T.C. Memo. 1998-362
UNITED STATES TAX COURT
SUDHIR P. SRIVASTAVA AND ELIZABETH S. PASCUAL, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 26605-95. Filed October 6, 1998.
Michael D. Cropper, for petitioners.
W. Mark Scott, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
PARR, Judge: Respondent determined deficiencies in, and
penalties on, the Federal income tax for 1991 and 19921 of Sudhir
P. Srivastava (petitioner) and Elizabeth S. Pascual (Pascual) as
follows:
Accuracy-Related Penalty
Year Deficiency Sec. 6662(a)
1991 $1,188,920 $237,784
1992 33,037 6,607
1
The deficiency for 1992 is for petitioners' short taxable
year that began on Jan. 1, 1992, and ended July 7, 1992.
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All section references are to the Internal Revenue Code in
effect for the taxable years in issue, and all Rule references
are to the Tax Court Rules of Practice and Procedure, unless
otherwise indicated. All dollar amounts are rounded to the
nearest dollar, unless otherwise indicated.
The issues for decision are: (1) Whether petitioners may
exclude from their gross income contingent fees of $3,455,500
paid to their attorneys from the settlement proceeds of
petitioner's personal injury suit. We hold they may not. (2)
Whether under section 104(a)(2) petitioners may exclude from
their gross income the entire amount of the settlement petitioner
received in 1991. We hold a portion of the amount petitioner
received in settlement is attributable to punitive damages and
interest and is taxable income to petitioners in the year it was
received. (3) Whether petitioners may deduct the attorney's fees
under section 162(a). We hold they may not deduct the attorney's
fees under section 162(a), but they may deduct the fees under
section 212(1), to the extent set out below. (4) Whether
petitioners are liable for an accuracy-related penalty pursuant
to section 6662 for 1991 and 1992. We hold they are to the
extent set out below.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
The stipulated facts and the accompanying exhibits are
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incorporated into our findings by this reference. Petitioners
were husband and wife during the taxable years at issue and filed
1991 and 1992 Forms 1040, U.S. Individual Income Tax Return,
using the status of "Married filing joint return". At the time
the petition in this case was filed, petitioners resided in
Midland, Texas.
Petitioner and Pascual are medical doctors. In 1970,
petitioner graduated from a medical school in India. He came to
St. Louis in 1972 for a residency in general surgery and later
went to Canada to complete a residency in general and
cardiothoracic surgery. In 1981, petitioner returned to the
United States to practice medicine in Texas. Petitioner is
certified as having an adequate level of training and practice
for the cardiac surgery specialty by the American Board of
Specialties Surgery and by the American Board of Thoracic
Surgery.
The Lawsuit
In 1984 and 1985, petitioner was practicing as a
cardiovascular thoracic surgeon in San Antonio, Texas. On
February 8, 1985, a San Antonio television station, KENS-TV,
began broadcasting a series of investigative reports about
petitioner and his practice entitled "A Second Opinion". KENS-TV
is a wholly owned subsidiary of Harte-Hanks Television, Inc.,
which in turn is owned by Harte-Hanks Communications, Inc.
(Harte-Hanks Television, Inc., and Harte-Hanks Communications,
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Inc., are referred to hereinafter as Harte-Hanks). The reports
claimed that petitioner performed unnecessary surgery and
delivered poor quality medical care; the reports alleged acts
that would be criminal under the laws of Texas. As a result of
the broadcast reports, petitioner's reputation and medical
practice were destroyed, his hospital privileges were revoked,
his medical malpractice insurance was canceled, and he was
subjected to multiple malpractice suits.
After the series aired, petitioner brought suit in the 224th
Judicial District Court of Bexar County, Texas, based upon
defamation due to libelous and false statements, invasion of
privacy, infliction of emotional distress, tortious interference
with contracts, libel per se, and loss of medical practice,
patients, and potential patients.2 Petitioner pled for actual
damages in an amount in excess of $8,500,000 and punitive damages
in an amount in excess of $2 million, with prejudgment interest
on damages, and interest on the judgment at the legal rate from
date of judgment.
The case was tried before a jury in San Antonio during March
and April 1990 resulting in a verdict on April 10, 1990. The
jury found that the broadcast series was defamatory and false,
impeached the honesty, integrity, virtue, or professional
2
The suit was styled Sudhir Srivastava, M.D. vs. Harte-
Hanks Television, Inc. d/b/a KENS-TV and Harte-Hanks
Communication, Inc..
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reputation of petitioner, and exposed him to public hatred,
ridicule, or financial injury; and that the television station
acted with knowledge of the falsity or with reckless disregard
for the truth or falsity of the subject matter of the broadcasts.
The jury also found that the series constituted an intentional
infliction of emotional distress and trauma on petitioner.
The jury awarded petitioner $11,500,000 in actual damages,
composed of the following amounts: $1,750,000 for loss of past
earnings from his medical practice, $5 million for loss of future
earning capacity, $1 million for past mental anguish, including
embarrassment and humiliation, $500,000 for future mental
anguish, $1,500,000 for loss of past reputation, and $1,750,000
for future loss of reputation. In addition, the jury awarded
punitive damages of $17,500,000, bringing the total award to $29
million, plus interest.
Petitioner moved for a posttrial amendment of his pleadings
to allow for damages in excess of $10,500,000, the total amount
he initially sought in his suit, and the court allowed petitioner
to amend his pleadings to conform to the adduced proof and the
jury's verdict. The district court then entered judgment (the
judgment).
Of the $11,500,000 in actual damages, the court found that
$4,250,000 represented actual damages that had occurred between
the date of the broadcast and the date of the judgment.
Prejudgment interest of $2,597,201 had accrued on this portion of
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the award, which brought the total actual damages and prejudgment
interest to $14,097,201 and the total actual and punitive damages
and prejudgment interest to $31,597,201. Postjudgment interest
of 10 percent per annum as provided by Texas law was ordered to
be paid on this total sum.
After the judgment was entered, Harte-Hanks moved for a new
trial, but its motion was denied on June 15, 1990. On August 3,
1990, Harte-Hanks appealed the case to the Court of Appeals for
the Fourth Court of Appeals District, San Antonio.3 However,
while the appeal was pending, the parties agreed to settle.
The Insurance Coverage
Harte-Hanks' insurance coverage, which insured it against
loss attributable to petitioner's claims against it, was
"tiered". That is, no insurance company provided coverage for
the full range of Harte-Hanks' potential liability; rather,
insurance was provided by several companies, and each insurance
company provided coverage for a defined level of liability. The
television station's insurance coverage was provided as follows:
Insurance Company Layer of Insurance Coverage
Lower Tier
Continental Casualty Co. (Continental) First $2 million
American Casualty Company1 Same as Continental
Mission Insurance Company (Mission) $2 million to $7 million
Western Employer's Casualty (Western) $7 million to $12 million
3
This case was styled Harte-Hanks Television, Inc. and
Harte-Hanks Communications, Inc. (Appellants) vs. Sudhir
Srivastava, M.D. (Appellee).
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Columbia Casualty Company (Columbia) $12 million to $22
million
Hudson Insurance Company (Hudson) Co-insurer with Columbia
Upper Tier
Federal Insurance Company (Federal) Above $22 million
1
Continental and American Casualty hereinafter are
collectively referred to as Continental.
After the judgment had been communicated to the insurance
companies, and while the appeal of the judgment was pending,
petitioner learned that Mission had been declared insolvent, and
Western was functionally insolvent. The insolvency of these two
companies created an uninsured gap in Harte-Hanks' coverage
between the $2 million and $12 million levels, which Harte-Hanks
had to cover to activate coverage at the upper levels.
The Settlement Agreement
On January 17, 1991, after prevailing at the trial level but
before he was aware that the two insurance companies were
insolvent, petitioner attempted to settle the entire case with
Harte-Hanks for $21 million; $9,500,000 to settle the actual
damages and $11,500,000 to settle the punitive damages. Although
this offer was rejected, the parties continued to negotiate.
On February 25, 1991, after he became aware of the insurance
companies' insolvency, petitioner authorized his attorneys to
settle with the lower tier insurance companies (the first $22
million of coverage) for $8,500,000, and to make a demand for
settlement upon the upper tier insurance company (Federal) for
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$2 million. On March 14, 1991, upon authorization of petitioner,
a partial settlement agreement (the agreement) was entered into
by petitioner, petitioner's attorneys, and Harte-Hanks.
The agreement provided for a payment to petitioner of
$8,500,000 from Harte-Hanks and its insurers. Of that amount,
Continental agreed to pay $2,100,000, and Harte-Hanks agreed to
pay $1 million to settle the first $7 million in principal
liability of the judgment. Harte-Hanks agreed to pay $2,400,000
to settle the principal amount of the judgment between $7 million
and $12 million, and to the extent necessary, to settle all
postjudgment interest liability on the first $22 million of the
judgment. Columbia and Hudson agreed to pay $3 million to settle
the principal amount of the judgment between $12 million and $22
million.
In reaching agreement, none of the payors considered whether
the amounts they were paying were for actual or punitive damages.
Nor did the payors or petitioner discuss any allocation of the
settlement amount between actual or punitive damages. Instead,
the parties regarded the judgment as a claim that totaled in
excess of $31 million, considered the tiered structure of the
insurance coverage, and tried to work out a settlement that
preserved petitioner's claim against the upper tier insurer and
resolved his claim against the lower tier insurers.4
4
Federal did not participate in the settlement
negotiations, nor did it join in the appeal of the trial court's
judgment. After the agreement was entered into, Federal filed a
(continued...)
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The Contingency Fee
Although petitioner was represented at trial by the law firm
of Branton & Hall, petitioner was initially represented in his
suit by "Racehorse" Haynes and his law firm (the Haynes Firm).
Petitioner's payment agreement with the Haynes firm was a
straight fee arrangement. However, due to difficulties
associated with the dissolution of the Haynes firm, petitioner's
case languished. By the time petitioner hired Branton & Hall on
May 30, 1989, he could not afford to pay the attorneys by the
hour; therefore, he agreed to a contingency fee arrangement.
The payment arrangement was characterized by Jim Branton
(Branton) as a "standard contingent fee arrangement". In
addition to providing that all expenses necessary to prepare the
case for settlement or trial, as well as expenses for trying the
case, were to be paid by the client, the fee contract provided in
relevant part that
the undersigned, hereinafter called CLIENTS, employ the
law firm of BRANTON & HALL, P.C., hereinafter called
ATTORNEYS, understanding that the legal services
rendered and to be rendered will be by ATTORNEYS of the
professional corporation at its discretion. CLIENTS
hereby sell, convey, and assign to BRANTON & HALL,
P.C., as consideration for said services a forty
percent (40%) interest in and to any and all causes of
action, claims, demands, judgment or recoveries which
4
(...continued)
motion seeking a declaratory judgment that it had no liability
for insurance coverage for any loss or damages arising out of the
judgment obtained against Harte-Hanks by petitioner.
Federal's motion was granted, and a judgment was entered on
Apr. 24, 1992, and subsequently affirmed by the Court of Appeals
for the Fifth Circuit. Federal Ins. Co. v. Srivastava, 2 F.3d 98
(5th Cir. 1993).
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CLIENTS may hold or receive because of damages and
injuries received and sustained by DR. SUDHIR
SRIVASTAVA and DR. ELIZABETH PASCUAL as a result of the
television broadcasts on Channel 5 in February 1985.
* * * * * * *
It is further agreed that this Contract does not
include the appeal of any Judgment, and in the event of
an appeal from any Judgment, CLIENTS shall advance the
anticipated costs of appeal and the percentage
contingent fee interest shall be increased from forty
percent (40%) to fifty percent (50%).
Later, while the settlement negotiations were in progress,
Branton & Hall hired Franklin S. Spears (Spears) in an of-
counsel capacity to aid the firm with the appeal of petitioner's
suit. Spears was also paid on a contingency fee basis. Spears'
contract with Branton & Hall provided that he would be paid a
contingency fee of $1,200,000 for the preparation of petitioner's
briefs upon recovery of the total amount of the judgment, and a
proportionally lesser amount if less than the total amount of the
judgment was obtained. In the event of a partial settlement
before the preparation and submission of petitioner's briefs,
Spears would collect an amount determined on a sliding scale for
each $1 million received in settlement.
When the case settled, Spears was paid $92,500 "off the
top"; that is, the fee due Spears was deducted from the
settlement proceeds before calculating the amount due Branton &
Hall. Branton & Hall was paid $3,363,000; 40 percent of the
settlement proceeds reduced by the $92,500 paid to Spears.
Petitioner received the balance of the proceeds, $5,044,500, from
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which petitioner paid Branton & Hall $44,730 for legal expenses.
Petitioners did not include any portion of the settlement
proceeds in their income. In the notice of deficiency,
respondent determined that the amounts paid to the attorneys did
not reduce the amount of the settlement proceeds includable in
petitioners' gross income; however, respondent allowed the
attorney's fees as a Schedule A miscellaneous itemized deduction.
OPINION
Issue 1. Whether Petitioners May Exclude From Their Gross Income
Contingent Fees Paid to Their Attorneys
Respondent determined that petitioners received $8,500,000
in settlement of their claim, and that they may not exclude from
their gross income the portion of the settlement proceeds paid to
Branton & Hall. Petitioners assert that they never realized the
amount paid to Branton & Hall, because they assigned Branton &
Hall a 40-percent-ownership interest in the cause of action.
Furthermore, petitioners assert that this issue was settled by
the Court of Appeals for the Fifth Circuit in Cotnam v.
Commissioner, 263 F.2d 119 (5th Cir. 1959), affg. in part and
revg. in part 28 T.C. 947 (1957). We disagree with petitioners
that Cotnam controls the Court's decision herein.
This case is appealable to the Court of Appeals for the
Fifth Circuit, and under the Golsen rule, we follow the law of
the circuit in which a case is appealable. Golsen v.
Commissioner, 54 T.C. 742 (1970), affd. 445 F.2d 985 (10th Cir.
1971). The Court of Appeals' decision in Cotnam v. Commissioner,
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supra, is based upon an interpretation of Alabama State law.
This case involves an interpretation of Texas State law. The
Golsen rule is therefore not applicable. See Golsen v.
Commissioner, supra at 757.
In the Cotnam case, the taxpayer had entered into a
contingent fee arrangement with her attorneys, under which the
taxpayer agreed to pay the attorneys 40 percent of any amount
recovered on a claim that they litigated on her behalf. The
taxpayer received a judgment on the claim, and a check in the
amount of the judgment was made payable to both her and the
attorneys. The attorneys retained their share of the proceeds,
and remitted the balance to the taxpayer. The Commissioner
treated the amount of the judgment as taxable income and allowed
a deduction for the attorney's fees. In holding that the amount
retained by the attorneys was not includable in the taxpayer's
gross income, the Court of Appeals for the Fifth Circuit
concluded that under applicable State (Alabama) law, the
contingent fee operated to assign to the attorneys
anequitablelien and interest as to 40 percent of the judgment.5
5
As stated in the provision of the Alabama Code relied
upon by the Court of Appeals for the Fifth Circuit:
2. Upon suits, judgments, and decrees for money,
* * * [attorneys] shall have a lien superior to all
liens but tax liens, and no person shall be at liberty
to satisfy said suit, judgment or decree, until the
lien or claim of the attorney for his fees is fully
satisfied; and attorneys at law shall have the same
(continued...)
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Cotnam v. Commissioner, supra at 125.
The State of Texas, unlike the State of Alabama, does not
regulate attorney's liens by statute. Instead, Texas relies upon
common law for authority on this issue. Thomson v. Findlater
Hardware Co., 156 S.W. 301, 303 (Tex. Civ. App. 1913).
In Texas, an attorney's lien is paramount to the rights of
the parties in the suit and is superior to other liens on the
money or property involved. In re Willis, 143 Bankr. 428, 432
(Bankr. E.D. Tex. 1992). However, a lien is neither property nor
a debt, but a right to have satisfaction out of property to
secure the payment of the debt. Crutcher v. Continental Natl.
Bank, 884 S.W.2d 884, 888 (Tex. App. 1994); Texas Bank & Trust
Co. v. Custom Leasing, Inc., 402 S.W.2d 926, 930 (Tex. Civ. App.
1966); Windham v. Citizens Natl. Bank, 105 S.W.2d 348, 350 (Tex.
Civ. App. 1937). In Texas, an attorney at law has not been given
a general lien on a cause of action or a judgment or money until
it was collected and in his hands. Finkelstein v. Roberts, 220
S.W. 401, 405 (Tex. Civ. App. 1920). Furthermore, while an
attorney has a lien on money collected by him for his client, he
has no such lien for the debt in the hands of the debtor before
5
(...continued)
right and power over said suits, judgments and decrees,
to enforce their liens, as their clients had or may
have for the amount due thereon to them. [Cotnam v.
Commissioner, 263 F.2d 119, 125 n.5 (5th Cir. 1959)
(quoting 46 Ala. Code sec. 64 (1940) (quotation marks
omitted)), affg. in part and revg. in part 28 T.C. 947
(1957).]
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the money has been collected. Thomson v. Findlater Hardware Co.,
supra at 303. Nor does a lien create an ownership interest in
the attorney. P&T Manufacturing Co. v. Exchange Sav. & Loan
Association, 633 S.W.2d 332 (Tex. App. 1982) (holders of valid
mechanic's lien who had not foreclosed could not sue for
conversion as they were not owners and did not have legal right
to possession).
We do not find under the common law of Texas that because
petitioner's attorneys were entitled to secure their earned
contingent fee with a lien on the proceeds, the lien was a
conveyance of an ownership interest in the settlement proceeds.
We turn next to petitioners' assertion that they never
realized the amount paid petitioner's attorneys as they
transferred to Branton & Hall a 40-percent ownership interest in
petitioner's cause of action. Petitioners submit the contingency
fee agreement as evidence of the transfer.
The question before us is to what extent, if any, petitioner
could transfer to his attorneys an interest in his cause of
action. We must look to the law of Texas for the answer to the
question thus posed. Our determination in this regard should,
according to the mandate of the Supreme Court of the United
States in Commissioner v. Estate of Bosch, 387 U.S. 456 (1967),
be predicated on State law, and the State's highest court is the
best authority on its own law.
In Dow Chem. Co. v. Benton, 357 S.W.2d 565 (Tex. 1962), the
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Supreme Court of Texas decided the issue of whether an attorney
may prosecute a cause of action on his own behalf to secure a
contingent fee after his client has been properly dismissed from
the case. The attorneys argued that the contingent fee contract
created in them "an immediate, vested, unrestricted, separate and
distinct interest in the plaintiff's cause of action."6 In
holding the attorneys may not litigate a case after their client
has been dismissed, the Supreme Court of Texas found that
attorneys operating under a contingent fee contract do not have
rights in a cause of action equal to those of their clients. Id.
at 567.
The court first noted the fact that as the case involved the
attorney-client relationship, it could not regard the case as one
involving an ordinary assignment, devoid of public policy
considerations. The court stated that the basic fallacy of the
attorney's position was that it ignored the fact that the
lawyer's rights, based on the contingent fee contract, are wholly
derivative from those of his client. In Texas, the attorney-
client relationship is one of principal and agent. Id.
6
The contingent fee contract, which the Texas Supreme
Court characterized as "the usual one", provided that the
plaintiff agreed to "sell, transfer, assign and convey to my said
attorneys the respective undivided interests in and to my said
claim * * * and to any judgment or judgments that I may obtain".
Dow Chem. Co. v. Benton, 357 S.W.2d 565, 566 (Tex. 1962). The
contract further provided that if the case settled before filing
of suit, the attorneys were to receive one-third of whatever was
recovered for the plaintiff, and they would receive greater
percentages if the suit was filed or appealed after trial. Id.
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Furthermore, the court stated that
there is but one cause of action. Our decisions uphold
an agreement to assign a part of the recovery on the
cause of action to the attorney. But we have never
held that the cause of action is divisible and may be
tried for only a percentage of the cause of action.
[Id.; emphasis added.]
An attorney with a contingent fee contract is not so
directly interested in the subject matter of a lawsuit as to make
him a party; thus, Texas attorneys operating under a contingent
fee contract do not have the same rights as their clients in the
cause of action.7
We conclude, therefore, that under the facts and
circumstances of this case, Branton & Hall and Spears had no
ownership interest in petitioner's claim before settlement.
Consequently, in analyzing this issue, we consider petitioner's
contingent fee agreement an agreement to assign a part of the
recovery on the cause of action to his attorneys.8
State law determines what property rights and interests a
taxpayer has, but Federal law determines the consequences of such
rights and interests for tax purposes. Lyeth v. Hoey, 305 U.S.
7
The court clarified that its holding does not necessarily
apply to the case where a plaintiff has assigned a portion of his
cause of action to an independent third party.
8
See Brenan v. LaMotte, 441 S.W.2d 626, 629 (Tex. Civ.
App. 1969) (contract of employment which stated "we do hereby
sell, transfer, * * * assign and convey unto * * *, our attorney,
an undivided interest" in whatever plaintiffs may realize out of
decedent's estate, held executory contract for contingent fee;
contract did not convey interest in estate).
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188 (1938). An attorney's right to compensation pursuant to a
contingency fee agreement is a property right determined under
applicable State law. Barnhill v. Johnson, 503 U.S. 393 (1992);
Marre v. United States, 117 F.3d 297, 307 (5th Cir. 1997);
Augustson v. Linea Aerea Nacional-Chile S.A., 76 F.3d 658, 662
(5th Cir. 1996). Under Texas State law, a contingency fee
agreement is generally considered to be an executory contract.
In re Willis, supra at 431; Brenan v. LaMotte, 441 S.W.2d 626,
630 (Tex. Civ. App. 1969); White v. Brookline Trust Co., 371
S.W.2d 597, 600 (Tex. Civ. App. 1963). Therefore, as a general
rule, an attorney does not receive a legal or equitable interest
pursuant to a contingency fee contract until the contingency
actually occurs. In re Willis, 143 Bankr. at 431.
Although it is unclear what constitutes the defining moment
at which the contingency occurs, at minimum, the contingency
cannot occur before judgment is affirmed on appeal or when the
time for filing an appeal has lapsed. Marre v. United States,
supra at 308 (comparing Lee v. Cherry, 812 S.W.2d 361, 363 (Tex.
App. 1991) (explaining that an executory contract is one that is
still unperformed by both parties or one with respect to which
something still remains to be done on both sides); White v.
Brookline Trust Co., supra (contingency occurs after prosecuting
or defending to final judgment all suits); Carroll v. Hunt, 168
S.W.2d 238, 240, 242 (Tex. Commn. App. 1943) (contingency occurs
after successful termination of the litigation)). Once the
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contingency occurs, the attorney has a lien on the judgment or
settlement securing his services. In re Willis, supra at 432.
Accordingly, until the contingent fee agreement between
petitioner and Branton & Hall ripened through finalization of the
lawsuit, it was executory. Once the contingency occurred, the
attorneys were entitled to a lien on the funds, which ultimately
was satisfied when they received payment according to the terms
of the agreement.
The Supreme Court has held that
The rule that income is not taxable until realized has
never been taken to mean that the taxpayer, * * * , who
has fully enjoyed the benefit of the economic gain
represented by his right to receive income, can escape
taxation because he has not himself received payment of
it from his obligor. * * * [Taxation] may occur when he
has made such use or disposition of his power to
receive or control the income as to procure in its
place other satisfactions which are of economic worth.
* * * * * * *
[T]he import of the statute is that the fruit is not to
be attributed to a different tree from that on which it
grew. [Helvering v. Horst, 311 U.S. 112, 116-120
(1940); citation omitted.]
It is for this reason that "[taxation cannot] be escaped by
anticipatory arrangements and contracts however skillfully
devised to prevent * * * [the settlement amount] when paid from
vesting even for a second in the man who earned it." Lucas v.
Earl, 281 U.S. 111, 115 (1930). It is clear that petitioner
enjoyed the full benefit of the settlement amount by using it to
pay his attorneys for their services. It is equally clear that
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as petitioner's attorneys could not be parties in the cause of
action and did not otherwise have rights in the cause of action
equal to those of petitioner, in the terms of Lucas v. Earl,
supra, the attorneys did not own any portion of the tree from
which the settlement proceeds were derived.
Accordingly, we find that petitioners realized benefit from
the entire amount of the settlement proceeds, and they may not
exclude from their gross income the portion of the settlement
proceeds paid to Branton & Hall and Spears.
Issue 2. Whether Under Section 104(a)(2) Petitioners May Exclude
the Entire Settlement Amount From Their Gross Income
Respondent and petitioners agree that the amount received by
petitioner for actual damages is excludable from petitioners'
income under section 104(a)(2).
Respondent determined that the $8,500,000 settlement amount
should be allocated proportionally to the judgment of $11,500,000
in actual damages, $17,500,000 in punitive damages, and
prejudgment interest of $2,597,201.9
Petitioners assert that as $8,500,000 is exactly the amount
that petitioner initially pled as actual damages, and as it is
9
We note that this method of allocation was approved in
Robinson v. Commissioner, 70 F.3d 34, 38 (5th Cir. 1995), affg.
in part, revg. in part and remanding 102 T.C. 116 (1994); see
also Rozpad v. Commissioner, T.C. Memo. 1997-528 (the judgment,
albeit not final, nonetheless furnishes an adequate guideline for
allocation by the Commissioner to the extent that it is composed
of both compensatory damages and prejudgment interest), affd. __
F.3d __ (1st Cir. Aug. 25, 1998).
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less than the amount awarded by the jury for only actual damages,
the entire settlement amount is excluded from their gross income
under section 104(a)(2). Respondent's determination is presumed
correct, and petitioners bear the burden of proving that
respondent's determinations are erroneous. Rule 142(a); Welch v.
Helvering, 290 U.S. 111, 115 (1933).
We have often been asked to decide the proper allocation of
proceeds of a settlement agreement in the context of section
104(a)(2). It is well settled that express allocations in a
settlement agreement will be respected to the extent that the
settlement agreement is entered into by the parties at arm's
length and in good faith. Robinson v. Commissioner, 70 F.3d 34
(5th Cir. 1995), affg. in part, revg. in part and remanding 102
T.C. 116 (1994). If a lawsuit is settled, but no express
allocations are made in the settlement agreement, we must
consider the pleadings, the jury awards, or any court orders or
judgments. Robinson v. Commissioner, 102 T.C. at 127. In order
to characterize income as taxable under section 61 or excluded
from taxation under section 104(a)(2), we must ascertain "in lieu
of what were damages awarded" or paid. Bent v. Commissioner, 87
T.C. 236, 244 (1986), affd. 835 F.2d 67 (3d Cir. 1987).
In the instant case, the partial settlement agreement does
not specify how the $8,500,000 settlement amount is allocated
between actual and punitive damages, or between principal and
interest. Accordingly, we consider all the facts and
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circumstances to ascertain in lieu of what the settlement amount
of $8,500,000 was paid. Id.
We do not find that the evidence supports petitioners'
assertion that none of the amount paid in settlement was paid in
lieu of either punitive damages or interest. To the contrary,
the partial settlement agreement shows that Harte-Hanks agreed to
pay, and petitioner agreed to accept, $2,400,000 in satisfaction
of the principal amount of the judgment between $7 million and
$12 million, and to extinguish any and all postjudgment interest
liability on the first $22 million of the judgment. Furthermore,
Columbia and Hudson agreed to pay, and petitioner agreed to
accept, $3 million in satisfaction of the principal amount of the
judgment between $12 million and $22 million. Columbia's and
Hudson's liability threshold was $12 million, and the judgment
provided total actual damages of $11,500,000; Columbia and Hudson
would not have paid $3 million unless they thought prejudgment
interest and punitive damages would total at least $3,500,000.
Harte-Hanks' agreement to pay postjudgment interest and
Columbia's and Hudson's actual payment of several millions of
dollars speak with a voice heard more clearly than petitioners'
assertions. We find that petitioners have not carried their
burden of proving that respondent's determinations are erroneous.
On brief, respondent proposes an alternative method of
allocation which he concedes may be "the most proper methodology
to use to allocate the settlement payment." Under this
- 22 -
alternative method, it is presumed that actual damages would be
paid before prejudgment interest, postjudgment interest, or
punitive damages, and that prejudgment interest would be paid
before punitive damages.
Under this methodology, the combined $3,100,000 payment made
by Continental and Harte-Hanks, which was the amount agreed upon
to settle Harte-Hanks' liability for the first $7 million of
damages, is allocated to settle $7 million of the $11,500,000 of
actual damages provided by the judgment. Accordingly,
petitioners would exclude $3,100,000 under section 104(a)(2) as
the settlement amount they received for $7 million worth of the
actual damages.
Harte-Hanks paid $2,400,000, to settle the principal amount
of the judgment between $7 million and $12 million, and to the
extent necessary, to settle all postjudgment interest on the
first $22 million of the judgment. This amount is allocated to
actual damages of $4,500,000,10 prejudgment interest of $500,000,
and postjudgment interest of $1,826,301.11 Accordingly,
$1,582,116 of the $2,400,000 payment is allocated to actual
10
This figure equals the $11,500,000 total actual damages
minus the $7 million actual damages which were settled for
$3,100,000.
11
Respondent calculated postjudgment interest on the first
$22 million of the judgment assuming a period of 303 days, from
May 15, 1990 (the judgment date), to Mar. 14, 1991 (the date of
the partial settlement agreement), a 365-day calendar year, and a
rate of 10 percent per annum.
- 23 -
damages,12 and the remaining $817,884 is allocated to prejudgment
and postjudgment interest.
Finally, the $3 million paid by Columbia and Hudson to
settle their liability for coverage between $12 million and $22
million is allocated entirely to prejudgment interest and
punitive damages. At this level, all of the $11,500,000 in
actual damages has been exhausted, in addition to $500,000 of
prejudgment interest and all of the postjudgment interest.
Furthermore, the settlement amount of $3 million for $10 million
of liability ($22 million minus $12 million) reflects the
diminished likelihood of petitioner's recovering damages and
interest in an amount above $12 million if the case was appealed.
Extending respondent's alternative method of allocation, we
find that of the $3 million paid by Columbia and Hudson, $629,160
was paid in lieu of prejudgment interest, and $2,370,840 was paid
in lieu of punitive damages.13
12
This amount is calculated by multiplying the $2,400,000
paid by Harte-Hanks by $4,500,000 of remaining actual damages
divided by the sum of the $4,500,000 (actual damages), $500,000
(prejudgment interest), and $1,826,301 (postjudgment interest).
13
In the alternative allocation scheme, respondent assumed
that the prejudgment interest would be paid before the punitive
damages. The prejudgment interest totaled $2,597,201, of which
$500,000 was already settled out of the $2,400,000 payment by
Harte-Hanks. Columbia and Hudson would therefore pay the balance
of the prejudgment interest, $2,097,201, before they paid any
punitive damages.
The portion of Columbia's and Hudson's payment allocated to
interest is calculated by dividing the balance of the prejudgment
interest by Columbia's and Hudson's total liability, $10 million,
(continued...)
- 24 -
Accordingly, on the basis of all the facts and circumstances
of this case, we find that $4,682,116 of the settlement proceeds
was paid to petitioner in lieu of actual damages, which is
excluded from gross income under section 104(a)(2), and
$3,817,884 was paid in lieu of punitive damages and interest,
which is included in gross income under section 61.
Issue 3. Deductibility of Attorney's Fees Under Section 162
In the notice of deficiency, respondent allowed petitioners
a deduction under sections 212(1) and 265 for legal fees
allocable to the taxable portion of the settlement proceeds.
Petitioners assert in their reply brief that if this Court finds
that petitioners realized the amount paid to petitioner's
attorneys, they are entitled to deduct that amount under section
162(a) as an ordinary and necessary expense incurred during the
taxable year in carrying on a trade or business.
In analyzing the issue of whether the attorney's fees were
an expense incurred for the production or collection of income
under section 212(1) or as an ordinary and necessary expense
under section 162(a), we consider the origin and character of the
claim with respect to which the litigation expense was incurred.
United States v. Gilmore, 372 U.S. 39 (1963).
13
(...continued)
and multiplying that amount by their $3 million payment.
Similarly, the amount allocated to punitive damages is
calculated by dividing the balance of their liability, $10
million minus $2,097,201, by their total liability, $10 million,
and multiplying that amount by their $3 million payment.
- 25 -
As there is no general Federal common law of torts, nor
controlling definitions in the tax code, we must look to State
law to analyze the nature of the claim litigated. Burnet v.
Harmel, 287 U.S. 103, 110 (1932) (State law creates legal
interests; Federal law determines when and how to tax).
Petitioner's personal injury suit was for libel, a
defamation action. All defamatory statements (whether libel or
slander) attack a person's good name.14 See MacFadden
Publications, Inc. v. Wilson, 121 S.W.2d 430 (Tex. Civ. App.
1938). Whether the defamatory attack is on the personal
reputation or the professional reputation of the individual, the
defamation is personal in nature. Gulf At. Life Ins. Co. v.
Hurlbut, 696 S.W.2d 83, 96-97 (Tex. App. 1985) (the action of
defamation is to protect the personal reputation of the injured
party, whereas the action for injurious falsehood or business
disparagement is to protect the economic interests of the injured
party against pecuniary loss), revd. and remanded on other
14
Texas law provides the following:
A libel is a defamation expressed in written
or other graphic form that tends to blacken the
memory of the dead or that tends to injure a
living person's reputation and thereby expose the
person to public hatred, contempt or ridicule, or
financial injury or to impeach any person's
honesty, integrity, virtue, or reputation or to
publish the natural defects of anyone and thereby
expose the person to public hatred, ridicule, or
financial injury. [Tex. Civ. Prac. & Rem. Code
Ann. sec. 73.001 (West 1997).]
- 26 -
grounds 749 S.W.2d 762, 766 (Tex. 1987). In Newspapers, Inc. v.
Matthews, 339 S.W.2d 890, 893 (Tex. 1960), the Texas Supreme
Court reaffirmed that a business is not the subject of libel and
that the defamation, if any, is of the owner of the business and
not the business itself, whether the owner be an individual,
partnership, or corporation.
If as a result of defamatory statements attacking the
individual's character, the individual suffers some impairment of
his professional relationships--in this case, petitioner's
relationship with his patients and hospitals--the injury is to
the person, although it may have derivative consequences for the
business. Roemer v. Commissioner, 716 F.2d 693 (9th Cir. 1983)
(a defamatory attack on one's character should not be confused
with the damage that flows from that injury), revg. 79 T.C. 398
(1982); see also Threlkeld v. Commissioner, 87 T.C. 1294 (1986)
(holding Roemer v. Commissioner, 79 T.C. 398 (1982), revd. 716
F.2d 693 (9th Cir. 1983), will no longer be followed by this
Court and expressing agreement with the reasoning for its
reversal by the Court of Appeals for the Ninth Circuit), affd.
848 F.2d 81 (6th Cir. 1988).
As the defamation of an individual is a personal injury
under the law of Texas, the expenses of litigating petitioner's
claim for personal injury are not deductible as ordinary and
necessary expenses incurred in carrying on a trade or business.
Petitioner cites McKay v. Commissioner, 102 T.C. 465 (1994),
- 27 -
vacated and remanded without published opinion 84 F.3d 433 (5th
Cir. 1996), as authority for deducting the costs of litigating a
personal injury suit as a business expense. We disagree.
In McKay, the taxpayer was an employee who brought suit for
wrongful termination, breach of employment contract, RICO, and
punitive damages. The taxpayer was awarded damages for lost
compensation, "future" damages, and punitive damages for
wrongful, malicious, and oppressive acts by his employer. After
trial, the parties settled, and the settlement agreement provided
that sums were paid in extinguishment of the taxpayer's tort
claim for wrongful discharge and extinguishment of his breach of
contract claim. In the settlement agreement, the parties agreed
that the amount attributable to the wrongful discharge claim
represented compensatory damages excludable under section
104(a)(2), and the amount allocable to the breach of contract
claim was includable in income under section 61.15 Finding that
the allocations were the result of an arm's-length negotiation
between hostile adversaries, this Court accepted the express
allocations in the settlement agreement. Id. at 487.
15
The Court of Appeals for the Fifth Circuit vacated our
decision in this case. Citing Commissioner v. Schleier, 515 U.S.
323 (1995), the Court of Appeals held that the damages
attributable to the taxpayer's wrongful discharge claim were not
excludable under sec. 104(a)(2), because they were not received
on account of a personal injury. McKay v. Commissioner, 84 F.3d
433 (5th Cir. 1996), vacating and remanding without published
opinion 102 T.C. 465 (1994).
- 28 -
We held that under section 265, the portion of the
attorney's fees allocable to the settlement amount for wrongful
discharge was not deductible, but the portion of the attorney's
fees allocable to the taxable portion of the suit, the breach of
contract action, was deductible under section 162.
The facts of McKay v. Commissioner, supra, are clearly
distinguishable from the facts of this case. In McKay, the
taxpayer had two causes of action--one arising from the law of
torts, the other from the law of contracts. The taxpayer in
McKay received separate settlement amounts for each claim. In
this case, petitioner has brought suit for a claim in tort,
personal injury. Furthermore, the damages petitioner received
all flow from the personal injury suit. McKay v. Commissioner,
supra, is therefore, inapposite.
We agree with respondent's determination that the portion of
petitioner's legal expenses allocable to the punitive damages and
the interest received on the award are deductible under section
212(1) as expenses paid for the production of income. This
treatment is consistent with other cases in which the taxpayer
received damages in a defamation action. See, e.g., Roemer v.
Commissioner, supra at 700; Church v. Commissioner, 80 T.C. 1104,
1110-1111 (1983).
Section 265, however, disallows deductions for amounts that
are allocable to tax-exempt income. Consequently, only the
attorney's fees attributable to punitive damages and interest are
- 29 -
deductible.
In Church v. Commissioner, supra, we used the following
formula to calculate the correct deduction:
Total attorney's fees Nonexempt income Deductible
and legal expenses X ----------------- = expenses
Total award
We have held that a portion of the settlement proceeds is
attributable to punitive damages and interest and is includable
in petitioners' income. Accordingly, we find that $1,572,173 of
attorney's fees and legal expenses is deductible under section
212(1) as a miscellaneous itemized expense.
Issue 4. Accuracy-Related Penalty Under Section 6662
Respondent determined that petitioners are liable for
accuracy-related penalties for the substantial understatement of
tax under section 6662(a) of $237,784 and $6,607 for 1991 and
1992, respectively. See sec. 6662(b)(2). Petitioners assert
that they are not liable for the penalty, because there was
substantial authority for their reporting position, and they
relied upon the advice of their professional tax adviser.
Section 6662(a) imposes a penalty in an amount equal to 20
percent of the portion of the underpayment of tax attributable to
one or more of the items set forth in subsection (b). Section
6662(b)(2) provides that section 6662 shall apply to any portion
of the underpayment attributable to any substantial
understatement of income tax.
There is a substantial understatement of income tax if the
- 30 -
amount of the understatement for the taxable year exceeds the
greater of (1) 10 percent of the tax required to be shown on the
return or (2) $5,000. Sec. 6662(d)(1)(A). For purposes of
section 6662(d)(1), "understatement" is defined as the excess of
tax required to be shown on the return over the amount of tax
that is shown on the return reduced by any rebate. Sec.
6662(d)(2)(A).
After adjustments,16 respondent determined that the amounts
of tax required to be shown on the returns are $1,194,296 and
$45,969, and the amounts of the understatements of tax are
$1,188,920 and $33,037 for 1991 and 1992, respectively. As each
of these understatement amounts exceeds the greater of 10 percent
of the tax required to be shown on the return or $5,000 for the
year at issue, respondent applied the penalty.
Section 6662(d)(2)(B)(i) provides that the amount of the
understatement shall be reduced by the portion of the
understatement that is attributable to the tax treatment of any
item if there is or was substantial authority for such treatment.
The substantial authority standard is an objective standard
16
Respondent determined that computational adjustments
should be made for 1991 which would preclude petitioners from
claiming deductions for personal exemptions, eliminated their
deductions for medical expenses, adjusted the amounts of self-
employment tax and the deduction for self-employment tax, and
increased the allowance for charitable contributions.
Respondent determined that computational adjustments should
be made for 1992 which would adjust petitioners' deduction for
charitable contributions to conform with the percentage
limitations.
- 31 -
involving an analysis of the law and application of the law to
relevant facts. Sec. 1.6662-4(d)(2), Income Tax Regs. There is
substantial authority for the tax treatment of an item if at the
time the return containing the item is filed or on the last day
of the taxable year to which the return relates, the weight of
the authorities supporting the treatment is substantial in
relation to the weight of authorities supporting contrary
treatment.17 Sec. 1.6662-4(d)(3)(i), (iv)(C), Income Tax Regs.
It is the taxpayer's responsibility to establish he is not
liable for the accuracy-related penalty imposed by section
6662(a). Rule 142(a); Tweeddale v. Commissioner, 92 T.C. 501,
505 (1989). Petitioners did not report any of the settlement
proceeds they received in 1991. We have found that a portion of
the proceeds is attributable to punitive damages and interest,
which are taxable under section 61. Therefore, the burden is on
petitioners to prove that there is substantial authority for
their reporting position.
Respondent pled in his answer that petitioners negligently
failed to report any portion of the settlement payment as gross
income for 1991 and, therefore, are liable for the section 6662
penalty for negligence or disregard of rules or regulations. See
sec. 6662(b)(1). This is a new matter; the burden of proof is
17
Petitioners timely filed their return for calendar year
1991 on Oct. 15, 1992, and the return for their short taxable
year 1992 on Mar. 15, 1993.
- 32 -
therefore on respondent to prove that petitioners were negligent
or disregarded rules or regulations. Rule 142(a).
Punitive Damages
The issue of whether punitive damages received in a tort or
tortlike suit are excludable from income was resolved by the
Supreme Court in O'Gilvie v. United States, 519 U.S. 79, 117 S.
Ct. 452 (1996). Before the Supreme Court's decision, the Courts
of Appeals for the Fourth, Ninth, and Tenth Circuits had held
that punitive damages are not excluded from income under section
104(a)(2), and the Court of Appeals for the Sixth Circuit had
held they are excluded.18 Id. at ___, 117 S. Ct. at 454. The
Supreme Court granted certiorari to resolve the conflict among
the circuits. The Supreme Court held that punitive damages
received in a tort suit for personal injuries were not received
"on account of" personal injuries and, therefore, were not
excluded from taxable gross income as defined during the years at
issue.19 Id.
18
See O'Gilvie v. United States, 66 F.3d 1550 (10th Cir.
1995), affd. 519 U.S. 79, 117 S. Ct. 452 (1996); Hawkins v.
United States, 30 F.3d 1077 (9th Cir. 1994); Horton v.
Commissioner, 33 F.3d 625 (6th Cir. 1994), affg. 100 T.C. 93
(1993); Commissioner v. Miller, 914 F.2d 586 (4th Cir. 1990),
revg. and remanding 93 T.C. 330 (1989).
19
The Omnibus Budget Reconciliation Act of 1989 (OBRA),
Pub. L. 101-239, sec. 7641(a), 103 Stat. 2379, amended sec.
104(a) by adding the sentence "Paragraph (2) shall not apply to
any punitive damages in connection with a case not involving
physical injury or physical sickness." OBRA sec. 7641(b)(2), 103
Stat. 2379, provided the amendment shall not apply to any amount
(continued...)
- 33 -
It is clear from the Supreme Court's decision that the issue
of whether punitive damages received in a tort suit are excluded
under section 104(a)(2) was unresolved at the time petitioners
filed their returns for 1991 and 1992.
Furthermore, before the decision in O'Gilvie v. United
States, supra, this Court decided Estate of Moore v.
Commissioner, T.C. Memo. 1994-4, revd. and remanded 53 F.3d 712
(5th Cir. 1995). In Estate of Moore, we held, citing Threlkeld
v. Commissioner, 87 T.C. 1294 (1986), and Roemer v. Commissioner,
716 F.2d 693 (9th Cir. 1983), that punitive damages received in a
settlement of a lawsuit for malicious prosecution and invasion of
privacy may be excluded from gross income pursuant to section
104(a)(2).
The Court of Appeals for the Fifth Circuit reversed Estate
of Moore v. Commissioner, supra, holding that punitive damages
awarded under Texas law are not intended to compensate plaintiffs
for injury and are therefore not excludable under section
104(a)(2). Estate of Moore v. Commissioner, 53 F.3d at 715-716.
After we decided Estate of Moore, but before it was
reversed, this Court decided Robinson v. Commissioner, 102 T.C.
19
(...continued)
received pursuant to any suit filed on or before July 10, 1989.
Petitioners filed suit in 1985 and are therefore within the
exception to the amendment.
The Supreme Court decided the issue in O'Gilvie v. United
States, 519 U.S. 79, 117 S. Ct. 452 (1996), upon the preamendment
version of sec. 104(a)(2); the holding is therefore applicable to
petitioners in this case.
- 34 -
116, 125-126 (1994), in which we stated:
Under section 104(a)(2), gross income does not include
the amount of any damages received (whether by suit or
agreement) on account of personal injuries or sickness.
From that section, and the regulations thereunder, we
understand that damages received through a settlement
of a lawsuit are excludable from gross income only if
the damages were received on account of a "tortlike
personal injury". For this purpose, no distinction is
drawn between tortlike personal injuries that are
physical versus tortlike personal injuries that are
nonphysical (i.e., psychological). Thus, for example,
damages are excludable from gross income under section
104(a)(2) if the damages were received pursuant to a
settlement of a tortlike personal injury that resulted
in: * * * punitive damages, Horton v. Commissioner, 100
T.C. 93, 96 (1993); see also Miller v. Commissioner, 93
T.C. 330, 337-342 (1989), revd. 914 F.2d 586 (4th Cir.
1990). [Some citations omitted; emphasis added.]
As the lawsuit in the Robinson case included an award for
mental anguish, as well as punitive damages, we allocated a
percentage of the settlement amount to punitive damages and held
that the taxpayers could exclude that percentage from their gross
income under section 104(a)(2). Id. at 136. The Court of
Appeals for the Fifth Circuit, citing Estate of Moore v.
Commissioner, 53 F.3d 712 (5th Cir. 1995), revg. and remanding
T.C. Memo. 1994-4, reversed that part of our decision. Robinson
v. Commissioner, 70 F.3d at 37 & n.4.
It is clear from these decisions that, until Estate of Moore
v. Commissioner, supra, was reversed, this Court was of the
opinion that taxpayers residing in Texas could exclude punitive
damages from income under section 104(a)(2). We therefore find
that there was substantial authority for petitioners' reporting
- 35 -
position with respect to the punitive damages portion of the
settlement amount.
Because of our finding that there was substantial authority
for petitioners' reporting position, we need not address the
issue of whether they were negligent in not reporting the
punitive damages as income.
Accordingly, we find that petitioners are not liable for the
section 6662(a) penalty for the portion of the underpayment of
tax attributable to the punitive damages portion of the
settlement amount.
Interest
Petitioners did not report any of the amount of the
settlement proceeds that they received in 1991 as interest
income. Respondent determined that a portion of the settlement
amount is attributable to interest. Petitioners have presented
no argument to support their reporting position on this issue,
other than their assertion that section 104(a)(2) excludes the
entire settlement amount.
In Kovacs v. Commissioner, 100 T.C. 124 (1993), affd. per
curiam without published opinion 25 F.3d 1048 (6th Cir. 1994), we
stated that we had last analyzed this issue in Aames v.
Commissioner, 94 T.C. 189 (1990), in which we held that interest
was not excludable under section 104(a)(2). In Aames, we drew a
distinction between the damages and the interest on the damages,
noting that the nature of interest is that it is paid because of
- 36 -
the delay in the receipt of a principal amount (the damage
award). Kovacs v. Commissioner, supra at 129.
Furthermore, in Kovacs, we stated that the issue of the
excludability of damages and the interest awarded thereon first
arose in Riddle v. Commissioner, 27 B.T.A. 1339 (1933), which
held, applying the predecessors of sections 61(a) and 104(a)(2),
that interest was not part of damages and is includable in
income. We also stated that since Riddle was decided in 1933, we
have found no cases which suggest that interest paid on an award
of damages received on account of personal injury is excludable
under section 104(a)(2).
Finally, we observed that since Riddle was decided, the
exclusion for personal injury damages has been reenacted and
amended numerous times; nevertheless, the statute continues to
exclude only "damages" and omits any reference to "interest",
which implies a continuing acceptance by Congress of the existing
interpretation of the exclusion.
Accordingly, we find that there was no substantial authority
for petitioners' reporting position for the interest portion of
the settlement amount they received in 1991.
Reasonable Cause and Good Faith Exception
Section 6664(c)(1) provides that the penalty under section
6662(a) shall not apply to any portion of an underpayment if it
is shown that there was reasonable cause for the taxpayer's
position with respect to that portion and that the taxpayer acted
- 37 -
in good faith with respect to that portion. Sec. 6664(c)(1).
The determination of whether a taxpayer acted with
reasonable cause and good faith within the meaning of section
6664(c)(1) is made on a case-by-case basis, taking into account
all the pertinent facts and circumstances. Sec. 1.6664-4(b)(1),
Income Tax Regs. The most important factor is the extent of the
taxpayer's efforts to assess the taxpayer's proper tax liability.
Id. Reliance on the advice of a professional (such as an
attorney or an accountant) does not necessarily demonstrate
reasonable cause and good faith. Reliance on professional
advice, however, constitutes reasonable cause and good faith if,
under all the circumstances, such reliance was reasonable and the
taxpayer acted in good faith. Id.
Petitioners assert that they are not liable for any section
6662(a) penalty, because they relied upon the advice of their
attorneys and their certified public accountant in reporting
their income.
Petitioner testified that at different times he asked
Branton, who was hired to represent petitioner in his personal
injury lawsuit, Thomas Weir (Weir), a tax attorney from San
Antonio, and Bill Elms (Elms), petitioners' certified public
accountant, if the settlement amount was taxable. Petitioner
testified that all told him that none of the settlement amount
was taxable.
Branton testified that he did not consider himself to be a
- 38 -
Federal tax lawyer. In response to a question by the Court,
Branton stated that whenever a client asked him whether an item
was taxable, his response has always been that he is not a tax
lawyer, and that the client should get a tax lawyer. Thus,
petitioners could not reasonably and in good faith rely upon
Branton regarding the taxability of the settlement amount. See
sec. 1.6664-4(b)(2), Example (1), Income Tax Regs.
Petitioner testified that he consulted with a tax attorney,
Weir. Petitioner was not certain whether he spoke with Weir on
the phone or consulted with him in person. Nor was petitioner
certain of what documents he provided Weir. We cannot assume the
testimony of absent witnesses would have been favorable to
petitioner. Rather, the normal inference is that it would have
been unfavorable. Pollack v. Commissioner, 47 T.C. 92, 108
(1966), affd. 392 F.2d 409 (5th Cir. 1968); Wichita Terminal
Elevator Co. v. Commissioner, 6 T.C. 1158, 1165 (1946), affd. 162
F.2d 513 (10th Cir. 1947).
Petitioner testified that he consulted with his accountant,
Elms. Elms testified that in his initial interview with
petitioner they talked extensively about the lawsuit. When Elms
prepared petitioners' Federal income tax return for 1991,
petitioners were involved in a bankruptcy proceeding and had
given their only copy of the settlement agreement to that court.
Elms therefore never saw a copy of the settlement agreement.
Petitioner did provide Elms with a copy of the Texas district
- 39 -
court's charge to the jury and the jury's answers to the
interrogatories submitted to them. This document lists the
amounts the jury awarded on each of the charges on which
petitioner brought suit; it does not, however, indicate that
prejudgment or postjudgment interest is to be provided on the
amounts.
Elms testified that at the time he prepared petitioners'
return, it was his understanding that punitive damages awarded on
a personal injury case were not taxable. Elms was concerned
whether the award included some interest income; however, he
concluded that no part of the amount received would be considered
interest income.
Petitioner signed the partial settlement agreement;
therefore, he knew that Harte-Hanks agreed to make a settlement
payment in part for all of the postjudgment interest on the first
$22 million of liability. Petitioner knew the actual damages
totaled $11,500,000, he knew that Columbia and Hudson were not
liable to pay anything unless the total award exceeded $12
million, and he knew that Columbia and Hudson paid $3 million to
settle their potential liability. Therefore, petitioner knew
that the settlement agreement contained pertinent information
that was not included in the document he provided Elms.
Petitioner, in possession of pertinent information, may not
claim good faith and reasonable cause when he stands mute while
his tax adviser in ignorance of such information comes to an
- 40 -
incorrect opinion.
We therefore find that petitioners are liable for the
section 6662(a) penalty for the portion of any underpayment of
the tax required to be shown on the return that is due to not
reporting the interest portion of the settlement amount as
income.
Due to our finding that petitioners are liable for the
accuracy-related penalty for the substantial understatement of
tax, we need not address the issue of whether they are liable for
the accuracy-related penalty for negligence or disregard of rules
or regulations. See sec. 1.6662-2(c), Income Tax Regs.
To reflect the foregoing,
Decision will be entered
under Rule 155.