T.C. Summary Opinion 2009-99
UNITED STATES TAX COURT
PAUL J. AND ALLEN C. PRINSTER, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 15675-07S. Filed June 30, 2009.
Paul J. and Allen C. Prinster, pro sese.
Michael W. Berwind, for respondent.
GERBER, Judge: This case was heard pursuant to the
provisions of section 7463 of the Internal Revenue Code in effect
when the petition was filed.1 Pursuant to section 7463(b), the
decision to be entered is not reviewable by any other court, and
1
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the year in issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
-2-
this opinion shall not be treated as precedent for any other
case.
Respondent determined for 2005 an income tax deficiency of
$18,392 and an accuracy-related penalty under section 6662(a) of
$3,678. At trial respondent moved to amend the pleadings in
order to seek a deficiency of $33,616 and a section 6662(a)
penalty of $6,723.20. The issues for decision are: (1) Whether
to grant respondent’s motion to amend the pleadings; (2) whether
payments that Paul Prinster (Mr. Prinster) and his attorney
received from his former employer are excludable from
petitioners’ gross income under section 104(a)(2); (3) whether
petitioners are entitled to deductions for travel, meals,
entertainment, and “listed property” expenses claimed on their
2005 return; and (4) whether petitioners are liable for the
section 6662(a) accuracy-related penalty.
Background
Some of the facts have been stipulated and are so found.
The stipulations of facts and the attached exhibits are
incorporated herein by this reference. Petitioners resided in
California when they filed their petition. Portions of the
record have been sealed at the request of petitioners.
The controversy underlying this case involves the
termination of Mr. Prinster’s employment. Mr. Prinster believed
the firing to be wrongful, and thereafter he suffered mental
-3-
distress. He also experienced hyperlipidemia, hypertension, and
other ailments, which he believed to be caused by that mental
distress. Petitioners hired an attorney, Mr. Lyon, who
represented Mr. Prinster in the controversy. Mr. Lyon filed suit
against the employer. The employer paid $76,500 to settle Mr.
Prinster’s claim in 2005. At Mr. Prinster’s request, $28,716.50
of that amount was paid directly to Mr. Lyon. The employer
accordingly issued Mr. Prinster and Mr. Lyon Forms 1099-MISC,
Miscellaneous Income, in the respective amounts paid to each of
them. Mr. Prinster asked Mr. Lyon whether the settlement was
taxable and was advised that it was not because it was
attributable to personal injuries.
Petitioners timely filed a joint Form 1040, U.S. Individual
Income Tax Return, for the 2005 tax year. They did not report
any of the former employer’s payments as income. They did report
$18,506 of income on Schedule C, Profit or Loss From Business,
from Mr. Prinster’s educational service business. They also
claimed Schedule C expenses of $494 for meals and entertainment,
$4,245 for travel, $1,876 for vehicles/machinery/equipment, and
$13,975 for car and truck expenses.
On April 26, 2007, respondent issued a notice of deficiency
in which he determined that petitioners had an income tax
deficiency of $18,392 for their 2005 tax year. In calculating
the deficiency respondent assumed that the income petitioners
-4-
reported on their Schedule C ($18,506) was attributable to the
payment from the former employer ($47,783.50) and thus mistakenly
believed that petitioners had underreported that payment by
$29,277. Respondent disallowed petitioners’ Schedule C expenses
for lack of substantiation, and other items were disallowed as a
result of computational limitations. Respondent also determined
a section 6662(a) accuracy-related penalty of $3,678.
Petitioners filed a petition with the Court on July 11,
2007. Respondent has conceded that petitioners have adequately
substantiated $960 of Schedule C rent or lease expenses.
However, during preparation for trial respondent discovered that
the $28,716.50 payment from the employer to Mr. Lyon was related
to the payment the employer made to Mr. Prinster. Respondent
also learned that the $18,506 of Schedule C income petitioners
reported was not from Mr. Prinster’s former employer. Respondent
subsequently moved to amend his answer to conform to the proof to
seek an increased deficiency and an increased penalty that
accounted for all of the payments from the employer.
Discussion
I. Respondent’s Motion To Amend the Pleadings
A party may amend a pleading only by leave of the Court, and
leave shall be given freely when justice so requires. Rule
41(a). When issues not raised by the pleadings are tried by
express or implied consent of the parties, the Court may allow
-5-
such amendment of the pleadings as necessary to cause them to
conform to the evidence presented at trial. Rule 41(b)(2).
Prejudice to the other party is a key factor in deciding whether
to allow an amendment to the pleadings. See Kroh v.
Commissioner, 98 T.C. 383, 389 (1992).
Petitioners stipulated, for purposes of trial, that Mr.
Prinster’s former employer paid him a total of $76,500.2 At
trial respondent moved to amend the pleadings to conform with the
evidence regarding the payments. Respondent seeks an increased
income tax deficiency and an increased section 6662(a) accuracy-
related penalty for petitioners’ 2005 tax year.
The notice of deficiency placed petitioners on notice that
respondent considered the payments from the employer to be
includable in their gross income. The extent of the payments,
including the payment to Mr. Prinster’s attorney, was known to
petitioners when respondent issued the notice of deficiency. The
amendment to the pleadings does not cause prejudice to
petitioners because they knew the correct amount of those
payments and of the potential for tax liability.
Accordingly, respondent’s motion to amend the pleadings will
be granted.
2
The stipulation renders moot respondent’s burden of proving
the increased deficiency under Rule 142(a).
-6-
II. Section 104(a)(2) Exclusion
Section 104(a)(2) provides an exclusion from gross income
for damages received on account of personal physical injury or
physical sickness. To qualify under section 104(a)(2), as
amended and in effect for amounts received after August 20, 1996,
taxpayers must show: (1) The underlying cause of action was
based upon tort or tort type rights; and (2) the damages were
received on account of personal physical injuries or physical
sickness. Commissioner v. Schleier, 515 U.S. 323, 336-337
(1995); sec. 1.104-1(c), Income Tax Regs.
A. Tort-Based Claim
The section 104(a)(2) requirement that petitioners’ claim
arise from a tort or tort type rights obligates us to examine
State law, because State law determines the nature of the claim.
Venable v. Commissioner, T.C. Memo. 2003-240, affd. 110 Fed.
Appx. 421 (5th Cir. 2004).
Under California law an employer’s right to fire an at-will
employee is limited by public policy considerations. Tameny v.
Atl. Richfield Co., 610 P.2d 1330, 1332-1333 (Cal. 1980). At-
will employees may recover tort damages from employers if they
can show they were discharged in contravention of fundamental
public policy. Id. at 1336. To prevail, employees must show
that important public constitutional or statutory interests were
-7-
contravened. Silo v. CHW Med. Found., 45 P.3d 1162, 1166 (Cal.
2002).
Mr. Prinster did have a tort-based wrongful termination
claim against his employer. He alleged his termination violated
the public policy concerning: (1) Making false statements (False
Statements Accountability Act of 1996, 18 U.S.C. sec. 1001
(2006); Holmes v. Gen. Dynamics Corp., 22 Cal. Rptr. 2d 172 (Ct.
App. 1993)); (2) whistleblowing (Cal. Lab. Code secs. 98.6,
1102.5, and 1105 (West 2003 & Supp. 2009); Cal. Govt. Code secs.
8547.3, 8547.8, 19683 (West 2005 & Supp. 2009)); (3) refusal to
commit illegal acts (Cal. Lab. Code sec. 2856 (West 2003)).
B. Physical Injury or Physical Sickness
For payments made after August 20, 1996, Congress amended
section 104(a)(2) to limit the exclusion to amounts received only
for physical injuries or physical illness. Small Business Job
Protection Act of 1996, Pub. L. 104-188, sec. 1605, 110 Stat.
1838. To determine whether the payment received was for a
physical injury or sickness, we must again examine the taxpayer’s
underlying claim. Connolly v. Commissioner, T.C. Memo. 2007-98.
The determining factor is the payor’s intent or dominant reason
for making the payment. Vincent v. Commissioner, T.C. Memo.
2005-95. This is generally determined by reference to the stated
reasons for the payment and the accompanying factual setting.
Stocks v. Commissioner, 98 T.C. 1, 11 (1992); Knoll v.
-8-
Commissioner, T.C. Memo. 2003-277. Generally, courts have
respected the allocation made when it is an arm’s-length
agreement made in good faith. Stadnyk v. Commissioner, T.C.
Memo. 2008-289; see Fono v. Commissioner, 79 T.C. 680 (1982),
affd. without published opinion 749 F.2d 37 (9th Cir. 1984).
Petitioners contend that Mr. Prinster suffered physical
sickness in the form of headaches, vomiting, diarrhea,
hypertension, hyperlipidemia, and diabetes.
Mr. Prinster’s ailments are not of the type contemplated by
section 104(a)(2). Emotional distress is not treated as a
physical injury or physical sickness except to the extent of
amounts paid for medical care attributable to the emotional
distress. Sec. 104(a) (flush language). “Physical
manifestations of emotional distress such as fatigue, insomnia,
and indigestion do not transform emotional distress into physical
injury or physical sickness.” Connolly v. Commissioner, supra.
In Lindsey v. Commissioner, T.C. Memo. 2004-113, affd. 422 F.3d
684 (8th Cir. 2005), the taxpayer also suffered from hypertension
and stress-related symptoms, and we held that these symptoms
related to emotional distress rather than physical sickness.
Absent proof of medical care expenses, petitioners have not
demonstrated any physical injury or physical sickness that gives
rise to the section 104(a)(2) exclusion.
-9-
Furthermore, petitioners have not sufficiently shown that
Mr. Prinster’s ailments resulted from his termination. The
record reflects that Mr. Prinster had already been suffering from
hyperlipidemia, and the record further suggests that Mr.
Prinster’s posttermination symptoms could also have been the
product of his diet and lifestyle. The record thus fails to
establish the cause of Mr. Prinster’s sickness.
Petitioners also failed to demonstrate that the payments
from his employer were for physical injuries. Though the sealed
portion of the record indicates that the payments were “for
alleged emotional and related physical injuries”, there is no
specificity about the amount, if any, that could be allocated to
either. In the absence of a basis for allocation, we presume the
entire amount is not excludable. See Taggi v. United States, 35
F.3d 93, 96 (2d Cir. 1994); Connolly v. Commissioner, supra;
Sodoma v. Commissioner, T.C. Memo. 1996-275, affd. without
published opinion 139 F.3d 899 (5th Cir. 1998).
C. Payment to Mr. Lyon
Petitioners contend that Mr. Prinster received only
$47,783.50 from his employer and that the $28,716.50 paid
directly to Mr. Lyon should therefore not be included in
petitioners’ gross income.
Gross income includes “all income from whatever source
derived” unless specifically excluded. Sec. 61(a). Section
-10-
61(a) is broadly interpreted, but exclusions from income are
narrowly defined. Commissioner v. Schleier, 515 U.S. at 327-328.
A taxpayer cannot exclude economic gain from gross income by
assigning that gain in advance to another party because gains are
taxed to those who earn them. Commissioner v. Banks, 543 U.S.
426 (2005); Lucas v. Earl, 281 U.S. 111, 114-115 (1930).
Mr. Prinster’s former employer agreed to pay him $76,500.
Petitioners were entitled to the $76,500 and the $28,716.50
payment therefore belonged to petitioners. Accordingly,
petitioners cannot avoid the incidence of tax on that payment
simply because that portion of the settlement was redirected to
Mr. Lyon. The cause of action generating the $76,500 payment
belonged to Mr. Prinster. Mr. Lyon was owed the amount of
$28,716.50 by Mr. Prinster for legal services rendered to Mr.
Prinster. Moreover, Mr. Prinster and his employer agreed that
“Each Party shall bear his or its own costs and attorneys’ fees.”
The employer made the $28,716.50 payment directly to Mr. Lyon
solely because Mr. Prinster requested it to do so. The
transaction is thus treated as if Mr. Prinster had received the
payment from his employer and then paid that amount over to Mr.
Lyon. The fact that Mr. Prinster arranged to have his employer
make a portion of the payment directly to Mr. Lyon does not
change the result.
-11-
Accordingly, we hold that petitioners must include in their
gross income the $76,500 paid by the former employer, even though
a portion was paid to Mr. Lyon.
D. Conclusion
Although petitioners have demonstrated that Mr. Prinster had
a tort-based claim, they have not established that any of the
payments from his employer were for physical injury or physical
sickness.
Petitioners therefore cannot exclude these payments from
their gross income.
III. Schedule C Expenses
Deductions are a matter of legislative grace, and taxpayers
bear the burden of establishing entitlement to claimed
deductions. Rule 142(a); INDOPCO, Inc. v. Commissioner, 503 U.S.
79, 84 (1992). Taxpayers are required to maintain adequate
records to establish the amount of their income and deductions.
Sec. 6001; sec. 1.6001-1(a), (e), Income Tax Regs.
When a taxpayer establishes that he has incurred deductible
expenses but is unable to substantiate the exact amounts, we
generally can estimate the deductible amount if sufficient
evidence exists to provide a rational basis for the estimate.
Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930);
Vanicek v. Commissioner, 85 T.C. 731, 742-743 (1985). However,
section 274(d) prohibits us from estimating a taxpayer’s travel,
-12-
entertainment, and “listed property” (e.g., automobiles and other
property used for transportation) expenses. Sanford v.
Commissioner, 50 T.C. 823, 827 (1968), affd. per curiam 412 F.2d
201 (2d Cir. 1969); sec. 1.274-5T(a), Temporary Income Tax Regs.,
50 Fed. Reg. 46014 (Nov. 6, 1985).
To deduct the items in dispute, all of which are subject to
strict substantiation requirements, petitioners must substantiate
either by adequate records or by sufficient evidence
corroborating their own statements: (A) The amount of each
expense; (B) the time and place the expense was incurred; (C) the
business purpose of the expense; and (D) the business
relationship to them of each expense incurred. Sec. 274(d);
Beale v. Commissioner, T.C. Memo. 2000-158. Expenses subject to
section 274 requirements may be substantiated by adequate records
where the taxpayer maintains an account book, a diary, a log, a
statement of expenses, trip sheets, or similar records prepared
contemporaneously with the expenditure supplemented by other
documentary evidence. Sec. 1.274-5(c)(2)(iii), Income Tax Regs.;
sec. 1.274-5T(c)(2), Temporary Income Tax Regs., 50 Fed. Reg.
46017 (Nov. 6, 1985). Substantiation by other sufficient
evidence requires the production of corroborative evidence in
support of a taxpayer’s statement specifically detailing the
required elements. Sec. 1.274-5T(c)(3), Temporary Income Tax
Regs., 50 Fed. Reg. 46020 (Nov. 6, 1985).
-13-
Mr. Prinster has failed to substantiate his Schedule C
expenses. The only evidence supporting the deductions he claimed
is his testimony that the expenses were incurred. He did not
produce adequate records or other sufficient evidence to
corroborate that testimony, and he therefore has not established
the amounts of these expenses. With the exception of the $960 of
rent or lease expenses that respondent has conceded, Mr. Prinster
is not entitled to deductions for his Schedule C expenses.
IV. Section 6662(a) Penalty
Section 6662(a) and (b)(1) and (2) imposes an accuracy-
related penalty of 20 percent on the portion of an underpayment
attributable to negligence, disregard of rules or regulations, or
a substantial understatement of income tax. Negligence includes
any failure to keep adequate books and records or to substantiate
items properly. Sec. 1.6662-3(b)(1), Income Tax Regs. An
understatement is substantial if it exceeds the greater of: (1)
10 percent of the tax required to be shown on the return for the
taxable year, or (2) $5,000. Sec. 6662(d)(1)(A); Neely v.
Commissioner, 85 T.C. 934, 947 (1985).
Petitioners had a substantial understatement of income tax
because their tax liability was understated by $33,616.
Petitioners were also negligent in that they failed to properly
substantiate their claimed Schedule C deductions.
-14-
Petitioners contend they should not be liable for the
section 6662(a) penalty on the portion of the deficiency
attributable to the payments from Mr. Prinster’s former employer
because Mr. Lyon advised Mr. Prinster that the payments were not
taxable.
Section 6664(c)(1) provides a defense to the section 6662
penalty for any portion of an underpayment where reasonable cause
existed and the taxpayers acted in good faith. In determining
whether a taxpayer reasonably relied in good faith on
professional advice, all facts and circumstances must be
considered, including the taxpayer’s education, sophistication,
and business experience. Sec. 1.6664-4(c)(1), Income Tax Regs.
Generally, the most important factor is the extent of the
taxpayer’s effort to assess the taxpayer’s proper tax liability.
Sec. 1.6664-4(b)(1), Income Tax Regs.
Mr. Prinster asked his attorney, Mr. Lyon, whether the
settlement was taxable. Mr. Lyon incorrectly advised that it was
not taxable because Mr. Prinster’s ailments were considered
physical injuries. Petitioners are not tax sophisticated, and
they relied on Mr. Lyon’s advice. It is generally reasonable for
the taxpayer to rely on an attorney’s tax advice as to a matter
of tax law, and the taxpayer is ordinarily not required to
challenge that advice. United States v. Boyle, 469 U.S. 241, 251
(1985). Here the reliance was in good faith and it was
-15-
reasonable for petitioners to rely on their adviser’s advice on
the transaction. Sec. 1.6664-4(c)(1), Income Tax Regs.
Accordingly, petitioners are not liable for the section
6662(a) penalty on the portion of the underpayment attributable
to their failure to report the $76,500 settlement. With respect
to petitioners’ claimed Schedule C expenses, however, petitioners
were negligent in failing to maintain proper substantiating
records and are liable for the section 6662(a) accuracy-related
penalty. We leave to the parties the computation of the correct
amount of the section 6662(a) penalty.
To reflect the foregoing,
An appropriate order will be
issued, and decision will be
entered under Rule 155.