Venable v. Comm'r

T.C. Memo. 2003-240

UNITED STATES TAX COURT

SANDRA G. VENABLE, Petitioner v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 10888-02. Filed August 13, 2003.

On Aug. 26, 1994, P filed a malicious prosecution

lawsuit in Texas against a former business associate.

After trial to a jury, P was awarded a favorable

verdict and judgment in August of 1996. A State

appellate court affirmed, and the Texas Supreme Court

denied review in 1998. The former business associate

then satisfied the judgment by means of a check dated

Oct. 29, 1998.

Held: Sec. 104, I.R.C., as amended by the Small

Business Job Protection Act of 1996, Pub. L. 104-188,

sec. 1605, 110 Stat. 1838, is applicable to determine

excludability from gross income of the damages P

received.

Held, further, the payment P received pursuant to

the malicious prosecution lawsuit is not excludable

from gross income for 1998 under sec. 104, I.R.C.

There is no evidence that any of the judgment award was

received on account of a personal physical injury or

physical sickness as required by sec. 104(a)(2),

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I.R.C., or for medical care attributable to emotional

distress as required by the flush language of sec.

104(a), I.R.C.

Hans I. Lindberg, for petitioner.

Gerald L. Brantley, for respondent.

MEMORANDUM OPINION

WHERRY, Judge: Respondent determined a Federal income tax

deficiency for petitioner’s 1998 taxable year of $157,357.

Respondent also determined an accuracy-related penalty under

section 6662(a) of $31,471 for 1998. After concessions, the

issue for decision is whether damages petitioner received in

satisfaction of a lawsuit judgment are includable in her gross

income for 1998.

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.

Background

This case was submitted fully stipulated pursuant to Rule

122. The stipulations of the parties, with accompanying

exhibits, are incorporated herein by this reference. At the time

the petition was filed in this case, petitioner resided in The

Woodlands, Texas.

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In the mid-1980s, petitioner and her then husband, Victor

Hubbard (Mr. Hubbard), now deceased, were involved in the

operation of a software development company. They were

introduced to Terry Thrift, Jr. (Mr. Thrift), who agreed to

invest in the venture. Subsequently, the financial condition and

business prospects of the company, as well as the relationship of

petitioner and Mr. Hubbard with Mr. Thrift, deteriorated.

Mr. Thrift thereafter filed a complaint against petitioner and

Mr. Hubbard with the District Attorney’s Office for Bexar County,

Texas, alleging, inter alia, theft of accounts receivable. In

response to this complaint, the District Attorney’s Office

instituted a criminal prosecution. On December 6, 1993, the

Assistant District Attorney assigned to the criminal case filed a

motion to dismiss.

On August 26, 1994, petitioner sued Mr. Thrift for malicious

prosecution in the 224th Judicial District, Bexar County, Texas.

Petitioner entered into a contingency fee contract with Attorney

Darby Riley (Mr. Riley) to represent her as plaintiff in this

lawsuit. The case was tried to a jury, and petitioner was

awarded a favorable verdict on August 16, 1996, in the amount of

$437,300, as follows:

Loss of earning capacity $9,800

Attorney’s fees to defend criminal charges 2,500

Mental anguish 150,000

Loss to reputation 275,000

Total 437,300

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The trial court signed a judgment on August 26, 1996, in the

amount of $524,760, which included the damages determined by the

jury and prejudgment interest.

Thereafter, Mr. Thrift posted a supersedeas bond and

appealed to the Court of Appeals, Fourth District, San Antonio,

Texas. On February 25, 1998, the appellate court delivered and

filed its opinion affirming the judgment of the trial court.

Thrift v. Hubbard, 974 S.W.2d 70 (Tex. App. 1998). A motion for

rehearing filed by Mr. Thrift was denied on May 6, 1998. Mr.

Thrift then filed a petition for review with the Texas Supreme

Court, which was denied on October 15, 1998.

By means of a cashier’s check dated October 29, 1998, and

made payable to petitioner and her attorney, Mr. Thrift remitted

$641,984.63 in satisfaction of the judgment. From this sum,

petitioner received a direct payment of $317,824.94 in net

proceeds. That amount represented petitioner’s 50-percent share

of the recovery after deduction of $2,417.38 in expenses paid by

her attorney and $750 in expert witness’s fees. Mr. Riley

received a corresponding $320,992.31.

On May 12, 1999, petitioner signed a Form 1040, U.S.

Individual Tax Return, for 1998. The return was received by the

Internal Revenue Service on May 16, 1999. Therein, petitioner

reported as income “lawsuit proceeds” of $107,424.83. She did

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not deduct, as an itemized deduction, any expenses related to the

malicious prosecution lawsuit.

Respondent on March 27, 2002, issued to petitioner a notice

of deficiency. In calculating the subject tax deficiency of

$157,357, respondent included in petitioner’s gross income the

full amount of the lawsuit settlement proceeds and treated the

attorney’s fees and other expenses incurred in connection

therewith as a miscellaneous itemized deduction. Respondent

further determined that petitioner was liable for the section

6662(a) accuracy-related penalty in the amount of $31,471 on

account of negligence or disregard of rules and regulations.

After the instant case was commenced, the parties submitted

stipulations of settled issues addressing certain of the

adjustments made in the notice of deficiency. As regards the

itemized deductions, specifically the contingent attorney’s fees

paid directly to Mr. Riley, the parties stipulated:

In the Notice of Deficiency, Respondent allowed

Petitioner’s contingent attorney’s fees as an itemized

deduction. Venue for appeal lies to the Court of

Appeals for the Fifth Circuit. The parties agree that

Petitioner’s gross income from the damage award does

not include the portion of the award paid directly to

her attorney, and Petitioner is not entitled to an

itemized deduction for the attorney’s fees paid to her

attorney. See Srivastava v. Commissioner, 220 F.3d

353, 365 (5th Cir. 2000), rev’g and remanding in part,

and aff’g on another issue, T.C. Memo. 1998-362.

Concerning the penalty, their stipulation reads:

The parties agree that if it is determined that

there is an underpayment of Petitioner’s 1998 income

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tax attributable to the amount of gross income

Petitioner received from the lawsuit recovery, the

accuracy related penalty provided in I.R.C. § 6662(a)

and (c) shall be computed. The amount of the penalty

imposed and assessed will be reduced by 50% from the

amount computed.

Discussion

I. General Rules

As a general rule, the Internal Revenue Code imposes a

Federal tax on the taxable income of every individual. Sec. 1.

Section 61(a) specifies that, “Except as otherwise provided”,

gross income for purposes of calculating such taxable income

means “all income from whatever source derived”. The compass of

this definition is broad, typically reaching any accretions to

wealth. Commissioner v. Schleier, 515 U.S. 323, 327 (1995);

Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 429-431 (1955).

Section 104, in contrast, provides otherwise with respect to

compensation for injuries or sickness. Such exclusions from

gross income are construed narrowly. Commissioner v. Schleier,

supra at 328; United States v. Burke, 504 U.S. 229, 248 (1992)

(Souter, J., concurring in judgment). Before its amendment on

August 20, 1996, by the Small Business Job Protection Act of 1996

(SBJPA), Pub. L. 104-188, sec. 1605, 110 Stat. 1838, section 104

read in pertinent part as follows:

SEC. 104. COMPENSATION FOR INJURIES OR SICKNESS.

(a) In General.--Except in the case of amounts

attributable to (and not in excess of) deductions

allowed under section 213 (relating to medical, etc.,

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expenses) for any prior taxable year, gross income does

not include--

* * * * * * *

(2) 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;

The reference to personal injuries in this former version of the

statute did not include purely economic injuries but did embrace

“nonphysical injuries to the individual, such as those affecting

emotions, reputation, or character”. United States v. Burke,

supra at 235 n.6, 239; see also Commissioner v. Schleier, supra

at 329-331.

The SBJPA then amended section 104, as relevant here, to

provide:

SEC. 104. COMPENSATION FOR INJURIES OR SICKNESS.

(a) In General.--Except in the case of amounts

attributable to (and not in excess of) deductions

allowed under section 213 (relating to medical, etc.,

expenses) for any prior taxable year, gross income does

not include--

* * * * * * *

(2) 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;

* * * * * * *

* * * For purposes of paragraph (2), emotional distress

shall not be treated as a physical injury or physical

sickness. The preceding sentence shall not apply to an

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amount of damages not in excess of the amount paid for

medical care * * * attributable to emotional distress.

Legislative history accompanying passage of the SBJPA

additionally 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.

Regulations promulgated under section 104 further define

“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.” Sec. 1.104-1(c), Income Tax Regs.

For purposes of applying the above statutory and regulatory

text in effect prior to the SBJPA, the U.S. Supreme Court in

Commissioner v. Schleier, supra at 336-337, established a two-

pronged test for ascertaining a taxpayer’s eligibility for the

section 104(a)(2) exclusion. As stated by the Supreme Court:

“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.’”

Id. at 337. This test has since been extended to apply to the

amended version of section 104, with the corresponding change

that the second prong now requires proof that the personal

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injuries or sickness for which the damages were received were

physical in nature. Shaltz v. Commissioner, T.C. Memo. 2003-173;

Henderson v. Commissioner, T.C. Memo. 2003-168; Prasil v.

Commissioner, T.C. Memo. 2003-100.

II. Contentions of the Parties

The dispute between the parties in this case turns in large

part upon which version of section 104 is applicable to

petitioner’s situation. Petitioner contends that the statute as

it existed before amendment by the SBJPA controls. Specifically,

petitioner alleges that to consider her case under the amended

section 104 would inappropriately give the law retroactive

effect, in violation of the standard set forth by the U.S.

Supreme Court in Landgraf v. USI Film Prods., 511 U.S. 244

(1994). Further, it is petitioner’s position that the majority

of the damages she received, in particular those for mental

anguish and loss to reputation, are properly excluded from gross

income pursuant to the law in effect when she filed her tort

cause of action in 1994.

Conversely, respondent maintains that the amended version of

section 104, requiring proof of physical injuries or sickness, is

applicable here. Respondent argues that because petitioner is a

cash basis taxpayer and received the payment in question after

the effective date of the SBJPA, excludability of the damages is

governed by the revised statute. Respondent then asserts that

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none of the amounts petitioner received were to compensate for

physical injuries or sickness.

The Court concludes, for the reasons explained below, that

section 104 as amended by the SBJPA is applicable to the instant

case. Further, petitioner is not entitled to the exclusion

afforded by section 104. The payment petitioner received

pursuant to the malicious prosecution lawsuit is therefore

subject to taxation under the default rule of section 61(a).

III. Analysis

A. Applicable Law

At the outset, we note that petitioner’s arguments regarding

retroactivity are premised on her contention that the relevant

conduct occurred in August of 1994 with the filing of the

malicious prosecution lawsuit. Respondent, in contrast, focuses

on 1998 when the judgment became final and petitioner received

the payment in question. For the sake of completeness and

because we conclude, under these facts, that application of the

amended section 104 would not run afoul of the standards

typically employed to evaluate retroactive legislation, we

discuss section 104 under those standards, including the test for

retroactivity advocated by petitioner.1

1

We note, however, that the amendment to sec. 104 is not in

fact a “retroactive” statute, in that the effective date

provision, quoted infra p. 12, was prospective only from the date

of enactment.

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Our conclusion that application of the amended version of

section 104 is permissible rests on two principal considerations.

First, to the extent that the test of Landgraf v. USI Film

Prods., supra, is pertinent in the context of tax legislation, a

point we do not reach, the rubric set forth therein supports

application of the revised statute. Second, application of

amended section 104 is likewise consistent with the standard for

retroactivity of tax laws expressly described in United States v.

Carlton, 512 U.S. 26 (1994).

In Landgraf v. USI Film Prods., supra at 280, the Supreme

Court stated the following rule:

When a case implicates a federal statute enacted

after the events in suit, the court’s first task is to

determine whether Congress has expressly prescribed the

statute’s proper reach. If Congress has done so, of

course, there is no need to resort to judicial default

rules. When, however, the statute contains no such

express command, the court must determine whether the

new statute would have retroactive effect, i.e.,

whether it would impair rights a party possessed when

he acted, increase a party’s liability for past

conduct, or impose new duties with respect to

transactions already completed. If the statute would

operate retroactively, our traditional presumption

teaches that it does not govern absent clear

congressional intent favoring such a result.

Hence, the threshold question is whether Congress expressly

provided that the disputed statute should apply retroactively or

prospectively. In the words of the Court of Appeals for the

Fifth Circuit, to which appeal in the instant case would normally

lie, “we must first determine whether Congress has clearly

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prescribed the temporal reach” of the section, and, “If Congress

has clearly expressed whether the statute should apply

retroactively, the inquiry ends.” Ojeda-Terrazas v. Ashcroft,

290 F.3d 292, 297 (5th Cir. 2002). For purposes of finding such

an unambiguous direction, the Supreme Court has further

explained: “‘[C]ases where this Court has found truly

“retroactive” effect adequately authorized by statute have

involved statutory language that was so clear that it could

sustain only one interpretation.’” INS v. St. Cyr, 533 U.S. 289,

316-317 (2001) (quoting Lindh v. Murphy, 521 U.S. 320, 328 n.4

(1997)).

SBJPA section 1605, after setting forth in subsections (a)

through (c) the amending language to be codified as part of

section 104, provided as follows:

(d) Effective Date.--

(1) In general.--Except as provided in paragraph (2),

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.

(2) Exception.--The amendments made by this section

shall not apply to any amount received under a written

binding agreement, court decree, or mediation award in

effect on (or issued on or before) September 13, 1995.

While the Supreme Court has indicated that “A statement that

a statute will become effective on a certain date does not even

arguably suggest that it has any application to conduct that

occurred at an earlier date”, Landgraf v. USI Film Prods., supra

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at 257, the above text constitutes markedly more than “the mere

promulgation of an effective date”, INS v. St. Cyr, supra at 317.

SBJPA section 1605(d)(1) does not just state when the law is to

take effect. Rather, the provision explicitly dictates the

particular conduct and the timing thereof to which the amendments

“shall apply”. According to the express text, receipt of

payments after the August 20, 1996, date of enactment falls

within the intended scope of the amended version of section 104,

unless the explicit exception for a prior binding agreement,

court decree, or mediation award is applicable.

Here, the jury verdict in petitioner’s favor was not

returned until August 16, 1996, and the appellate process was not

completed until the Texas Supreme Court denied review on

October 15, 1998. Petitioner’s situation therefore fails to

satisfy the requisites for relief under SBJPA section 1605(d)(2).

In such event, SBJPA section 1605(d)(1) explicitly and

unambiguously prescribes the temporal reach of the section 104

amendments to the situation at hand. We conclude that Landgraf

v. USI Film Prods., 511 U.S. 244 (1994), would pose no barrier

here to application of the revised section 104.

Moreover, less than 2 months after issuing its decision in

Landgraf, and without reference thereto, the Supreme Court

decided United States v. Carlton, supra. The issue in United

States v. Carlton, supra at 27, was the propriety of retroactive

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application of an amendment made to a Federal estate tax statute.

In that context, the Supreme Court explained as follows:

This Court repeatedly has upheld retroactive tax

legislation against a due process challenge. Some of

its decisions have stated that the validity of a

retroactive tax provision under the Due Process Clause

depends upon whether retroactive application is so

harsh and oppressive as to transgress the

constitutional limitation. The harsh and oppressive

formulation, however, does not differ from the

prohibition against arbitrary and irrational

legislation that applies generally to enactments in the

sphere of economic policy. The due process standard to

be applied to tax statutes with retroactive effect,

therefore, is the same as that generally applicable to

retroactive economic legislation: * * * that burden is

met simply by showing that the retroactive application

of the legislation is itself justified by a rational

legislative purpose. [Id. at 30-31; internal

quotations and citations omitted.]

The Supreme Court further noted:

“Taxation is neither a penalty imposed on the taxpayer

nor a liability which he assumes by contract. It is

but a way of apportioning the cost of government among

those who in some measure are privileged to enjoy its

benefits and must bear its burdens. Since no citizen

enjoys immunity from that burden, its retroactive

imposition does not necessarily infringe due process *

* * ” [Id. at 33 (quoting Welch v. Henry, 305 U.S.

134, 146-147 (1938)).]

In general, the raising of Government revenue is considered

a sufficient and legitimate legislative purpose for supporting a

“modest” period of retroactivity. Id. at 32-33; id. at 37

(O’Connor, J., concurring in judgment); NationsBank v. United

States, 269 F.3d 1332, 1337-1338 (Fed. Cir. 2002); Quarty v.

United States, 170 F.3d 961, 967 (9th Cir. 1999); Furlong v.

Commissioner, 36 F.3d 25, 27-28 (7th Cir. 1994), affg. T.C. Memo.

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1993-191. The principal exception to this reasoning discernible

from caselaw arises in scenarios involving imposition of a

“wholly new tax”. See United States v. Carlton, 512 U.S. at 34;

Quarty v. United States, supra at 966-967; Furlong v.

Commissioner, supra at 27; Wiggins v. Commissioner, 904 F.2d 311,

314 (5th Cir. 1990), affg. 92 T.C. 869 (1989).

The imposition of a wholly new tax is to be distinguished

from changes in the rate of an existing tax. United States v.

Darusmont, 449 U.S. 292, 298-300 (1981); Quarty v. United States,

supra at 966-967; Honeywell, Inc. v. United States, 973 F.2d 638,

642-643 (8th Cir. 1992); Estate of Ekins v. Commissioner, 797

F.2d 481, 484-485 (7th Cir. 1986); Fein v. United States, 730

F.2d 1211, 1212-1214 (8th Cir. 1984); Estate of Ceppi v.

Commissioner, 698 F.2d 17, 20-21 (1st Cir. 1983), affg. 78 T.C.

320 (1982). Furthermore, amendments which eliminate an

exemption, exclusion, or tax credit have repeatedly been

construed as “‘closer in kind and in effect to a mere increase in

the tax rate than to the enactment of a wholly new tax.’”

Honeywell, Inc. v. United States, supra at 642-643 (quoting Fein

v. United States, supra at 1213); see also Estate of Ekins v.

Commissioner, supra at 484-485; Estate of Ceppi v. Commissioner,

supra at 17, 21.

Turning to the case at bar, the amendment to section 104

restricted the availability of an exclusion from gross income.

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In such instance, retroactivity would not be constitutionally

objectionable on grounds related to a wholly new tax.

Accordingly, petitioner’s situation does not present reason for

departure from the lenient standards typically employed to

evaluate tax legislation.

As regards legitimate governmental purpose, the legislative

history accompanying the SBJPA notes that “Courts have

interpreted the exclusion from gross income of damages received

on account of personal injury or sickness broadly in some cases

to cover awards for personal injury that do not relate to a

physical injury or sickness.” H. Conf. Rept. 104-737, supra at

300, 1996-3 C.B. at 1040. Congress’s choice to narrow the

exclusion, and any retroactive application of the change, would

therefore appear to be rationally linked to the legitimate

objective of raising revenue. Legislative history further

reveals that the change was intended as a curative measure

designed to reduce or eliminate ambiguity in the otherwise

applicable law. Reference is made to “confusion” that “led to

substantial litigation”, including the Supreme Court cases of

Commissioner v. Schleier, 515 U.S. 323 (1995), and United States

v. Burke, 504 U.S. 229 (1992). H. Rept. 104-586, at 143 (1996),

1996-3 C.B. 331, 481.

In addition, the period of “retroactivity” alleged by

petitioner in this case, i.e., slightly less than 2 years, does

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not exceed what has been upheld in other tax litigation. See,

e.g., Licari v. Commissioner, 946 F.2d 690 (9th Cir. 1991)

(upholding application of tax penalty passed in 1986 to returns

previously filed for years 1982 through 1984), affg. T.C. Memo.

1990-4; Canisius Coll. v. United States, 799 F.2d 18, 26-27 (2d

Cir. 1986) (upholding 4-year retroactive application); Temple

Univ. v. United States, 769 F.2d 126 (3d Cir. 1985) (upholding at

least a 4-year retroactive application); Rocanova v. United

States, 955 F. Supp. 27 (S.D.N.Y. 1996) (upholding retroactive

application of amendment extending statute of limitation on tax

collection actions from 6 to 10 years), affd. 109 F.3d 127 (2d

Cir. 1997). As the Court of Appeals for the Fifth Circuit has

observed: “The Supreme Court has never explicitly imposed a time

limit on the retroactivity of a tax statute’s application.”

Wiggins v. Commissioner, supra at 316. Accordingly, the Court of

Appeals for the Fifth Circuit has further opined that “the ‘harsh

and oppressive’ test * * * does not limit retroactivity to one

year, but instead requires a case-by-case analysis in which the

length of the period affected is but one factor to be

considered.” Id.

To summarize, we conclude that, to the extent petitioner

raises issues of retroactivity, application of the amendment to

section 104 would not violate the standards requiring a rational

purpose and reasonable period. The tests employed to evaluate

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retroactive legislation therefore do not justify refusal to apply

the law in effect for the tax year under consideration.

B. Application of Section 104 as Amended

As indicated above, the first requirement for the section

104(a)(2) exclusion is that the claim underlying the funds

received must be based on tort or tort type rights. Commissioner

v. Schleier, supra at 337. A tort is defined as a “‘civil wrong,

other than breach of contract, for which the court will provide a

remedy in the form of an action for damages.’” United States v.

Burke, supra at 234 (quoting Keeton et al., Prosser & Keeton on

the Law of Torts 2 (1984)). State law typically determines the

nature of the legal interests involved. Bland v. Commissioner,

T.C. Memo. 2000-98; Massot v. Commissioner, T.C. Memo. 2000-24.

Here, the parties do not dispute that petitioner’s malicious

prosecution lawsuit sounded in tort under Texas law.

The second requirement for exclusion under section 104 as

amended demands that the damages be received on account of

personal physical injuries or physical sickness. Prasil v.

Commissioner, T.C. Memo. 2003-100. Petitioner’s award comprised

amounts for loss of earning capacity, for attorney’s fees to

defend criminal charges, for mental anguish, and for loss to

reputation. None of these categories is based on a physical

injury or sickness. The amended version of the statute provides

that emotional distress is not a physical injury or physical

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sickness, except to the limited extent of allowing an exclusion

for damages up to the amount paid for medical care necessitated

by emotional distress. Petitioner is unable to take advantage

even of this limited exception because there is no evidence of

how much, if anything, she spent to obtain medical care. Thus,

the Court holds that petitioner is not entitled under section 104

to exclude from income any portion of the payment she received

pursuant to the malicious prosecution lawsuit.

To reflect the foregoing and concessions by the parties,

which, inter alia and as noted previously, resolved the section

6662(a) penalty issue,

Decision will be entered

under Rule 155.