and necessary business expenses, deductible under § 162. See Rev. Rul. 92-80, 1992-2 C.B. 57 (public relations expenses deductible where related to the taxpayer's trade or business); see also Treas. Reg. § 1.162-1(a) (advertising and promotional expenses are deductible as ordinary business expenses). These costs were incurred and paid in FY 2024.
Supplemental Forensic Audit (Pinnacle Audit & Advisory LLP): $1,460,000. RGC's independent auditor, Pinnacle Audit & Advisory, performed a supplemental forensic audit of RGC's FY 2023 financial statements, with particular focus on revenue recognition, related-party transactions, and the alleged "Vermilion Holdings LLC" dealings. The supplemental audit was undertaken to refute the GPR allegations, provide evidentiary support for the litigation, and satisfy requests from the NGCB, the SEC, and institutional investors. Audit and accounting fees are deductible as ordinary business expenses under § 162. See Treas. Reg. § 1.162-1(a). These costs were incurred and substantially paid in FY 2024, with a small remaining balance invoiced in early FY 2025.
Gaming Regulatory Counsel (Hargrove & Sato LLP): $987,000. RGC engaged Hargrove & Sato, a gaming-law boutique, to coordinate RGC's response to the NGCB audit of its RNG systems, the NJDGE review, and the MGC inquiries. Hargrove & Sato also managed communications with the SEC's Division of Enforcement in connection with the informal inquiry. Legal fees incurred to maintain gaming licenses and respond to regulatory inquiries are ordinary and necessary business expenses of a gaming company, deductible under § 162. These costs were incurred and paid in FY 2024.
Summary of Total Deductible Professional Costs:
These deductions will partially offset the $14.75 million in taxable settlement income, reducing the net taxable impact of the settlement to approximately $6,715,000 (before considering state taxes and apportionment effects). The resulting estimated federal tax liability on the net settlement income, at the 21% corporate rate, is approximately $1,410,000.
It should be noted that the timing of these deductions varies. The out-of-pocket professional costs ($4,627,000) were largely incurred and paid in FY 2024, while the Calderwood & Harkness fees and costs (approximately $3,408,166) will span FY 2024 and FY 2025 depending on billing cycles. The success premium, as discussed above, will be deductible in FY 2025. To the extent that certain deductions fall in FY 2024 while the settlement income is recognized in FY 2025, there may be a timing mismatch that affects RGC's taxable income in each year. RGC's tax team should model this timing mismatch and consider whether any adjustments are warranted.
C. IRC § 162(f) Considerations
IRC § 162(f), as amended by the Tax Cuts and Jobs Act of 2017 ("TCJA"), disallows deductions for any amount paid or incurred "to, or at the direction of, a government or governmental entity" in relation to "the violation of any law or the investigation or inquiry into the potential violation of any law." The provision was significantly expanded by the TCJA (effective for amounts paid or incurred after December 22, 2017) to cover not only fines and penalties but also certain settlement payments made to governmental entities, including restitution and disgorgement payments, subject to limited exceptions for amounts that constitute restitution (including remediation of property) or amounts paid to come into compliance with a law.
This provision is inapplicable to the present settlement for several independent reasons:
(a) The settlement is a private-party payment between private litigants. No government entity — federal, state, or local — is a party to the Settlement Agreement, a recipient of any portion of the Settlement Payment, or a beneficiary of any component of the settlement relief.
(b) The SEC informal inquiry was closed with no action on August 16, 2024. The SEC's Division of Enforcement confirmed by letter that no enforcement proceeding would be recommended. No governmental fine, penalty, disgorgement order, or other governmental sanction has been assessed against RGC or the Defendants in connection with the matters at issue.
(c) The NGCB, NJDGE, and MGC reviews all concluded without adverse findings or the imposition of any fines, penalties, or remedial requirements.
Accordingly, IRC § 162(f) does not limit the deductibility of any of RGC's litigation costs or the Defendants' settlement payment. All professional costs identified above remain fully deductible under § 162(a) as ordinary and necessary business expenses.
V. State Tax Considerations
A. Nevada. RGC is incorporated in Nevada and maintains its principal executive offices in Las Vegas, Nevada. Nevada does not impose a corporate income tax or a personal income tax, and the settlement proceeds will therefore not be subject to a Nevada income tax.
However, Nevada does impose a Commerce Tax on business entities whose Nevada gross revenue exceeds $4 million in a given fiscal year. Nev. Rev. Stat. § 363C.200. RGC's FY 2023 Nevada gross revenue was approximately $3.42 billion (consolidated), well above the $4 million threshold. The Commerce Tax is imposed at varying rates depending on the taxpayer's industry classification; for the "arts, entertainment, and recreation" category (NAICS 71), the rate is 0.19%.
Settlement proceeds classified as "other income" would not typically constitute "gross revenue" for Commerce Tax purposes, as the Commerce Tax is generally limited to revenue derived from the taxpayer's core business activities in Nevada. See Nev. Rev. Stat. § 363C.040 (defining "gross revenue" for Commerce Tax purposes). However, the Nevada Department of Taxation has not issued specific guidance on the treatment of litigation settlement proceeds under the Commerce Tax, and this question should be confirmed with RGC's Nevada tax advisors. The potential Commerce Tax exposure, even if the settlement proceeds were includible, would be modest — approximately $28,025 ($14.75 million × 0.19%) — but should be addressed for completeness.
B. California. California imposes a franchise tax on corporations doing business in the state, at a rate of 8.84% of net income apportioned to California. Cal. Rev. & Tax. Code § 23151(a). RGC is registered to do business in California and files California franchise tax returns as part of its multi-state filing obligations.
The $14.75 million in settlement proceeds would be subject to California franchise tax to the extent the income is apportioned to California under RGC's existing apportionment formula. California employs a single-sales-factor apportionment formula for most taxpayers (Cal. Rev. & Tax. Code § 25128.7), under which income is apportioned based on the ratio of California sales to total sales. RGC's California sales factor — driven primarily by revenue from its California-adjacent operations and any California-sourced income — will determine the portion of the settlement income apportioned to California.
There is an additional question as to whether the settlement proceeds constitute "business income" or "nonbusiness income" under the Uniform Division of Income for Tax Purposes Act ("UDITPA"), as adopted in California. Business income is apportioned using the sales factor; nonbusiness income is allocated entirely to the state of the taxpayer's commercial domicile (Nevada, in RGC's case). Because the settlement arises directly from RGC's core business operations — the defense of its commercial reputation and the recovery of business losses — the proceeds would most likely be classified as "business income" subject to apportionment. See Cal. Rev. & Tax. Code § 25120(a) (defining "business income" as income arising from transactions and activity in the regular course of the taxpayer's trade or business, including income from tangible and intangible property if the acquisition, management, and disposition of the property constitute integral parts of the taxpayer's regular trade or business operations).
If the settlement income is classified as business income, the portion apportioned to California under RGC's sales factor would be subject to the 8.84% franchise tax rate. RGC's California apportionment percentage should be obtained from CFO Priya Ramaswaran or RGC's state tax advisors to model the California tax exposure.
The deductibility of RGC's litigation costs for California franchise tax purposes generally conforms to the federal treatment under IRC § 162, as California's franchise tax law incorporates the Internal Revenue Code with certain modifications. Cal. Rev. & Tax. Code § 24343 (conforming to IRC § 162 for trade or business expenses). Accordingly, the professional costs identified in Part IV should be deductible for California purposes as well.
C. Other States
RGC operates eleven casino-resort properties across three states: Nevada, New Jersey, and Mississippi. The Company is required to file income or franchise tax returns in each of these states, and potentially in additional states where it has nexus through sales, employees, or other activities.
The settlement proceeds will be subject to apportionment across all filing states under each state's applicable apportionment formula. The key state-specific considerations are as follows:
New Jersey. New Jersey imposes a Corporation Business Tax at a rate of 11.5% (for taxpayers with allocated taxable net income exceeding $1 million, through tax year 2025; the rate is scheduled to decrease to 9.0% for tax years beginning after December 31, 2025, under current law). N.J. Rev. Stat. § 54:10A-5. New Jersey uses a single-sales-factor apportionment formula. The settlement income apportioned to New Jersey under RGC's sales factor would be subject to the applicable corporate tax rate. New Jersey generally conforms to federal treatment of settlement proceeds and litigation cost deductions, with certain modifications.
Mississippi. Mississippi imposes a corporate income tax at a rate of 5% on taxable income exceeding $10,000. Miss. Code Ann. § 27-7-5. Mississippi uses a three-factor apportionment formula (property, payroll, and sales), with sales double-weighted. The settlement income apportioned to Mississippi would be subject to the 5% rate.
A comprehensive multi-state apportionment analysis for the settlement proceeds is beyond the scope of this memorandum and should be performed by RGC's internal tax team or its state and local tax advisors. The firm is available to assist with this analysis if requested.
VI. Financial Reporting Considerations
The tax treatment of the settlement proceeds, while the primary focus of this memorandum, must be coordinated with the financial reporting treatment under U.S. Generally Accepted Accounting Principles ("GAAP").
Under ASC 450, Contingencies (formerly SFAS No. 5), gain contingencies — including anticipated litigation recoveries — should not be recognized in the financial statements until they are realized or realizable. ASC 450-30-25-1 provides that "[a] contingency that might result in a gain usually should not be reflected in the financial statements . . . because to do so might be to recognize revenue before its realization." RGC has likely been disclosing the pending litigation as a gain contingency in the notes to its financial statements, consistent with ASC 450-30-50-1, without recognizing any income.
Upon execution of the Settlement Agreement on January 6, 2025, the gain contingency will be resolved, and RGC should recognize the $14.75 million as income in its FY 2025 financial statements. The settlement income will most likely be reported as "other income" or "gain on litigation settlement" in RGC's consolidated statement of operations. The precise financial statement line item and presentation should be determined in consultation with Pinnacle Audit & Advisory LLP (engagement partner Walter Ng, CPA), in accordance with ASC 450 and any applicable SEC Staff guidance on the presentation of litigation settlements.
Pinnacle Audit & Advisory should also be consulted regarding the following ancillary reporting considerations:
• Tax Provision Impact. The recognition of $14.75 million in settlement income, partially offset by approximately $8.035 million in deductible professional costs, will affect RGC's income tax provision under ASC 740, Income Taxes. The current and deferred tax effects of the settlement should be reflected in RGC's FY 2025 tax provision, including any state income tax effects.
• SEC Disclosure. RGC's obligations as a publicly traded company require disclosure of material litigation outcomes in its periodic filings with the SEC. The settlement will likely be disclosed in the "Legal Proceedings" section of RGC's Annual Report on Form 10-K for the fiscal year ending December 31, 2025, and may require earlier disclosure in a Current Report on Form 8-K (Item 8.01, Other Events) if RGC determines the settlement is material. Given that $14.75 million represents less than 0.25% of RGC's current market capitalization, the materiality determination may turn on qualitative factors — including the significance of the reputational vindication and the public attention given to the GPR reports — rather than quantitative factors alone.
• Confidentiality Tension. The Settlement Agreement contains a confidentiality provision restricting disclosure of the settlement amount. However, SEC reporting obligations supersede contractual confidentiality restrictions to the extent disclosure is required by applicable securities laws and regulations. RGC's VP of Investor Relations, Janelle Hu, and its outside auditors at Pinnacle should coordinate to determine the appropriate level of disclosure, consistent with both the confidentiality provision and SEC requirements. The Settlement Agreement should include a customary carve-out permitting disclosure "as required by law, regulation, or legal process," which the current draft does include.
VII. Timing of Income Recognition
The timing of income recognition for the $14.75 million settlement is an important consideration for RGC's tax planning and financial reporting.
RGC reports on a calendar fiscal year (January 1 through December 31) and uses the accrual method of accounting, as required for publicly traded corporations. Under the accrual method, income is recognized in the taxable year in which "all events have occurred which fix the right to receive such income and the amount thereof can be determined with reasonable accuracy." Treas. Reg. § 1.451-1(a). This is commonly known as the "all events test."
The chronology of the settlement is as follows:
• December 4, 2024: The parties executed the Mediator's Term Sheet at the conclusion of the mediation session before Judge Watanabe (Ret.), reflecting the material economic terms of the settlement, including the $14.75 million payment amount, the funding allocation between Ironclad and the GPR entities, and the principal non-monetary relief components.
• January 6, 2025 (expected): The parties are expected to execute the definitive Settlement Agreement and Mutual Release, which will contain all material terms, representations, warranties, conditions precedent, and release provisions.
• February 5, 2025 (expected): The Settlement Payment of $14.75 million is required to be deposited into escrow at Great Basin Trust Company, N.A., within thirty (30) calendar days of execution of the Settlement Agreement.
The critical question is whether the settlement income should be recognized in FY 2024 (the year the Mediator's Term Sheet was signed) or FY 2025 (the year the definitive Settlement Agreement will be executed and the funds deposited into escrow).
The income should be recognized in FY 2025. The Mediator's Term Sheet, while evidencing the parties' agreement on material terms, is not a binding and enforceable contract in the same manner as the definitive Settlement Agreement. The Term Sheet is subject to the negotiation and execution of a definitive agreement containing additional material terms (including the mutual releases, California Civil Code § 1542 waiver, confidentiality provisions, and conditions precedent to disbursement). Until the Settlement Agreement is executed, RGC does not have a fixed and enforceable right to receive the $14.75 million, and the "all events" test is not satisfied.
Moreover, even if the Mediator's Term Sheet were deemed to establish a binding obligation (which is arguable under California law, depending on the specific language of the Term Sheet and the parties' intent), the amount of the settlement is not determinable with reasonable accuracy until the definitive agreement is executed and the conditions precedent are established. The Target Deposit Date of February 5, 2025 — thirty days after execution — confirms that the parties intended the obligation to become fixed upon execution, not upon signing the Term Sheet.
Accordingly, the $14.75 million should be included in RGC's gross income for the taxable year ending December 31, 2025. This is also consistent with the financial reporting treatment under ASC 450, which would recognize the gain upon execution of the Settlement Agreement (i.e., in FY 2025, assuming a calendar fiscal year).
If any dispute arises regarding the enforceability of the Mediator's Term Sheet — for example, if one of the Defendants seeks to repudiate the Term Sheet before execution of the definitive agreement — the "all events" test would clearly not be satisfied until the dispute is resolved and the definitive Settlement Agreement is executed. This further supports recognition in FY 2025.
VIII. Recommendations
Based on the analysis set forth in this memorandum, I recommend the following action items, which should be addressed before the anticipated Effective Date of January 6, 2025, to the extent practicable:
1. Coordinate with RGC's Tax Advisors and Pinnacle Audit & Advisory LLP. Before the Effective Date, the Calderwood & Harkness team should facilitate a call or meeting among the following stakeholders to discuss the tax and financial reporting treatment of the $14.75 million settlement:
• Walter Ng, CPA, engagement partner at Pinnacle Audit & Advisory LLP (RGC's independent auditor);
• Priya Ramaswaran, CFO of Redstone Gaming Corp.;
• RGC's internal tax team (reporting to the CFO); and
• Francesca Morano and/or Carlos Espinoza from Calderwood & Harkness.
The purpose of this coordination is to ensure alignment between the tax return treatment (ordinary income under § 61; deductions under § 162), the financial statement presentation (gain on litigation settlement under ASC 450), and the SEC disclosure strategy. This coordination should occur as early as possible in the week of December 23, 2024, or immediately following the holiday period, to allow adequate time for any necessary revisions to the Settlement Agreement or related documentation before the January 6 execution date.
2. Evaluate Settlement Agreement Allocation Language. The team should evaluate whether to propose the inclusion of an allocation clause in the Settlement Agreement that assigns specific portions of the $14.75 million to different damage categories (e.g., compensatory damages for lost profits, damages for reputational injury, reimbursement of out-of-pocket costs). Such an allocation would require negotiation with defense counsel at Caldwell, Tseng & Barrow LLP (Raymond Caldwell and Natalie Orenstein) and potentially with Ironclad Surety & Insurance Co. (claims representative Daniel Royce), as the allocation could affect the tax treatment of the payment on the Defendants' and insurer's side. Given RGC's status as a C corporation, where both ordinary income and capital gains are taxed at the uniform 21% federal rate, the benefit of an allocation may be marginal. However, the allocation could have implications for state tax treatment, financial reporting presentation, and future tax audits, and the team should weigh these considerations before deciding.
3. Document the Basis for Deductions. RGC should ensure that all litigation costs, crisis-communications expenses, forensic audit costs, and regulatory counsel fees are properly documented and categorized as ordinary and necessary business expenses under IRC § 162. Specifically:
• All invoices from Calderwood & Harkness, Crestline Equity Partners Group, Pinnacle Audit & Advisory, and Hargrove & Sato should be maintained in RGC's records with clear descriptions of the services provided and their connection to the GPR litigation and related business activities;
• The Calderwood & Harkness engagement letter, as amended, should be reviewed to confirm that the fee structure (Discounted hourly fees plus success premium) is clearly documented;
• RGC's internal tax team should categorize each cost item for tax return purposes and maintain contemporaneous documentation supporting the § 162 deduction.
4. Confirm State Apportionment Treatment. RGC's multi-state operations — encompassing eleven casino-resort properties in Nevada, New Jersey, and Mississippi — require careful apportionment analysis for the settlement proceeds across all filing states. The team should work with RGC's state and local tax advisors to:
• Determine whether the settlement proceeds constitute "business income" or "nonbusiness income" under each state's apportionment rules;
• Calculate the portion of the $14.75 million apportioned to each filing state based on RGC's applicable apportionment factors;
• Model the aggregate state income tax exposure arising from the settlement; and
• Confirm that the Nevada Commerce Tax does not apply to the settlement proceeds.
5. SEC Disclosure Coordination. The team should work with Janelle Hu (VP of Investor Relations) and Pinnacle Audit & Advisory to determine the appropriate level of disclosure in RGC's SEC filings, including:
• Whether a Current Report on Form 8-K is required to disclose the settlement as a material event;
• The appropriate disclosure in the "Legal Proceedings" and "Management's Discussion and Analysis" sections of RGC's upcoming 10-K for FY 2025; and
• The interplay between the Settlement Agreement's confidentiality provision and SEC disclosure obligations, including the adequacy of the carve-out for legally required disclosures.
6. Timing. All tax and financial reporting decisions should be finalized as promptly as possible, and in any event before the escrow deposit deadline of February 5, 2025. Specifically:
• The Settlement Agreement should be finalized and circulated for execution by Jan