T.C. Memo. 2000-166
UNITED STATES TAX COURT
JOHN C. ARCHER AND NANCY M. ARCHER, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 11587-98. Filed May 22, 2000.
Robert E. Reetz, Jr., Kenneth D. Owens, and Carleton A.
Davis, for petitioners.
Rosemary Schell, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
COLVIN, Judge: Respondent determined a deficiency in
petitioners’ income tax of $23,188 for 1994 and a penalty of
$4,637.60 under section 6662(a) for substantial understatement of
tax.
After concessions, the issues for decision are:
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1. Whether petitioners may deduct $37,739 for 1994 which
petitioners contend they paid to settle a threatened lawsuit.1
We hold that they may not.
2. Whether petitioners are liable under section 6662(a)
for a penalty of $4,637.60 for 1994 for substantial
understatement of income tax. We hold that they are.
Section references are to the Internal Revenue Code in
effect for 1994. Rule references are to the Tax Court Rules of
Practice and Procedure. References to petitioner are to John C.
Archer.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
A. Petitioners
Petitioner lived in Liberty, Texas, and petitioner Nancy M.
Archer lived in Austin, Texas, when they filed their petition.
Petitioners were cash basis, calendar year taxpayers. Petitioner
is a lawyer who specializes in collecting delinquent taxes for
Texas counties and districts.
B. Petitioner’s Law Firm
Parmer, Archer, Young & Steen, P.C. (PAYS), a professional
service corporation, was incorporated before 1994 under the Texas
Professional Corporation Act. PAYS provided legal services to
1
Petitioners concede that they may not deduct $37,606 of
the $75,345 that they deducted for settlement of a threatened
lawsuit.
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Texas counties, school districts, cities, and water districts
relating to collection of delinquent taxes.
PAYS was an S corporation. Petitioner held 100 shares in
PAYS, which was a 10-percent ownership interest. Petitioner’s
adjusted basis in his 100 shares was $92,039.
In 1994, petitioner became dissatisfied with PAYS’
management and decided to open his own law office and represent
certain PAYS clients. The officers of PAYS learned about
petitioner’s plan, discharged him from the firm, and threatened
to sue him for tortious interference with PAYS’ contracts with
its clients.
C. The Settlement Agreement
On December 23, 1994, petitioner and PAYS negotiated and
settled their dispute. Their agreement had five pages.
Petitioner and the remaining PAYS members initialed each page,
and signed the agreement on page 5. The first two pages of the
agreement (part 1) were entitled “AGREEMENT TO PURCHASE/SELL
SHARES”. The heading “ASSIGNMENT AND NON-COMPETITION” appears at
the top center of the third, fourth, and fifth pages of the
agreement (part 2). Centered beneath that title is “PAGE TWO” on
the fourth page and “PAGE THREE” on the fifth page. In part 2,
petitioner and PAYS resolved the threatened lawsuit related to
petitioner’s plan to take the Liberty County account with him.
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The following chart lists the provisions in parts 1 and 2 of
the agreement which benefit PAYS or petitioner:
Provisions Which Benefit PAYS Provisions Which Benefit Petitioner
Contained in part 1: Contained in part 1:
1. PAYS gets petitioner’s 100 1. PAYS forgives petitioner’s $12,500
shares. (No value stated.) debt to PAYS.
2. Petitioner will pay the 2. PAYS assumes petitioner’s $37,000 debt
$25,000 deductible for any to Henry Steen, Jr. and Gates Steen.
payment made for a claim against
him under PAYS’ professional 3. PAYS will try to obtain a release of
lawyer’s liability policy. (No petitioner’s guarantee of the PAYS note to
value stated.) Chester Young, or will indemnify
petitioner against claims arising from
Contained in part 2: that guarantee. (No value stated.)
1. Petitioner will not compete 4. PAYS will give petitioner three
with PAYS for tax collection computers. (Stipulated value of $2,000.)
contracts, other than the two
assigned to him, for a period of 5. PAYS will indemnify against judgments
2 years (petitioner’s covenant arising out of a pending lawsuit unless
not to compete). (No value petitioner made the statement which is the
stated.) subject of the lawsuit. (No value
stated.)
2. Petitioner will make no claim
for any part of legal fees earned 6. PAYS gives petitioner an interest in
for services provided to Liberty the settlement of a certain lawsuit.
County before January 1, 1995 (Stipulated value of $2,800.)
(petitioner’s covenant not to
sue). (No value stated.) 7. PAYS releases petitioner from
liability as a guarantor of the firm's
3. Petitioner will indemnify $100,000 line of credit. (No value
PAYS and its shareholders and stated.)
directors from any claims
resulting from his departure and Contained in parts 1 and 2:
the contract assignments. (No
value stated.) 1. PAYS assigns its collection contracts
with Liberty County and Trinity County to
4. Petitioner will return all petitioner. (No value stated.)
PAYS property not specifically
given to him under the agreement. 2. PAYS will not sue petitioner or
(No value stated.) Liberty County for cancelling or assigning
the Liberty County contract (PAYS'
covenant not to sue). (No value stated.)
No specific items were given by one party to the agreement
for any specific items given by the other party.
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D. Petitioners’ Income Tax Return
Frank Melvin (Melvin), a certified public accountant
(C.P.A.) licensed in Texas, prepared petitioners’ 1994 income tax
return. Petitioners deducted $75,345 on their 1994 Schedule C,
Profit or Loss From Business (Sole Proprietorship), for
litigation settlement (i.e., PAYS’ covenant not to sue). On
Schedule D, Capital Gains and Losses, they reported that they
sold PAYS stock for $75,345, that their basis in that stock was
$75,345, and that their net long-term capital gain or loss was
zero.
OPINION
A. Whether Petitioners Paid $37,739 to Settle a Threatened
Lawsuit for 1994
1. Contentions of the Parties
Petitioners contend that a taxpayer may deduct as a business
expense settlement payments made to avoid litigation related to
the taxpayer’s business. See Anchor Coupling Co. v. United
States, 427 F.2d 429, 433 (7th Cir. 1970). Petitioners contend
that petitioners paid at least $37,739 to PAYS to settle PAYS’
threatened lawsuit against petitioner (i.e., for PAYS’ covenant
not to sue). Respondent contends that petitioners have not shown
how much they paid to settle the threatened lawsuit.
As cash basis, calendar year taxpayers, petitioners may
deduct an expense in the year in which the expense was paid in
cash or its equivalent. See Helvering v. Price, 309 U.S. 409,
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413 (1940). Petitioners did not pay any cash to settle the
threatened lawsuit. Thus, petitioners must prove how much they
paid in 1994 in the equivalent of cash to settle the threatened
lawsuit. See Rule 142(a).
2. Whether Petitioners Paid $37,739 in 1994 To Settle the
Threatened Lawsuit
Petitioners contend that the amount that petitioner paid to
settle the threatened lawsuit can be derived from the values
stated in the agreement and stipulated values for some of the
provisions of the agreement.2 We disagree. PAYS benefitted from
six provisions in the agreement. There is no stated or
stipulated value for any of those provisions. Petitioner
benefited from nine provisions in the agreement, five of which
have a stated or stipulated value and four of which do not.
Petitioners calculate the value of PAYS’ covenant not to sue
(item 5 under consideration received by petitioner in the chart
below) as follows:
Consideration given by petitioner Amount
1. PAYS stock $92,039
Consideration received by petitioner
1. Forgiveness of debt to PAYS 12,500
2. Release of debts to Henry Steen, Jr., 37,000
and Gates Steen
2
Respondent contends that the settlement consists of two
separate agreements. We disagree. PAYS and petitioner prepared
and executed the settlement at the same time. They signed the
settlement only at the end of page 5. We doubt that they would
have agreed to either part without agreeing to both parts. We
conclude that the settlement is one agreement.
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3. Three computers 2,000
4. 30 percent of the proceeds from 2,800
Archer v. Houseman
5. PAYS’ covenant not to sue 37,739
(litigation settlement)
Total 92,039
For petitioners’ calculation to be valid, petitioner’s stock
in PAYS must have a value of at least $92,039, and the following
provisions in the agreement must have no value or values that
benefit the two parties to the agreement equally: (1)
Petitioner’s agreement to pay the $25,000 deductible for
professional liability claims payments, (2) petitioner’s covenant
not to compete, (3) petitioner’s covenant not to sue, (4)
petitioner’s agreement to indemnify PAYS for claims due to his
departure, (5) petitioner’s agreement to return PAYS’ property
not specifically given to him, (6) PAYS’ agreement to obtain
release or indemnify petitioner with respect to the note to
Chester Young, (7) PAYS’ agreement to indemnify petitioner
against judgments in a pending lawsuit, (8) PAYS’ assignment of
its collection contracts with Liberty and Trinity Counties to
petitioner, and (9) PAYS’ release of petitioner from liability
for the $100,000 line of credit. Petitioners did not establish
that these items have no value or have offsetting values. Thus,
it is impossible to calculate the value of PAYS’ covenant not to
sue.3
3
Petitioners contend that petitioner’s stock was worth
(continued...)
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Petitioners contend that the fact that PAYS and its
shareholders did not hesitate to file suits against each other
when a shareholder left the firm shows that PAYS’ covenant not to
sue had value. We recognize that PAYS’ covenant not to sue may
well have had value. However, petitioners have not given us a
satisfactory basis to estimate its value.
We conclude that petitioners have failed to show that they
may deduct $37,739, or any other amount, as a litigation
expense.4
B. Whether Petitioners Are Liable for the Accuracy-Related
Penalty for Substantial Understatement Under Section 6662
Petitioners contend that they are not liable for the
accuracy-related penalty under section 6662 because they properly
relied on their accountant and because the transaction was
complex.
A taxpayer may be liable for an accuracy-related penalty on
a substantial understatement of tax. See sec. 6662. The
understatement is reduced to the extent that it (1) is based on
substantial authority, (2) is adequately disclosed on the return
3
(...continued)
$200,000 to $250,000 or that it was worth at least $92,039, the
amount of their adjusted basis. Regardless of the value of
petitioner’s PAYS stock, it would not establish the value of
PAYS’ covenant not to sue for the reasons given in the
accompanying text.
4
Because of this conclusion, we need not decide, as
petitioners contend, whether 1994 is the proper year to deduct
the litigation expense.
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or in a statement attached to the return and there is a
reasonable basis for the tax treatment of that item, or (3) is
due to reasonable cause and petitioners acted in good faith. See
secs. 6662(d)(2)(B)(i) and (ii), 6664(c)(1); sec. 1.6664-4(c),
Income Tax Regs. Petitioners do not contend that they have
substantial authority for their positions or that they adequately
disclosed their positions on their returns. They contend only
that they had reasonable cause and acted in good faith.
Petitioners concede that they may not deduct as a bad debt
loss $37,606 of the $75,345 they claimed as a litigation expense
for 1994. We have concluded that they may not deduct any amount
as a litigation expense for 1994.
Petitioners contend that they had reasonable cause and acted
in good faith because they relied on their accountant and the
transaction was complex. Petitioners point out that they are not
required to question whether their accountant is competent,
citing Streber v. Commissioner, 138 F.3d 216, 220 (5th Cir.
1998), revg. T.C. Memo. 1995-601, and Reser v. Commissioner, 112
F.3d 1258 (5th Cir. 1997), affg. in part and revg. in part
(including on this issue) T.C. Memo. 1995-572.
To establish good faith reliance on the advice of a
competent adviser, a taxpayer must show: (1) That he or she
provided the return preparer with complete and accurate
information, (2) that an incorrect return resulted from the
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preparer’s mistakes, and (3) that the taxpayer was relying in
good faith on the advice of a competent return preparer. See
Westbrook v. Commissioner, 68 F.3d. 868, 881 (5th Cir. 1995),
affg. T.C. Memo. 1993-634; Cramer v. Commissioner, 101 T.C. 225,
251 (1993), affd. 64 F.3d 1406 (9th Cir. 1995). Petitioner
testified in general terms that he described the substance of the
sale of the shares to Melvin, but petitioners have not shown that
they provided Melvin with complete and accurate information or
that the incorrect return resulted from Melvin’s mistakes.
Melvin did not testify.
The taxpayers in Streber v. Commissioner, supra, were about
20 and 25 years old and lacked business experience when they each
received an inheritance of more than $1 million. They hired a
lawyer to advise them of their potential tax liability. They
followed the advice of the lawyer. Petitioner is not like the
taxpayers in Streber because he is a lawyer, and he negotiated
the agreement at issue.
The taxpayer in Reser v. Commissioner, supra, was not
personally involved with the transaction which caused the
deficiency. See id. at 1268. In contrast, petitioner personally
negotiated the terms of the agreement in the instant case. The
tax issue in Reser was a complex basis computation for which the
taxpayer had no special knowledge. See id. In contrast, the
issue of how much the parties allocated to PAYS’ covenant not to
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sue is a question of fact. In Reser, two C.P.A.’s from a
national accounting firm (one of whom testified at trial) agreed
that the taxpayers were entitled to the deduction they claimed.
See id. at 1271. In contrast, petitioners’ C.P.A. did not
testify in this case.
We conclude that petitioners are liable for the section 6662
penalty. To reflect concessions and the foregoing,
Decision will be entered
under Rule 155.