T.C. Memo. 2004-113
UNITED STATES TAX COURT
PAUL S. LINDSEY, JR. AND KRISTEN L. LINDSEY, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 16843-02. Filed May 11, 2004.
Jim J. Shoemake, Dwight E. Cole, and Matthew S. McBride, for
petitioners.
Michael W. Bitner, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
COHEN, Judge: Respondent determined deficiencies in
petitioners’ Federal income taxes, an addition to tax, and a
penalty as follows:
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Addition to Tax Penalty
Year Deficiency Sec. 6651(a)(1) Sec. 6662(a)
1996 $725,255 $171,058 $145,051
1997 4,494 -- –-
After a concession by petitioners, the issues for decision
are: (1) Whether any amount of the $2,000,000 that petitioner
received from a settlement in 1996 is excludable from gross
income under section 104(a)(2); (2) whether petitioners are
liable for an addition to tax under section 6651(a)(1); and
(3) whether petitioners are liable for an accuracy-related
penalty under section 6662(a). The parties agree that the
deficiency for 1997 depends on our resolution of the section
104(a)(2) issue for 1996.
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years in issue.
FINDINGS OF FACT
Some of the facts have been stipulated, and the stipulated
facts are incorporated in our findings by this reference.
Petitioners resided in Texas during the years in issue;
petitioners resided in Missouri at the time they filed their
petition in this case.
Empire Gas Corp.
Paul S. Lindsey, Jr. (petitioner), has been involved in the
propane industry since February 1964. In August 1967, petitioner
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began working for Empire Gas Corp. (EGC), a corporation engaged
in the liquefied petroleum business.
In June 1994, petitioner and his wife, Kristen L. Lindsey
(Lindsey), acquired a controlling interest in EGC. On or about
June 30, 1994, petitioner became chief executive officer and
chairman of the board of EGC.
EGC’s Agreement With Northwestern Growth Co.
In late summer of 1994, petitioner was introduced by Morgan
Stanley, the investment banking house used by EGC, to
representatives from Northwest Public Service Co. (NPSC), a
utility company. In 1995, EGC entered into an agreement with
Northwestern Growth Co. (NGC), a subsidiary of NPSC, to acquire
Synergy, a propane company. In furtherance of their agreement,
EGC and NGC formed SYN, Inc. (SYN), which was to acquire Synergy.
Once Synergy was acquired, EGC was to supply the management team
to operate it, and NGC was to supply the necessary financial
resources. EGC also was to manage any other propane companies
acquired by NGC through SYN. In exchange for its management
services, EGC was to receive a 30-percent ownership interest in
SYN. SYN acquired Synergy in August 1995.
NGC wanted SYN to grow, with the ultimate goal of entering
the public financial market through the sale of interests in a
master limited partnership (MLP). To that end, petitioner used
his contacts in the propane industry to pursue the acquisition of
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other propane companies for the benefit of SYN. EGC dealt
primarily with smaller companies and introduced larger multi
state companies to representatives of NGC. In late 1995 or early
1996, petitioner introduced NGC to representatives of Coast Gas,
a propane retailer.
Dispute Between EGC and NGC
In late spring or early summer of 1996, representatives of
NGC met with petitioner to discuss the possibility of terminating
NGC and SYN’s relationship with EGC. Shortly thereafter,
petitioner learned that NGC was going to acquire not only Coast
Gas, but also Empire Energy, a company that was originally part
of EGC. Petitioner also learned that NGC did not intend for EGC
to manage SYN in the future. Petitioner believed NGC’s actions
violated the agreement between EGC and NGC with respect to the
management of SYN.
On September 20, 1996, EGC sought and obtained a temporary
restraining order to halt NGC’s acquisition of Empire Energy. On
September 22, 1996, petitioner and Valerie Schall (Schall), an
executive vice president of EGC, met with Dick Hylland (Hylland)
and Dan Newell (Newell), representatives of NGC, in an attempt to
resolve all issues and potential claims that arose or might have
arisen from the dispute between EGC and NGC over the operation of
SYN (the dispute). During that meeting, Schall raised a claim
for compensation due petitioner as a result of the dispute.
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Neither Schall nor petitioner informed Hylland or Newell that
petitioner was suffering from a physical injury or physical
sickness as a result of the dispute. By the end of the meeting,
those present had negotiated a document titled “Issues to be
Resolved in Final Agreement”, which stated, in part:
Upon effective closing of the contemplated Coast,
Empire Energy, and SYN MLP transactions, NGC in
resolution of all arrangements among NGC, SYN, and
Empire Gas Corporation [EGC] would provide a cash
payment of $20.0 million to Empire Gas and/or Paul S.
Lindsey [petitioner]. In the event that Coast and
Empire Energy acquisitions close and the MLP has not
been effected by June 30, 1997 the cash payment in
resolution of all arrangements shall be $15.0 million.
The Termination Agreement
On September 28, 1996, the dispute was resolved by the
execution of a termination agreement. The termination agreement
provided, in part:
(e) NGC and Paul S. Lindsey, Jr. [petitioner]
hereby agree that, in exchange for the written general
release from Mr. Lindsey * * *, $2,000,000 of the
Payment Amount shall be allocated to Mr. Lindsey, as
the controlling shareholder of EGC, in settlement of
his claims for tortious interference with contracts,
for personal injury including injury to Mr. Lindsey’s
personal and professional reputation and emotional
distress, humiliation and embarrassment resulting from
termination of the Synergy Acquisition documents, and
Mr. Lindsey shall provide consulting services to NGC as
the parties may agree * * *
Petitioner or EGC proposed the split between petitioner and EGC
of the $20 million settlement that was initially agreed upon on
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September 22, 1996. The termination agreement was signed by
petitioner on behalf of himself and EGC.
From September 22, 1996, through the time of the execution
of the termination agreement, neither petitioner nor any
representative of petitioner or EGC provided a representative of
NGC or SYN with (1) substantiation of any medical expenses
incurred by petitioner, (2) information as to any treatments or
medications prescribed for petitioner, or (3) an exact dollar
figure that would compensate petitioner for any personal injuries
petitioner claims to have suffered as a direct result of the
dispute.
Receipt of Settlement Proceeds; Federal Tax Return
On or about December 17, 1996, petitioner received a check
from NGC in the amount of $2 million pursuant to the termination
agreement. NGC did not issue a Form 1099 to petitioner with
respect to that payment.
Petitioners requested an automatic 4-month extension to file
their 1996 tax return. On January 15, 1998, petitioners filed
their 1996 tax return, on which they reported a tax liability of
zero. Petitioners did not report the $2 million settlement
proceeds.
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OPINION
Applicable Statute
Section 61(a) includes in gross income “all income from
whatever source derived” unless otherwise provided. Section
104(a)(2) provides otherwise. Before it was amended by the Small
Business Job Protection Act of 1996 (SBJPA), Pub. L. 104-188,
sec. 1605, 110 Stat. 1838, section 104(a)(2) excluded from gross
income amounts received on account of personal injuries or
sickness. While the reference to personal injuries or sickness
did not include damages received pursuant to the settlement of
purely economic rights, it did include “nonphysical injuries to
the individual, such as those affecting emotions, reputation, or
character”. United States v. Burke, 504 U.S. 229, 236 n.6
(1992); see Robinson v. Commissioner, 102 T.C. 116, 126 (1994),
affd. in part and revd. in part on another issue 70 F.3d 34 (5th
Cir. 1995); see also Fono v. Commissioner, 79 T.C. 680, 692
(1982), affd. without published opinion 749 F.2d 37 (9th Cir.
1984).
On August 20, 1996, the SBJPA amended section 104(a)(2) to
exclude from gross income “the amount of any damages (other than
punitive damages) received (whether by suit or agreement and
whether as lump sums or as periodic payments) on account of
personal physical injuries or physical sickness”. SBJPA sec.
1605(a), 110 Stat. 1838. The flush language of 104(a) explains
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that “emotional distress shall not be treated as a physical
injury or physical sickness.” Only reimbursements for actual
medical care for such injuries are now excludable. The
legislative history of this amendment clarifies that “the term
emotional distress includes symptoms (e.g., insomnia, headaches,
stomach disorders) which may result from such emotional
distress.” H. Conf. Rept. 104-737, at 301 n.56 (1996), 1996-3
C.B. 741, 1041 n.56. Section 1605(d) of the SBJPA, 110 Stat.
1839, provides that (with an inapplicable exception) “the
amendments made by this section shall apply to amounts received
after the date of the enactment of this Act, in taxable years
ending after such date.” The SBJPA was enacted on August 20,
1996. Id. at 1755.
Petitioners contend that the “clear language” of section
1605(d) of the SBJPA dictates that the SBJPA amendments to
section 104(a)(2) are not effective until 1997 because 1997 is
“the tax year ending after the effective date of the enactment of
the SBJPA”. Petitioners argue that, if Congress had intended for
the amendments to become effective in the middle of a year, then
it could have unambiguously stated so. Petitioners misinterpret
this statutory language.
Petitioners’ 1996 taxable year ended December 31, 1996,
which is after the date of the enactment of the SBJPA.
Petitioner received the settlement proceeds on December 17, 1996,
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which is also after the date of enactment of the SBJPA but before
the end of the 1996 taxable year. Thus, applying the plain
language of the statute, petitioner’s receipt of the settlement
proceeds was in a taxable year ending after the effective date of
the amendment. See, e.g., Filson, The Legislative Drafter’s Desk
Reference (1992), illustration in sec. 26.4, Event-related
effective dates. Accordingly, we apply section 104(a)(2), as
amended by the SBJPA.
Application
In interpreting section 104(a)(2), the Supreme Court has
held that amounts are excludable from gross income only when
(1) the underlying cause of action giving rise to the recovery is
based on tort or tort-type rights and (2) the damages were
received on account of personal injuries or sickness.
Commissioner v. Schleier, 515 U.S. 323, 336-337 (1995); sec.
1.104-1(c), Income Tax Regs. This test has been extended to
apply to the SBJPA amendments to section 104(a)(2). See Shaltz
v. Commissioner, T.C. Memo. 2003-173; Henderson v. Commissioner,
T.C. Memo. 2003-168. Accordingly, the second prong of the test
requires proof that the damages were received on account of
personal physical injuries or physical sickness.
If damages are received pursuant to a settlement agreement,
the nature of the claim that was the actual basis for settlement,
rather than the validity of the claim, determines whether the
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damages were received on account of tortlike personal injuries.
See Robinson v. Commissioner, supra at 126. The determination of
the nature of the claim is factual and is made by reference to
the settlement agreement in light of the surrounding
circumstances. Id. A key question to ask is: “‘In lieu of what
were the damages awarded?’” Id. (quoting Raytheon Prod. Corp. v.
Commissioner, 144 F.2d 110, 113 (1st Cir. 1944), affg. 1 T.C. 952
(1943)). An important factor in determining the validity of the
agreement is the intent of the payor. Id. at 127.
Petitioners contend that section 7491, which was added to
the Code by the Internal Revenue Service Restructuring and Reform
Act of 1998, Pub. L. 105-206, sec. 3001, 112 Stat. 726, shifts to
respondent the burden of proof of the nature of the claim.
Respondent, however, argues that petitioners have not satisfied
the statutory requirements under section 7491 because petitioners
neither cooperated with reasonable requests for information nor
presented credible evidence. See sec. 7491(a)(1) and (2)(B). In
this case, we need not decide whether petitioners have complied
with the requirements of section 7491 because the resolution of
this issue does not depend on which party has the burden of
proof. We resolve this issue on the preponderance of the
evidence in the record.
Under the terms of the termination agreement, petitioner was
awarded $2 million “in settlement of his claims for tortious
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interference with contracts, for personal injury including injury
to [petitioner’s] personal and professional reputation and
emotional distress, [and] humiliation and embarrassment”.
Petitioners argue that, because the termination agreement
specifically sets forth the claims that formed the basis for
settlement, we need not look to the intent of the payor.
Assuming, arguendo, that the claims stated in the
termination agreement accurately reflect the basis for
settlement, any amount received on such basis is nevertheless
includable in gross income because it was not received on account
of personal physical injury or physical sickness within the
meaning of section 104(a)(2). As explained above, Congress
explicitly excluded from the definition of physical injuries or
physical sickness emotional distress and related injuries. Sec.
104(a); see H. Conf. Rept. 104-737, at 301 n.56, supra, 1996-3
C.B. at 1041 n.56. Injury to reputation, humiliation, and
embarrassment are akin to emotional distress. See Shaltz v.
Commissioner, T.C. Memo. 2003-173. Moreover, tortious
interference with contracts is an economic injury, not a physical
injury, and so damages received on account thereof are not
excludable under section 104(a)(2). See Robinson v.
Commissioner, 102 T.C. 126.
Petitioners nevertheless argue that petitioner suffered a
physical injury. In support thereof, petitioners presented the
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testimony of William Taylor (Taylor), petitioner’s treating
physician. Even he, however, acknowledged that petitioner’s
symptoms were the result of the “usual stress related to the
buyout of a large gas company”. Taylor testified as follows:
Q: And tell us generally please, if you would,
based on your notes, your findings of that physical
[examination] in June of 1995.
A: * * * And my overall assessment at that time
was that he had an unremarkable exam.
* * * * * * *
Q: And would you tell us, please, what were your
findings and conclusions based on that exam in June of
1996?
A: Okay. At that time, his only complaint was
having usual stress related to the buyout of a large
gas company. He noted low energy.
He was complaining of loud snoring, easy
fatigability during the day. Occasional indigestion.
* * * Again, difficulty sleeping, some stress.
Q: Did your assessment show that he had
hypertension?
A: Yes.
Although petitioners had introduced into evidence the nature
of petitioner’s alleged physical injury at this point in the
testimony, petitioners’ counsel continued by asking Taylor what
consequences might occur if hypertension goes untreated. Taylor
testified that hypertension can lead to strokes, heart attacks,
and kidney disease. What petitioner might have suffered had his
hypertension gone untreated, however, is not any injury for which
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he made claim or for which he was compensated by NGC. What
petitioner did suffer–-fatigability, occasional indigestion, and
difficulty sleeping–-are the types of injuries or sicknesses that
Congress intended to be encompassed within the definition of
emotional distress. See H. Conf. Rept. 104-737, at 301 n.56,
supra, 1996-3 C.B. at 1041 n.56. Consequently, amounts received
on the basis of such injuries are not excludable from gross
income under section 104(a)(2) even if the underlying cause of
action sounds in tort.
Even if petitioner had suffered a personal physical injury
within the meaning of section 104(a)(2), such injury could not
have been the basis for settlement because, as the parties
stipulated, petitioner did not communicate any physical injury to
representatives of NGC during the settlement negotiations.
Clearly he did not make a claim for medical expenses that had
been incurred as a result of his injury. Petitioners
nevertheless argue that, even though petitioner’s injury
(presumably the hypertension) was not disclosed to NGC during the
settlement negotiations, “this in no way lessens its existence or
the extent of such injury.” Respondent does not dispute the
symptoms described by petitioner. The key, however, is not
simply whether petitioner suffered an injury, but whether that
injury was the basis for any portion of the settlement. In this
case, NGC was unaware that petitioner was suffering from any
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physical injury, and so neither petitioner’s physical injury nor
medical expense could have been the basis for settlement.
On this record, we conclude that petitioner did not receive
the settlement proceeds on account of personal physical injuries
or physical sickness within the meaning of section 104(a)(2), as
amended by the SBJPA. We therefore hold that the entire
settlement amount is includable in petitioners’ gross income.
Addition to Tax and Penalty
Respondent determined an addition to tax for failure to file
timely under section 6651(a)(1) and an accuracy-related penalty
for substantial understatement or negligence or disregard of the
rules or regulations under section 6662(a). Respondent has the
burden of production under section 7491(c) for the addition to
tax and the penalty and must come forward with sufficient
evidence showing that they are appropriate. See Higbee v.
Commissioner, 116 T.C. 438, 446-447 (2001).
Respondent determined the addition to tax for late filing
because, although petitioners received a 4-month extension to
file their 1996 tax return, petitioners did not file until
January 15, 1998. The due date with the extension was August 15,
1997. Respondent has met his burden under section 7491(c) by
establishing petitioners’ late filing.
To avoid the addition to tax for filing a late return,
petitioners have the burden of proving that the failure to file
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did not result from willful neglect and that the failure was due
to reasonable cause. See United Stated v. Boyle, 469 U.S. 241,
245 (1985). To prove reasonable cause, a taxpayer must show that
he or she exercised ordinary business care and prudence but
nevertheless could not file the return when it was due. See
Crocker v. Commissioner, 92 T.C. 899, 913 (1989); sec. 301.6651-
1(c)(1), Proced. & Admin. Regs.
Petitioners have presented neither evidence nor argument as
to why they did not file their 1996 tax return timely. Instead,
petitioners argue that, because the settlement proceeds are
excludable from gross income, the related addition to tax under
section 6651(a) must not be allowed.
As we concluded, supra, petitioners must include the entire
settlement amount in gross income. Because petitioners have not
shown that their failure to file timely was due to reasonable
cause, respondent’s determination with respect to the addition to
tax under section 6651(a)(1) is sustained.
Under section 6662(a), a taxpayer may be liable for a
penalty of 20 percent on the portion of an underpayment of tax
attributable to a substantial understatement of tax or due to
negligence or disregard of the rules or regulations. Sec.
6662(b). Whether the penalty is applied because of a substantial
understatement of tax or negligence or disregard of the rules or
regulations, the accuracy-related penalty is not imposed with
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respect to any portion of the understatement as to which the
taxpayer acted with reasonable cause and in good faith. Sec.
6664(c)(1); Higbee v. Commissioner, supra at 448-449. The
decision as to whether the taxpayer acted with reasonable cause
and good faith depends upon all the pertinent facts and
circumstances. Sec. 1.6664-4(b)(1), Income Tax Regs.
The term “understatement” is defined as the excess of the
amount of tax required to be shown on the return for the taxable
year over the amount of tax shown on the return for the taxable
year. Sec. 6662(d)(2)(A). A substantial understatement exists
if the understatement exceeds the greater of (1) 10 percent of
the tax required to be shown on the return or (2) $5,000. The
$2 million that petitioners failed to report accounts for all
(using a stacking basis) or almost all (using a proportional
basis) of the deficiency, which exceeds the greater of 10 percent
of the tax required to be shown on petitioners’ tax return or
$5,000. Accordingly, respondent’s burden of production under
section 7491(c) is satisfied.
Petitioners contend that they are not liable for the penalty
under section 6662(a) because “the effective date of the SBJPA
was unclear, at best”. Petitioners argue that “it is
inconceivable that an individual self-preparing an income tax
return would have knowledge of a purported change to the tax code
which occurred in the middle of the tax year.” Petitioners,
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however, have not shown what, if anything, they did to discern
the authority on which they relied to justify the exclusion of
the settlement proceeds from gross income or to determine the
correct effective date of the amendments to section 104(a)(2).
They have not identified any tax professionals that they
consulted or on whom they relied. Because petitioners have not
shown reasonable cause or good faith for their failure to include
the settlement proceeds in gross income, the penalty determined
by respondent is sustained.
To reflect the foregoing and the concession of petitioners,
Decision will be entered
for respondent.