The opinion
T.C. Memo. 2003-64
UNITED STATES TAX COURT
ED AND PATRICIA A. MONTGOMERY, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 1816-00. Filed March 5, 2003.
David H. McQuaig, for petitioner.
Felicia L. Branch, for respondent.
MEMORANDUM OPINION
DINAN, Special Trial Judge: Respondent determined
deficiencies in petitioners’ Federal income taxes of $2,975 and
$3,537, and accuracy-related penalties of $595 and $707.40, for
the taxable years 1996 and 1997. By amended answer, respondent
pled increased deficiencies and penalties for each year in issue,
for deficiencies totaling $5,355 and $6,351, and penalties
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totaling $1,071 and $1,270, in the respective years. Unless
otherwise indicated, section references are to the Internal
Revenue Code in effect for the years in issue, and all Rule
references are to the Tax Court Rules of Practice and Procedure.
The issues for decision are, with respect to each year in
issue: (1) Whether certain damages received by petitioners from
a lawsuit are fully includable in gross income; (2) whether
Southern Financial Investment Services, Inc., an S corporation
wholly owned by petitioner husband, operated a trade or business
within the meaning of section 162 or conducted an activity not
engaged in for profit within the meaning of section 183; and (3)
whether petitioners are liable for the accuracy-related penalties
under section 6662(a).
Some of the facts have been stipulated and are so found.
The stipulations of fact and the attached exhibits are
incorporated herein by this reference. Petitioners resided in
Jacksonville, Florida, on the date the petition was filed in this
case.
Lawsuit Proceeds
Background
In 1987, petitioner husband (petitioner) filed suit in the
United States District Court, Eastern District of Texas, against
his former employer, Leveretts Chapel Independent School District
(the district), and the individual school board members (the
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defendants). Petitioner and the district had an employment
contract under which petitioner was employed as superintendent of
the district. After his employment was terminated prematurely
under the contract, petitioner filed a complaint setting forth
three causes of action, alleging (1) the defendants deprived
petitioner of his property interest in a written employment
contract without due process in violation of the Fourteenth
Amendment to the United States Constitution; (2) the defendants
conspired to deprive petitioner of his federally protected right
to due process in violation of 42 U.S.C. secs. 1983, 1985, and
1986; and (3) the defendants breached petitioner’s employment
contract, causing a loss of salary and various benefits. The
complaint prayed for (1) lost wages, benefits, and compensatory
damages of $250,000; (2) punitive damages of $500,000; and (3)
costs and attorney’s fees. The complaint alleged that
petitioner’s contract had been breached, and his rights violated,
after a meeting of the school board on or about January 13, 1986.
Petitioner claimed that he had sustained a loss of salary and
benefits “in excess of $40,000 per year”, a loss of participation
in a retirement system, and a loss of living quarters. He also
claimed that the breach of the contract resulted in a loss of
continued employment beyond the term of the contract, causing
losses of future wages in the amount of $150,000. A copy of the
contract attached to the complaint stated that the contract’s
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term was from July 1, 1985, through June 30, 1988, and that
petitioner’s annual salary was set at $37,000. The contract also
stated that petitioner was to receive certain other benefits,
including furnished housing.
The final judgment in petitioner’s lawsuit was filed on July
20, 1989. Petitioner received damages of $185,000, which had
been reduced by order of remittitur from a jury award of
$450,000, and costs and attorney’s fees of $15,556.70.
Petitioner was also awarded interest on these amounts. On July
20, 1992, an order of execution of writ of mandamus was filed in
the district court compelling satisfaction of the “civil rights
judgment” filed 3 years earlier. This order further provided
that, if necessary, the school district was to levy additional
taxes to satisfy the judgment; the court cited case law that such
measures were appropriate where needed “to vindicate
constitutional guarantees”. In each of 1996 and 1997,
petitioners received a $30,000 payment towards the satisfaction
of this judgment. In 1996, the payment consisted of $21,489 in
interest and $8,511 in principal. In 1997, the payment consisted
of $19,966 in interest and $10,034 in principal.
Petitioners filed joint Federal income tax returns for 1996
and 1997. Petitioners reported as income on these returns the
portions of the yearly $30,000 payments representing interest
income, but they did not report the remaining portions of the
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payments. Respondent did not make an adjustment in the statutory
notice of deficiency with respect to this issue. By amended
answer, respondent asserts that petitioners must include in gross
income the principal portions of the payments, $8,511 in 1996 and
$10,034 in 1997.
Discussion
Gross income generally includes income from whatever source
derived, unless excluded by statute. Sec. 61(a). The exclusion
upon which petitioners rely in this case is that of section
104(a)(2), which excludes from gross income “the amount of any
damages received (whether by suit or agreement and whether as
lump sums or as periodic payments) on account of personal
injuries or sickness.”1 The Supreme Court, in Commissioner v.
Schleier, 515 U.S. 323 (1995), summarized the requirements of
section 104(a)(2) as follows:
In sum, the plain language of § 104(a)(2), the text of
the applicable regulation, and our decision in Burke
establish two independent requirements that a taxpayer must
meet before a recovery may be excluded under § 104(a)(2).
First, the taxpayer must demonstrate that the underlying
cause of action giving rise to the recovery is “based upon
tort or tort type rights”; and second, the taxpayer must
show that the damages were received “on account of personal
injuries or sickness.” * * *
1
Sec. 104(a)(2) was amended by the Small Business Job
Protection Act of 1996, Pub. L. 104-188, sec. 1605, 110 Stat.
1755, 1838. We apply the statute as it was in effect prior to
amendment because the payments in this case were received
pursuant to a court decree issued before September 13, 1995. Id.
sec. 1605(d)(2), 110 Stat. 1838.
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Id. at 336-337. Amounts received as punitive damages are not
received “on account of personal injuries or sickness” and thus
are not excludable from gross income under section 104(a)(2).
O’Gilvie v. United States, 519 U.S. 79, 101 (1996).
Prior to the Supreme Court’s decision in Schleier, this
Court had held that damages received under a 42 U.S.C. sec. 1983
(hereinafter referred to as sec. 1983) claim are excludable from
income under section 104(a)(2). Bent v. Commissioner, 87 T.C.
236 (1986), affd. 835 F.2d 67 (3d Cir. 1987). See also Metzger
v. Commissioner, 88 T.C. 834 (1987), affd. without published
opinion 845 F.2d 1013 (3d Cir. 1988). In Bent, the taxpayer was
a high school teacher who had brought suit after the school board
had declined to rehire him. He sued the school board for breach
of contract and various sec. 1983 claims. After a court had
rejected all of the taxpayer’s claims except a sec. 1983 claim
based on a violation of the First Amendment right to free speech,
the taxpayer settled the case. This Court held that the
settlement payment received by the taxpayer was excludable from
income under section 104(a)(2). In so holding, the Court found
that, under the circumstances of the case, the taxpayer’s
recovery of lost wages was an element of the compensatory damages
available under sec. 1983 and was not an independent basis for
recovery. The Third Circuit affirmed, expressing agreement with
our reasoning and conclusions.
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Respondent attempts to distinguish Bent from the present
case, arguing in part that Schleier stands for the proposition
that damages received for economic injury do not qualify for the
section 104(a)(2) exclusion, and that this Court’s holding in
Bent that lost wages may be a measure of personal injury “has
clearly lost its vitality” following Schleier. We agree with
respondent insofar as damages received on account of economic
injury are not excludable under section 104(a)(2) pursuant to
Schleier. Quantum Company Trust v. Commissioner, T.C. Memo.
2000-149.
Respondent bears the burden of proof with respect to this
issue because it was raised by respondent for the first time in
his answer. Rule 142(a).
In the case at hand, neither party has attempted to break
down the $185,000 in damages into portions attributable to the
various categories of damages sought by petitioner in his
lawsuit. We therefore examine each category of damages sought
therein.
First, petitioner sought punitive damages of $500,000. Any
portion of the amounts awarded to petitioner which represent
punitive damages is not excludable from income under section
104(a)(2). O’Gilvie v. United States, supra.
Second, petitioner sought compensatory damages of $250,000.
We are convinced that these damages sought by petitioner were for
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economic injury, not personal injury. The complaint alleged lost
wages and benefits “in excess of $40,000 per year”. Because the
contract was breached with approximately 2-1/2 years remaining
(from January 1986 through June 1988), this would result in
approximately $100,000 of lost wages and benefits. The complaint
further alleged lost future wages of $150,000. Because the total
amount of compensatory damages sought by petitioner was $250,000,
we find that the entire amount was sought as a result of the
economic injury suffered by petitioner. Thus, regardless of
whether certain civil rights damages may be excluded from income
under other circumstances, they may not in this case because the
damages awarded to petitioner were not awarded on account of
personal injury or sickness. Commissioner v. Schleier, supra.
Rather, they were to make petitioner whole economically as a
result of his lost employment. Any portion of the amounts
awarded to petitioner which represent the requested compensatory
damages is not excludable from income under section 104(a)(2).
Id.; Quantum Company Trust v. Commissioner, supra.
S Corporation Loss
Background
During the years in issue, petitioner taught at Florida
Community College at Jacksonville and held several other part-
time positions. Petitioner wife was employed by the Duval County
School Board. On their joint Federal income tax returns, they
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reported combined taxable wage income of $43,251 in 1996 and
$52,187 in 1997. In addition, petitioners received $30,000 of
income in each year representing the payments resulting from the
lawsuit discussed above.
During the years in issue, petitioner was the sole
shareholder of an S corporation named Southern Financial
Investment Services, Inc. (SFIS). SFIS was incorporated in
January 1990, and elected Subchapter S status in 1996. From its
incorporation until the time of trial, SFIS had never generated
positive net income. The following represents the “receipts” and
“deductions” of SFIS in each of the years for which the amounts
appear in the record:
1991 1993 1994 1995 1996 1997
Receipts $-0- $-0- $49,705 $3,829 $335 $292
Deductions -0- -0- (79,611) (54,445) (15,308) (15,163)
Net loss -0- -0- (29,906) (50,616) (14,973) (14,871)
In the years in issue, SFIS reported the following on its
corporate Federal income tax returns:
1996 1997
Gross receipts $335 $292
Cost of goods sold -0- (4,947)
Rents -0- (1,200)
Taxes and licenses (2,551) (1,193)
Interest (2,592) (23)
Depreciation (289) (289)
Advertising (372) (114)
Legal/professional (2,577) (2,577)
Other expenses (6,927) (4,820)
Ordinary loss (14,973) (14,871)
In each year, petitioners claimed a deduction for the entire loss
on their individual income tax return as petitioner’s 100 percent
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share of SFIS’s loss. In the statutory notice of deficiency,
respondent disallowed the deductions in full. Respondent
determined that, because the activities of SFIS were not operated
with a profit motive during the years in issue, the allowable
deductions for expenses related thereto are limited to the amount
of SFIS’s income in each year.
Discussion
Under section 162(a), a taxpayer may deduct the ordinary and
necessary expenses paid or incurred during the taxable year in
carrying on its trade or business. A taxpayer is engaged in a
trade or business if the taxpayer is involved in the activity
with continuity and regularity and with the primary purpose of
making a profit. Commissioner v. Groetzinger, 480 U.S. 23, 35
(1987).
If an activity of a taxpayer is not conducted for profit,
section 183(a) disallows all deductions related thereto, except
as provided by section 183(b). An activity is not conducted for
profit if it is one with respect to which deductions are not
allowable under section 162 or section 212(1) or (2).2 Sec.
183(c). If an activity of a taxpayer is not for profit, section
183(b) allows the taxpayer to deduct (1) expenses which otherwise
would have been allowable without regard to profit motive, and
2
Sec. 212 applies only to individuals and is therefore
inapplicable to SFIS.
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(2) certain additional expenses to the extent of the gross income
derived from the activity, less those deductions of the first
type.
A taxpayer must have an actual and honest profit objective
in order for an activity to be one which is for profit. Surloff
v. Commissioner, 81 T.C. 210, 233 (1983); Dreicer v.
Commissioner, 78 T.C. 642, 644 (1982), affd. without published
opinion 702 F.2d 1205 (D.C. Cir. 1983); sec. 1.183-2(a), Income
Tax Regs. This determination is made at the corporate level with
respect to the activities of an S corporation. Baldwin v.
Commissioner, T.C. Memo. 2002-162; sec. 1.183-1(f), Income Tax
Regs. However, we look to the intent of an S corporation’s sole
shareholder in deciding whether the corporation had the requisite
profit objective. Baldwin v. Commissioner, supra. In
determining whether the requisite intention to make a profit
exists, greater weight is given to objective facts than to the
taxpayer’s self-serving characterization of his intent. Id.;
Dreicer v. Commissioner, supra at 645; sec. 1.183-2(a), Income
Tax Regs. The regulations set forth a nonexclusive list of
factors to be considered in determining whether the taxpayer has
the requisite profit objective: (1) The manner in which the
taxpayer carries on the activity; (2) the expertise of the
taxpayer or his advisers; (3) the time and effort expended by the
taxpayer in carrying on the activity; (4) the expectation that
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the assets used in the activity may appreciate in value; (5) the
success of the taxpayer in carrying on other similar or
dissimilar activities; (6) the taxpayer’s history of income or
losses with respect to the activity; (7) the amount of occasional
profits, if any, which are earned; (8) the financial status of
the taxpayer; and (9) elements of personal pleasure or
recreation. Section 1.183-2(b), Income Tax Regs.
Petitioners bear the burden of proving that respondent’s
determinations in the notice of deficiency are in error. Rule
142(a).3
The parties’ stipulation states that SFIS and petitioner
were engaged in “multi-level marketing type activities” with
respect to the products of several companies, and that the 1996
and 1997 gross receipts were from commissions and the sale of
products. However, petitioners have provided no reliable
evidence that any such activities conducted by SFIS or petitioner
had the requisite profit objective. The tax returns filed by
SFIS are merely uncorroborated assertions, not evidence of any
activity. Apart from the generic description in the parties’
stipulation, the only evidence in the record concerning the
purported activities is petitioner’s cursory testimony, which we
3
Sec. 7491(a) does not shift the burden of proof to
respondent in this case because petitioners have provided no
credible evidence with respect to the activities of SFIS. Sec.
7491(a)(1).
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do not find to be reliable.4 Petitioners did not produce a
single item of corroborating evidence, such as a ledger, time
log, bank account record, receipt, or invoice.
Petitioners have not shown that petitioner and SFIS were
involved in any activity with continuity and regularity, and they
have not shown that any of the objective factors enumerated above
demonstrate an intent to profit. We therefore find that SFIS was
not engaged in a trade or business and is not entitled to any
business expense deductions. Sec. 162(a); Commissioner v.
Groetzinger, supra. With no underlying trade or business, SFIS
is limited to the deductions allowed by respondent pursuant to
section 183(b). Sec. 183(a), (c).
Negligence
In the notice of deficiency, respondent determined that
petitioners are liable for accuracy-related penalties under
section 6662(a) of $595 in 1996 and $704.40 in 1997. This
determination is based upon the adjustments made with respect to
the disallowed SFIS losses. By amended answer, respondent seeks
to increase the penalties to $1,071 in 1996 and $1,270 in 1997.
This increase is based upon the unreported income from the
litigation proceeds.
4
Petitioner testified that SFIS has been engaged in a
variety of activities, including real estate and sales of pre-
paid calling cards, gold coins, “a vitamin-type product that kind
of replaces Viagra”, and a “program for debt freedom”.
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Although respondent bears the burden of production with
respect to the determination of negligence in the notice of
deficiency, petitioners ultimately bear the burden of proof.
Sec. 7491(c); Rule 142(a). Respondent bears the burden of proof
with respect to the increase in the penalties. Sec. 7491(c).
Section 6662(a) imposes a 20-percent penalty on the portion
of an underpayment attributable to any one of various factors,
one of which is negligence or disregard of rules or regulations.
Sec. 6662(b)(1). “Negligence” includes any failure to make a
reasonable attempt to comply with the provisions of the Internal
Revenue Code, including any failure to keep adequate books and
records or to substantiate items properly. Sec. 6662(c); sec.
1.6662-3(b)(1), Income Tax Regs. 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 and that the
taxpayer acted in good faith with respect to that portion. The
determination of whether a taxpayer acted with reasonable cause
and in good faith 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 effort to assess his proper tax
liability for the year. Id.
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There is no evidence in the record relevant to ascertaining
petitioners’ liability for the accuracy-related penalties with
respect to the unreported lawsuit proceeds: Their authority or
rationale for reporting only a portion of the $30,000 payments
received from the lawsuit is unknown. The fact that petitioners
reported the bulk of the payments--the portions representing
interest--indicates they may have been advised to exclude the
amounts representing principal on the authority of Bent v.
Commissioner, 87 T.C. 236 (1986), affd. 835 F.2d 67 (3d Cir.
1987). Regardless, because the record is devoid of any facts
concerning this issue, and because respondent bears the burden of
proof, we hold that petitioners are not liable for the increased
penalties sought by respondent in his amended answer.
Petitioners, however, failed to show that SFIS was engaged
in a business, they did not produce books and records for SFIS,
they did not provide substantiation for any of the individual
expenses shown on the tax return of SFIS, and they did not show
any effort to assess their proper tax liability with respect to
the losses from SFIS claimed on their individual returns for the
years in issue. We find petitioners to be negligent, and we
sustain respondent’s determination that petitioners are liable
for the accuracy-related penalties, with respect to the claimed
deductions for losses from SFIS.
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To reflect the foregoing,
Decision will be entered
for respondent.5
5
Decision will be entered for respondent for (1) the
deficiencies in the increased amounts pled by respondent in his
amended answer, and (2) the penalties in the amounts determined
in the statutory notice of deficiency.