T.C. Memo. 1998-240
UNITED STATES TAX COURT
WALTER E. HESS AND HELEN L. HESS, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 8857-97. Filed July 2, 1998.
Milton J. Schubin and Sydney E. Unger, for petitioners.
John Aletta, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
LARO, Judge: Walter E. Hess and Helen L. Hess petitioned
the Court to redetermine respondent's determination of the
following deficiencies in Federal income tax and accuracy-related
penalties under section 6662(a):
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Accuracy-Related Penalty
Sec.
Year Deficiency 6662(a)
1992 $17,970 $3,594
1993 167,629 33,526
Following the parties' concessions, we must decide:
1. Whether section 104(a)(2) excludes from Walter E. Hess's
(Mr. Hess) 1993 gross income $425,000 of settlement proceeds he
received during that year. We hold it does not.
2. Whether Mr. Hess may deduct for 1993 a $170,040
long-term capital loss on his separation from employment with
L.G. Balfour Co. (Balfour). We hold he may not.
3. Whether Mr. Hess is liable for the accuracy-related
penalty determined by respondent under section 6662(a) for 1993.
We hold he is.
Unless otherwise indicated, section references are to the
Internal Revenue Code in effect for the years in issue. Rule
references are to the Tax Court Rules of Practice and Procedure.
Dollar amounts are rounded to the nearest dollar. Although
Helen L. Hess (Mrs. Hess) is a copetitioner, for simplicity and
clarity, we refer to Mr. Hess as the sole petitioner.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
The stipulations of fact and the exhibits submitted therewith are
incorporated herein by this reference. Petitioner and Mrs. Hess
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resided in Darien, Connecticut, when they petitioned the Court.
They filed 1992 and 1993 Forms 1040, U.S. Individual Income Tax
Returns, using the filing status of "Married filing joint
return". Petitioner graduated from Duke University with a
bachelor of arts degree in business.
Balfour employed petitioner from November 10, 1969, through
June 14, 1991, as a commercial representative. Balfour
manufactured and sold award items, such as jewelry, plaques, and
trophies, and petitioner had the exclusive right to sell
Balfour's products in New York City and certain surrounding
areas. For each Balfour product sold in petitioner's sales
territory, Balfour paid him a commission equal to the difference
between the price paid by the purchaser and the price charged
petitioner. Balfour issued petitioner Forms W-2, Wage and Tax
Statements, listing the total commissions that it paid him during
each year.
Balfour let its retiring salesmen sell their sales
territories to other Balfour salesmen. On January 1, 1971,
Louis S. Myers (Mr. Myers), a retiring salesman, sold petitioner
the exclusive right to service Balfour's New York City sales
territory. Pursuant to the sale, Mr. Myers transferred his sales
accounts to petitioner from January 1, 1971, through December 31,
1973, and petitioner received credits to his commission account
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for sales on these accounts after their transfer. Mr. Myers
received payments (known as equity payments) equal to the sum of
(1) the commissions credited to his account for orders entered on
the transferred accounts in the year before their transfer to
petitioner and (2) the commissions credited to petitioner's sales
account during 1970 from accounts transferred to him before 1970.
The equity payments were made in five equal annual installments
by way of offsetting debits and credits that Balfour posted to
the commission accounts that it maintained for petitioner and
Mr. Myers. Balfour did not include the debited commissions in
the commissions shown on petitioner's Forms W-2.
Sometime during 1989 or 1990, petitioner and Balfour entered
into a dispute over petitioner's commissions. The dispute
centered mainly on petitioner's accounts with AT&T, Prudential,
and the New York Giants and on a $281,773 commission that Balfour
had mistakenly paid petitioner during 1990. Petitioner also was
unhappy with the way Balfour manufactured and delivered its
products to customers in his sales territory.
During May 1991, petitioner talked to Robbins, Inc.
(Robbins), a competitor of Balfour, about leaving Balfour to work
for Robbins. One month later, on June 14, 1991, petitioner
resigned from Balfour and began working for Robbins as a sales
representative. Petitioner continued to work for Robbins through
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1993 and beyond, and he continued to sell award products to
customers which he had previously serviced for Balfour.
Also on June 14, 1991, petitioner filed suit in Federal
District Court (the District Court) against Balfour and its
parent corporation, Town & Country Corp. (T&C). Petitioner's
complaint and amended complaint asserted claims mainly for:
(1) Breach of contract, (2) destruction of his equity in his
sales territory, (3) failure to pay wages under Connecticut law,
(4) unlawful deductions from wages in violation of Connecticut
law, (5) conversion, and (6) constructive discharge. Neither the
complaint nor the amended complaint alleged that Balfour or T&C
caused petitioner to suffer a physical or emotional injury, and
neither pleading prayed for damages from such an injury. In
their answers, Balfour and T&C denied the material allegations
set forth in petitioner's pleadings, and they asserted various
affirmative defenses and counterclaims against him for breach of
contract, conversion, replevin, unjust enrichment, breach of duty
of loyalty, tortious interference, and unfair competition.
On March 13, 1992, petitioner served Balfour with
interrogatory responses identifying and describing his requested
damages to include: (1) $3,012,793 for breach of contract,
(2) $1.2 million for lost equity, (3) $9,359,849 for failure to
pay wages; (4) $1,262,448 for unlawful deduction from wages,
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(5) $12,594,636 for conversion of commissions, (6) $1,756,147 for
equity in sales territory, and (7) $4,108,158 for constructive
discharge. Petitioner alleged that his damages for constructive
discharge were: (1) $2,352,011 in commissions owed him for
Prudential, AT&T, the New York Giants, and NBA contracts and
(2) lost equity payments of $1,756,147 from not being allowed to
retire under Balfour's equity program. Petitioner did not assert
any claim for damages for a physical or emotional injury
purportedly caused by Balfour.
Balfour and petitioner both moved for summary judgment on
petitioner's claims of lost equity, statutory wage violations,
and conversion, and petitioner also moved for summary judgment on
all of Balfour's counterclaims. On December 16, 1992,
petitioner, through his attorney, submitted a document to the
District Court explaining his position on his claims. This
document addressed petitioner's claims for: (1) Commissions owed
on the AT&T, Prudential, and the New York Giants contracts,
(2) lost commissions on NBA accounts removed from his sales
territory, (3) lost equity in his sales territory, (4) violations
of Connecticut wage statutes, (5) conversion, (6) wrongful
discharge, and (7) Balfour's counterclaims. The document did not
address any physical or emotional injury purportedly suffered by
petitioner.
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On April 26, 1993, Balfour offered petitioner $500,000 to
settle the litigation. The offer was made to compensate
petitioner for his alleged lost commissions and equity.
Petitioner rejected Balfour's offer, and he made a counteroffer
of $1.86 million based on the following claims: (1) AT&T
contract commissions of $465,000, (2) Prudential contract
commissions of $122,000, (3) the New York Giants contract
commissions of $50,000, (4) NBA accounts of $15,000, (5) All-Star
game commissions of $5,000, (6) pipeline commissions of $14,400,
(7) chargebacks of $5,000, (8) lost equity of $660,000, and
(9) litigation costs of $125,000.
Later, on or about May 5, 1993, the District Court granted
summary judgment in Balfour's favor on petitioner's claims that
equity in his sales territory had been destroyed and that Balfour
violated Connecticut's wage laws. The wage claims were denied
because the court concluded that Massachusetts, rather than
Connecticut, law applied. In denying the equity claim, the court
held that petitioner had not suffered a loss because he continued
to service his former accounts after leaving Balfour. The
District Court also denied petitioner's motion for summary
judgment on his claims of breach of contract, conversion, and
constructive discharge, and it denied his motion for summary
judgment on all of Balfour's counterclaims except for replevin.
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On June 30, 1993, after petitioner had moved the District Court
to reconsider and clarify its rulings, the court affirmed its
rulings stating that petitioner's claims for lost equity, whether
explicitly or implicitly raised, were all dismissed.
On June 2, 1993, after receiving the court's ruling on the
summary judgment motions, Balfour rejected petitioner's $1.86
million offer and offered to settle the litigation for $200,000.
This offer included compensation for lost commissions; it did not
include any compensation for a purported constructive discharge
or physical or emotional injury. Petitioner rejected this offer.
On or about August 26, 1993, petitioner served additional
interrogatory responses upon Balfour's attorney identifying his
damages as follows: (1) $2,118,180 for breach of contract,
(2) $5,848,501 for failure to pay wages, (3) $294,136 for
unlawful deduction from wages, (4) $5,317,121 for conversion of
commissions, (5) $2,497,734 for equity in sales territory, and
(6) $7,968,252 for constructive discharge. Petitioner alleged
that his damages for constructive discharge were: (1) $152,092
for commissions earned before June 14, 1991, (2) $421,440 for
commissions earned after July 1, 1991, through December 31, 1993,
under the AT&T contract, (3) $88,478 for commissions earned from
June 15 through December 31, 1991, under the Prudential contract,
(4) $2,497,734 in earned equity payments, (5) $2,812,508 in lost
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future earnings representing the amount petitioner would have
earned if he had worked for Balfour until age 65, and (6) $2
million in emotional distress.
Shortly after the additional interrogatory responses were
served on Balfour's attorney, but before she had read them,
Balfour and petitioner agreed to settle the litigation by having
Balfour pay petitioner $550,000. Balfour intended that this
payment would compensate petitioner for commissions purportedly
owed him, primarily on the AT&T account; it was not intended to
compensate petitioner for a purported constructive discharge or
physical or emotional injury. At the time of settlement, neither
Balfour nor its attorney knew that petitioner was claiming
damages for an emotional injury, and petitioner had never given
Balfour any reports detailing such an injury.
Beginning in mid-September 1993, the attorneys for Balfour
and petitioner began discussing the language to be used in the
settlement agreement, and the attorneys exchanged drafts of the
agreement. Petitioner's attorney asked that the agreement
allocate $425,000 of the $550,000 settlement payment to a claim
for constructive discharge and that the remaining $125,000 be
allocated to attorney's fees. Petitioner's attorney made this
request because petitioner's accountant had advised the attorney
that such an allocation would render the settlement proceeds
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nontaxable. To satisfy the concerns of Balfour's attorney that
such an allocation could expose Balfour to liability,
petitioner's attorney agreed to insert language in the agreement
stating that petitioner would indemnify Balfour for any Federal
income tax liability asserted against Balfour for unpaid Federal,
State, or local taxes owed on the settlement payment to
petitioner.
On November 30, 1993, petitioner and Balfour signed a
settlement agreement. Paragraph 1 stated that petitioner would
receive $425,000 and that his attorneys would receive $125,000.
The agreement stated that the $425,000 payment settled
claims for compensatory damages arising out of alleged
wrongful discharge, * * * [and]
* * * * * * *
Neither this Agreement nor any action on the part of
Balfour or Town & Country required by the Agreement,
nor the allocation or description of the Settlement
Amount as recited in paragraph 1 hereof, constitutes an
admission by Balfour or Town & Country of any unlawful
or tortious action.
The latter language was placed in the agreement as a caveat to
the statement in paragraph 1 that the settlement payment was made
to compensate petitioner for his claim of wrongful discharge.
The agreement also let petitioner represent Balfour's competitors
and sell non-Balfour products or services to Balfour's customers
in the New York City territory.
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On December 6, 1993, Balfour issued petitioner a check for
$425,000, and it issued his attorneys a check for $125,000.
Balfour later issued petitioner a Form 1099-MISC, Miscellaneous
Income, reflecting the settlement payment, and it deducted the
settlement amount on its Federal income tax return as a
commission expense.
Petitioner's 1992 Form 1040 claimed a deduction for legal
fees of $95,274 from the Balfour litigation. His 1993 Form 1040
did not report any of the settlement payment as income, claiming
that it was nontaxable. The 1993 Form 1040 claimed a long-term
capital loss of $170,040 in connection with petitioner's
termination of employment from Balfour.
Respondent determined that section 104(a)(2) did not apply
to exclude the $425,000 payment from petitioner's 1993 gross
income. Respondent also determined that petitioner could not
deduct the claimed loss because: (1) He had not established his
basis in the underlying asset and (2) he had not established that
his right to sell products in New York City became worthless
during 1992 or 1993.
OPINION
1. Taxability of Settlement Proceeds
We must decide whether petitioner received any of the
settlement proceeds on account of a personal injury. To the
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extent that he did, the funds are excludable from his gross
income. Sec. 104(a)(2). To the extent that he did not, the
funds are includable in his gross income. Sec. 61(a). Because
respondent determined that none of the proceeds are excludable
from petitioner's gross income under section 104(a)(2),
petitioner must prove otherwise. Rule 142(a); Welch v.
Helvering, 290 U.S. 111, 115 (1933); Robinson v. Commissioner,
102 T.C. 116, 124 (1994), affd. in part, revd. in part on an
issue not relevant herein and remanded 70 F.3d 34 (5th Cir.
1995).
Petitioner argues that the settlement proceeds are
excludable from his gross income because the settlement agreement
states explicitly that he received the proceeds for a personal
injury. Petitioner alleges that his litigation with Balfour was
adversarial and that he entered into the allocation set forth in
the settlement agreement to "maximize his relatively meager
recovery". Petitioner alleges that his cause of action against
Balfour for constructive discharge was real. Respondent argues
that none of the $425,000 is excludable from petitioner's gross
income because none of it was paid to him for a personal injury.
Respondent argues that the allocation set forth in the settlement
agreement should be disregarded because it was not the product of
arm's-length negotiations between Balfour and petitioner.
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We agree with respondent that the allocation in the
settlement agreement does not control our decision herein, and
that none of the settlement proceeds are excludable from
petitioner's gross income under section 104(a)(2). Under
section 104(a)(2), settlement proceeds are excluded from gross
income to the extent that: (1) The cause of action underlying
the recovery of the proceeds is based upon tort or tort type
rights and (2) the proceeds are received on account of a personal
injury or sickness. Section 104(a)(2) is inapplicable when
either of these requirements is not met. Sec. 104(a)(2);
Commissioner v. Schleier, 515 U.S. 323, 336-337 (1995);
United States v. Burke, 504 U.S. 229, 233 (1992); sec. 1.104-
1(c), Income Tax Regs.
The nature of the claim underlying a damage award, rather
than the validity of the claim, determines whether damages fall
within this two-part test. United States v. Burke, supra at 237;
Robinson v. Commissioner, supra at 125-126. Ascertaining the
nature of the claim is a factual determination that is generally
made by reference to the settlement agreement, in light of the
facts and circumstances surrounding it. Key to this
determination is the "intent of the payor" in making the payment.
Knuckles v. Commissioner, 349 F.2d 610, 613 (10th Cir. 1965),
affg. T.C. Memo. 1964-33; Agar v. Commissioner, 290 F.2d 283, 284
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(2d Cir. 1961), affg. per curiam T.C. Memo. 1960-21; Seay v.
Commissioner, 58 T.C. 32, 37 (1972). We ask ourselves: "In lieu
of what were the damages awarded?" Robinson v. Commissioner,
102 T.C. at 126-127, and the cases cited thereat. Although the
payee's belief is relevant to this inquiry, the ultimate
character of the payment rests on the payor's dominant reason for
making the payment. See Agar v. Commissioner, supra at 284;
Fono v. Commissioner, 79 T.C. 680 (1982), affd. without published
opinion 749 F.2d 37 (9th Cir. 1984). A payor's intent may
sometimes be found in the characterization of the payment in a
settlement agreement (or other executed document), but such a
characterization is not always dispositive, for example, when the
record proves the characterization inconsistent with the
realities of the settlement. Bagley v. Commissioner, 105 T.C.
396, 406 (1995), affd. 121 F.3d 393 (8th Cir. 1977); Robinson v.
Commissioner, supra; Threlkeld v. Commissioner, 87 T.C. 1294,
1306-1307 (1986), affd. 848 F.2d 81 (6th Cir. 1988); see Knuckles
v. Commissioner, supra at 613; Eisler v. Commissioner, 59 T.C.
634, 640 (1973).
Petitioner argues that the settlement agreement in issue
characterizes Balfour's reason for making the settlement payment
to petitioner as compensation for a personal injury. We read the
record, however, not to support this characterization. In
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contrast with petitioner's argument that Balfour paid him the
settlement as compensation for a personal injury, we find that
Balfour's dominant reason for paying the settlement was to
compensate petitioner for commissions which Balfour could be
called upon to pay him in the event he prevailed in the District
Court suit.
Petitioner focuses only on the settlement agreement and asks
the Court to do likewise. We decline to do so. In Robinson v.
Commissioner, supra, the taxpayers sued a State bank for failing
to release a lien on their property. After the jury returned a
verdict in their favor for approximately $60 million, including
$6 million for lost profits, $1.5 million for mental anguish, and
$50 million in punitive damages, the parties to that proceeding
settled. In the final judgment reflecting the settlement, which
was drafted by the parties and signed by the trial judge,
95 percent of the settlement proceeds was allocated to mental
anguish and 5 percent was allocated to lost profits. We held
that this allocation did not control the taxability of the
proceeds to the taxpayers. We noted that the allocation was
"uncontested, nonadversarial, and entirely tax motivated", and
that it did not accurately "reflect the realities of * * * [the
parties'] settlement." Id. at 129.
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The same is true here. While the underlying litigation was
certainly adversarial, the parties were no longer adversaries
after they agreed on a settlement in principle. Petitioner
wanted the settlement payment connected to a tort so that he
could maximize his recovery by avoiding taxes on his recovery.
Balfour, on the other hand, did not care whether the settlement
proceeds were allocated to tortlike personal injury damages
vis-a-vis other damages. Balfour's only concerns were that all
of petitioner's claims be settled, that nothing be done to
compromise its right to deduct the settlement, and that it be
indemnified for any tax liability resulting from a
mischaracterization of the settlement payment. Balfour, in
effect, gave petitioner the green light to allocate the proceeds
unilaterally in the manner that he desired, and petitioner did
so, allocating the payment in a way that would maximize his
recovery to the neglect of the fisc. Petitioner and Balfour did
not prepare the settlement agreement by realistically evaluating
the damages claimed in the lawsuit and allocating petitioner's
recovery accordingly. Nor did the attorneys for the parties
there ever discuss the merits of petitioner's constructive
discharge claim. As a matter of fact, neither Balfour nor its
attorney was even aware that petitioner had just recently made a
new claim for $2 million in emotional distress.
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In a setting such as this, where the parties to a settlement
agreement fail to reflect their agreement accurately in a written
document, we will not accept the allocation set forth in that
document. That petitioner may have wanted the payment to be
characterized as compensation for a tortlike personal injury does
not govern the taxation of the payment for purposes of section
104(a)(2). The taxability of the payment, as discussed above,
turns on the payor's intent. Because none of the $425,000
payment compensated petitioner for a tortlike personal injury, we
hold for respondent on this issue. None of the $425,000 payment
is excludable under section 104(a)(2); i.e., the payment is fully
taxable under section 61(a). As conceded by respondent as a
result of this holding, petitioner may deduct for 1992 $95,274 of
legal expenses connected with the lawsuit.
2. Deduction of Long-Term Capital Loss
Petitioner must disprove respondent's determination that he
may not deduct his reported capital loss of $170,040. Rule
142(a); Welch v. Helvering, 290 U.S. at 115. Deductions are a
matter of legislative grace, and petitioner must show that his
claimed loss falls within the terms of the statute. New Colonial
Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). Petitioner
argues that he may deduct the loss because he lost the exclusive
sales territory that he purchased from Mr. Myers.
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We disagree with petitioner's claim that he may deduct his
reported loss of $170,040. An individual may deduct an uninsured
loss sustained during the taxable year if the loss was incurred:
(1) In a trade or business or a for-profit transaction or (2) on
account of a casualty or theft. Sec. 165(a), (c). A loss "must
be evidenced by closed and completed transactions, fixed by
identifiable events, and * * * actually sustained during the
taxable year." Sec. 1.165-1(b), Income Tax Regs; see also
sec. 1.165-1(d)(1), Income Tax Regs. The deduction for a loss is
limited to the individual's basis in the underlying asset, as
determined under section 1011, see sec. 165(b); Leighton v.
Commissioner, T.C. Memo. 1995-515, affd. without published
opinion 108 F.3d 332 (5th Cir. 1997); Fisher v. Commissioner,
T.C. Memo. 1986-141; sec. 1.165-1(c), Income Tax Regs., and the
individual bears the burden of proving his or her basis,
Millsap v. Commissioner, 46 T.C. 751, 760 (1966), affd. 387 F.2d
420 (8th Cir. 1968). A loss cannot be computed where the
individual's basis in the asset is not proven. Towers v.
Commissioner, 24 T.C. 199, 239 (1955), affd. on other grounds sub
nom. Bonney v. Commissioner, 247 F.2d 237 (2d Cir. 1957); Heckett
v. Commissioner, 8 T.C. 841 (1947); see also Fisher v.
Commissioner, supra.
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Petitioner has not established that his separation from
employment with Balfour caused him to incur a loss during 1993 on
his New York City sales territory. In fact, a similar claim by
petitioner was rejected by the District Court when it ruled that
petitioner incurred no loss of equity in his sales territory
because he continued to service accounts in that territory after
leaving Balfour. As the court stated:
Hess argues that even though he has taken his accounts
to a Balfour competitor, Balfour must compensate him
for his equity. In reality, what Hess bought in 1971
from Mr. Myers was the right to service accounts in a
specific territory. To now take those accounts from
that territory, yet demand payment from Balfour for the
value of the territory, flies in the face of contract
law, not to mention common sense.
Petitioner also has not proven that he has a basis in the
sales territory. Petitioner "paid" Mr. Myers for this territory
with income that was not previously taxed to petitioner.
Petitioner's "payments" were made through debits to his sales
account, and these debits were not included as taxable income on
the Forms W-2 that Balfour issued to him. Nor does the record
reveal that petitioner otherwise reported these debits as income
on his returns. Because petitioner's "payments" for his sales
territory were not included in his gross income, he lacks a basis
therein which, in turn, precludes him from deducting a loss on
its alleged destruction.
3. Accuracy-Related Penalty
Respondent determined that petitioner is liable for an
accuracy-related penalty for negligence under section 6662(a) for
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1993. Section 6662 imposes an accuracy-related penalty equal to
20 percent of any portion of an underpayment of tax that is
attributable to negligence or disregard of rules or regulations.
See sec. 6662(a) and (b). The term "negligence" means "any
failure to make a reasonable attempt to comply with the
provisions of [the Code]". Sec. 6662(c). This includes any
failure to exercise due care or to do what a reasonable and
ordinarily prudent person would do under the circumstances.
See Rybak v. Commissioner, 91 T.C. 524, 565 (1988); Neely v.
Commissioner, 85 T.C. 934, 947 (1985). The term "disregard"
includes any careless, reckless, or intentional disregard.
Sec. 6662(c).
Petitioner must prove respondent's determination of
negligence wrong. Rule 142(a); Bixby v. Commissioner, 58 T.C.
757, 791 (1972). Petitioner's complete argument against this
penalty is: "As the foregoing discussion and Proposed Findings
demonstrate, * * * [petitioner] had a solid basis for * * * [his]
tax position. No grounds exist for imposing penalties under IRC
§ 6662(a)." We disagree; we are unable to find that petitioner
had a solid basis for his positions herein. Petitioner is a
sophisticated and longtime businessman who holds a business
degree from Duke University. Yet he deliberately painted his
settlement agreement with Balfour to appear that he received the
settlement payment for a personal injury although he knew that
the payment was intended to compensate him for taxable
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commissions. He also claimed a deduction for a $170,040 loss on
his sales territory, knowing that he had no basis therein, that
he still worked in this territory after leaving Balfour, and that
the District Court had rejected his claim to have suffered such a
loss. We conclude that petitioner is liable for the accuracy-
related penalty determined by respondent under section 6662(a)
for 1993.
In reaching all our holdings herein, we have considered all
arguments made by petitioner and, to the extent not discussed
above, find them to be without merit. To reflect the foregoing,
Decision will be entered
under Rule 155.