The opinion
T.C. Memo. 1998-18
UNITED STATES TAX COURT
WILLIAM J. GOEDEN AND CAROL S. GOEDEN, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 21994-94. Filed January 14, 1998.
John W. Hein, for petitioners.
J. Paul Knap, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
WRIGHT, Judge: Respondent determined deficiencies in
petitioners' Federal income taxes, an addition to tax for
substantial understatement of tax and accuracy-related penalties,
as follows:
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Addition to Tax Penalty
Year Deficiency Sec. 6661 Sec. 6662(a)
1988 $8,760 $2,190 ---
1989 2,423 --- $485
1990 7,532 --- 1,506
Petitioners have alleged and claimed in their petition that,
based on their amended Federal income tax returns for 1988, 1989,
and 1990, they are entitled to refunds for those years in the
amounts of $896, $1,567, and $1,574, respectively.
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years in issue. All
Rule references are to the Tax Court Rules of Practice and
Procedure.
After concessions by respondent,1 the issues to be decided
are: (1) Whether all or any part of the payments received in the
years 1988 through 1990 by petitioner William J. Goeden from
State Central Credit Union, pursuant to a settlement agreement,
is excludable from gross income under section 104(a)(2) as
damages received on account of personal injuries; (2) whether
petitioners are entitled to deduct any part of attorney's fees
1
Respondent has conceded that the value of health and
life insurance coverage received by petitioner from State Central
Credit Union during the years in issue is excludable from gross
income. Respondent has also conceded that, to the extent
attorney's fees were paid in 1988 for the purpose of obtaining
taxable income, petitioners are entitled to deduct such fees as a
miscellaneous itemized deduction in that year.
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paid in 1988 in connection with the settlement agreement; (3)
whether petitioners are liable for the addition to tax for
substantial understatement of tax under section 6661 for 1988;
and (4) whether petitioners are liable for the accuracy-related
penalties under section 6662(a) for 1989 and 1990.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
The stipulation of facts and the attached exhibits are
incorporated herein by this reference.
Petitioners resided in Brookfield, Wisconsin, at the time
their petition was filed in this case.
William J. Goeden (petitioner) was employed in several
positions by State Central Credit Union (the credit union) from
January 14, 1957, until he resigned on September 15, 1988,
serving as its president since April 1, 1981. Petitioner did not
have a written employment contract with the credit union at any
time during his employment.
On February 29, 1988, at an executive session of the credit
union's board of directors, a majority of the board (by a 4 to 3
vote) passed a resolution authorizing and directing its chairman
to:
(1) Provide written notice to Mr. William J. Goeden,
President of State Central Credit Union, that the Board
may remove him as an officer and director of State
Central Credit Union for violation of applicable law,
the Articles of Incorporation of State Central, the
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Bylaws and/or for any other good and sufficient cause
including but not limited to the following:
(a) The NCUA's [National Credit Union
Association] expressed concerns over
management practices including underwriting
policies and collection policies;
(b) Mismanagement associated with Dale Armstrong
and Cemetery Services, Inc.;
(c) Mismanagement associated with the purchase of
automobile conditional sales contracts;
(d) Mismanagement associated with the failure to
follow applicable FHA regulations in
connection with its home improvement loan
program;
(e) Mismanagement associated with employee
problems and concerns; and
(f) Failure to follow Board policies and Bylaws
in connection with the foregoing.
(2) Set forth in writing the reasons for the proposed
removal;
(3) Establish a time and location at which Mr. Goeden
may appear before the Board to rebut allegations
made against him which such time to be not less
than five (5) business days subsequent to mailing
to Mr. Goeden the Written notice described herein.
Various matters pertaining to petitioner's employment were
discussed at nine board meetings held between April 8, 1988, and
September 15, 1988. Although some of the allegations of
petitioner's mismanagement were challenged by some board members
as being false, neither petitioner nor his attorney, as reflected
in the board's minutes, specifically indicated at board meetings
that a suit based entirely on libel, injury to professional
reputation, or defamation would be brought by petitioner against
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the credit union. Petitioner never filed suit against the credit
union for libel, defamation, or any other cause of action.
Members of the board expressed serious concern at some
meetings about their possible personal liability as directors and
about a potential breach of petitioner's implied employment
contract. A claim of age discrimination was also a concern of
the board, as well as avoiding a possible suit for "wrongful
termination" under Wisconsin laws. In at least two board
meetings the members' discussion related to a settlement based on
retirement pay for petitioner.
At the May 4, 1988, board meeting petitioner's attorney
argued that petitioner committed no wrongs, that his proposed
termination would be unfair, and that he was being used as a
scapegoat for the credit union's problems. He charged that
petitioner's proposed termination was not in keeping with the
employee relations policies of the credit union. Consequently,
he stated that petitioner's proposed termination would be
regarded as a breach of his employment contract and that board
members who voted in favor of termination would be exposed to
personal liability. He stated that there would be extensive
discovery and litigation if petitioner were discharged.
In the board's executive session on May 4, 1988, a member
stated that it was necessary to determine whether the board
needed "just cause" to terminate petitioner and whether the
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discharge could be considered a "wrongful termination". A member
also expressed concern that the board could be sued by petitioner
and inquired whether the board's indemnity policy would pay for
any damages which might result.
The charges of mismanagement made against petitioner caused
damage to his professional reputation in the credit union
industry and prevented him from obtaining another responsible
position in his profession at the management level. He was asked
to resign as a member of the board of directors of the Tyme
Corporation.
On or about September 15, 1988, petitioner and the credit
union entered into a written settlement agreement which provided,
in pertinent part, as follows:
WHEREAS, the Board of Directors of the Credit Union
instituted proceedings on February 29, 1988, to consider the
removal of Goeden from his positions as President and
Director of the Credit Union.
WHEREAS, Goeden has indicated litigation would be
commenced against the Credit Union and any directors who
participated in his removal as President and Director and it
is anticipated such litigation would be protracted,
complicated and time-consuming for the parties;
WHEREAS, it is the mutual intent of the parties that
the payments made pursuant to this Settlement Agreement are
made by or on behalf of the Credit Union and received by
Goeden in settlement of any and all claims Goeden may have
against the Credit Union or any of its officers and/or
directors, either individually or in combination with
others, including but not limited to any and all claims for
defamation, libel, slander, age discrimination, tortious
interference with Goeden's trade, profession and right to
earn a living, injury to Goeden's business and professional
reputation and standing in the business community and
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tortious interference with Goeden's right to be free from
interference with his employment or other claims entitling
Goeden to seek compensatory damages for personal injuries,
injury to Goeden's feelings and humiliation and damages for
alleged violations of his civil and statutory rights;
* * * * * * *
NOW, THEREFORE, in consideration of the promises
contained herein, the parties agree as follows;
1. The parties to this Agreement will execute the
General Mutual Release and Statement that is
attached as Exhibit A and incorporated herein.
2. Goeden will receive the sum of Fifty Thousand
Dollars ($50,000) immediately upon execution of
this Settlement Agreement.
3. The Credit Union will be responsible for the
payment to Goeden of monthly monetary sums as
follows:
(a) Three Thousand Five Hundred Dollars ($3,500)
commencing as of September 15, 1988, and
thereafter paid monthly with the final
payment to be made on or by October 15, 1992.
(b) Three Thousand Four Hundred Sixty Seven
Dollars ($3,467) paid on or by November 15,
1992, and Three Thousand Dollars ($3,000)
thereafter paid monthly with the final
payment to be made on or by October 15, 1995,
in the amount of Three Thousand Four Hundred
Dollars ($3,400);
(c) Taxes, if any, with regard to the payments
are Goeden's responsibility.
(d) The above payments are to be made to Goeden
on or by the 15th day of each month.
(e) In the event of Goeden's death, the payments
will be paid to his spouse, if living, or to
his estate if not. Payments to Mrs. Goeden
would be made to her estate if she were to
die after Goeden and during the period when
such payments are required hereunder.
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(f) Earnings from other sources will not serve to
reduce or be offset against any payments or
benefits due to or received by Goeden, Mrs.
Goeden or their estates hereunder.
(g) The above payments may not be reduced,
eliminated or set-off against future claims,
if any, the Credit Union might bring against
Goeden unless and until a final non-
appealable judgment or court order has been
entered against Goeden with respect to such
claim or claims.
4. Goeden will resign as President and terminate his
employment with the Credit Union as of September
15, 1988. Goeden's employment termination will be
recorded as a Board approved early retirement.
Goeden will not seek or accept any future
relationship with the Credit Union as an officer,
director or employee.
The settlement agreement also provided that the credit union
would continue to pay group health and dental insurance for
petitioner and his family until he reached age 65 (he was then
57), and to pay certain premiums on his life insurance. The
credit union agreed to provide petitioner with Medicare
Supplement Insurance after he reached age 65.
The settlement agreement did not allocate the payments
received by petitioner to any particular cause of action.
On September 15, 1988, petitioner and the credit union
signed a general mutual release and statement. In it, petitioner
agreed to discharge from liability the credit union and its
directors and officers for any and all causes of action,
including age discrimination, breach of contract whether express
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or implied, and libel, slander, defamation, damage to reputation,
and intentional or negligent infliction of emotional distress.
Pursuant to the settlement agreement, petitioner received
from the credit union a lump-sum payment of $50,000 on September
15, 1988, and monthly payments totaling $14,000 in 1988, $42,000
in 1989, and $42,000 in 1990.
In an attachment to their Federal income tax returns for
each of the years 1988, 1989, and 1990, relying on the advice of
their certified public accountant from KPMG Peat Marwick, the
firm which prepared them, petitioners reported an amount under
"miscellaneous other income" which was 25 percent of the monthly
payments as the "taxable portion of settlement with State Central
Credit Union". They also reported in 1988 an amount that was 25
percent of the $50,000 lump-sum payment. They claimed a
deduction of $13,750 for attorney's fees paid in 1988. The
returns did not disclose the full amount of the payments received
by petitioner or the percentage reported. The returns did not
report as income any part of the value of petitioner's health and
life insurance coverage.
On or about December 9, 1991, petitioners filed amended
Federal income tax returns for 1988, 1989, and 1990, containing
the following explanation:
On the return as originally filed the taxpayer had included
in Other Income the "taxable portion" of settlement proceeds
received from State Central Union. The settlement proceeds
arose from an employment discrimination claim.
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At the time the returns were prepared, there were a few
court cases which supported an allocation of the proceeds
between personal injury damages (nontaxable) and contract-
type claims (taxable). Based on such decisions, the
taxpayer allocated 25% of the proceeds to contract-type
claims and allocated the remaining 75% of the proceeds as
nontaxable personal injury payments.
Recently, the courts have reversed earlier cases and have
ruled favorably for the taxpayers, as they have ruled that
100% of the payments in similar fact cases should be
excludible from taxable income. Specifically, the Downey v.
Commissioner, 97 T.C. 10 (1991) case recently overruled its
prior decision in Rickel v. Commissioner, 90-1 USTC Para
50,200 (3rd Cir. 1990).
Thus, petitioners claimed in the amended returns that all of the
payments received by petitioner were excludable from gross income
under section 104(a)(2). Consequently, they adjusted their
itemized deductions by claiming that the attorney's fees are not
deductible. The amended returns claimed refunds of $896 for
1988, $1,567 for 1989, and $1,574 for 1990.
In the notice of deficiency dated August 30, 1994,
respondent increased petitioners' gross income by $48,437 in
1988, $31,500 in 1989, and $31,500 in 1990, including in their
gross income all of the monthly payments petitioner received from
the credit union and all of the $50,000 lump-sum payment. The
notice allowed an additional itemized deduction of $41,250 in
1988 for attorney's fees.
The petition filed in this case on November 28, 1994, prior
to the Supreme Court's decision in Commissioner v. Schleier, 515
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U.S. 323 (1995), alleged that petitioner had causes of action
against the credit union for libel and age discrimination.
OPINION
Issue 1. Excludability of Settlement Payments
Petitioners contend that the payments received by petitioner
from the credit union pursuant to the terms of the settlement
agreement were based entirely on tort or tort type claims and
therefore all of the payments are excludable from gross income
under section 104(a)(2). To the contrary, respondent contends
that all of the payments received by petitioner are includable in
his gross income because they were made by the credit union for
reasons which rendered them subject to tax. We agree with
petitioners in part and with respondent in part. Based on this
record, we conclude that an allocation should be made.
Section 61(a) provides that, except as otherwise provided in
the Code, gross income means "all income from whatever source
derived". The Supreme Court has stated that the statutory
definition of gross income is broad and reflects Congressional
intent to exert the full measure of its taxing power and to bring
within the definition of income any accession to wealth. United
States v. Burke, 504 U.S. 229, 233 (1992). Thus, any receipt of
funds or other accession to wealth received by a taxpayer is
presumed to be gross income unless the taxpayer can establish
that the accession fits into one of the specific exclusions
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created by other sections of the Code. Commissioner v. Glenshaw
Glass Co., 348 U.S. 426, 430-432 (1955).
One exclusion is contained in section 104(a)(2). It permits
a taxpayer to exclude from gross income "the amount of any
damages received (whether by suit or agreement and whether as
lump-sums or periodic payments) on account of personal injuries
or sickness". Section 1.104-(1)(c), Income Tax Regs., defines
the term "damages received (whether by suit or agreement)" as an
amount received (other than workmen's compensation) through
prosecution of a legal suit or action based upon tort or tort
type rights, or through a settlement agreement entered into in
lieu of such prosecution.
The Supreme Court, in addressing the scope of section
104(a)(2), has applied the default rule of statutory
interpretation that exclusions from income must be narrowly
construed. Commissioner v. Schleier, 515 U.S. at 328. Thus, a
taxpayer seeking the exclusion must demonstrate not only that the
underlying claim giving rise to the recovery was based on tort or
tort type rights but also that the damages were received on
account of personal injuries or sickness. Id. at 336-337.
In the absence of express language in the settlement
agreement stating how the payments made to petitioner should be
allocated "on account of personal injuries", the intent of the
payor (the credit union) in making the payments is a key factor
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to consider in applying section 104(a)(2). Knuckles v.
Commissioner, 349 F.2d 610, 612 (10th Cir. 1965), affg. T.C.
Memo. 1964-33; Stocks v. Commissioner, 98 T.C. 1, 10 (1992).
As indicated in our findings of fact, the credit union's
board of directors had several motives for making the payments to
petitioner. The documentary or testimonial evidence shows that
such motives were to avoid (1) a suit for libel, defamation, or
damage to petitioner's professional reputation; (2) a suit for
age discrimination or wrongful discharge; (3) expenses of
litigation; and (4) claims for breach of an implied employment
contract. In addition, the board wanted to provide petitioner
with retirement pay. Because the intent of the credit union in
making payments to petitioner is derived from all of the above
motives, we think an allocation of the payments is appropriate
and necessary under these facts and circumstances. Stocks v.
Commissioner, supra at 16-17.
In view of the testimony of Hugo W. Wandt, Jr., and Richard
H.E. Smith, who were members of the credit union's board of
directors, and William French, an attorney who represented
petitioner in negotiations with the board, we are persuaded that
the claim for defamation and damage to professional reputation
was the predominant reason motivating the credit union's payments
to petitioner. Respondent did not attempt to rebut this
testimony by calling witnesses, especially other members of the
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credit union's board of directors. Instead, respondent countered
with the assertion that petitioners failed to carry their burden
of proof as to the intent of the payor credit union. We reject
this assertion.
Respondent does not dispute that payments received on
account of traditional causes of action for libel, slander,
personal embarrassment, or defamation are excludable from gross
income, whether the damage is to the taxpayer's personal or
professional reputation. See Threlkeld v. Commissioner, 87 T.C.
1294 (1986), affd. 848 F.2d 81 (6th Cir. 1988).
Other evidence shows that some of the payments were
motivated by claims that were not "on account of personal
injuries" within the scope of section 104(a)(2) and,
consequently, are includable in petitioner's gross income.
Accordingly, it is our best judgment, based on the record as
a whole, that 60 percent of the payments are allocable to the
potential claim for defamation and damage to professional
reputation and 40 percent to the other potential claims.
Therefore, we hold that 60 percent of the payments received by
petitioner are excludable from his gross income under section
104(a)(2), and the remainder is includable in his gross income.
Issue 2. Deductibility of Attorney's fees
Having concluded that 60 percent of the payments to
petitioner are excludable from gross income and 40 percent are
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includable, it follows that the attorney's fees should be
allocated in the same proportion as the excludable and includable
portions of the settlement payments. Section 265(a)(1) precludes
a deduction for an amount paid for legal fees if it is allocable
to a class of income exempt from taxation. See also Stocks v.
Commissioner, 98 T.C. at 18; Metzger v. Commissioner, 88 T.C.
834, 860 (1987), affd. without published opinion 845 F.2d 1013
(3d Cir. 1988); sec. 1.265-1(c), Income Tax Regs. We so hold.
Issue 3. Section 6661 Addition to Tax
Respondent determined that petitioners are liable for an
addition to tax under section 6661 for substantial understatement
of tax for 1988. Petitioners contend that they are not liable
for the addition to tax because (1) there was substantial
authority for reporting as taxable only part of the settlement
payments received in that year, and (2) their Federal income tax
return adequately disclosed the settlement with the credit union.
We agree with petitioners.
Section 6661(a), for returns due on or before December 31,
1989, provided for an addition to tax if there was a substantial
understatement of income tax for the taxable year. In the case
of additions to tax assessed after October 21, 1986, the amount
of the addition to tax is equal to 25 percent of the amount of
any underpayment attributable to such understatement. Omnibus
Budget Reconciliation Act of 1986, Pub. L. 99-509, sec. 8002(c),
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100 Stat. 1874, 1951; Licari v. Commissioner, 946 F.2d 690, 692
(9th Cir. 1991), affg. T.C. Memo. 1990-4; Pallottini v.
Commissioner, 90 T.C. 498 (1988).
Section 6661(b)(1)(A) provided that a substantial
understatement of income tax exists if the amount of the
understatement exceeds the greater of 10 percent of the tax
required to be shown on the return or $5,000. An understatement
was 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
imposed which is shown in the return, reduced by any rebate.
Sec. 6661(b)(2)(A).
In general, section 6661(b)(2)(B) provided that the
understatement is deemed to be reduced to the extent it is
attributable to: (1) The tax treatment of an item for which
there was substantial authority; or (2) any items with respect to
which the relevant facts affecting the item's tax treatment are
adequately disclosed in the return or in a statement attached to
the return.
At the time petitioners timely filed their Federal income
tax return for 1988 there was substantial authority for treating
some of the settlement payments petitioner received from the
credit union as excludable from his gross income. Damages to
professional or business reputation were excludable under section
104(a)(2) as being based on tort or tort type claims. Threlkeld
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v. Commissioner, supra (involving a civil lawsuit for malicious
prosecution); Roemer v. Commissioner, 716 F.2d 693 (9th Cir.
1983), revg. 79 T.C. 398 (1982) (involving a civil suit for
injury to a person's reputation caused by defamatory statements
constituting libel). The law was unsettled with respect to the
excludability of claims based on age discrimination. See Downey
v. Commissioner, 97 T.C. 150 (1991), supplemented by 100 T.C. 634
(1993), revd. and remd. 33 F.3d 836 (7th Cir. 1994).
It is problematic whether petitioners adequately disclosed
the item regarding the settlement payments in their 1988 return.
While it was not a full and detailed disclosure, we are inclined
to view it as adequate because respondent was alerted to the fact
that petitioner had received settlement payments from the credit
union, some taxable and some nontaxable. The disclosure in the
attachment to the return led to respondent's audit of the item
which in turn resulted in the principal adjustment contained in
the notice of deficiency.
Accordingly, we hold that petitioners are not liable for the
addition to tax under section 6661(a) for 1988.
Issue 4. Section 6662(a) Accuracy-Related Penalties
Respondent determined that petitioners are liable for
accuracy-related penalties for negligence under section
6662(a)(1) for 1989, and for a substantial understatement of
income tax under section 6662(a)(2) and negligence under section
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6662(a)(1) for 1990. Petitioners contend that they are not
liable for the accuracy-related penalties for either year. We
agree with petitioners.
The facts and circumstances as to whether there was a
substantial understatement of income tax for 1990 are similar to
those pertaining to 1988. We have previously concluded that for
1988 there was substantial authority for petitioners' treatment
of the settlement payments received from the credit union and an
adequate disclosure of the item's tax treatment in their return.
We reach the same conclusion with respect to 1990 and hold that
there was not a substantial understatement of income tax for that
year. See also sec. 6664(c) (relating to reasonable cause and
good faith).
For the years 1989 and 1990 we also conclude that
petitioners were not negligent in filing their returns.
Taxpayers are liable for a penalty equal to 20 percent of
the part of the underpayment to which section 6662(a) applies.
Negligence is a lack of due care or failure to do what a
reasonable and ordinarily prudent person would do under the
circumstances. Zmuda v. Commissioner, 731 F.2d 1417, 1422 (9th
Cir. 1984), affg. 79 T.C. 714 (1982); Neely v. Commissioner, 85
T.C. 934, 947 (1985). For purposes of section 6662(a),
negligence is a failure to reasonably attempt to comply with the
provisions of the Internal Revenue Code. Sec. 6662(c). The
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accuracy-related penalty under section 6662(a) does not apply to
any part of an underpayment if the taxpayer shows that there is
reasonable cause for that part of the underpayment and that the
taxpayer acted in good faith based on the facts and
circumstances. Section 6664(c).
Mr. French, petitioner's attorney during the negotiations
with the credit union, was a trial lawyer, not a tax lawyer.
Because he thought petitioner needed competent tax advice about
how the settlement payments should be reported for Federal income
tax purposes, he recommended that petitioner consult James L.
Mohr, a certified public accountant and tax specialist with KPMG
Peat Marwick. He introduced petitioner to Mr. Mohr, who was
hired to advise petitioner with respect to the tax aspects of the
settlement. KPMG Peat Marwick prepared petitioners' Federal
income tax returns for 1988, 1989, and 1990. Petitioner
consulted with Mr. Mohr and provided him with all the necessary
and relevant information required for the preparation of the
returns. The information was complete and accurate. Mr. Mohr
did the tax research to determine the then current status of the
law under section 104(a)(2). Although he thought the settlement,
for the most part, was based on tort type claims that resulted in
the payments' being excludable from gross income, he advised
petitioner to report 25 percent of the settlement payments as
taxable in an attempt to be reasonable and to avoid future
problems in dealing with the issue if questioned on audit by the
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Internal Revenue Service. Later, after this Court's first
opinion in Downey v. Commissioner, 97 T.C. 150 (1991), KPMG Peat
Marwick prepared amended Federal income tax returns for 1988,
1989, and 1990, which petitioners filed on December 9, 1991,
claiming that all of the settlement payments were excludable from
petitioner's gross income.
Under some circumstances a taxpayer may avoid liability for
negligence if reasonable reliance on a competent professional
adviser is shown. United States v. Boyle, 469 U.S. 241 (1985);
Freytag v. Commissioner, 89 T.C. 849, 888 (1987), affd. 904 F.2d
1011 (5th Cir. 1990), affd. 501 U.S. 868 (1991). Here it is
clear that petitioners made a good faith effort and acted
reasonably and prudently in attempting to comply with section
6662 by supplying their certified public accountant with all the
information necessary to correctly report the item subject to
adjustment. Petitioners hired an experienced accountant and tax
expert, and they relied on his advice. Therefore, we hold that
the imposition of the accuracy-related penalties for negligence
for 1989 and 1990 was improper and that petitioners are not
liable for them.
To reflect concessions and our conclusions with respect to
the contested issues,
Decision will be entered
under Rule 155.
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