Green v. CIR

IN THE UNITED STATES COURT OF APPEALS

FOR THE FIFTH CIRCUIT United States Court of Appeals

Fifth Circuit

FILED

November 7, 2007

No. 06-60597 & 06-60779 Charles R. Fulbruge III

Clerk

GEORGE G. GREEN

Petitioner-Appellant

v.

COMMISSIONER OF INTERNAL REVENUE

Respondent-Appellee

Appeal from the United States Tax Court

Before GARWOOD, JOLLY, and STEWART, Circuit Judges.

CARL E. STEWART, Circuit Judge:

This appeal involves a final order of the United States Tax Court finding

that Petitioner-Appellant George Green (“Green”) failed to properly report

settlement proceeds as taxable income and improperly deducted certain

expenditures and losses as business expenses and losses. The Tax Court also

sustained the Commissioner’s assessment of accuracy-related penalties for these

deficiencies. We affirm.

I. FACTUAL AND PROCEDURAL BACKGROUND

The income at issue in this case resulted from a whistleblower lawsuit that

Green brought against the Texas Department of Human Services (“TDHS”), the

failure of the state of Texas to pay the resulting judgment, and ultimately, a

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monetary settlement between Green and Texas. The following facts, except

where noted, are taken from the Tax Court’s Findings of Fact.

A. Whistleblower Lawsuit

While working as an architect for TDHS, Green came to believe that

officials with TDHS were engaged in a pattern of fraud and corruption. Green

discussed the misconduct with his supervisors, and when they failed to act, he

advised numerous TDHS employees that he intended to report the misconduct

to authorities outside of the department. On December 12, 1989, Green was

fired for allegedly abusing sick leave, falsifying official documents, and misusing

his business phone.1

On March 9, 1990, Green filed suit against TDHS under the Texas

Whistleblower Act. Green’s suit was tried before a jury in August and

September of 1991. The jury found that Green was fired in retaliation for

reporting misconduct at TDHS, and awarded Green $3,459,832 in compensatory

damages and $10,000,000 in punitive damages.2 On October 10, 1991, the trial

court entered judgment in favor of Green in the amount of $13,773,461.96.3

1

TDHS also referred the matter to the district attorney for prosecution of alleged

criminal violations, and Green was indicted for falsifying documents, a third-degree felony.

After the filing of Green’s whistleblower suit, the district attorney offered to drop the criminal

charges against Green if he would drop his lawsuit. Green refused. Shortly before the trial

of the criminal case, the district attorney dismissed the charges under the indictment, pending

further investigation.

2

The jury’s award of compensatory damages was allocated as follows:

Loss of earning capacity: $928,000

Past mental anguish: $1,000,000

Future mental anguish: $1,500,000

Out-of-pocket expenses: $31,832

In addition, the trial court awarded prejudgment in interest in the amount of $154,246.57

through September 24, 1991, with an additional $237.97 per day until the judgment was

signed. The judgment bore post-judgment interest of 10 percent per annum until paid.

3

The Tax Court’s opinion states that judgment was entered in the amount stated

above, $13,773,461.96. However, according to the parties’ First Stipulation of Facts submitted

to the Tax Court, as well as the Government’s brief, judgment was entered in the amount of

$13,775,000. The difference is immaterial for our purposes.

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B. Green’s Efforts to Collect the Judgment

After the entry of the judgment in October, 1991, Texas failed to pay Green

any portion of the judgment awarded.4 In 1993, after discharging his trial

attorney, Green instituted legal proceedings and attempted to secure a

legislative appropriation to obtain satisfaction of the judgment. His efforts were

unavailing.

In February of 1994, to assist him in the collection of the judgment, Green

hired new counsel, John C. Augustine (“Augustine”), and a team of consultants

to help him by raising public consciousness of his plight and getting the

attention of lawmakers. In order to fund the collection attempts, Green sold an

interest in $1,000,000 of his ultimate recovery, if any, to James U. King (“King”)

for $500,000. In 1995, Green formed Green Capital Corp. (“Green Capital”) and

TS Capital Asset, LLC (“TS Capital”) for the purpose of employing consultants

and advisers, including legal consultants, publicists, and other professionals, to

attempt to collect the judgment from Texas. In connection with these

businesses, Green maintained an office.

During 1994 and 1995, Green filed abstracts of judgments in several

counties against Texas, all of which were unsuccessful in securing payment.

Green and his representatives attempted to influence public opinion with

newspaper articles, magazine articles, and television broadcasts about Green’s

4

Under Texas law, when an individual is awarded a judgment against the state, he

must seek a legislative appropriation to collect the damages awarded to him. See Tex. Dept.

of Human Servs. v. Green, 855 S.W.2d 136, 145 (Tex. App. 1993). The Texas Legislature, a

bicameral body, convenes only in odd-numbered years. All bills that affect revenues or

expenditures are referred to the Legislative Budget Board which estimates the probable

revenue cost of a bill. The legislature may choose, through the appropriation process to pay

all, some, or none of an individual’s judgment against the state. See Tex. Civ. Prac. and

Remedies Code Ch. 109, et seq.; Fed. Sign v. Tex. S. Univ., 951 S.W.2d 401, 415 (Tex. 1997)

(Hecht, J. concurring). When the legislature is not in session, the Governor of Texas or the

Legislative Budget Board may, by emergency measure, propose an expenditure or distribution

of funds by a state agency. Tex. Const. art. XVI, § 69; Tex. Gov’t Code Ann. § 317.002(b); §

317.003(a).

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struggle to obtain satisfaction of his judgment. Green also filed a declaratory

judgment action in a Texas trial court against Texas and the attorney general.

Additionally, Green attempted to secure a legislative appropriation to pay the

judgment. In 1995, two bills were introduced during the 74th regular session of

the Texas Legislature to appropriate funds to satisfy the judgment, but neither

of the bills were enacted.

During this time, Green was involved in a lawsuit with Allied Interests,

Inc. (“Allied”), in which Green was being sued for expenses owed to Allied for

services it rendered in connection with Green’s attempt to collect the judgment.

In 1996, a judgment in favor of Allied was entered against Green and Green

Capital. In 1998, Green paid Allied $753,629, including punitive damages of

$365,000, in satisfaction of Allied’s judgment.

Between 1991 and 1995, while engaged in his efforts to collect the

judgment, Green’s mental and physical health deteriorated significantly,

requiring repeated hospitalization for a bleeding ulcer.

C. Settlement

After the legislature failed to appropriate funds for payment of the

judgment, Green approached the Legislature Budget Board (“LBB”). Green and

Augustine worked with Lieutenant Governor Bob Bullock (“Bullock”), the

chairman of the LBB, in order to convince the LBB that an emergency

warranted the issuance of a budget execution order authorizing TDHS to expend

funds to satisfy the taxpayer’s judgment. Green met with Bullock on several

occasions to discuss Green’s unsuccessful efforts to collect the judgment and his

continued stress and failing health. Augustine informed Bullock that Green was

willing to negotiate some sort of settlement and that at that point, the judgment

had reached over $20,000,000 because of the accruing interest.

Although not noted by the Tax Court, the foreman of the jury in the

whistleblower lawsuit, Richard G. Fogg (“Fogg”), also advocated on Green’s

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behalf. Fogg attended one of Bullock’s meetings with Green and discussed

Green’s ongoing health problems stemming from the collection of the judgment.

During this meeting, Bullock told Green and Fogg that “there wasn’t enough

money in the State treasury to pay [you] for what you went through.”

Green and Texas entered into a written Release and Settlement

Agreement (“settlement agreement”) dated November 8, 1995. Augustine and

Harry G. Potter, III (“Potter”), a special assistant attorney general for Texas,

were responsible for drafting the agreement. In relevant part, the settlement

agreement provided:

4. The State shall make a cash payment of

$3,427,999.87 to Plaintiff for damages for loss of

earning capacity, mental anguish and suffering

(past) and suffering (future), in accordance with

the findings specified and incorporated into the

Final Judgment in Cause No. 480,701.

[(“Paragraph Four”)]

5. The State shall fund annuities for additional

damages associated with the Final Judgment in

Cause No. 480,701, which in turn shall pay to

Plaintiff monthly installments, commencing

January 4, 1996 and continuing until December

4, 1998, each in the amount of $13,499 with a

final judgment payable on January 4, 1999 in the

amount of $3,000,000. The State shall purchase

the annuity contracts described herein naming

Plaintiff as payee in order to ensure that these

monetary obligations are met. [(“Paragraph

Five”)]

6. For all other damages, including punitive,

prejudgment and post-judgment interest, the

State shall fund an annuity or annuities, which

in turn shall pay to Plaintiff monthly

installments, commencing on January 4, 1996

and continuing until December 4, 1998, each in

the amount of $7,924 with a final payment

payable on January 4, 1999 in the amount of

$1,761,000. [(“Paragraph Six”)]

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A quorum of the LBB met on November 15, 1995 and proposed a budget

execution order that authorized TDHS to pay Green: “a settlement, including

attorneys fees . . . in the amount of $13,775,000, contingent on the fact that

acceptance of this amount by George Green constitutes a complete release by

George Green of all claims and causes of action that George Green may have

against the state of Texas arising from the case of George Green v. Department

of Human Services.” On November 15, 1995, the LBB adopted the proposed

budget execution order, which was ratified by then Governor George W. Bush.

On November 17, 1995 Green received a payment for $3,427,999. Green

received $13,455 per month from January, 1996, through December, 1998, under

the first annuity, and $7,924 per month during the same period from the second

annuity. Additionally, in January, 1999, Green received the final payments of

$3,000,000 and $1,761,000 under the respective annuities. The total amount

paid under Paragraphs Five and Six of the settlement agreement was

$10,347,000.13.

D. Green’s Tax Returns

On his 1995 federal tax return, Green excluded the payment of

$3,427,999.87 that he received under § 104(a)(2) of the Internal Revenue Code

(“Code”), which provides an exclusion for “damages received . . . on account of

personal injury or sickness.” On his federal tax returns for 1996, 1997, and

1998, Green reported the annual payment of $95,088 ($7,924 per month) from

the second annuity, made under Paragraph Six of the settlement agreement, as

taxable income. In those three years, Green did not report the $161,988 ($13,499

per month) received under the first annuity and Paragraph Five as taxable. In

statements attached to the 1997 and 1998 returns,5 Green asserted that the

$161,988 was not taxable because it represented additional damages other than

5

Green’s 1997, 1998, and 1999 returns were prepared by Hunter & Atkins Inc.

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punitive and interest and is excluded from income under § 104(a)(2) of the Code.

Green did not report the lump-sum payments of $3,000,000 and $1,761,000 as

taxable income on his tax return for 1999. Instead, he attached a statement to

his return claiming that the $3,000,000 constituted “additional damages”

received from Texas and that the $1,761,000 constituted “all other damages” and

asserting that both payments were excludable under § 104(a)(2) of the Code.

For each of the years 1995 through 1996, Green claimed losses with

respect to his interests in Green Capital and/or TS Capital. These claimed losses

arose from expenses incurred by Green in attempting to collect his judgment and

defend himself in the Allied litigation. Such expenses consisted of, among other

things, payments to attorneys and consultants and office expenses. Green

deducted all of these expenses as trade or business expenses under § 162 of the

Code. As a result of the claimed losses, totaling $1,470,789, Green reported no

tax due for any years at issue except 1997, for which Green reported a tax due

of $8,066.

In July, 2001, Green filed amended federal income tax returns for the

years 1996, 1997, and 1998. On the amended returns, Green claimed that

$95,088 of reported income was not includable as income under § 104(a)(2). This

resulted in Green requesting a refund of $7,654 for 1997.

E. Legal Proceedings

Upon auditing Green’s return, the Commissioner of Internal Revenue

(“Commissioner”) issued two notices of deficiency to Green, one for 1995 through

1998, and one for 1999. The Commissioner determined that all of the payments

received by taxpayer from Texas during the years at issue were includable in

Green’s income. The Commissioner also disallowed all losses claimed by Green

with respect to his interests in Green Capital and TS Capital for the years at

issue. In addition, the Commissioner determined that Green was liable for

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accuracy-related penalties under § 6622(a) of the Code for all of the years at

issue.

Green filed two petitions in the Tax Court seeking redetermination of the

deficiencies. The Commissioner conceded that the $3,427,999.87 received by the

taxpayer under Paragraph Four of the settlement agreement, which provided for

the payment of compensatory damages to taxpayer, was excludable from his

gross income under § 104(a)(2) of the Code. As to the excludability of the

payments under Paragraphs Five and Six of the settlement agreement; the

deductibility of the business expenses; and the appropriateness of the accuracy-

related penalties, the Tax Court conducted a trial.

First, the Tax Court found that Green had failed to establish that

Paragraph Five of the settlement agreement was intended to compensate Green

for personal injuries or sickness arising out of the whistleblower lawsuit. The

court found that “all compensatory damages awarded in the final judgment [of

the whistleblower] lawsuit were expressly allocated in paragraph 4 of the

settlement agreement.” Accordingly, Green was required to include in gross

income the $3,485,964 in payments he received under Paragraph Five of the

settlement agreement for “additional damages” during the years in issue.

Second, the court found that the payments made under Paragraph Six of the

settlement agreement were not excludable from Green’s income under §

104(a)(2) of the Code. Third, the court concluded that Green’s losses and

expenses resulting from Green Capital and TS Capital, were not deductible

under § 162 of the Code as trade or business expenses, but instead were only

deductible under § 212 of the Code as expenses related to the production or

collection of income. The Court found that Green’s payment of punitive damages

to Allied was not deductible under either section. Finally, the court held that

Green was liable for 20% accuracy-related penalties under § 6662 of the Code

because he had no reasonable basis for excluding from his income the full

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amount of payments under the settlement agreement. Green timely appealed

the decision of the Tax Court.

II. STANDARD OF REVIEW

We apply the same standard of review to decisions of the Tax Court that

we apply to district court decisions. Arevalo v. Comm'r, 469 F.3d 436, 438 (5th

Cir. 2006). Findings of fact are reviewed for clear error and issues of law are

reviewed de novo. Id. Clear error exists when this court is left with the definite

and firm conviction that a mistake has been made. Streber v. Comm’r, 138 F.3d

216, 219 (1998).

III. ANALYSIS

Green argues the following on appeal: (1) the Tax Court erred in finding

that the payments under Paragraph Five of the settlement agreement were not

excludable income under § 104(a)(2) of the Code; (2) the Tax Court erred in

concluding that the expenses incurred by Green in collecting the judgment and

the punitive damages paid to Allied are not deductible as business expenses

under § 162 of the Code; and (3) the Tax Court erred in concluding that Green

was liable for 20% accuracy-related penalties. Green conceded at oral argument

that the Tax Court was correct in finding that the payments received by Green

under Paragraph Six of the settlement agreement were not excludable from

Green’s income. We address the remaining issues in turn.

A. § 104(a)(2) and Payments Made Under Paragraph Five of the

Settlement Agreement

Paragraph Five of the settlement agreement provided that “[t]he State

shall fund annuities for additional damages associated with the Final

Judgment” in Green’s whistleblower case. (emphasis added) At issue is whether

the $3,485,964 in payments for “additional damages” under Paragraph Five are

excludable under § 104(a)(2) Code as “damages received. . . on account of

personal injury or sickness. The Tax Court’s finding that Green failed to

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establish that payments under Paragraph Five were allocable to personal injury

or sickness is a finding of fact that we review for clear error. See Robinson v.

Comm’r, 70 F.3d 34, 38 (5th Cir. 1995); Srivastava v. Comm’r, 220 F.3d 353, 365

(5th Cir. 2000) (“We review the allocations made by the Tax Court only for clear

error.”), overruled on other grounds by Comm’r v. Banks, 543 U.S. 426 (2005).

Green argues that the payments are excludable under § 104(a)(2) of the

Code. That section states, in relevant part, that “gross income does not include

. . . any damages received (whether by suit or agreement and whether as lump

sums or as periodic payments) on account of personal injury or sickness.”6 The

Supreme Court has held that amounts are excludable under § 104(a)(2) only

when: (1) the underlying cause of action giving rise to the recovery is based on

tort or tortlike rights; and (2) the damages were received on account of personal

injury or sickness. Comm’r v. Schleier, 515 U.S. 323, 336-37 (1995); see also

Chamberlain v. Unites States, 401 F.3d 335, 341 (5th Cir. 2005). To constitute

damages received “on account of” personal injury, an amount must be awarded

“by reason of” or “because of” personal injury, and must compensate a victim for

the loss of personal or financial capital. Chamberlain, 401 F.3d at 341; see also

United States v. O’Gilvie, 519 U.S. 79, 86-87 (1996). There is no dispute that the

claims underlying Green’s claims were tort-like, or that Green suffered personal

injury. Thus, the issue is whether Green satisfied prong two’s requirement that

the payments under Paragraph Five for “additional damages” were received on

account of Green’s personal injuries or sickness.

6

In 1996, Congress amended § 104(a)(2). As amended, the section excludes from gross

income only damages paid on account of “personal physical injuries or physical sickness.”

However, the legislation included a transition rule applicable 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.” Because the parties agreed below that the pre-1996 law

governed the taxability of the settlement payments at issue, we will apply that version.

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When determining the tax treatment of a settlement, we must ask “in lieu

of what was the . . . settlement awarded?” Srivastava, 220 F.3d at 365 (citing

Knuckles v. Commissioner, 349 F.2d 610 (10th Cir. 1965)); see also Treas. Reg.

§ 1-104.1(c) (as amended in 1970) (defining “damages received” as “an amount

received . . . through a settlement agreement entered into in lieu of [a]

prosecution” of tort). Where damages are received under a written settlement

agreement, “the focus is on the origin and characteristics of the claims settled

in determining whether such damages are excludable under § 104(a)(2).”

Pipitone v. United States, 180 F.3d 859, 862 (7th Cir. 1999); see also Francisco

v. United States, 267 F.3d 303, 319 (3d Cir. 2001) (“It is a tenet of federal law

that income received in settlement of a claim should be taxed in the same

manner as if it had been received in court.”). Therefore, to succeed Green was

required to establish that the payments under Paragraph Five were made “in

lieu” of damages for personal or physical injuries, not for punitive damages or

economic loss. See O’Gilvie, 519 U.S. at 83 (finding that punitive damages are

not “on account of” personal injuries or sickness).

We first look to the language of the agreement itself for indicia of purpose.

See Greer v. United States, 207 F.3d 322, 329 (6th Cir. 2000). Where the

settlement agreement lacks express language of purpose, the court looks beyond

the agreement to other evidence that may shed light on the ‘intent of the payor

as to the purpose in making the payment.’” Id. (quoting Knuckles v. Comm’r, 349

F.2d 610, 613 (10th Cir. 1965)); see also Gadja v. Comm’r, 158 F.3d 802, 804 (5th

Cir. 2005) (noting that under § 104(a)(2) intent of the employer governs

treatment of a severance payment). Ultimately, the character of the payment

hinges on the payor’s dominant reason for making the payment. The evidence

considered by the court may include the amount paid, the evidence adduced at

trial, the underlying judgment, the factual circumstances that led to the

agreement, and any other facts that may reveal the payor’s intent. See, e.g.,

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Dotson v. United States, 87 F.3d 682, 687-88 (5th Cir. 1996); Pipitone, 180 F.3d

at 864-65. We heed the wisdom that “when assessing the tax implications of a

settlement agreement, courts should neither engage in speculation nor blind

themselves to the settlement’s realities.” Bagley v. Comm’r, 121 F.3d 393, 395

(8th Cir. 1997). Instead, the court should discern “the claim the parties, in good

faith, intended to settle for.” Dotson, 87 F.3d at 688.

The language of Paragraph Five does not resolve whether the payments

were made “on account of” Green’s injuries. Paragraph Five simply refers to

“additional damages.” This is in contrast to both of the other paragraphs—

Paragraph Four payments are clearly intended to compensate Green for “loss of

earning capacity, mental anguish and suffering (past) and mental anguish and

suffering (future) and the payments under Paragraph Six are intended to

compensate Green for “all other damages, including punitive, pre-judgment, and

post-judgment interest.” However, there is no such explanation of what

“additional damages” this Paragraph Five was intended to compensate for.

Green contends that the payments were intended to compensate him for the

injuries sustained in securing payment of the judgment. The Government

responds that the Paragraph Five payments were punitive damages cloaked in

“other damages” language for political reasons.

Looking beyond the words of the agreement to the payor’s purpose, we

find that it was not clearly erroneous for the trial court to conclude that the

payments made under Paragraph Five were not made to compensate Green for

personal or physical injuries for the following reasons. Green claims that in

refusing to acknowledge that the payments made under Paragraph Five were

intended to compensate Green for personal injuries, the trial court ignored the

evidence and failed to consider the testimony presented at trial. Green argues

that even under the highly deferential “clearly erroneous” standard, he is

entitled to relief because the evidence presented at trial conclusively established

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that the money paid under Paragraph Five was intended to compensate Green

for personal injuries received in attempting to collect on the judgment. This

argument is not supported by the record.

First, an examination of the settlement agreement in conjunction with the

jury verdict in the underlying whistleblower suit supports the Tax Court’s

findings. “Where there has been a judgment in a trial court that preceded the

settlement of the claims, the most persuasive evidence of the payor’s intent in

settling the case is the previous award of that court.” Francisco, 267 F.3d at 320;

see also Robinson, 70 F.3d at 38 (the verdict provides “the best indication of the

worth of the [taxpayer’s] claims). Here, the trial court in the whistleblower

litigation awarded Green $13,775,000 in damages– almost the same amount that

Texas paid to Green under the settlement agreement. Further, the amount of

compensatory damages awarded by the jury in the whistleblower lawsuit for the

loss of earning capacity and past and future mental anguish and suffering,

$3,427,999.97, mirrored exactly the amount of compensatory damages paid

under Paragraph Four of the settlement agreement. The logical import, then,

is that the remainder of the settlement, including the amounts paid under

Paragraph Five, was intended to compensate Green for the remainder of the

judgment– consisting only of punitive damages and interest.

Second, Green points to the testimony of both Potter and Augustine that

Texas was opposed to paying punitive damages and wanted to minimize the

amount of punitive damages paid. Thus, he argues, the damages paid under

Paragraph Five could not possibly have been punitive damages, but were meant

to compensate Green for the injuries he sustained in his attempts to collect.

However, viewing the testimony presented at the trial as a whole, it appears

that although the Paragraph Five payments were intended to satisfy the

punitive damages portion of the judgment, they were labeled otherwise because

of political considerations. Potter testified that neither he, nor his office, had

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undertaken any independent investigation of Green’s injuries and that he lacked

personal knowledge of Green’s injuries resulting from his efforts to collect the

judgment. Potter also testified that Paragraph Five “could have been the same

type of [damages] as paragraph four.” This testimony undercuts Green’s

assertion that the Paragraph Five payments were intended to compensate for

post-judgment injuries. Further, Potter explained that Texas’s opposition to

paying punitive damages “was pretty much a matter of public policy.” Thus,

given the political climate, along with Potter’s lack of knowledge of Green’s post-

judgment injury, the Tax Court did not err in finding that the Paragraph Five

payments were intended to satisfy a portion of the punitive damages and

interest awarded to Green, but were labeled otherwise.

Third, Green points to Bullock’s knowledge of his post-judgment injuries

in support of his argument that Paragraph Five was intended to compensate him

for these injuries. The testimony of Green, Fogg, and Augustine established that

Bullock was aware of Green’s hardship and health problems stemming from the

collection efforts. Very likely, it was these compelling facts which led Bullock to

help Green obtain satisfaction of the judgment in the first place. However,

Bullock was not responsible for negotiating the settlement or drafting the

settlement agreement. Green did not produce any evidence that Bullock

informed Potter about Green’s postjudgment injuries, and in fact, Potter testified

that he was unaware of any postjudgment injuries. Bullock’s knowledge of

Green’s health condition does not satisfy Green’s burden of establishing that

Texas intended the money paid under Paragraph Five to compensate Green for

personal injury or sickness.

Finally, Augustine testified that his intent was to obtain from Texas full

payment of the punitive damages and interest. Fogg testified that in his

meeting with Bullock, he told Bullock that he expected Green to get a minimum

of what was owed to him by the jury verdict. Both of these statements confirm

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that the overall goal of the settlement negotiations and eventual agreement was

to provide Green with a monetary settlement equal to the judgment entered

against the state.

We agree with the Tax Court’s conclusion that “the record lacks any

evidentiary basis for concluding that a specific portion of the [Paragraph Five]

annuity was allocable to any personal injury or sickness.” Admittedly, the

language used in Paragraph Five is less than clear. But it is Green who bears

the ultimate burden of proving that the amounts paid under Paragraph Five

were meant to compensate him for personal injuries or sickness. He has not met

that burden. As such, the payments made under Paragraph Five of the

settlement agreement are not excludable under § 104(a)(2).

B. Deductibility of Business Expenses and Punitive Damages Paid to

Allied

Green appeals the Tax Court’s determination that the expenses and losses

he incurred in connection with Green Capital and TS Capital are not deductible

under § 162 of the Code as “ordinary and necessary expenses paid or incurred

. . . in carrying on any trade or business.”7 The Commissioner concedes that

Green substantiated the underlying expenses, but argues that they were

deductible only as “ordinary and necessary expenses paid or incurred . . . for the

production or collection of income” under § 212(1) of the Code.

Section 162 of the Code permits a deduction for all “ordinary and

necessary expenses paid or incurred during the taxable year in carrying on any

trade or business.” 26 U.S.C. § 162. In contrast, deductions are allowed under

§ 212 for “the ordinary and necessary expenses paid or incurred during the

7

It is more favorable for a taxpayer to deduct expenses under § 162. Expenses deducted

under § 162(a) generally are subtracted in full from gross income to arrive at adjusted gross

income. However, expenses deducted under § 212 ordinarily are subtracted from gross income

to arrive at taxable income and are subject to certain floor limitations set out in § 67(a) of the

Code. Also, under § 56(b) of the Code, a deduction under § 212 may be limited by application

of the alternative minimum tax.

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taxable year . . . for the production or collection of income.” 26 U.S.C. § 212. A

deduction claimed under § 212(1) “must meet the same requirements applicable

to trade or business expenses under § 162, except that the person claiming the

deduction need not be in the trade or business.” Simon v. Comm’r, 830 F.2d 499,

501 (2d Cir. 1987)); Snyder v. United States, 674 F.2d 1359, 1364 (10th Cir. 1982)

(same). The purpose of § 212 is to provide for deductions in “those pecuniarily

motivated or profit seeking activities which are neither the conduct of the

taxpayer’s trade or business on the one hand nor the mere satisfactions of his

needs as a human and those of his family on the other.” Petschek v. United

States, 335 F.2d 734, 735 (2d Cir. 1964).8

In order to be engaged in carrying on a trade or business, the taxpayer

“must be involved in the activity with continuity and regularity and . . . the

taxpayer’s primary purpose for engaging in the activity must be for income or

profit.” Comm’r v. Groetzinger, 480 U.S. 23, 35 (1987). The concept of trade or

business is a “concept which falls far short of reaching every income or profit

making activity.” Whipple v. Comm’r, 373 U.S. 193, 202 (1963). A sporadic

activity, a hobby, or an amusement does not qualify as a “trade or business.”

Groetzinger, 480 U.S. at 35. The determination of whether Green was engaged

in carrying on a trade or business is a determination of fact that we review for

clear error. See Westbrook v. Comm’r, 68 F.3d 868, 874 (5th Cir. 1995); Jackson

v. Comm’r, 864 F.2d 1521, 1524 (10th Cir. 1989).

8

Congress’s purpose in enacting § 212 was to put all income producing activities on

equal footing. United States v. Gilmore, 27 U.S. 39 (1963). Thus, at the time the predecessor

to § 212 was adopted, deductions under § 162 and § 212 had the same effect. Id. However,

beginning in 1986, Congress distinguished between the two, limiting the deductibility of non-

business expenses. The rationale was that some of the § 212 expenses had only a very tenuous

relationship to any income-producing activity and had personal-consumption benefits as well.

See Leah Witcher Jackson, Won the Legal Battle, but at What Tax Cost to Your Client: Tax

Consequences of Contingency Fee Arrangements Leading up to and After Commissioner v.

Banks, 57 Baylor L. Rev. 47, 110-12 (2005).

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No. 06-60597 & 06-60779

The Tax Court found that although Green “continuously and regularly

engaged in the activity of attempting to recover his judgment between 1991 and

1995,” it “could not conclude that [Green] was in a trade or business in the

customary use of those terms.” The Tax Court reasoned that “[a]lthough a trade

or business requires continuous and regular activity, continuity and regularity

do not, standing alone, constitute a trade or business.” The Tax Court’s

conclusions are well-supported by the record in this case. Green’s asserted

purpose in forming Green Capital and TS capital, as noted by the Tax Court

“was to secure the compensation to which he was entitled.” While Green’s

attempt to secure satisfaction of this personal judgment qualifies as an income

seeking activity; it does not qualify as a business or trade. Expenditures may

only be deducted under § 162 “if the facts and the circumstances indicate that

the taxpayer made them primarily in furtherance of a bona fide profit objective

independent of tax consequences.” Copeland v. Comm’r, 290 F.3d 326, 335 (5th

Cir. 2002). Here, the record demonstrates that Green formed the two companies

solely for the purpose of paying expenses associated with the collection of a

judgment that was rendered prior to the establishment of the businesses.

Further, the businesses had no independent purpose beyond the payment of

these legal expenses. Were we to find that the funneling through a business of

Green’s expenses in collecting a personal judgment were sufficient to meet the

requirements of § 162, the distinction between § 162 and § 212 would be

abrogated. The Tax Court did not clearly err in determining that Green’s

expenses and losses from Green Capital and T.S. Capital were not incurred in

carrying on any trade or business. Cf. Alexander v. IRS, 72 F.3d 938 (1st Cir.

1995) (expenses incurred by employee in settling post-termination lawsuit not

deductible as independent business expense because lawsuit proximately

resulted from his employment).

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No. 06-60597 & 06-60779

Additionally, Green argues that the $365,000 portion of his payment in

satisfaction of Allied’s judgment, constituting exemplary damages, is deductible

under § 162. This judgment was entered against Green for non-payment of

expenses associated with collection of the judgment. Punitive damages may be

deductible under § 162 as a business expense, but only to the extent that such

expense is “ordinary and necessary ” and is incurred in connection with a “trade

or business.” Tax Court found that the punitive damages payment was not

deductible because Green failed to explain the basis of the award against Green

or show that the expense was ordinary or necessary. Green has not

demonstrated that this conclusion was clearly erroneous. As such, we affirm

that Tax Court’s holding that Green’s punitive damages payment is not

deductible under § 162.

C. Accuracy-Related Penalties

Green appeals the Tax Court’s affirmance of the Commissioner’s

assessment of accuracy-related penalties under § 6662 of the Code on Green’s

income tax returns from 1995 through 1999. The determination of whether

Green acted with reasonable cause and in good faith in making a substantial

understatement of tax liability is a factual issue that we review for clear error.

Srivastava, 220 F.3d at 367; see also Treas. Reg. § 1.6664-4(b)(1) (as amended

2003) (“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

pertinent facts and circumstances.”)

Under § 6662 of the Code, a taxpayer may be liable for a penalty of twenty

percent on the portion of underpayment of tax due to “any substantial

understatement of income tax.” 26 U.S.C. § 6662 (b)(2). A “substantial

understatement” is defined as an understatement of tax liability on a tax return

that exceeds the greater of (1) 10% of the tax required to be shown on the return

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No. 06-60597 & 06-60779

for the taxable year; or (2) $5,000. 26 U.S.C. § 6662 (d)(1)(A), (d)(2).9 This

penalty does not apply to any portion of an underpayment if the taxpayer shows

“that there was reasonable cause for such portion and that the taxpayer acted

in good faith with respect to such portion.” 26 U.S.C. § 6664(c)(1); see also

Higbee v. Comm’r, 116 T.C. 438, 488 (T.C. 2001).

For the reasons discussed above, Green’s failure to pay tax on the

settlement payments and his deduction of the business expenses and losses were

in error. He argues however, that the Tax Court erred in upholding the

penalties because he acted in good faith and with reasonable cause.

The Tax Court found that Green did not act with reasonable cause and

good faith. It found that Green was negligent in excluding the entire settlement

recovery from his income, while, at the same time, deducting in full the expenses

he incurred to collect the whistleblower judgment. Further, the Tax Court found

that Green’s inclusion of the Paragraph Six payments in 1996, 1997, and 1998

indicated his knowledge that punitive damages and interest were not excluded

under § 104 of the Code. The Tax Court also found that, although Green had

assistance in preparing his return in 1997 and 1998, there was no evidence as

to what Green told the preparer, what the preparer told Green, and whether or

not Green’s reliance on any advice from the preparer was reasonable.

Based on all of the facts and circumstances, it was not clear error for the

Tax Court to find that Green failed to act with reasonable cause and good faith.

9

Section 6662 provides that taxpayers may reduce the amount of an understatement,

and hence the penalty imposed, by that portion of the understatement resulting from a position

taken by the taxpayer for which there was substantial authority or, if the position is disclosed

adequately on the tax return, for which there was a reasonable basis for such treatment. 26

U.S.C. § 6662(d)(2)(B)(i)-(ii). The Tax Court found that Green failed to establish that he was

entitled to the benefit of either of these provisions. On appeal, Green does not appear to argue

that the Tax Court erred in this respect, but to the extent that he does, his argument is

rejected.

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We sustain the assessment of penalties for 1996 through 1999 for the substantial

understatement of tax and for 1995 through 1999 for the disallowed deductions.

IV. CONCLUSION

For the foregoing reasons, we AFFIRM the Tax Court’s determinations

that: (1) the payments made under Paragraph Five of the settlement were not

excludable under § 104(a)(2) of the Code; (2) Green was entitled to deduct

expenses and losses related to Green Capital and TS Capital under § 212 of the

Code, and not under § 162 of the Code, and that Green was not entitled to deduct

the payment of punitive damages to Allied; and (3) the Tax Court’s affirmance

of the accuracy-related penalties was not in error.

20