Petition for Writ of Certiorari — Polone v. Commissioner of Internal Revenue (No. 07-1038)

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QD O71038FEB &- 2008

No. _—-——s— OFFICE OF THE CLERK

In the

Supreme Court of the United States

GAVIN POLONE,

Petitioner,

COMMISSIONER OF INTERNAL REVENUE,

Respondent

On Petition for Writ of Certiorari to the United States

Court of Appeals for the Ninth Circuit

PETITION FOR WRIT OF CERTIORARI

CARTER G. PHILLIPS JAMES M. HARRIS*

SIDLEY AUSTIN LLP EDWIN L. NORRIS

1501 K Street NW JONATHAN M. BRENNER

Washington, DC 20005 SIDLEY AUSTIN LLP

(202) 736-8000 555 W. 5th Street, 40th FI.

Los Angeles, CA 90013

(213) 896-6000

Counsel for Petitioner

February 8, 2008 * Counsel of Record

WILSON-EPES PRINTING CO., INC. — (202) 789-0096 -— WASHINGTON, D.C. 20002

QUESTIONS PRESENTED FOR REVIEW

1. Whether 26 U.S.C. § 104(a)(2), as amended by

the Small Business Job Protection Act of 1996

(““SBJPA”), which eliminated the prior statutory

provision excluding from the definition of gross

income payments in respect of non-physical personal

injury, thus making such payments subject to income

tax for the first time in history, constituted a “wholly

new tax” that therefore may not permissibly be

applied retroactively.

2. Whether, as urged in the petition pending in

Murphy v. Internal Revenue, No. 07-802, settlement

payments received on account of non-physical injuries

may permissibly be included in the taxpayer’s gross

income and made subject to income tax.

PARTIES TO THE PROCEEDING

Gavin Polone is the petitioner in this Court and

was the petitioner and appellant in the court of

appeals.

The Commissioner of Internal Revenue is the

respondent in this Court and was the respondent in

the court of appeals.

RULE 29.6 CORPORATE DISCLOSURE

STATEMENT

Applicant Gavin Polone is an individual and not a

corporation.

PETITION FOR A WRIT OF CERTIORARI

OPINIONS BELOW

JURISDICTION

STATUTORY PROVISIONS INVOLVED

STATEMENT OF THE CASE

TABLE OF CONTENTS

REASONS FOR GRANTING THE PETITION

IT.

THIS COURT HAS LONG

CONDEMNED RETROACTIVE

APPLICATION OF LEGISLATION

IMPOSING A “WHOLLY NEW TAX.”.......... 13

BY MAKING PAYMENTS RECEIVED

FOR NON-PHYSICAL PERSONAL

INJURIES TAXABLE FOR THE FIRST

TIME IN HISTORY, POST-SBJPA

§104(A)(2) IMPOSED A WHOLLY NEW

WN aiinain sinks cietes ncecain alguna aacbiee alain nieds 17

GUIDANCE FROM THIS COURT IS

NECESSARY TO ALLOW TAXPAYERS

THE POSSIBILITY OF FORESEEING

WHAT FORMS OF TAXES MIGHT BE

APPLIED RETROACTIVELY............00000000... 20

ererereeees

OOP eRe ee Pee PPP eee CPPCC ee eee eee eee eee eee

SECRETE EERE EE EERE EEE SEE EEE EEE EEE EEE ED OBES

ee eeeeeeeeseses

IV. INCOME TAX MAY NOT

PERMISSIBLY BE IMPOSED ON

AMOUNTS RECEIVED ON ACCOUNT

OF NON-PHYSICAL PERSONAL

SPIE ata cxtantssaseassncaibeuncsdolenecetaienceurkeeciicie 24

Se II Sis nish a Sbxiccdicthcha re sania ensennnntennianicnasanisden 25

APPENDIX A: Polone v. Commissioner of

Internal Revenue, 505 F.3d 966 (9th Cir.

EARN a MORNE R Perce Se TR 8 9 ea eRe TOR la

APPENDIX B: Polone v. Commissioner of

Internal Revenue, 479 F.3d 1019 (9th Cir.

sik oie tencecas maak alee eule tec nous taabdeenentisiiieans l3a

APPENDIX C: Polone v. Commissioner of

Internal Revenue, 449 F.3d 1041 (9th Cir.

= rarely ee here ee Rea NE Ro rly er pt ea 24a

APPENDIX D: Polone v. Commissioner of

Internal Revenue, T.C. Memo 2003-339

RR _-RRC eo r e g ea nee aE 35a

APPENDIX E: 26 U.S.C. § 1044 ........................... 94a

APPENDIX F: 26 U.S.C. § 104 (1995) ...... 99a

TABLE OF AUTHORITIES

CASES Page

Appendroat v. United States,

490 F. Supp. 490 (W.D. Pa. 1980).................0.. 15

Blodgett v. Holden,

rei Bin eS ee gd ene 13, 14, 16, 20

Commissioner v. Glenshaw Glass Co.,

Be ON oa dnc stn aiscsiccsencanismeuccsatedstonanecas 18

Dotson v. United States,

BF © ree Re Ce Cr EI onaisivvivcs cicessecencssocncosess 18

Doyle v. Mitchell Bros.,

Tae FT, Te Ce a, NR iiidnccsvvivacvceassisaiancces 18

General Motors Corp. v. Romein,

0 ois cae asda 14

Landgraf v. USI Film Products,

ee Os citric 12

Milliken v. United States,

Ee ee iio sss thacocenesencceracteveeecanamea 13

Murphy v. Internal Revenue Serv.,

ME ee SI. Ga. FED viv vsncesesivncccnsinasivees 19

Murphy v. Internal Revenue Serv.,

453 F.6d 170 CC. Cae. BOOT) vicvccscscccccnsssocsne 19, 24

Netsky v. United States,

G52 F. Supp. TES (ED). Pa. LOSE) ancccecccsvececsseccacs 15

Nichols v. Coolidge,

Es I EE ccccckecctaccccenctecccces 14, 15, 16, 20

O’Gilvie v. United States,

I a eae 18

Quarty v. United States,

ee ne ee as eabeseeas 15

Roemer v. Commissioner,

716 F.2d 693 (Sth Cir. 1983) ................c.cccccsoseces. 17

Rosenberg v. United States,

1986 U.S. Dist. LEXIS 18835 (C.D. Cal

EEE ats A. SCOR ce Ee CT ER 15

Threlkeld v. Commissioner,

Be ce ek Ce Gre, BO vnccincccaccacccccncdccosacncccce 17

United States v. Cariton,

ee I siasesaesecmane passim

Untermyer v. Anderson,

ry ee so. sai ceaneccaunans 14, 16, 20

Warren Jones v. Commissioner,

ee BI UE Ge. RONG OID vicnccnccccocceccccucceccoceecens 7

Welch v. Henry,

nn sl elaeanablinasiennaie’ 22

STATUTES Page

oo ie uadedcenekelaseselaneaaneinn 1

ooo a sepecmeinemenoeaneaann 19

Be na Oe I eich unepeniintcmendceonnnsnasenns passim

Vii

DB UGC, © MODE oecsesnciccccosessvnsscsesrercosncesssassessovssonsan 7,9

BG U.B.C. § 225461) ......ccceccccncececsocossenscecsccasecesnsseseses. 2

OTHER AUTHORITIES Page

Small Business Job Protection Act of 1996,

Pub. L. No 91-190, § 1605, 110 Stat. 1755

(effective as of August 26, 1996)....................... 2.

H.R. 3448, 104th Cong. (1996) ....................cccceceeeee

Murphy v. Internal Revenue Service,

No. 07-802 (filed Dec. 13, 2007).....................002..

PETITION FOR A WRIT OF CERTIORARI

Petitioner Gavin Polone respectfully petitions for a

writ of certiorari to review the judgment of the

United States Court of Appeals for the Ninth Circuit

in this case.

OPINIONS BELOW

The Tax Court’s opinion was published as T.C.

Memo 2003-339 and is reproduced in the appendix

hereto (“App.”) at 35a-93a. The Ninth Circuit’s initial

opinion affirming the Tax Court opinion was

published at 449 F.3d 1041 (2006) and is reproduced

at App. 24a-34a. The panel subsequently entered an

order withdrawing the initial opinion, filing a

substituted opinion and denying rehearing, which

order and opinion were published at 479 F.3d 1019

(2007) and are reproduced at App. 13a-23a. The

panel subsequently entered an order withdrawing its

second opinion, filing a substituted opinion and

denying requests for rehearing and rehearing en

banc, which order and superseding opinion were

published at 505 F.3d 966 (9th Cir. 2007) and are

reproduced at App. la-12a.

JURISDICTION

The judgment of the court of appeals was entered

October 11, 2007. The court of appeals denied

requests for rehearing and rehearing en banc on

October 11, 2007. On December 17, 2007, Polone was

granted an extension of time to file his petition for

writ of certiorari to and including February 8, 2008.

The jurisdiction of the Supreme Court is invoked

pursuant to 28 U.S.C. § 1254(1).

STATUTORY PROVISIONS INVOLVED IN THIS

CASE

As currently codified, Section 104(a)(2) to Title 26 of

the United States Code provides that:

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. . . 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... .

This statutory provision is reproduced in full in the

appendix to this petition, App. 94a-98a.

Prior to its amendment by the Small Business Job

Protection Act of 1996, Pub. L. No 91-190, § 1605, 110

Stat. 1755 (effective as of August 26, 1996), Section

104(a)(2) to Title 26 of the United States code

provided that:

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...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....

This statutory provision is reproduced in full in the

appendix to this petition, App. 99a-102a.

STATEMENT OF THE CASE

iL Petitioner Gavin Polone was employed as a

talent agent from 1989 until April 21, 1996 by United

Talent Agency, Inc. (“UTA”). In 1992, Polone entered

into an Employment Agreement with UTA which

provided for base annual compensation, annual

increases and a_e discretionary bonus, which

Agreement was later amended and extended until

March 30, 1998.

The Employment Agreement permitted UTA to

terminate Polone without lability for “cause,” which

was defined to include certain criminal convictions,

material breaches of the Employment Agreement,

and fraudulent, illegal, or immoral activity that

materially affected UTA or its reputation. It also

gave UTA the right to terminate’ Polone’s

employment without cause, in which event UTA

would have specified liabilities to Polone.

2. UTA terminated Polone’s employment on April

21, 1996. The next two days, reports appeared in The

Hollywood Reporter, Daily Variety and The Los

Angeles Times and on local TV regarding Polone’s

termination. These reports contained defamatory

statements by UTA’s principals about Polone,

including that he had been terminated for cause, had

harassed UTA employees, and had _ behavioral

problems.

Polone’s counsel immediately prepared a complaint

against UTA, including tort claims for defamation,

intentional infliction of emotional _ distress,

intentional interference with prospective economic

advantage, invasion of privacy and _ wrongful

termination, as well as a claim for breach of contract.

Polone’s counsel informed UTA that Polone’s claims

were worth $20.25 million, $8.25 million representing

items due under his Employment Agreement, and

$12 million representing damages for defamation and

other tort injuries.

On May 3, 1996, Polone and UTA entered into a

Defamation Settlement Agreement and Mutual

General Release (the “Settlement Agreement”) to

settle his defamation and other tort claims.' Under

that Agreement, UTA was obligated to make four $ 1

million payments to Polone over time. UTA made

those payments on May 3, 1996, November 11, 1996,

May 5, 1997 and November 11, 1998 (the

“Settlement Payments’).

UTA’s obligation to make the Settlement Payments

was not contingent upon the occurrence of any event.

1 The same day, they entered into a separate settlement

agreement as to Polone’s breach of contract claims.

UTA was one of the largest talent agencies in the

world when the settlement was -reached, in sound

financial condition and highly profitable with

revenues close to $50 million a year and significant

long term guaranteed receivables.

At the time of the Settlement Agreement, then-

effective 26 U.S.C. § 104(a)(2)2 excluded from income

settlement payments made on account of defamation

claims. App. 5a, 99a. In August 1996, that statute

was amended by the Small Business Job Protection

Act of 1996 (“SBPJA”) to eliminate the exclusion of

such settlement payments from income. Pub. L. No.

91-190, § 1605, 110 Stat. 1755; App. 5a. H.R. 3448,

the bill that ultimately became the SBJPA, was

initially introduced in Congress on May 14, 1996,

after the Settlement Agreement had been executed

and the first Settlement Payment made.

3. Polone excluded from his income on his 1996

federal tax return the May 1996 Settlement Payment,

though he erroneously included the November 1996

Settlement Payment in that return. On April 16,

1998, he filed an amended 1996 federal income tax

return seeking to reverse the inclusion of the

November 1996 Settlement Payment and to obtain a

refund. Polone excluded the May 1997 and

November 1998 Settlement Payments from his

income on his subsequent federal returns.

2 Unless otherwise indicated, all statutory cites herein are to

the Internal Revenue Code, 26 U.S.C. § 1 et seq.

The Commissioner of Internal Revenue denied

Polone’s refund claim by notice dated February 15,

2000. Several months later, he sent Polone a Notice

of Deficiency disallowing the exclusions from Polone’s

income for the last three Settlement Payments.

4. On December 7, 2000, Polone filed a petition in

the Tax Court to redetermine the deficiencies

asserted against him as to the final three Settlement

Payments.

On February 14, 2002, Polone filed a complaint in

the United States District Court, Central District of

California, seeking a refund of the federal income

taxes attributable to the inclusion in income of the

November 1996 Settlement Payment. On August 9,

2002, in order to consolidate his claims in one case,

Polone amended his petition in Tax Court to include

his refund claim, which amendment the Tax Court

accepted.

The Tax Court conducted a trial in late 2002. As

their trial briefs made clear, the parties agreed that,

before its amendment by the SBJPA as of August 20,

1996, 26 U.S.C. §104(a)(2), provided that settlement

payments regarding defamation and personal injury

claims were absolutely excludable from the taxpayer’s

gross income. They further agreed that post-SBJPA

§104(a)(2) limits the exclusion to physical personal

injuries, thus for the first time in history making

taxable settlement payments received on account of

defamation claims. By its terms, post-SBJPA

§104(a)(2) applies to any “amount received” after

August 20, 1996.

In his briefs, Polone contended that the May 1996

Settlement Payment was subject to pre-SBJPA

§104(a)(2) and thus excludable from income because

(i) he had received the payment on account of his

defamation claim (ii) before enactment of the SBJPA.

Polone further contended that the last three

Settlement Payments were also subject to pre-SBJPA

§104(a)(2) because UTA had become obligated to

make them when the Settlement Agreement was

executed prior to the SBJPA effective date. In his

view, the Settlement Agreement constituted a “sale

or other disposition of property” within the meaning

of §1001 from which Polone had at that time

“realized” the full amount UTA had obligated itself to

pay. See Warren Jones v. Commissioner, 574 F.2d

788 (9th Cir. 1975) (deferred payment obligations

under a settlement agreement constitute “amount

received” for tax purposes in year obligation created if

it had ascertainable fair market value at that time).

Alternatively, Polone argued the retroactive

application of post-SBJPA §104(a)(2) as to the last

three Settlement Payments would violate due process

under well-settled law barring the _ retroactive

application of new taxes.

The Commissioner contended the Settlement

Payments had not been made on account of Polone’s

defamation claim. He argued that, even if they had

been, UTA’s obligation to make the latter three

Settlement Payments did not constitute an “amount

realized” within the meaning of §1001 by Polone on

May 3, 1996; he thus contended those Payments were

governed by post-SBJPA §104(a)(2) and were not

excludable. And he argued there was no

constitutional impediment to applying post-SBJPA

§104(a)(2) to the final three Settlement Payments.

5. After concluding all the Settlement Payments

were made on behalf of Polone’s defamation claim,

the Tax Court opinion held that the May 1996

Payment was governed by pre-SBJPA §104(a)(2)

because it had been received before the SBJPA

effective date. It thus ruled that Payment was

excludable from taxation.

The Tax Court then held that UTA’s obligation to

make the November 1996, May 1997 and November

1998 Settlement Payments did not constitute an

amount realized or received by Polone before the

August 20, 1996 SBJPA effective date. And it

concluded that application of post-SBJPA §104(a)(2)

to those Payments was not “retroactive,” and, if

retroactive, not unconstitutional. Accordingly, it

concluded the final three Settlement Payments were

subject to post-SBJPA §104(a)(2) and not excludable.

The Tax Court ultimately entered a Final Decision

decreeing Polone was not liable for any deficiency

respecting the May 1996 Payment, was not entitled

to a refund respecting the November 1996 Payment,

and was liable for a deficiency of $407,880 for both

the May 1997 and November 1998 Payments (plus

interest), which deficiency Polone has paid subject to

reimbursement depending upon the outcome of this

litigation.

6. Polone appealed to the United States Court of

Appeals for the Ninth Circuit, which issued its

original opinion in this matter in 2006. App. 24a-34a.

In response to Polone’s rehearing petition, the panel

withdrew its original opinion and entered a

superseded opinion. App. 13a-23a. In response to a

subsequent petition, the panel withdrew its second

opinion, entering in its place its final opinion and

judgment. App. la-12a.

The final panel opinion affirmed the decision of the

Tax Court (as had the superseded opinions).

Initially, the pane] rejected Polone’s’ threshold

contention that the proper tax treatment of the last

three Settlement Payments was determined on May

3, 1996, when UTA became unconditionally obligated

to make them. App. 7a-Qa. In its view, the

settlement did not constitute a “sale or other

disposition of property” within the meaning of §1001

from which Polone had “realized” at that time the full

amount UTA had unconditionally obligated itself to

pay. ld.

The panel thus held Polone was subject to tax on

the latter three Settlement Payments, even though

such Payments were statutorily excluded from

taxation at the time UTA had become unconditionally

obligated to make them. Jd.

The panel then rejected Polone’s alternative

contention that post-SBJPA could not be permissibly

applied to the latter three Settlement Payments

because due _ process’ prohibits the _ retroactive

application of new taxes. /d. at 9a-12a. According to

the panel, “the fact that Polone’s tax dispute

stemmed from his settlement with UTA—conduct

that antedated the revisions to § 104—does not mean

that § 104 operates retrospectively when it is applied

to settlement payments that Polone received after its

effective date.” Jd. at 12a.

REASONS FOR GRANTING THE PETITION

This case presents the question of whether an

amendment to the tax code, making taxable for the

first time in history settlement payments received on

account of non-physical personal injury, constitutes a

“wholly new tax” that cannot be retroactively applied

to payments under an agreement entered into when

such payments were not taxable.

The Ninth Circuit erroneously determined that the

November 1996, May 1997, and November 1998

Settlement Payments could permissibly be governed

by post-SBJPA §104(a)(2)—under which they would

be taxable—even though UTA became

unconditionally obligated to make those Payments

before the effective date of that statute. It affirmed

the Tax Court’s conclusion that the retroactive

application of the new statute to Polone did not

violate due process because “Congress’s choice to

narrow the exclusion {under §104(a)(2)], and any

retroactive application of the change, would therefore

appear to be rationally linked to the legitimate

objective of raising revenue.”? App. 12a, 89a.

3 The Commissioner conceded in the Ninth Circuit that post-

SBJPA §104(a)(2) “could be construed as operating retroactively

[here] insofar as it applies to damages that are received post-

enactment, but pursuant to agreements entered into between

September 13, 1995 and the statute’s effective date of August

20, 1996.” This concession was well-taken. The SBJPA was

introduced on May 14, 1996, and became effective on August 20,

1996. Section 1605(d)(1) of the SBJPA provides that the

amendments made by SBJPA §1605 shall apply to “amounts

received after August 20, 1996,” the statute’s effective date.

SBJPA §1605(d), 110 Stat. 1755. SBRJPA §1605(d)(2) goes on to

provide, however, that the amendments to §104(a)(2) “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.” (The September 13,

1995 date had appeared in a binding contract provision relating

to a modification of Section 104 that was contained in a bill in

the previous term, but that modification was not enacted;

apparently, that date was carried over inadvertently into the

SBJPA without being updated as logic, fairness and customary

Congressional practice would have dictated.) Thus, post-SBJPA

§104(a)(2) on its face applies retroactively to binding contracts,

such as Polone’s Settlement Agreement, that had been entered

into during the eleven months preceding the SBJPA’s effective

date. As a consequence, Polone had no opportunity to structure

his affairs to take into account the dramatic tax change reflected

by the adoption of the SBJPA.

Nonetheless, the Ninth Circuit also determined that amended

§ 104(a) had not been retroactively applied to Polone’s

Settlement Payments because the Settlement Payments were

due after the SBJPA amendment was enacted and, therefore,

(continued...)

The Ninth Circuit’s erroneous conclusion merits

this Court’s plenary review because it conflicts with a

long line of cases—the continued vitality of which

this Court reaffirmed in United States v. Carlton, 512

U.S. 26 (1994)—that prohibits the retroactive

application of “wholly new taxes.” In economic effect,

the amendment to §104(a)(2) constitutes a “wholly

new tax.” Pre-SBJPA §104(a)(2) altogether excluded

from federal income tax settlement payments made

in respect of non-physical personal injury claims. In

contrast, post-SBJPA §104(a)(2), overruling 78 years

of settled law, made such settlements taxable as

income for the first time.

the court reasoned, “new legal consequences” had not been

applied to a “completed act.” App. 10a-12a.

This determination was incorrect. The “completed act” at

issue for this analysis was UTA’s obligation to make the

Settlement Payments. That obligation became complete at the

time the Settlement Agreement was executed—months before

SBJPA was enacted. Once he signed the agreement, Polone did

not have to engage in any other acts in order to receive the

Settlement Payments to which he was entitled, making the

transaction to be taxed complete and the Payments an “amount

realized.” Thus, the application of the SBJPA amendment to

Polone was retroactive—it attached new consequences (by

making the Payments taxable) to a transaction already passed

(UTA’s absolute obligation to make the Payments). See, e.g.,

Landgraf v. USI Film Products, 511 U.S. 244, 269 (1994)

(“Every statute, which takes away or impairs vested rights

acquired under existing laws, or creates a new obligation,

imposes a new duty, or attaches a new disability, in respect to

transactions or considerations already past, must be deemed

retrospective.”).

It is particularly important that the Court review

this issue at this time. Although it reaffirmed

recently the vitality of the ban against retroactive

application of “wholly new taxes,” it has not had any

occasion since doing so to articulate when a tax

statute runs afoul of this ban. By rejecting the

contention Congress had enacted a “wholly new tax”

here—even though settlement payments for non-

physical injuries had never in history been subject to

income tax at all—the Ninth Circuit’s opinion calls

into question whether any retroactive tax statute

would run afoul of the ban against retroactive

application of new taxes. And because (i) many, if

not most, tax statutes provide for some period of

retroactivity, and (ii) tax policy has become a central

issue in the contemporary national political debate,

providing clarity to this unsettled area of law is of

dynamic importance to individual and corporate

taxpayers alike.

I. THIS COURT HAS LONG CONDEMNED

RETROACTIVE APPLICATION OF

LEGISLATION IMPOSING A “WHOLLY

NEW TAX.”

A retroactive taxation statute runs afoul of

constitutional limits when it is “so arbitrary and

capricious that its enforcement would amount to

deprivation of property without due process of law.”

Blodgett v. Holden, 275 U.S. 142, 147 (1927); see also

Carlton, supra, 512 U.S. at 30 (recognizing

continuing prohibition against “arbitrary and

irrational legislation”); Milliken v. United States, 283

U.S. 15, 20-21 (1931); Nichols v. Coolidge, 274 U.S.

531, 542 (1927); Untermyer v. Anderson, 276 U.S.

440, 445 (1928). As this Court has long recognized,

retroactive legislation “presents problems of

unfairness that are more serious than those posed by

prospective legislation, because it can deprive citizens

of legitimate expectations and upset _ settled

transactions.” General Motors Corp. v. Romein, 503

U.S. 181, 191 (1992).

In Blodgett and Untermeyer, the Court reviewed the

application of Section 319 of the Revenue Act of 1924,

which established a new gift tax. 275 U.S. at 145-

146; 276 U.S. at 445. In each case, it invalidated the

retroactive application of the gift tax statute to gifts

made prior to its enactment. 275 U.S. at 147; 276

U.S. at 445. In doing so, the Court stressed that the

taxpayers had no reason to foresee the later

imposition of this new form of tax when the gifts were

made. 275 U.S. at 147; 276 U.S. at 445-46.

The Court applied the same analysis in Nichols to

invalidate the retroactive application of the statute

imposing the then-new estate tax. 274 U.S. at 542-

43. That statute sought to include the value of

property transferred prior to death (even if prior to

the statute’s enactment) in a decedent’s taxable

estate. Jd. The Court concluded that taxing property

transferred prior to the statute’s enactment violated

due process. Id.

Several subsequent decisions recognize the

constitutionally significant distinction between the

retroactive imposition of “wholly new taxes” (_.e.

Blodgett, Untermeyer, and Nichols) and modifications

to existing tax rates. For example, Quarty v. United

States, 170 F.3d 961, 964, 966-67 (9th Cir. 1999)

sanctioned the retroactive reinstatement of the 53%

and 55% maximum federal estate and gift tax rates

which had been lowered to a 50% rate 7 months

earlier. Likewise, Appendrodt v. United States, 490

F. Supp. 490, 491-92 (W.D. Pa. 1980), sanctioned a

retroactive increase in tax rate from 10% to 15%.

Conversely, several pre-Carlion lower court

decisions determined that retroactive application of a

“wholly new tax” violates due process, principally

because a “wholly new tax” is less foreseeable than an

alteration in the rate of a pre-existing tax. See

Netsky v. United States, 652 F. Supp. 783, 786 (E.D.

Pa. 1986), rev'd on other grounds, 859 F.2d 1 (8rd Cir.

1988); and Rosenberg. v. United States, 1986 U.S.

Dist. LEXIS 18835 at *17 (C.D. Cal 1986), reud on

other grounds sub nom., United States v. Wells Fargo

Bank, 485 U.S. 351 (1988) (invalidating retroactive

application of a new federal statute that for the first

time subjected public housing agency obligations to

the estate tax).

Carlton, this Court’s. most recent review of the

permissibility of retroactive tax legislation, likewise

recognizes the constitutional distinction between

alterations to existing tax treatment and the adoption

of a “wholly new tax.” Carlton concerned the

permissibility of a retroactive amendment to §2057, a

statute that, as originally enacted, permitted a

decedent’s estate to exclude 50% of the sales proceeds

from the transfer of securities to an employee stock

ownership plan. Within three months of its

enactment, the IRS recognized that §2057 contair ed

an unintended loophole. Later that year, Congress

amended §2057 to eliminate the loophole, making the

amendment retroactive to the statute’s original. Jd at

29.

Rejecting the position of a taxpayer who had

structured his estate to exploit the loophole, the

Court sanctioned the “modest” retroactive application

of the amendment. It stressed that the amendment

was curative in nature and designed solely to “correct

what [Congress] reasonably viewed as a mistake” in

the original and recent drafting of §2057. Jd. at 32.

Of particular significance here, while questioning

the continued validity of Blodgett, Untermyer, and

Nichols in analyzing the permissibility of retroactive

tax legislation generally, the Court emphasized that

those decisions still authoritatively condemned the

retroactive application of a “wholly new tax,” 512

U.S. at 30-31, 34 (those decisions apply to situations

“involving ‘the creation of a wholly new tax,’...’[but

not the] constitutionality of subsequent amendments

that bring about certain changes in the operation of

the tax laws”); see also id. at 38 (O’Connor, J..,

concurring) (recognizing “wholly new tax” cannot be

imposed retroactively).

However, because the taxpayer there had not

contended the amendment constituted a “wholly new

tax,’ the Court had no occasion to articulate the test

for determining when tax legislation imposes such a

new tax. As explained below, it is essential for the

Court now to provide this necessary guidance.

Il. BY MAKING PAYMENTS RECEIVED FOR

NON-PHYSICAL PERSONAL INJURIES

TAXABLE. FOR THE FIRST TIME IN

HISTORY, POST-SBJPA §104(A)(2)

IMPOSED A WHOLLY NEW TAX.

As a matter of common sense and basic economics,

the enactment of SBJPA § 104(a)(2), which included

payments on account of non-physical injuries such as

defamation within the definition of gross income for

the first time in history, constituted a “wholly new

tax.”

When the Settlement Agreement for Polone’s

defamation claim was executed on May 3, 1996, pre-

SBJPA § 104(a)(2) provided that “the amount of any

damages received (whether received by suit or

agreement and whether as lump sum or as periodic

payments) on account of personal injuries or

sickness” is excluded from gross income. App. 99a.

Indeed, beginning with the Revenue Act of 1918 and

continuing until the enactment of the SBJPA,

compensation for “personal injuries or sickness” has

always been excluded from the definition of gross

income’ _ See, e.g., former §§ 213(b)(6), 22(b)(5). And

the case law has long recognized that damages for

defamation constituted a “personal injury” within the

meaning of that exclusion. Roemer v. Commissioner,

716 F.2d 693 (9th Cir. 1983); Threlkeld v.

Commissioner, 848 F.2d 81 (6th Cir. 1988).

The pre-SBJPA treatment of personal injury

damages under §104(a)(2) was consistent with the

well-recognized distinction between damages that

constitute an “accession to wealth” and those that

constitute a “restorataon of capital,” i.e., that make a

person “whole” by restoring something that was lost.

Accessions to wealth have consistently been treated

as taxable income, while the restoration of capital has

not. See O’Gilvie v. United States, 519 U.S. 79 (1996)

(“restoration of capital [is] not income. . . upon which

the law impose[s] a tax”); Commissioner v. Glenshaw

Glass Co., 348 U.S. 426, 430, 432 n.8 (1955) (personal

injury damages are “compensatory only” and

nontaxable); and Doyle v. Mitchell Bros., 235 F. 686,

688 (6th Cir. 1916) (compensation for fire losses not

income). Because defamation damages serve to

restore to a person something taken from him,‘ it was

natural to include such damages within the pre-

SBJPA “gross income” exclusion. See Dotson v.

United States, 87 F.3d 682, 685 (5th Cir. 1996)

(“Congress first enacted the _ personal injury

compensation exclusion in 1918 at a time when such

payments were considered the return of human

capital, and thus not constitutionally taxable ‘income’

under the 16th amendment.”).

4 The Ninth Circuit made this point in its initial opinion,

noting “[t]he money that Polone received as part of his

settlement with UTA served to restore any loss to his reputation

caused by UTA’s alleged defamation and to make him whole....”

App. 3la. It deleted this discussion in its final opinion. App. la-

12a.

But as the D.C. Circuit recently noted, Congress

overturned this long-standing rule in part when it

enacted the SBJPA and, for the first time, included

payments for non-physical injuries taxable within the

definition of “gross income.” Murphy v. Internal

Revenue Serv., 493 F.3d 170, 179-80 (D.C. Cir. 2007)

(“Murphy IT’) (cert. pet. pending).® In doing so, post-

SBJPA § 104(a)(2) effectively imposed a “wholly new

tax” on defamation settlement payments, as

illustrated by the radical change in Polone’s tax

treatment. When Polone executed the Settlement

Agreement, all- the Settlement Payments were

excluded entirely from his gross income under long-

standing law. In contrast, under post-SBJPA Polone

went from owing nothing to owing over one million

dollars in taxes. If such a radical and unforeseeable

5 In Murphy, the taxpayer contended the award she received

for emotional distress and reputation loss was “not a gain or an

accession to wealth and therefore not part of gross income.” 493

F.3d at 176. In its initial opinion, the D.C. Circuit agreed with

the taxpayer that “the emotional well-being and good reputation

she enjoyed before they were diminished by her former employer

were not taxable as income....therefore, the compensation she

received in lieu of what she lost cannot be considered income.”

Murphy v. Internal Revenue Serv., 406 F.2d 49, 89 (D.C. Cir.

2006 (“Murphy I’). But in Murphy II, the Court held the

taxpayer's compensation was taxable because “Congress

implicitly amended §61 to cover [non-physical personal injury

damages] when it amended §104(a) [in 1996].” 493 F.3d at 179-

80.

change in the tax laws does not constitute a “wholly

new tax,” it is hard to imagine what would.®

Ill. GUIDANCE FROM THIS COURT IS

NECESSARY TO ALLOW TAXPAYERS

THE POSSIBILITY OF FORESEEING

WHAT FORMS OF TAXES MIGHT BE

APPLIED RETROACTIVELY.

There are several related reasons why it is of

paramount importance for this Court to provide

clarity regarding the scope, if any, of Congress’

authority to retroactively apply new taxes.

To begin with, the decision here flatly conflicts with

the Court’s prior decisions in Blodgett, Untermyer,

and Nichols. In each of those cases, the Court barred

the retroactive application of a “wholly new tax” to a

transaction consummated before the tax was enacted.

But that is exactly what occurred here. Polone

consummated the Settlement Agreement when pre-

6 Polone executed the Settlement Agreement on May 3, 1996,

before the introduction of the bill that became SBJPA. Had it

been foreseeable that §104(a)(2) would be modified retroactively

to make the Settlement Payments taxable, Polone could have

taken various steps to retain the agreed-upon value of the

Settlement, including negotiating for (a) an immediate, up-front

settlement payment directly by UTA; (b) a structured settlement

under which he received an immediate up-front payment from a

third party, who in turn received payments from UTA over time;

or (c) increased settlement payments to offset the tax liability.

Polone testified he would have negotiated for such terms had he

known the Settlement Payments would be taxable.

SBJPA §104(a)(2) provided that all the Payments

thereunder would be excluded altogether from his

gross income. However, the Ninth Circuit’s opinion

permits Polone to be taxed on those Payments under

a statute that had not even been proposed when the

Settlement Agreement was executed. Unless this

Court grants certiorari to resolve the conflict thus

created, substantial uncertainty will exist as to

whether Carlton, Blodgett, Untermyer, and Nichols

continue to bar the retroactive application of “wholly

new taxes.” 512 U.S. at 30-31, 34.

The uncertainty created by the decision here will be

intolerable. Tax, even more than most disciplines, is

an area of the law that uniquely calls for

predictability. Practitioners must be able to advise

their clients of the likely tax consequences of.

potential financial structures and arrangements.

And, because the ultimate tax consequences can have

such a dramatic impact on the net value of a deal,

chents have an exceedingly strong interest in being

able to receive clear advice.

It is precisely because of such concerns that the

retroactive application of “wholly «ew tax” has

traditionally been condemned:

The governmental interest in revising the tax

laws must at some point give way to the

taxpayer's interest in finality and repose. For

example, a “wholly new tax” cannot be imposed

retroactively, even though such a tax would

surely serve to raise money. Because the tax

consequences of commercial transactions are a

relevant, and sometimes dispositive,

consideration in a taxpayer's decisions regarding

the use of his capital, it is arbitrary to tax

transactions that were not subject to taxation at

the time the taxpayer entered into them.

Carlton, supra, 512 U.S. at 37-38 (internal citations

omitted) (O’Connor, J., concurring), citing United

States v. Hemme, 476 U.S. 558, 568 (1986) and Welch

v. Henry, 305 U.S. 134, 147 (1938).

The present case, if not reviewed, will severely

compromise the certainty required in a rational tax

system. Taxpayers will be unable to consummate

transactions secure in the knowledge that the

transactions will not be subject to altogether new

taxes that have not yet even been proposed.

Moreover, the potential scope of such uncertainty is

enormous. It is “customary congressional practice”

for nearly all tax statutes to be given some period of

retroactivity in order to allow the legislature to raise

revenue as needed. Carlton, supra, 512 U.S. at 37

(O’Connor, J., concurring), quoting United States v.

Darusmont, 449 U.S. 292, 296-97 (1981). And

because tax policy is of uniquely central importance

in this election year, there is a real likelihood that

new taxes will be imposed, many, if not most,

containing express retroactivity provisions. Without

review, Congress will lack guidance as to when it can

retroactively apply new tax legislation. And

taxpayers will likewise lack guidance as to when they

may safely rely on existing law in structuring their

business arrangements.

The constitutional stakes in this case can be

demonstrated by a simple example. Suppose a

married couple decide to sell their home for a

$200,000 gain in order to purchase another home.

When they enter into a contract for the sale of their

residence, they know their $200,000 gain will be

excludable from income under §121. Further suppose

that, the month after they sign a contract to buy a

new home and while they are in escrow on the sale of

their old home, Congress considers and enacts

legislation to ecliminate the §121 exclusion, making

the new statute retroactive except for gains under a

binding contract in effect a year before the effective

date of the new statute.

Under this scenario, when the homeowners close

the sale of their home, they will realize a taxable gain

of $200,000, which will produce a $70,000 federal

income tax lability if the new statute is applied

retroactively. That liability will likely leave them far

short of the funds needed to complete the purchase of

the new home for which they had contracted.

This example demonstrates the hardship that could

result for innocent taxpayers unless the traditional

rule barring retroactive application of “wholly new

taxes” is both reaffirmed and enforced. Certiorari

should be granted to resolve the uncertainties

surrounding the limits of Congress’ power to enact

retroactive tax legislation that destroys a taxpayer’s

interest in “finality and repose,” by taxing

transactions that were not taxable when the taxpayer

entered into them.

IV. INCOME TAX MAY NOT PERMISSIBLY

BE IMPOSED ON AMOUNTS RECEIVED

ON ACCOUNT OF NON-PHYSICAL

PERSONAL INJURY.

In addition, this case also involves the precise issue

raised by the recently filed petition for certiorari in

Murphy v. Internal Revenue Service, No. 07-802—

namely, whether it is permissible under the Internal

Revenue Code, the Constitution and the Court’s prior

opinions to require a taxpayer to pay income tax on

settlement amounts received on account of non-

physical personal injuries. As the Murphy petition

demonstrates, such taxation is impermissible

because such payments do not constitute an

“accession to wealth.” Because Polone, like the

petitioner in Murphy, has been compelled to pay

income tax on such settlement payments, the Court

should grant this petition in the event it grants the

Murphy petition.

CONCLUSION

For the foregoing reasons, the petition for a writ of

certiorari should be granted.

Respectfully submitted,

JAMES M. HARRIS

Counsel of Record

EDWIN L. NORRIS

JONATHAN M. BRENNER

SIDLEY AUSTIN LLP

555 W. 5th Street, 40th Fl.

Los Angeles, CA 90013

(213) 896-6000

CARTER G. PHILLIPS

SIDLEY AUSTIN LLP

1501 K Street NW

Washington, DC 20005

(202) 736-8000

February 8, 2008 Counsel for Petitioner

APPENDIX

APPENDIX A

UNITED STATES COURT OF APPEALS

FOR THE NINTH CIRCUIT

Argued April 6, 2006 Decided October 11, 2007

No. 04-72672

GAVIN POLONE,

COMMISSIONER OF INTERNAL REVENUE,

Respondent.

Appeal from the United States Tax Court

(Tax Ct. No. 12665-00)

On Denial of Rehearing

James M. Harris, Edwin L. Norris, Jonathan M.

Brenner, Sidley Austin Brown & Wood LLP, for

appellant Gavin Polone.,

Bridget M. Rowan, Kenneth L. Greene, Eileen J.

O’Connor, United States Department of Justice, for

appellee Comm’r of the Internal Revenue Service.

Appeal from a Decision of the United States Tax

Court. Tax Ct. No. 12665-00.

Before: JEROME FARRIS and SIDNEY BR.

THOMAS, Circuit Judges, and GEORGE SCHIA-

VELLI, District Judge.

ORDER

The opinion filed March 12, 2007, is withdrawn and

a substituted opinion is filed concurrently with this

order.

With the filing of the opinion, the panel has voted

to deny the petition for rehearing. Judge Thomas

voted to reject the suggestion for rehearing en banc

and Judges Farris and Schiavelli so recommend.

The full court has been advised of the suggestion

for rehearing en banc, and no judge of the court has

requested a vote on the suggestion for rehearing en

banc. Fed. R.App. P. 35(b).

The petition for rehearing is denied and the

suggestion for rehearing en banc is rejected.

No further petitions for rehearing or petitions for

rehearing en banc shall be filed or entertained in this

case.

The motion to modify opinion is denied as moot.

OPINION

THOMAS, Circuit Judge:

This appeal presents the question of whether

payments received after the effective date of

amendments to 26 U.S.C. § 104(a)(2) based on a

defamation settlement agreement executed prior to

the effective date can be excluded from gross income.

The Honorable George Schiavelli, United States District

Judge for the Central District of California, sitting by designa-

tion.

We conclude that the amendments apply to payments

received after the effective date of the amendment,

and we affirm the judgment of the Tax Court.

Gavin Polone worked as a talent agent at United

Talent Agency (“UTA”) from 1989 until April 21,

1996, when he was fired. After terminating Polone,

UTA spoke with various entertainment industry

trade publications, and made statements about

Polone’s termination. Specifically, UTA alleged that

Polone was terminated for “inappropriate behavior.”

Poloue hired counsel, and sent UTA a demand

letter on April 22, 1996. The letter alleged that UTA

had made defamatory statements about Polone, and

requested that UTA “cease and desist from making

further defamatory statements.” On April 24, 1996,

Polone filed a complaint in the Los Angeles County

Superior Court alleging, among other things,

wrongful termination and defamation. Polone and.

UTA settled both claims on May 3, 1996.

Polone received $2 million as settlement of the

wrongful termination claim, which is not at issue in

this case. As part of the settlement of the defamation

claim, UTA issued a press release retracting its

previous statements about Polone’s termination, and

paid Polone $4 million. The $4 million was paid in

four installments of $1 million, which Polone received

on May 3, 1996; November 11, 1996; May 5, 1997;

and November 11, 1998.

Polone, a cash basis taxpayer, did not include the

May 1996 payment on his 1996 federal income tax

return. He included the November 1996 payment,

but later filed an amended 1996 return seeking a

refund. He did not pay taxes on the May 1997

or November 1998 payments. Polone justified his

failure to pay taxes on this income on our decision in

Warren Jones Co. v. Comm’r, 524 F.2d 788 (9th

Cir.1975), alleging that Warren Jones Co. required

him “to treat his receipt of his former employer's

promise to pay $4 million as an amount realized in

the 1996 taxable year at the time of his receipt of the

promise to pay.”

In September 2000, the IRS sent Polone a

deficiency notice for his failure to pay taxes on the

settlement payments he received in May 1996, May

1997, and November 1998. Polone petitioned for

review in the Tax Court in December 2000. He also

filed an amended petition in August 2002, claiming

that the IRS should have reduced his 1996 taxable

income by $1 million because he had erroneously paid

taxes on the November 1996 settlement payment.

The Tax Court held that Polone owed taxes on the

May 1997 and November 1998 settlement payments,

and that the taxes he paid on the November 1996

settlement payment were proper. Polone v. Comm’r,;

T.C. Memo 2003-339 (2003). The Tax Court also held

that Polone did not owe any taxes on the May 1996

settlement payment. Jd. He appeals.

Section 6l(a) of the Tax Code defines “gross

income” as “all income from whatever source de-

rived.” 26 U.S.C. § 61(a). Thus, subject to certain

exemptions, which are to be construed narrowly,

§ 6l1(a) applies to all income, including settlement

payments. Comm’r v. Schleier, 515 U.S. 323, 328,

115 S.Ct. 2159, 132 L.Ed.2d 294 (1995) (“the default

rule of statutory interpretation [is] that exclusions

from income must be narrowly construed.” (quota-

tions omitted)); Comm’r v. Glenshaw Glass, 348 U.S.

426, 431, 75 S.Ct. 473, 99 L.Ed. 483 (1955) (“The

mere fact that payments were extracted from the

wrongdoers as punishment for unlawful conduct can

not detract from their character as taxable income to

the recipients.”).

In May 1996, when Polone and UTA settled, 26

U.S.C. § 104 exempted “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” from a taxpayer’s gross

income. 26 U.S.C. § 104(aX(2) (1995). The term

“personal injuries” in § 104 had been interpreted to

include damages from settlements of defamation

claims. Roemer v. Comm’r, 716 F.2d 693, 700 (9th

Cir.1983).

Congress amended § 104 in August 1996 so that it

exempted “the amount of any damages (other than

punitive damages) received (whether by suit or

agreement and whether as lump sums or periodic

payments) on account of personal physical injuries or

physical sickness.”. 26 U.S.C. § 104(a)\(1) (1996)

(emphasis added). The amendment legislatively

overruled court decisions, like Roemer, that had

exempted awards for nonphysical injuries from a

taxpayer's gross income. See H.R. Conf. Rep. 104-737

at 301, U.S. Code Cong. & Admin. News 1996, pp.

1677, 1793 (“Thus, the exclusion from gross income

does not apply to any damages received . . . based on

a claim of... injury to reputation.”). The effective

date of the amendments was August 20, 1996, but

there was an exception to the amendment for

“amount[s] received under a written binding agree-

ment, court decree, or mediation award in effect on

(or issued before) September 13, 1995.” 26 U.S.C.

§ 104, Application of August 20, 1996 Amendments.

Here, the Tax Court held that pre-amendment

§ 104 applied to Polone’s May 1996 payment from

UTA, but that post-amendment § 104 applied to the

November 1996, May 1997, and November 1998

payments because Polone received those payments

after the amendment’s effective date. Polone, T.C.

Memo 2003-339 at 66. As a result, it held that the

May 1996 payment was tax exempt, but that the

other payments were not. Jd. at 68. Polone argues

that the pre-amendment § 104 applies to all four

settlement payments he received, and thus that the

$4 million in its entirety is tax exempt. Whether the

May 1996 version of § 104 or the amended version of

§ 104 governs the settlement payments that Polone

received after the amendment’s effective date is a

question of statutory interpretation that we review

de novo. Leslie v. Comm’r, 146 F.3d 643, 648 (9th

Cir.1998).

Applying the plain language of § 104, the Tax Court

properly held that the November 1996, May 1997,

and November 1998 payments were taxable. The

amended statute applies to any damages received

after its effective date of August 20, 1996, unless the

parties had contracted prior to September 13, 1995.

P.L. 104-188, Title I, Subtitle F, Part 1, § 1605(d).’

Although Polone settled his claims with UTA in May

1996, he did not actually receive the three payments

in question until well after the effective date of

the amendments to § 104. Because the settlement

was not in effect before September 13, 1995, it

was not subject to the exception to amended § 104

for preexisting settlement agreements. Thus, the

amended version of § 104 applies to the payments

' September 13, 1995 was the date upon which Congress first

proposed to amend § 104. H.R. 2491 (104th Cong., 1995).

Polone received in November 1996, May 1997,

and November 1998, and the Tax.Court properly

sustained the IRS’s deficiency notice.

Polone, citing our decision in Warren Jones Co.,

argues that under 26 U.S.C. § 1001, which explains

how to calculate taxable gain from the “sale or other

disposition of property,” his entire settlement of $4

million was realized on May 3, £996, the date of

settlement, even though UTA paid him in install-

ments. Therefore, he argues, pre-amendment § 104

applies to the entire $4 million he received from UTA.

The application of § 1001 to Polone’s settlement with

UTA is a question of statutory interpretation that we

review de novo. Leslie, 146 F.3d at 648.

A straightforward reading of § 104-and a broader

inquiry into the system of taxation under this

section-counsels against Polone’s novel proposal to

import § 1001 to the structured settlement context.

Section 1001 provides that the “gain from the sale or

other disposition of property shall be the excess of the

amount realized therefrom over the adjusted basis.”

26 U.S.C. § 100l(a). It is true that, as a general

matter, a legal claim can be considered property for

purposes of § 1001. See, eg., United States v.

Stonehill, 83 F.3d 1156, 1159 (9th Cir. 1996). But

§ 104 specifically refers to “amounts received,” and

not “amounts realized”-a critical distinction in

deciding whether to treat structured settlements as

dispositions of property. 26 U.S.C. § 104. Indeed, we

have yet to find a case has treated structured

settlements taxed under § 104 as dispositions of

property and not as ordinary income received. The

cases cited by Polone for this proposition are plainly

inapposite. See Herbert’s Estate v. Comm’r, 139 F.2d

756 (3d Cir. 1943) (satisfaction of debt by debtor

considered a “disposition”; however, taxed year re-

ceived, not year obligation created); United States v.

Davis, 370 U.S. 65, 82 S.Ct. 1190, 8 L.Ed.2d 335

(1962) (transfer of property in compliance with

divorce settlement agreement treated as a disposition

of property, rendering the transaction a taxable

event); Cook v. United States, 904 F.2d 107 (1st Cir.

1990) (same); Reynolds v. Comm’r, 77 T.C.M. 1479

(1999) (same). These divorce settlements determined

that divorce transactions were taxable events in the

first instance; the cases were later legislatively

overruled by enactment of section 1041 of the

Internal Revenue Code, 26 U.S.C. § 1041. Cook, 904

F.2d at 109 n.1. Such holdings are irrelevant to

structured settlements taxed under § 104, which

clearly contemplates that payments be taxed the year

in which they are received.

- Warren Jones Co. does require a taxpayer to report

the amount realized the year property is disposed

of under § 1001; however, for the reasons just ex-

plained, there is no reason to apply § 1001 to

personal injury settlements in the first place. We

should also note that decisions of the Tax Court

support this conclusion. See, e.g., Alexander uv.

Comm’r, 69 T.C.M. (CCH) 1792 (1995); Nahey uv.

Comm’r, 111 T.C. 256 (1998).

Were we to adopt Polone’s interpretation of the tax

code, payees of structured settlements would be

forced to pay taxes on the full prospective amount of

the settlement on the date of the settlement, some-

times years before receiving that amount. This

would subvert congressional policy to encourage

structured settlement as opposed to lump-sum

schemes. See Staff of Joint Comm. on Taxation,

106th Cong., Tax Treatment of Structured Settle-

ment Arrangements (Comm. Print 1999) (available at

http:// www.house.gov/jct/x-15-99.htm). Moreover, in

order to alleviate this burdensome result, we would

have no choice but to also import the opt-out pro-

vision available for income received from installment

sales, 26 U.S.C. § 453(d). Cf. Warren Jones Co., 524

F.2d at 792-93 (determining that Congress enacted

the opt-out provision to alleviate the “hardships”

associated with reporting an installment sale as the

full fair market value of the property, received on the

date contracted). We have found no congressional

support for such overreaching. Congressional intent

is clear: structured settlements are to be taxed as

payments are received.

Polone also argues that pre-amendment § 104

should apply to the settlement payments he received

in November 1996, May 1997, and November 1998

because applying amended § 104 to those payments

would amount to retroactive legislation in violation of

his Fifth Amendment due process rights.” We review

this constitutional claim de novo. Quarty v. United

States, 170 F.3d 961, 965 (9th Cir. 1999).

Retroactive legislation runs the risk of offending

the Due Process Clause of the Fifth Amendment,

Landgraf v. USI Film Prods., 511 U.S. 244, 114 S.Ct.

2 We do not address whether amended § 104(a)({2) violates the

Sixteenth Amendment of the Constitution, as Polone failed to

raise the issue on appeal. The power of Congress to tax income

is provided in the Sixteenth Amendment: “The Congress shall

have power to law and collect taxes on incomes, from whatever

source derived, without apportionment among the several States,

and without regard to any census or enumeration.”

10a

1483, 128 L.Ed.2d 229 (1994), and the Supreme

Court has provided various formulas for determining

whether a particular statute applies retroactively.

For example, the Court has considered whether a

statute “takes away or impairs vested rights acquired

under existing laws,” id. at 269, 114 S.Ct. 1483

(quoting Society for Propagation of the Gospel uv.

Wheeler, 22 F. Cas. 756 (CC NH 1814)), or whether a

law “changes the legal consequences of acts com-

pleted before its effective date,” id. at 269 n. 23, 114

S.Ct. 1483 (quoting i, 482 U.S. 423, 430, 107 S.Ct.

2446, 96 L.Ed.2d 351 (1987)).

The thrust of the various tests is that to operate

retroactively, a statute must actually “attach[ ] new

legal consequences” to completed, past conduct. Jd.

at 270, 107 S.Ct. 2446. It is not enough that a

statute “is applied in a case arising from conduct

antedating the statute’s enactment,” or that a statute

“upsets expectations based in prior law.” Id. at 269-

270, 107 S.Ct. 2446. Thus, for example, even though

“a new property tax or zoning regulation may upset

the reasonable expectations that prompted those

affected to acquire property,” a change in the

property tax regime would not be _ considered

retroactive with respect to all who had purchased

property prior to the effective date of the amendment.

See id. at 270 n. 24, 107 S.Ct. 2446.

Applying this test to § 104, we hold that amended §

104 was constitutionally applied to the payments

Polone received in November 1996, May 1997, and

November 1998. As explained above, the amendment

to § 104 explicitly applied only to amounts received

after its effective date, which was August 20, 1996.

26 U.S.C. § 104, Application of August 20, 1996

Amendments. Although it is possible for a statute

lla

with a seemingly prospective application to apply

retroactively in some circumstances, Landgraf, 511

U.S. at 258-59, 114 S.Ct. 1483, the amendments to

§ 104 did not because they did not attach new legal

consequences to completed payments. On the con-

trary, the amendments applied only prospectively, to

payments made after their date of enactment.

Compare with Untermyer v. Anderson, 276 U.S. 440,

445, 48 S.Ct. 353, 72 L.Ed. 645 (1928) (a tax was

retroactive where it applied to “bona fide gifts not

made in anticipation of death and fully consummated

prior to” the statute’s effective date) (emphasis

added); Blodgett v. Holden, 275 U.S. 142, 147, 48

S.Ct. 105, 72 L.Ed. 206 (1927) (same).

Polone argues that the amendments to § 104 apply

retroactively because his settlement with UTA was

“finalized on May 3, 1996, more than three months

before the enactment of the statute.” This argument

is unconvincing for two reasons. First, although the

settlement contract may have been “finalized” in the

sense that both parties signed it, settlement of

Polone’s defamation claim was nowhere near

complete as of August 20, 1996. On the contrary,

UTA still had to make three payments to Polone, and

he had to honor his promise to guard UTA’s

confidential information. Thus, the Tax Court did

not apply amended § 104 to a contract that was “fully

consummated” prior to the amendment’s effective

date, as was the case in Untermyer and Blodgett.

Rather, amended § 104 was applied to a contract

whose fulfillment was still a work in progress.

Second, Polone’s argument falls squarely into the

Supreme Court’s warning that “[a] statute does not

operate ‘retrospectively’ merely because it is applied

in a case arising from conduct antedating the

statute’s enactment.” Landgraf, 511 U.S. at 269, 114

12a

S.Ct. 1483. The fact that Polone’s tax dispute

stemmed from his settlement with UTA-conduct that

antedated the revisions to § 104-does not mean that

§ 104 operates retrospectively when it is applied to

settlement payments that Polone received after its

effective date.

For the reasons explained above, we agree with the

Tax Court that the settlement payments received by

Polone after August, 1996 are taxable as ordinary

income.

Affirmed.

13a

APPENDIX B

UNITED STATES COURT OF APPEALS

FOR THE NINTH CIRCUIT

Argued April 6, 2006 Decided March 12, 2007

No. 04-72672

GAVIN POLONE,

Petitioner,

Vv.

COMMISSIONER OF INTERNAL REVENUE,

Respondent.

Appeal from the United States Tax Court

(Tax Ct. No. 12665-00)

On Denial of Rehearing

James M. Harris, Edwin L. Norris, Jonathan M.

Brenner,’ Sidley Austin Brown & Wood LLP, for

appellant Gavin Polone.

Bridget M. Rowan, Kenneth L. Greene, Eileen J.

O’Connor, United States Department of Justice, for

appellee Commissioner of the Internal Revenue

Service.

Appeal from a Decision of the United States Tax

Court. Tax Ct. No. 12665-00.

l4a

Before: FARRIS and THOMAS, Circuit Judges,

and SCHIAVELLI, District Judge.

ORDER

The panel has decided to amend the opinion filed

June 5, 2006. The opinion is withdrawn and a

substituted opinion is filed concurrently with this

order. With the filing of the amended opinion, the

petition for rehearing is DENIED.

OPINION

THOMAS, Circuit Judge:

This appeal presents the question of whether pay-

ments received after the effective date of amend-

ments to 26 U.S.C. § 104(a)(2) based on a defamation

settlement agreement executed prior to the effective

date can be excluded from gross income. We conclude

that the amendments apply to payments received

after the effective date of the amendment, and we

affirm the judgment of the Tax Court.

Gavin Polone worked as a talent agent at United

Talent Agency (“UTA”) from 1989 until April 21,

1996, when he was fired. After terminating Polone,

UTA spoke with various entertainment industry

trade publications, and made statements about

Polone’s termination. Specifically, UTA alleged that

Polone was terminated for “inappropriate behavior.”

Polone hired counsel, and sent UTA a demand

letter on April 22, 1996. The letter alleged that UTA

had made defamatory statements about Polone, and

‘ The Honorable George Schiavelli, United States District

Judge for the Central District of California, sitting by

designation.

15a

requested that UTA “cease and desist from making

further defamatory statements.” On April 24, 1996,

Polone filed a complaint in the Los Angeles County

Superior Court alleging, among other things, wrong-

ful termination and defamation. Polone and UTA

settled both claims on May 3, 1996.

Polone received $2 million as settlement of the

wrongful termination claim, which is not at issue in

this case. As part of the settlement of the defamation

claim, UTA issued a press release retracting its

previous statements about Polone’s termination, and

paid Polone $4 million. The $4 million was paid in

four installments of $1 million, which Polone received

on May 3, 1996; November 11, 1996; May 5, 1997;

and November 11, 1998.

Polone, a cash basis taxpayer, did not include the

May 1996 payment on his 1996 federal income tax

return. He included the November 1996 payment,

but later filed an amended 1996 return seeking a

refund. He did not pay taxes on the May 1997

or November 1998 payments. Polone justified his

failure to pay taxes on this income on our decision in

Warren Jones Co. v. Comm’r, 524 F.2d 788 (9th

Cir.1975), alleging that Warren Jones Co. required

him “to treat his receipt of his former employer’s

promise to pay $4 million as an amount realized in

the 1996 taxable year at the time of his receipt of the

promise to pay.”

In September 2000, the IRS sent Polone a de-

ficiency notice for his failure to pay taxes on the

settlement payments he received in May 1996, May

1997, and November 1998. Polone petitioned for

review in the Tax Court in December 2000. He also

filed an amended petition in August 2002, claiming

that the IRS should have reduced his 1996 taxable

16a

income by $1 million because he had erroneously paid

taxes on the November 1996 settlement payment.

The Tax Court held that Polone owed taxes on the

May 1997 and November 1998 settlement payments,

and that the taxes he paid on the November 1996

settlement payment were proper. Polone v. Comm’r,

T.C. Memo 2003-339 (2003). The Tax Court also held

that Polone did not owe any taxes on the May 1996

settlement payment. Jd. He appeals.

Section 61(a) of the Tax Code defines “gross in-

come” as “all income from whatever source derived.”

26 U.S.C. § 61(a). Thus, subject to certain exemp-

tions, which are to be construed narrowly, § 61(a)

applies to all income, including settlement payments.

Comm’r v. Schleier, 515 U.S. 323, 328, 115 S.Ct.

2159, 132 L.Ed.2d 294 (1995) (“the default rule of

statutory interpretation [is] that exclusions from

income must be narrowly construed.” (quotations

omitted)); Comm’r v. Glenshaw Glass, 348 U.S. 426,

431, 75 S.Ct. 473, 99 L.Ed. 483 (1955) (“The mere fact

that payments were extracted from the wrongdoers

as punishment for unlawful conduct can not de-

tract from their character as taxable income to the

recipients.”).

In May 1996, when Polone and UTA settled, 26

U.S.C. § 104 exempted “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” from a taxpayer’s gross

income. 26 U.S.C. § 104(a)(2) (1995). The term

“personal injuries” in § 104 had been interpreted to

include damages from settlements of defamation

claims. Roemer v. Comm’r, 716 F.2d 693, 700 (9th

Cir. 1983).

17a

Congress amended § 104 in August 1996 so that it

exempted “the amount of any damages (other than

punitive damages) received (whether by suit or

agreement and whether as lump sums or periodic

payments) on account of personal physical injuries

or physical sickness.” 26 U.S.C. § 104(a)(1) (1996)

(emphasis added). The amendment legislatively

overruled court decisions, like Roemer, that had

exempted awards for nonphysical injuries from a

taxpayer’s gross income. See H.R. CONF. REP. 104-

737 at 301 (“Thus, the exclusion from grc s income

does not apply to any damages received ... based on a

claim of ... injury to reputation.”). The effective date

of the amendments was August 20, 1996, but there

was an exception to the amendment for “amount(s]

received under a written binding agreement, court

decree, or mediation award in effect on (or issued

before) September 13, 1995.” 26 U.S.C. § 104, Appli-

cation of August 20, 1996 Amendments.

Here, the Tax Court held that pre-amendment

§ 104 applied to Polone’s May 1996 payment from

UTA, but that post-amendment § 104 applied to the

November 1996, May 1997, and November 1998

payments because Polone received those payments

after the amendment’s effective date. Polone, T.C.

Memo 2003-339 at 66. As a result, it held that the

May 1996 payment was tax exempt, but that the

other payments were not. /d. at 68. Polone argues

that the pre-amendment § 104 applies to all four

settlement payments he received, and thus that the

$4 million in its entirety is tax exempt. Whether the

May 1996 version of § 104 or the amended version of

§ 104 governs the settlement payments that Polone

received after the amendment’s effective date is a

question of statutory interpretation that we review

18a

de novo. Leslie v. Comm’r, 146 F.3d 643, 648 (9th

Cir. 1998).

Applying the plain language of § 104, the Tax

Court properly held that the November 1996, May

1997, and November 1998 payments were taxable.

The amended statute applies to any damages re-

ceived after its effective date of August 20, 1996,

unless the parties had contracted prior to September

13, 1995. P.L. 104-188, Title I, Subtitle F, Part 1,

§ 1605(d)." Although Polone settled his claims with

UTA in May 1996, he did not actually receive the

three payments in question until well after the

effective date of the amendments to § 104. Because

the settlement was not in effect before September 13,

1995, it was not subject to the exception to amended

§ 104 for preexisting settlement agreements. Thus,

the amended version of § 104 applies to the payments

Polone received in November 1996, May 1997,

and November 1998, and the Tax Court properly

sustained the IRS’s deficiency notice.

Ill

Polone, citing our decision in Warren Jones Co.,

argues that under 26 U.S.C. § 1001, which explains

how to calculate taxable gain from the “sale or other

disposition of property,” his entire settlement of $4

million was realized on May 3, 1996, the date of

settlement, even though UTA paid him in install-

ments. Therefore, he argues, pre-amendment § 104

applies to the entire $4 million he received from UTA.

The application of § 1001 to Polone’s settlement with

UTA is a question of statutory interpretation that we

review de novo. Leslie, 146 F.3d at 648.

' September 13, 1995 was the date upon which Congress first

proposed to amend § 104. H.R. 2491 (104th Cong., 1995).

19a

Section 1001 provides that the “gain from the sale

or other disposition of property shall be the excess of

the amount realized therefrom over the adjusted

basis.” 26 U.S.C. § 1001(a). Although a legal claim

could be considered property for purposes of § 1001,

see, e.g., United States v. Stonehill, 83 F.3d 1156,

1159 (9th Cir. 1996) (holding that a legal claim is

property for purposes of the federal tax lien statute,

26 U.S.C. § 6321), in order to fall within the boun-

daries of § 1001(a), property must be transferable, 26

U.S.C. § 1001(a). Because a personal injury claim,

such as Polone’s defamation claim, is not trans-

ferable, § 1001 does not apply to a settlement of such

a claim.

California Civil Code § 954° permits a plaintiff to

transfer actions arising out of breach of contract or

injuries to personal or real property, but not

defamation claims, which are “founded upon wrongs

of a purely personal nature such as to the reputation

or the feelings of the one injured.” Goodley v. Wank

& Wank, Inc., 62 Cal.App.3d 389, 133 Cal.Rptr. 83,

85 (1976). See also Baum v. Duckor, Spradling &

Metzger, 72 Cal.App.4th 54, 84 Cal.Rptr.2d 703, 709

(1999) (“Thus, causes of action for personal injuries

arising out of a tort are not assignable nor are those

founded upon wrongs of a purely personal nature

such as to the reputation or the feelings of the one

injured.”).

2 We apply California law to determine whether Polone's

defamation claim was transferable for purposes of § 1001

because “state law determines the nature of the legal interest

the taxpayer has in the property. Once the court determines the

state law right possessed by the taxpayer, then the federal tax

consequences are solely a matter of federal law.” Stonehill, 83

F.3d at 1159.

20a

As the California courts have noted, defamation

does not “interfer[e] with a property right, economic

relations, or the sale of goods.” Truck Ins. Exch. v.

Bennett, 53 Cal.App.4th 75, 61 Cal.Rptr.2d 497, 503

(1997). Rather, “defamation invades the interest in

personal or professional reputation and good name.

A defamation claim vindicates personal interests, and

is a personal injury.” Jd. Such a personal injury

cannot reasonably be transferred within the meaning

of § 1001, in that one cannot sell or dispose of one’s

dignity as a commodity on the open markct. Because

Polone’s defamation claim was not transferable under

California law, his settlement with UTA could not

have been a “sale or other disposition of property” for

purposes of § 1001.

Polone also argues that pre-amendment § 104

should apply to the settlement payments he received

in November 1996, May 1997, and November 1998

because applying amended § 104 to those payments

would amount to retroactive legislation in violation of

his Fifth Amendment due process rights.” We review

this constitutional claim de novo. Quarty v. United

States, 170 F.3d 961, 965 (9th Cir.1999).

Retroactive legislation runs the risk of offending

the Due Process Clause of the Fifth Amendment,

Landgraf v. USI Film Prods., 511 U.S. 244, 114 S.Ct.

3 We do not address whether amended § 104(a)(2) violates the

Sixteenth Amendment of the Constitution, as Polone failed to

raise the issue on appeal. The power of Congress to tax income

is provided in the Sixteenth Amendment: “The Congress shall

have power to law and collect taxes on incomes, from what-

ever source derived, without apportionment among the several

States, and without regard to any census or enumeration.”

2la

1483, 128 L.Ed.2d 229 (1994), and the Supreme

Court has provided various formulas for determining

whether a particular statute applies retroactively.

For example, the Court has considered whether a

statute “takes away or impairs vested rights acquired

under existing laws,” id. at 269, 114 S.Ct. 1483

(quoting Society for Propagation of the Gospel v.

Wheeler, 22 F.Cas. 756 (CC NH 1814)), or whether a

law “changes the legal consequences of acts com-

pleted before its effective date,” id. at 269, 114 S.Ct.

1483 n. 23 (quoting Miller v. Florida, 482 U.S. 423,

430, 107 S.Ct. 2446, 96 L.Ed.2d 351 (1987)).

The thrust of the various tests is-that to operate

retroactively, a statute must actually “attach[ ] new

legal consequences” to completed, past conduct. Id.

at 270,114 S.Ct. 1483. It is not enough that a statute

“is applied in a case arising from conduct antedating

the statute’s enactment,” or that a statute “upsets

expectations based in prior law.” Jd. at 269-270, 114

S.Ct. 1483. Thus, for example, even though “a new

property tax or zoning regulation may upset the

reasonable expectations that prompted those affected

to acquire property,” a change in the property tax

regime would not be considered retroactive with

respect to all who had purchased property prior to

the effective date of the amendment. See id. at 270,

114 S.Ct. 1483 n.24. |

Applying this test to § 104, we hold that amended

§ 104 was constitutionally applied to the payments

Polone received in November 1996, May 1997, and

November 1998. As explained above, the amendment

to § 104 explicitly applied only to amounts received

after its effective date, which was August 20, 1996.

26 U.S.C. § 104, Application of August 20, 1996

Amendments. Although it is possible for a statute

22a

with a seemingly prospective application to apply

retroactively in some circumstances, Landgraf, 511

U.S. at 258-59, 114 S.Ct. 1483, the amendments to

§ 104 did not because they did not attach new legal

consequences to completed payments. On the

contrary, the amendments applied only prospectively,

to payments made after their date of enactment.

- Compare with Untermyer v. Anderson, 276 U.S. 440,

445, 48 S.Ct. 353, 72 L.Ed. 645 (1928) (a tax was

retroactive where it applied to “bona fide gifts not

made in anticipation of death and fully consummated

prior to” the statute’s effective date) (emphasis

added); Blodgett v. Holden, 275 U.S. 142, 147, 48

S.Ct. 105, 72 L.Ed. 206 (1927) (same).

Polone argues that the amendments to § 104 apply

retroactively because his settlement with UTA was

“finalized on May 3, 1996, more than three months

before the enactment of the statute.” This argument

is unconvincing for two reasons. First, although the

settlement contract may have been “finalized” in the

sense that both parties signed it, settlement of

Polone’s defamation claim was nowhere near com-

plete as of August 20, 1996. On the contrary, UTA

still had to make three payments to Polone, and he

had to honor his promise to guard UTA’s confidential

information. Thus, the Tax Court did not apply

amended § 104 to a contract that was “fully

consummated” prior to the amendment’s effective

date, as was the case in Untermyer and Blodgett.

Rather, amended § 104 was applied to a contract

whose fulfillment was still a work in progress.

Second, Polone’s argument falls squarely into the

Supreme Court’s warning that “[a] statute does not

operate ‘retrospectively merely because it is applied

in a case arising from conduct antedating the

statute’s enactment.” Landgraf, 511 U.S. at 269, 114

23a

S.Ct. 1483. The fact that Polone’s tax dispute

stemmed from his settlement with UTA-conduct that

antedated the revisions to § 104-does not mean that

§ 104 operates retrospectively when it is applied to

settlement payments that Polone received after its

effective date.

For the reasons explained above, we agree with the

Tax Court that the settlement payments received by

Polone after August, 1996 are taxable as ordinary

income.

Affirmed.

24a

APPENDIX C

UNITED STATES COURT OF APPEALS

FOR THE NINTH CIRCUIT

Argued April 6, 2006 Decided June 5, 2007

No. 04-72672

GAVIN POLONE,

Petitioner,

Vv.

COMMISSIONER OF INTERNAL REVENUF,

Respondent.

Appeal from the United States Tax Court

(Tax Ct. No. 12665-00)

James M. Harris, Edwin L. Norris, Jonathan M.

‘Brenner, Sidley Austin Brown & Wood LLP, for

appellant Gavin Polone.

Bridget M. Rowan, Kenneth L. Greene, Eileen J.

O’Connor, United States Department of Justice, for

appellee Commissioner of the Internal Revenue

Service.

Before: FARRIS and THOMAS, Circuit Judges,

and GEORGE SCHIAVELLI, District Judge.

* The Honorable George Schiavelli, United States District

Judge for the Central District of California, sitting by

designation.

25a

THOMAS, Circuit Judge.

This appeal presents the question of whether

payments received after the effective date of amend-

ments to 26 U.S.C. § 104(a)(2) based on a defamation

settlement agreement executed prior to the effective

date can be excluded from gross income. We conclude

that the amendments apply to payments received

after the effective date of the amendment, and we

affirm the judgment of the Tax Court.

Gavin Polone worked as a talent agent at United

Talent Agency (“UTA”) from 1989 until April 21,

1996, when he was fired. After terminating Polone,

UTA spoke with various entertainment industry

trade publications, and made statements about

Polone’s termination. Specifically, UTA alleged that

Polone was terminated for “inappropriate behavior.”

Polone hired counsel, and sent UTA a demand

letter on April 22, 1996. The letter alleged that UTA

had made defamatory statements about Polone, and

requested that UTA “cease and desist from making

further defamatory statements.” On April 24, 1996,

Polone filed a complaint in the Los Angeles County

Superior Court alleging, among other things, wrong-

ful termination and defamation. Polone and UTA

settled both claims on May 3, 1996.

Polone received $2 million as settlement of the

wrongful termination claim, which is not at issue in

this case. As part of the settlement of the defamation

claim, UTA issued a press release retracting its

previous statements about Polone’s termination, and

paid Polone $4 million. The $4 million was paid in

four installments of $1 million, which Polone received

26a

on May 3, 1996; November 11, 1996; May 5, 1997;

and November 11, 1998.

Polone, a cash basis taxpayer, did not include the

May 1996 payment on his 1996 federal income tax

return. He included the November 1996 payment,

but later filed an amended 1996 return seeking a

refund. He did not pay taxes on the May 1997

or November 1998 payments. Polone justified his

failure to pay taxes on this income on our decision in

Warren Jones Co. v. Comm’r, 524 F.2d 788 (9th Cir.

1975), alleging that Warren Jones Co. required him

“to treat his receipt of his former employer’s promise

to pay $4 million as an amount realized in the 1996

taxable year at the time of his receipt of the promise

to pay.”

In September 2000, the IRS sent Polone a de-

ficiency notice for his failure to pay taxes on the

settlement payments he received in May 1996, May

1997, and November 1998. Polone petitioned for

review in the Tax Court in December 2000. He also

filed an amended petition in August 2002, claiming

that the IRS should have reduced his 1996 taxable

income by $1 million because he had erroneously paid

taxes on the November 1996 settlement payment.

The Tax Court held that Polone owed taxes on the

May 1997 and November 1998 settlement payments,

and that the taxes he paid on the November 1996

settlement payment were proper. Polone v. Comm’,

T.C. Memo 2003-339 (2003). The Tax Court also held

that Polone did not owe any taxes on the May 1996

settlement payment. Jd. He appeals.

Section 61(a) of the Tax Code defines “gross in-

come” as “all income from whatever source derived.”

27a

26 U.S.C. § 61(a). Thus, subject to certain exemp-

tions, which are to be construed narrowly, § 61(a)

applies to all income, including settlement payments.

Comm’r v. Schleier, 515 U.S. 323, 328, 115 S.Ct.

2159, 132 L.Ed.2d 294 (1995) (“the default rule

of statutory interpretation [is] that exclusions from

income must be narrowly construed.”(quotations

omitted)); Comm’r v. Glenshaw Glass, 348 U.S. 426,

431, 75 S.Ct. 473, 99 L.Ed. 483 (1955) (“The mere fact

that payments were extracted from the wrongdoers

as punishment for unlawful conduct can not detract

from their character as taxable income to the

recipients.”).

In May 1996, when Polone and UTA settled, 26

U.S.C. § 104 exempted “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” from a taxpayer’s gross

income. 26 U.S.C. § 104(a)(2) (1995). The term

“personal injuries” in § 104 had been interpreted to

include damages from settlements of defamation

claims. Roemer v. Comm’r, 716 F.2d 693, 700 (9th

Cir. 1983).

Congress amended § 104 in August 1996 so that it

exempted “the amount of any damages (other than

punitive damages) received (whether by suit or

agreement and whether as lump sums or periodic

payments) on account of personal physical injuries

or physical sickness.” 26 U.S.C. § 104(a)(1) (1996)

(emphasis added). The amendment legislatively

overruled court decisions, like Roemer, that had

exempted awards for nonphysical injuries from a

taxpayer’s gross income. See H.R. CONF. REP. 104-

737 at 301 (“Thus, the exclusion from gross income

does not apply to any damages received ... based on a

28a

claim of... injury to reputation.”). The effective date

of the amendments was August 20, 1996, but there

was an exception to the amendment for “amountf[s]

received under a written binding agreement, court

decree, or mediation award in effect on (or issued

before) September 13, 1995.” 26 U.S.C. § 104, Appli-

cation of August 20, 1996 Amendments.

Here, the Tax Court held that pre-amendment

§ 104 applied to Polone’s May 1996 payment from

UTA, but that post-amendment § 104 applied to the

November 1996, May 1997, and November 1998 pay-

ments because Polone received those payments after

the amendment’s effective date. Polone, T.C. Memo

2003-339 at 66. As a result, it held that the May

1996 payment was tax exempt, but that the other

payments were not. Jd. at 68. Polone argues that the

pre-amendment § 104 applies to all four settlement

payments he received, and thus that the $4 million in

its entirety is tax exempt. Whether the May 1996

version of § 104 or the amended version of § 104

governs the settlement payments that Polone re-

ceived after the amendment’s effective date is a

question of statutory interpretation that we review

de novo. Leslie v. Comm’r, 146 F.3d 643, 648 (9th

Cir. 1998).

Applying the plain language of § 104, the Tax

Court properly held that the November 1996, May

1997, and November 1998 payments were taxable.

The amended statute applies to any damages received

after its effective date of August 20, 1996, unless the

parties had contracted prior to September 13, 1995.

P.L. 104-188, Title I, Subtitle F, Part 1, § 1605(d).’

‘ September 13, 1995 was the date upon which Congress first

proposed to amend § 104. H.R. 2491 (104th Cong. 1995).

29a

Although Polone settled his claims with UTA in May

1996, he did not actually receive the three payments

in question until well after the effective date of the

amendments to § 104. Because the settlement was

not in effect before September 13, 1995, it was not

subject to the exception to amended § 104 for pre-

existing settlement agreements. Thus, the amended

version of § 104 applies to the payments Polone

received in November 1996, May 1997, and Novem-

ber 1998, and the Tax Court properly sustained the

IRS’s deficiency notice.

Ill

Polone, citing our decision in Warren Jones Co.,

argues that under 26 U.S.C. § 1001, which explains

how to calculate taxable gain from the “sale or other

disposition of property,” his entire settlement of $4

million was realized on May 3, 1996, the date of

settlement, even though UTA paid him in install-

ments. Therefore, he argues, pre-amendment § 104

applies to the entire $4 million he received from UTA.

The application of § 1001 to Polone’s settlement with

UTA is a question of statutory interpretation that we

review de novo. Leslie, 146 F.3d at 648.

Section 1001 provides that the “gain from the sale

or other disposition of property shall be the excess

of the amount realized therefrom over the adjusted

basis.” 26 U.S.C. § 1001(a).* To fall within its

* For purposes of this appeal, we assume, but do not decide,

that a legal claim could be considered property for purposes of

§ 1001. See, e.g., United States v. Stonehill, 83 F.3d 1156, 1159

(9th Cir. 1996) (holding that a legal claim is property for

purposes of the federal tax lien statute, 26 U.S.C. § 6321);

Herbert’s Estate v. Comm’r, 139 F.2d 756 (3d Cir. 1943) (noting

that a stockholder's claim against a corporation was property for

purposes of 26 U.S.C. § 111, the predecessor to § 1001).

30a

boundaries, property must (1) have an “adjusted

basis” and (2) be transferable. Jd. Because a

personal injury claim, such as Polone’s defamation

claim, does not have an adjusted basis and is not

transferable, § 1001 does not apply to a settlement of

such a claim.

To calculate the “adjusted basis,” § 1001(a) looks to

26 U.S.C. § 1011, which, in turn, looks to 26 U.S.C.

§ 1012. Section 1012 states, “The basis of property

shall be the cost of such property, except as otherwise

provided in this subchapter.” 26 U.S.C. § 1012. It

then specifically references sections of the Internal

Revenue Code dealing with corporate distributions,

partnerships, and capital gains. Id.

Polone’s defamation claim has no adjusted basis

within the meaning of § 1001. It was not a corporate

distribution, partnership revenue, or a capital gain.

Therefore, its “adjusted basis” would have had to

have been calculated pursuant to § 1012. A § 1012

calculation, however, is based on cost, which is

antithetical to a defamation claim. As the California

courts have noted, defamation does not “interfer[e]

with a property right, economic relations, or the

sale of goods.” Truck Ins. Exch. v. Bennett, 53

Cal.App.4th 75, 61 Cal.Rptr.2d 497, 503 (1997).

Rather, “defamation invades the interest in personal

or professional reputation and good name. A def-

amation claim vindicates personal interests, and is a

personal injury.” Jd. Such a personal injury cannot

reasonably be said to have a cost in the traditional

market sense that § 1012 requires, in that one cannot

sell one’s dignity as a commodity on the open market.

Moreover, “[t]he test for characterizing proceeds of

litigation is stated most simply as ‘In licu of what

were the damages awarded?” and courts must look to

3la

the nature of the underlying claim when classifying

damages awards for tax purposes. Tribune Pub. Co.

v. United States, 836 F.2d 1176, 1178 (9th Cir. 1988)

(citation omitted). We have explained that “(d]am-

ages paid for personal injuries ... make the taxpayer

whole from a previous loss of personal rights-because,

in effect, they restore a loss to capital.” Starrels v.

Comm’, 304 F.2d 574, 576 (9th Cir. 1962). As a

result, treating the settlement of a personal injury

claim as a “gain” for purposes of § 1001 would be at

odds with this basic concept of tort law. The money

that Polone received as part of his settlement with

UTA served to restore any loss to his reputation

caused by UTA’s alleged defamation and to make

him whole. Such a restorative payment cannot be

considered an “amount realized” for purposes of

§ 1001 because it simply put Polone in the position in

which he would have found himself had the alleged

defamation never happened.

Turning briefly to the issue of transferability,

California Civil Code § 954° permits a plaintiff to

transfer actions arising out of breach of contract

or injuries tc personal or real property, but not

defamation claims, which are “founded upon wrongs

of a purely personal nature such as to the reputation

or the feelings of the one injured.” Goodley v. Wank

& Wank, Inc., 62 Cal.App.3d 389, 133 Cal.Rptr. 83,

85 (1976). See also Baum v. Duckor, Spradling &

° We apply California law to determine whether Polone’s

defamation claim was transferable for purposes of § 1001

because “state law determines the nature of the legal interest

the taxpayer has in the property. Once the court determines the

state-law right possessed by the taxpayer, then the federal tax

consequences are solely a matter of federal law.” Stonehill, 83

F.3d at 1159.

32a

Metzger, 72 Cal.App.4th 54, 84 Cal.Rptr.2d 703, 709

(1999) (“Thus, causes of action for personal injuries

arising out of a tort are not assignable nor are those

founded upon wrongs of a purely personal nature

such as to the reputation or the feelings of the one

injured.”). Because Polone’s defamation claim had

no adjusted basis and was not transferable under

California law, his settlement with UTA could not

have been a “sale or other disposition of property” for

purposes of § 1001.

Polone also argues that pre-amendment § 104

should apply to the settlement payments he received

in November 1996, May 1997, and November 1998

because applying amended § 104 to those payments

would amount to retroactive legislation in violation of

his Fifth Amendment due process rights. We review

this constitutional claim de novo. Quarty v. United

States, 170 F.3d 961, 965 (9th Cir. 1999).

Retroactive legislation runs the risk of offending

the Due Process Clause of the Fifth Amendment,

Landgraf v. USIFilm Prods., 511 U.S. 244, 114 S.Ct.

1483, 128 L.Ed.2d 229 (1994), and the Supreme

Court has provided various formulas for determining

whether a particular statute applies retroactively.

For example, the Court has considered whether a

statute “takes away or impairs vested rights acquired

under existing laws,” id. at 269, 114 S.Ct. 1483

(quoting Society for Propagation of the Gospel v.

Wheeler, 22 F.Cas. 756 (1814)), or whether a law

“changes the legal consequences of acts completed

before its effective date,” id. at 269 n.23,114 S.Ct.

1483 (quoting Miller v. Florida, 482 U.S. 423, 430,

107 S.Ct. 2446, 96 L.Ed.2d 351 (1987)).

33a

The thrust of the various tests is that to operate

retroactively, a statute must actually “attach| |] new

legal consequences” to completed, past conduct. 7d.

at 270,114 S.Ct. 1483. It is not enough that a statute

“is applied in a case arising from conduct antedating

the statute’s enactment,” or that a statute “upsets

expectations based in prior law.” Id. at 269-270, 114

S.Ct. 1483. Thus, for example, even though “a new

property tax or zoning regulation may upset the

reasonable expectations that prompted those affected

to acquire property,” a change in the property tax

regime would not be considered retroactive with

respect to all who had purchased property prior to

the effective date of the amendment. See id. at 270

n.24, 114S.Ct. 1483.

Applying this test to § 104, we hold that amended

§ 104 was constitutionally applied to the payments

Polone received in November 1996, May 1997, and

November 1998. As explained above, the amendment

to § 104 explicitly applied only to amounts received

after its effective date, which was August 20, 1996.

26 U.S.C. § 104, Application of August 20, 1996

Amendments. Although it is possible for a statute

with a seemingly prospective application to apply

retroactively in some circumstances, Landgraf, 511

U.S. at 258-59, 114 S.Ct. 1483, the amendments to

§ 104 did not because they did not attach new legal

consequences to completed payments. On the con-

trary, the amendments applied only prospectively, to

payments made after their date of enactment.

Compare with Untermyer v. Anderson, 276 U.S. 440,

445, 48 S.Ct. 353, 72 L.Ed. 645 (1928) (a tax was

retroactive where it applied to “bona fide gifts not

made in anticipation of death and fully consummated

prior to” the statute’s effective date) (emphasis

34a

added); Blodgett v. Holden, 275 U.S. 142, .147, 48

S.Ct. 105, 72 L.Ed. 206 (1927) (same).

Polone argues that the amendments to § 104 apply

retroactively because his settlement with UTA was

“finalized on May 3, 1996, more than three months

before the enactment of the statute.” This argument

is unconvincing for two reasons. First, although the

settlement contract may have been “finalized” in

the sense that both parties signed it, settlement of

Polone’s defamation claim was nowhere near

complete as of August 20, 1996. On the contrary,

UTA still had to make three payments to Polone, and

he had to honor his promise to guard UTA’s

confidential information. Thus, the Tax Court did

not apply amended § 104 to a contract that was “fully

consummated” prior to the amendment’s effective

date, as was the case in Untermyer and Blodgett.

Rather, amended § 104 was applied to a contract

whose fulfillment was still a work in progress.

Second, Polone’s argument falls squarely into the

Supreme Court’s warning that “[a] statute does not

operate ‘retrospectively merely because it is applied

in a case arising from conduct antedating the

statute’s enactment.” Landgraf, 511 U.S. at 269, 114

S.Ct. 1483. The fact that Polone’s tax dispute

stemmed from his settlement with UTA-conduct that

antedated the revisions to § 104-does not mean that

§ 104 operates retrospectively when it is applied to

settlement payments that Polone received after its

effective date.

For the reasons explained above, we agree with the

Tax Court that the settlement payments received by

Polone after August, 1996 are taxable as ordinary

income. |

Affirmed

35a

APPENDIX D

UNITED STATES TAX COURT

No. 12665-00

GAVIN POLONE,

Petitioner,

Vv.

COMMISSIONER OF INTERNAL REVENUE,

Respondent.

Dec. 16, 2003

Edwin L. Norris, Jonathan M. Brenner, and Ethan

D. Millar, for petitioner.

Steven M. Roth, Mark A. Weiner, and Leslie B.

Van Der Wal, for respondent.

MEMORANDUM FINDINGS OF FACT

AND OPINION

VASQUEZ, J.

P was a high-profile; successful Hollywood talent

agent. P represented numerous Hollywood stars.

Until 1996, P worked for a major Hollywood talent

agency (U).

On Apr. 21, 1996, U fired P. U leaked P’s

termination to the media. The press coverage of P’s

termination was extensive and defamatory to P..:

P immediately hired attorneys to represent him

against U. P’s attorneys prepared a complaint

alleging, among other things, defamation and breach

of contract. P and U engaged in settlement nego-

tiations that were extremely hostile, adversarial, and

36a

acrimonious. P and U quickly settled P’s claims.

U agreed to pay $4 million to settle the defamation

claim and $2 million plus “back-end” payments to

settle the breach of contract claim. P was paid

the $4 million in four installments of $1 million in

May 1996, November 1996, May 1997, and November

1998.

Even though there was a quick settlement and a

public apology by U, P’s career as a talent agent was

ended by his termination and the negative public-

ity. Subsequently, P became a talent manager and

producer.

P, after consultation with tax professionals, did not

include the May 1996, May 1997, or November 1998

payments in income on his tax returns for 1996,

1997, and 1998. P initially included the November

1996 payment in income but later filed an amended

return seeking a refund of taxes associated with this

payment. P’s returns contained detailed statements

disclosing P’s reasons for excluding the payments

from income.

R audited P’s 1996, 1997, and 1998 returns.

During the audit, P’s attorney delayed several times

in responding to R. P did not provide certain

documents requested by R. P refused to be inter-

viewed by R. R denied P’s claim for refund and

determined that none of the $4 million paid to settle

the defamation claim was excludable from income,

and P was liable for a penalty pursuant to sec. 6662,

I.R.C., for all years.

Held: P did not cooperate with R. Accordingly,

P bears the burden of proof. Sec. 7491(a), I.R.C.;

Rule 142(a).

37a

Held, further, pursuant to sec. 104(a)(2), I.R.C.,

before its amendment by the Small Business Job

Protection Act of 1996 (SBJPA), Pub.L. 104-188, sec.

1605, 110 Stat. 1838, the May 1996 payment is

excludable from income for 1996.

Held, further, pursuant to sec. 104(a)(2), I.R.C., as

amended by the SBJPA, P is not entitled to an

overpayment for 1996, and the May 1997 payment

and the November 1998 payment are not excludable

from income.

Held, further, P is not liable for the penalty pur-

suant to sec. 6662, I.R.C., for 1996, 1997, and 1998.

Respondent determined the following deficiencies

in and penalties on petitioner’s Federal income tax:

Year Deficiency Penalty Sec. 6662

1996 $407,880 $81,567

1997 407,880 81,567

1998 407,880 81,567

Unless otherwise indicated, all 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: (1) Which party bears

the burden of proof; (2) whether four $1 million

payments petitioner received from United Talent

Agency, Inc. (UTA), in May 1996, November 1996,

May 1997, and November 1998 are excludable

from petitioner’s gross income pursuant to section

104(a)(2); and (3) whether petitioner is liable for the

accuracy-related penalty for 1996, 1997, and 1998.

38a

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. At

the time he filed the petition, petitioner resided in

Beverly Hills, California.

Talent Agencies and Talent Agents

Talent agencies are regulated businesses in the

State of California. They procure employment and

negotiate deals for their clients. For these services,

talent agencies receive a maximum commission of

10 percent. This industry is a very competitive

business-every day someone tries to steal someone

else’s clients. To be a successful talent agent requires

an aggressive personality.

Petitioner’s Career as a Talent Agent

After graduating from the University of California

at Berkeley with a bachelors degree in film,

petitioner became a talent agent. Petitioner signed

and represented many young writers for television

shows that became “hits”. Petitioner primarily rep-

resented clients who were in the television industry;

however, he also represented clients in the feature

film industry. His clients were directors, writers,

producers, and actors. Some of petitioner’s clients,

who numbered over 75, included: Maria Conchita

Alonso, Larry David (creator of “Seinfeld”), David

_' We make our findings of fact on the basis of the credible

evidence. We note that some of the witnesses were credible with

regard to only certain portions of their testimony. The animosity

between petitioner and UTA rendered some testimony not

credible. Additionally some testimony was conclusory and/or

questionable in certain material respects.

39a

Foley, Gregory Hines, David Koepp (whose credits

include “Jurassic Park”, “Carlito's Way”, and “Mis-

sion Impossible”), Norm MacDonald, Conan O’Brien,

Bronson Pinchot, John Singleton, and several writers

from “The Simpsons” and “Seinfeld”.

Martin Bauer and Peter Benedek owned the Bauer

Benedek Agency (BBA).’ BBA was a talent agency.

In the summer of 1989, after working at Inter-

national Creative Management (ICM), one of the

three largest Hollywood talent agencies,’ for 4 years,

petitioner left ICM and began working at BBA.

Petitioner had offers to work for other agencies but

chose BBA. BBA primarily had feature film clients.

Petitioner went to BBA to build its television busi-

ness. Petitioner’s initial salary at BBA was $90,000.

In 1990, BBA increased his salary to $150,000.

In 1991, Leading Artists Agency (LAA), primarily a

television talent agency, merged with BBA to become

UTA. James Berkus, a founding partner in LAA, is a

talent agent at UTA and the chairman of UTA. Mr.’

Berkus, an attorney, has been in the entertainment

industry for over 25 years.

From 1991 through 1998, with the exception of a

short period in 1996, Mr. Bauer was the president of

UTA. From sometime in 1996 through 1998, he was

a cochairman of UTA. During April 1996, however,

* Messrs. Bauer and Benedek were also attorneys.

* During the years in issue, the three largest talent agencies

in Hollywood, in alphabetical order, were the Creative Artists

Agency (CAA), International Creative Management (ICM), and

the William Morris Agency (William Morris).

40a

Mr. Bauer was not on good terms with the other

people involved in the management of UTA.*

From its inception until April 21, 1996, petitioner

worked as a talent agent for UTA. Petitioner’s initial

salary at UTA was $150,000.

Since its inception, UTA has grown in the number

of its employees and the amount of revenue it has

generated. In 1996, UTA was the fourth “most

prestigious” talent agency in Hollywood. During

1995 and/or 1996, UTA “packaged” seven shows

including “Cybil”, “Married . . . With Children”, “The

Drew Carey Show”, and “Mad About You”. During

1996, UTA represented high-profile stars includ-

ing Sandra Bullock, Jim Carey, Lawrence Kasdan,

Martin Lawrence, John Singleton, Jean-Claude Van

Damme, and the Coen brothers.

During his employment at UTA, petitioner became

“the de facto leader” of the television department—

the largest earning department at UTA. By 1996,

petitioner was the number one or number two

revenue generator at UTA.

Petitioner worked extremely hard. He worked long

hours 7 days a week. During the first 6 years of his

career, he took a total of only 4 weeks’ vacation.

Petitioner fought aggressively for his clients. Peti-

tioner was extremely successful in representing his

clients.

On January 27, 1992, petitioner and UTA entered

into an employment contract (employment agree-

ment). The employment agreement provided peti-

“ Mr. Bauer is no longer associated, and has an adversarial

relationship, with UTA. As of the time of trial, he was a talent

manager.

4la

tioner with base compensation of $350,000 per year

with a 10-percent annual increase and a discre-

tionary bonus. The employment agreement had a

term of 5 years.

The employment agreement provided that UTA

could terminate petitioner at any time for “cause”.

The employment agreement defined “cause” as: (1) A

conviction for any felony that was’ materially in-

jurious to UTA; (2) any breach by petitioner of any of

the material terms or covenants of the employment

agreement; or (3) any fraudulent, illegal, or immoral

activity by petitioner that materially and adversely

affected UTA or UTA’s reputation. Pursuant to the

employment agreement, if UTA terminated petitioner

for cause, UTA had no further liability to peti-

tioner except for compensation accrued to the date

of termination.

The employment agreement also provided that

UTA was not required to use petitioner’s services and

had the unilateral right to terminate his employment

without cause. In that event, UTA would be required

to pay petitioner his base salary, petitioner would not

be required to mitigate damages, and petitioner’s

income from other employment would not reduce the

amount owed to him by UTA. In order to terminate

petitioner without cause, the elected directors of UTA

would have to approve the termination unanimously.

After its execution, the employment agreement was

amended several times for various reasons, including

to increase petitioner’s base salary.

Wendy Casselith’s Accusation of Sexual Harassment

Wendy Casselith was employed by UTA as peti-

tioner’s assistant. Around April 1994, Ms. Casselith

accused petitioner of verbally abusing and sexually

42a

harassing her. She hired an attorney to pursue

claims against UTA. UTA resolved Ms. Casselith’s

claims by paying Ms. Casselith.

Petitioner Remains at UTA

As of January 1995, petitioner’s base salary at

UTA was $1 million per year.

On May 1, 1995, UTA and petitioner amended the

employment agreement (May 1995 amendment) to

extend its term until March 30, 1998, and to increase

petitioner’s base salary to $2 million per year. The

May 1995 amendment also provided that petitioner

exchanged his interest in the UTA termination of

employment plan for (1) 25 percent of the com-

missions received by UTA from package fees or

profits (or advances on profits) from petitioner’s

clients’ projects which were booked or being

negotiated by UTA while petitioner was at UTA or

were payable under the terms of agency agreements

signed by petitioner’s clients while he was at UTA,

and (2) all revenue, not just package fees and profits,

on Conan O’Brien’s deal for “Late Night With Conan

O’Brien” (altogether, the back-end payments).° Addi-

tionally, petitioner agreed that his bonus would be at

UTA’s discretion and would be based upon his

performance, his attitude, and the performance of

UTA. Except as expressly modified therein, the

terms of the employment agreement remained in

effect.

* The May 1995 amendment provides examples including

“25% of * * * the commissions received from Larry David’s

‘Seinfeld’ profits”.

43a

Petitioner’s Relationship With UTA

Petitioner’s interaction with UTA’s management

committee, partners,’ agents, assistants, and employ-

ees often was confrontational. Petitiomer was tough

on, and demanding of, other agents amd assistants.

During his employment at UTA, petitioner prided

himself in being brash, outspoken, amd aggressive.

Petitioner’s persona was eccentric, physically demon-

strative, and intense.

During his employment at UTA, petitioner grew

dissatisfied with some of UTA’s practices. He felt the

television department employees were undercom-

pensated, compensation was not based on merit,

money was being wasted, and UTA was not run

efficiently. Petitioner believed that personal ex-

penses of the partners were inappropriately being

claimed as business expenses (such as country club

memberships), that improper personal loans were

being made to the partners, and that there were

problems with drug use.

Petitioner repeatedly disagreed with and chal-

lenged the partners and management committee of

UTA with respect to the way they ran the agency and

regarding compensation. On at least two occasions,

petitioner proposed that he either withdraw or be

removed as a partner.

* The witnesses used the words “principals” and “partners”

with regard to UTA interchangeably. For convenience, we do so

as well. The title “partner” at a talent agency does not

necessarily mean that this person has an ownership interest in

the agency.

44a

Events Leading Up To Petitioner’s Termination

In March 1996, when he had 2 years left on his

employment contract, petitioner met with UTA’s

principals to discuss problems petitioner had with

how UTA conducted its business. In March 1996, the

principals of UTA were Mr. Bauer, Mr. Berkus,

Mr. Benedek, Gary Cosay, J.J. Harris, David Schiff,

Nick Stevens, Jeremy Zimmer, and petitioner.’ At

that time, UTA’s board of directors and owners were

Mr. Bauer, Mr. Berkus, Mr. Benedek, and Mr. Cosay.

Although Mr. Harris and Mr. Schiff were partners,

they did not have a say in the operation of UTA.

During this period, there was infighting between

Mr. Bauer and Mr. Berkus that created an acri-

monious atmosphere at UTA.

At the March 1996 meeting, UTA offered to raise

petitioner’s salary to $2.5 million per year; however,

UTA wanted petitioner to commit to 5 years with

UTA. At this time, UTA was having problems mak-

ing deals and re-signing junior agents. Petitioner felt

that no one at UTA wanted to address the problems

petitioner had with UTA. Petitioner stated that he

would not agree to the offer, he would finish his

contract, and then he would leave UTA. Petitioner

believed that the other partners were frightened that

petitioner’s clients would leave with him.

Nancy Jones’s Accusation of Sexual Harassment

During early 1996, Nancy Jones was a talent agent

at UTA. Petitioner helped hire Ms. Jones. She

worked with petitioner in the television department

for many years. Although petitioner did not describe

his relationship with Ms. Jones as a “romantic

" Petitioner was not a partner when LAA and BBA merged.

45a

relationship”, at one point he and Ms. Jones had a

“personal and sexual relationship”. They went on

vacation together to Mexico and traveled together

outside the office.

In early 1996, petitioner talked with Ms. Jones

about her performance. He felt that she was not

working hard, she was embarrassing clients, and she

had claimed to be sick when she actually took a

vacation to New York City. Ms. Jones suggested that

she should be let out of her contract even though she

had several years left on it. At this time, Ms. Jones

was seeking to leave UTA and join CAA.

In or about April 1996, Ms. Jones made accusa-

tions to Mr. Benedek that petitioner was sexually

harassing and abusing her. Although she did ‘not

demand monetary compensation, she demanded to be

released from her written employment agreement or

she would make her claims public.

UTA, over Mr. Bauer’s objection, released Ms. °

Jones from her contract in exchange for her releasing

UTA from her sexual harassment claims. Ms. Jones

left UTA and joined CAA. Ms. Jones later state? that

she never intended to file a complaint against U'.’A.

Petitioner’s Termination

On or about Sunday, April 21, 1996, a meeting was

held at Mr. Zimmer’s home to discuss terminat-

ing petitioner's employment (April 21 meeting). Mr.

Benedek, Mr. Berkus, Mr. Cosay, Mr. Stevens, and

Mr. Zimmer attended the April 21 meeting. Mr.

Bauer was not invited. Everyone attending the April

21 meeting participated in the discussion about what

to do to petitioner. The April 21 meeting lasted

approximately 1 hour, and at the end of the April 21

46a

meeting, all present agreed to terminate petitioner’s

employment.

Although it was not UTA’s practice to terminate an

employee on a Sunday or without notice, on Sunday,

April 21, 1996, UTA terminated petitioner's em-

ployment. Mr. Bauer was the only board member not

informed of the meeting, and he did not give his

consent to terminate petitioner without cause. Mr.

Bauer felt betrayed and treated with a lack of respect

by the actions of the other partners present at the

April 21 meeting. Mr. Zimmer later told Mr. Bauer

to look at the bright side of the firing: they cculd go

after petitioners clients together. In the end,

however, most of petitioner’s clients left UTA.

Events Following UTA’s Decision To Terminate

Petitioner

Immediately after deciding to terminate petitioner,

UTA contacted the media so that they would hear

from UTA about petitioner’s termination and not

from petitioner or someone else. It was not UTA’s

general practice to contact the media to announce the

termination of an agent.

That same day, Mr. Stevens called petitioner at

home and informed him that he was fired for cause

on account of his inappropriate behavior towards Ms.

Jones. It is unclear, however, whether Mr. Stevens

called petitioner before or after calling the news

media. Petitioner was shaken, upset, and fearful

about his future after learning he had been fired.

Since petitioner knew he needed an attorney, he

called an old friend from high school, Brad Berenson,

who was an attorney at Sidley Austin Brown &

Wood (Sidley Austin) in Washington, D.C. Petitioner

explained to Mr. Berenson what had happened, and

47va

Mr. Berenson told petitioner that he would call Sidley

Austin’s Los Angeles office and get back to petitioner.

Mr. Berenson called petitioner back and gave him

the name of Peter I. Ostroff, who was the head of the

litigation group at Sidley Austin in Los Angeles,

California. On April 21, 1996, petitioner engaged

Sidley Austin to represent him.

Among the other individuals petitioner called on

April 21, 1996, after being informed of his termi-

nation, was Bill Block, president of ICM. Mr. Block

had previously expressed an interest in retaining

petitioner’s services. Mr. Block said he was going to

have to call petitioner back after discussing matters

with his other partners at a company retreat that

was being held on Monday, April 22, 1996, at the

Four Seasons in Santa Barbara, California (ICM

retreat).

Late in the day on April 21, 1996, petitioner went

to UTA’s offices to collect his personal effects. A

guard was posted at UTA’s offices. Usually, there

was no guard. Petitioner’s electronic key no longer

worked. The guard asked petitioner for petitioner’s

driver’s license. Petitioner showed the guard his

license, and the guard informed petitioner he was not

allowed in. Petitioner called Mr. Berkus in the hope

that he would be allowed to enter the office and

retrieve his belongings, but Mr. Berkus would not

come to the phone.

On April 22 and 23, 1996, Daily Variety, the

Hollywood Reporter, and the Los Angeles Times

published articles regarding petitioner’s termination.”

* Daily Variety and the Hollywood Reporter are widely read

each business day by people in the entertainment industry. The

Los Angeles Times is a newspaper of general circulation in

48a

UTA’s termination of petitioner was also reported on

KTLA Channel 5 and KNX News Radio.

The front page of the Monday, April 22, 1996,

edition of Daily Variety had the banner headline

“UTA ZAPS POLONE”. Beneath the banner head-

line was the phrase “Agency cites behavior; agent

denies charge”. The article included the following

statements:

United Talent Agency’s Gavin Polone * * * was

abruptly fired from UTA Sunday over what

agency partners referred to as “inappropriate”

behavior toward fellow TV agent Nancy Jones,

who resigned Wednesday.

“We have terminated his employment,” UTA

partner Jim Berkus told Daily Variety on

Sunday. “The decision was ours. We called

today (Sunday) and told him. We felt the way he

accorded himself with colleagues and employees

was inappropriate. His behavior toward (fellow

TV agent) Nancy Jones was of significant

concern to us.”

Polone was ordered to attend a counseling

session with an attorney who specialized in

behavioral problems.

UTA however had not hired an attorney who

specialized in behavioral problems to counsel peti-

tioner. Furthermore, petitioner had not been ordered

to seek counseling from such an attorney or other

professional.

Southern California. In April 1996, the daily paid circulation of

these papers was as follows: (1) Daily Variety, over 25,000

people, (2) the Hollywood Reporter, over 20,000 people, and (3)

the Los Angeles Times, over 1 million people.

49a

The Monday, April 22, 1996, edition of the

Hollywood Reporter also contained an article about

petitioner’s termination. The article included the

following statements:

Reached Sunday, a spokesman for the agency

would only comment “We have terminated Gavin

Polone’s employment at United Talent Agency

for reasons that his philosophy on inter-personal

relationships and ours are antithetical * * *.”

* * * sources inside the agency said the move

was triggered late in the week after another

employee, TV agent Nancy Jones, approached

management and asked to be released from her

contract because of Polone’s allegedly inappropri-

ate behavior toward her.

The Tuesday, April 23, 1996, edition of the Los

Angeles Times reported that “One allegation from

UTA is that Polone was abusive toward Nancy Jones,

an agent there who worked under him.”

The Tuesday, April 23, 1996, edition of Daily

Variety again reported: “Agency partners said the

cause for the firing was Polone’s ‘inappropriate’

behavior toward fellow TV agent Nancy Jones, who

resigned Wednesday” and “partner Jim Berkus said

on Sunday: ‘We felt the way he accorded himself

with colleagues and employees was inappropriate.

His behavior toward Nancy Jones was of significant

concern to us.”

Petitioner started receiving calls from journalists

asking for comments. Petitioner believed that the

statements in the articles attributed to UTA were

false and that UTA had no cause to fire him.

Petitioner told the journalists that none of the

statements were true.

50a

Petitioner’s Prospects With ICM

On Monday, April 22, 1996, the ICM retreat was

attended by the executives of ICM and approximately

80 agents (including personnel from ICM’s London

office). Jeff Berg, the chairman or CEO of ICM, was

at the ICM retreat. The articles about petitioner that

appeared in the trade publications that morning were

brought to the ICM retreat. At the ICM retreat, Mr.

Berg spoke to those in attendance and, referring

to petitioner, stated: “This is the poster boy for

bad behavior” and “This kind of behavior will not

be tolerated at ICM”. Mr. Berg had the articles

about petitioner in his hand when he made these

statements.

Toni Howard, a senior vice president in the motion

picture department of ICM, attended the ICM

retreat. When Ms. Howard learned that ICM was in

discussions to hire petitioner, she opposed hiring

petitioner. She spoke to six executives at ICM and

questioned how ICM could hire petitioner after

noting the articles in the trade publications.

Eventually, petitioner met with ICM. ICM would

not hire him, in part because of the articles in the

trade publications.

Petitioner’s 1996 Litigation Against UTA

On Monday, April 22, 1996, petitioner met with

Mr. Ostroff to discuss his legal claims against UTA.

Mr. Ostroff prepared a draft complaint that alleged

the following claims against UTA: Defamation,

intentional infliction of emotional distress, inten-

tional interference with prospective economic ad-

vantage, invasion of privacy, wrongful termination,

and breach of contract (the complaint). Petitioner’s

primary concern was to “clear his name”. He wanted

5la

UTA to retract what UTA had said and to apologize.

Petitioner and Mr. Ostroff wanted to resolve

petitioner’s claims against UTA as quickly as possible

in order to mitigate the damages to petitioner’s

reputation. Petitioner was also concerned that UTA

had the resources to make litigation of these claims

very expensive, that litigation would tie up his life

and ruin any chance he had of starting a new career,

and that UTA might fabricate more (and worse)

stories about him.

That same day, Mr. Ostroff sent a letter to UTA

that, among other things, asserted legal claims

against UTA based on UTA’s alleged unlawful and

tortious actions and demanded that (1) UTA cease

and desist from making further defamatory state-

ments regarding petitioner, (2) UTA allow petitioner

access to his personal files, and (3) UTA pay

petitioner all of his earned but unpaid wages. Mr.

Ostroff also proposed a meeting by the afternoon of

Tuesday, April 23, 1996. Petitioner hoped that UTA

would admit that UTA had made a “massive mistake”

and apologize.

Settlement Negotiations

On Tuesday, April 23, 1996, a meeting was held at

the office of UTA’s attorneys, O'Melveny & Myers, in

Los Angeles, California (April 23 meeting). Peti-

tioner, Mr. Ostroff, Lori Dillman (another attorney

for petitioner from Sidley Austin), Mr. Berkus, Mr.

Benedek, and Scott Dunham of O’Melveny & Myers

attended the April 23 meeting. Mr. Dunham, Healy

Condon, and David Wyle represented UTA in the

April 1996 dispute with petitioner.” The atmosphere

* Although the record is somewhat unclear, it appears that

the dispute in April 1996 was not the only dispute, or

52a

and the negotiations at the April 23 meeting were

hostile, adversarial, and acrimonious.

At the April 23 meeting, Mr. Ostroff summarized

the elements of the complaint. The complaint in-

cluded the following allegations: ®

15. Over the course of his employment with

UTA and his service on the Management Com-

mittee, and especially in the last six months of

his employment with UTA, Plaintiff became

aware of and concerned by a number of improper

and/or illegal acts and practices occurring within

UTA, which were undertaken by or with the

authorization and ratification of, defendants

BENEDEK, BERKUS, STEVENS, ZIMMER, and

COSAY. Over a period of several months,

Plaintiff made known to defendants BENEDEK,

BERKUS, STEVENS, ZIMMER, and COSAY

Plaintiffs concerns that these acts and practices

were wrongful and/or illegal and could expose

UTA to liability, condemnation within the indus-

try, loss of clients, and general damage and

harm. * * * The acts and practices about which

threatened/actual litigation, between petitioner and UTA.

Apparently, sometime after the settlement of the defamation

and breach of contract claims was reached, petitioner allegedly

violated th: confidentiality provisions. of the settlement

agreements. When Mr. Bauer was informed that petitioner was

allegedly violating the confidentiality provisions of the settle-

ment agreements and speaking to the Internal Revenue Service

regarding UTA’s principals, he instructed UTA’s attorneys to

initiate a lawsuit against petitioner for, among other things,

breach of the settlement agreements and misappropriation of

trade secrets.

The redactions noted are contained in the copy of the

complaint submitted to the Court.

53a

Plaintiff complained included, but were not

limited to, the following:

A. The defrauding of UTA clients through

misrepresentation that commission rates were in

most instances non-negotiable at 10% and uni-

form for all clients, while in truth, UTA agreed to

special reduced commission deals with selected

and favored clients;

D. Illegally recording, as phony “loans” that

were interest-free and never intended to be paid

back to UTA, payments made by UTA to [names

redacted] to cover country club fees, among other

things, so as to disguise income to said persons

for tax purposes; and

E. Condoning and tolerating illegal use of

controlled substances by UTA employees * * *

and by one member of the [redacted] who par-

ticipated in the illegal use of drugs with other

employees of UTA at a company retreat.

16. In response to Plaintiffs complaints about

their improper and illegal conduct, defendants

BENEDEK, BERKUS, STEVENS, ZIMMER, and

COSAY failed to put a stop to the conduct and,

in fact, gave every indication that the conduct

would continue.

21. * * * the conduct [of Mr. Polone] alleged

[by UTA] was not at variance with and in no

instances worse than the standards of conduct

tolerated at UTA by defendants in view of the

fact that defendants had themselves routinely

committed sexual, for example, misconduct in

connection with their employment, including

sexual liaisons between [name redacted] and

various subordinate employees of UTA, and

54a

unwelcome sexual pursuit of a client of the firm

by [name redacted].

Some of the redacted portions of the complaint

contained accusations that Mr. Benedek had sexually

harassed UTA clients.

Mr. Ostroff also advised UTA that petitioner would

file the complaint unless a settlement could be

reached quickly. Mr. Ostroff informed UTA that he

thought petitioners claims against UTA totaled

approximately $20 million. Mr. Ostroff estimated the

contract damages to be worth approximately $8

million and the tort damages, because of the egre-

gious nature of and publicity surrounding petitioner’s

termination, to be worth approximately $12 million.

Petitioner was serious about prosecuting the com-

plaint in the event a settlement was not reached

with UTA.

Mr. Berkus felt that petitioner’s attorneys were

being aggressive and that petitioner’s monetary

demand was absurd. Mr. Berkus scoffed at, and was

derisive of, petitioner’s settlement offer. He felt that

petitioner was attempting to extort money from UTA.

Mr. Dunham spoke for UTA at the April 23

meeting. He indicated that UTA had the right to fire

petitioner without cause and would owe petitioner

only $4 million if he was fired without cause. UTA’s

initial offer was between $2 million and $3 million.

UTA adamantly defended its actions.

No agreement was reached between petitioner and

UTA at the April 23 meeting. At the time, Ms.

Dillman thought that the complaint was going to be

filed, and no agreement would be reached.

55a

That evening, petitioner spoke to Mr. Bauer. After

speaking to Mr. Bauer, petitioner felt he had a

stronger case against UTA. Mr. Bauer told petitioner

that he was never consulted about firing petitioner,

nothing about the situation was handled appro-

priately, UTA had defamed petitioner, he was

considering suing UTA as well, and he believed that

petitioner had not harassed Ms. Jones.

Negotiations continued after the April 23 meeting.

Mr. Dunham indicated that UTA wanted to resolve

the matter and gave Mr. Ostroff and Sidley Austin

permission. to speak directly to Mr. Berkus. Mr.

Dunham felt comfortable with Mr. Berkus’s ability to

negotiate a deal with petitioner’s attorneys. Mr.

Berkus’s business was the negotiation of deals, and

the issue to be negotiated was financial (i.e., how

much to pay petitioner for each cause of action).

Mr. Berkus negotiated directly with Mr. Ostroff

and Ms. Dillman. Petitioner made a counterproposal

of $9.25 million, and UTA countered with $4 million.

These monetary demands were accompanied by

additional terms. Petitioner wanted Jay Sures (an

agent at UTA) released from his contract, an apology

and retraction, the ability to compete with UTA,

vacation pay, and his personal effects that were

still in UTA’s offices. UTA wanted a noncompete

agreement, a nonsolicitation agreement, and a re-

lease from the defamation claim. Each side de-

manded terms that the other rejected.

Settlement Reached

On Wednesday, April 24, 1996, only days after

petitioner’s discharge, petitioner and UTA reached an

agreement. UTA agreed to pay petitioner $4 million

to settle the defamation claim and $2 million plus the

56a

back-end payments to settle the breach of contract

claim." Petitioner wanted payment up front; how-

ever, UTA would not agree to an up-front payment.

At the time of the settlement, the back-end

payments were estimated to be worth approximately

$2 million. As of the time of trial, petitioner had

received significantly more than $2 million in back-

end payments, and the back-end payments were

continuing to be made to petitioner.

That same day, Ms. Dillman faxed a letter to UTA

regarding the settlement reached between petitioner

and UTA (April 24, 1996, letter). Also on that day,

Mr. Berkus made handwritten notations on the April

24, 1996, letter, signed it, and faxed it back to

petitioner’s counsel. The terms contained in the

April 24, 1996, letter included a provision whereby

UTA would pay petitioner a total of $6 million in

several installments, and petitioner would also be

entitled to the back-end payments.

Before he signed the April 24, 1996, letter,

Mr. Berkus spoke with Mr. Bauer, Mr. Benedek,

Mr. Cosay, Mr. Stevens, and Mr. Zimmer. The

decision to settle was a group decision by UTA’s

management-all knew about the agreement and

" The agreement also consisted of many other monetary and

nonmonetary aspects. These included a confidentiality provi-

sion, petitioner’s right to audit UTA, UTA’s reimbursement of

unpaid expenses petitioner incurred for UTA, UTA’s provision of

health insurance to petitioner, UTA’s payment of petitioner's

accrued vacation days, UTA’s payment of all petitioner’s legal

fees incurred in connection with “this dispute”, petitioner’s

refraining from interfering with collection of accounts receivable

from petitioner’s clients, petitioner’s refraining from disclosing

UTA trade secrets, petitioner’s ability to compete against UTA,

and the exchange of mutual and general releases.

57a

agreed with the obligation UTA was assuming.

Mr. Berkus sensed that petitioner was extremely

close to filing the complaint when he signed the April

24 letter. Mr. Berkus took very seriously petitioner’s

threats to file the complaint.

On Wednesday, April 24, 1996, UTA issued the

following press release, as was required by the

agreement reached on April 24, 1996:

Upon further investigation, we have deter-

mined that there were insufficient grounds to

terminate Gavin Polone’s employment for cause.

We regret any misconception created as a result

of the reporting of these events in the media.

We have reached an amicable settlement with

Gavin Polone and wish him well in his future

endeavors.

The entire press release was reported in the

Hollywood Reporter in its Thursday, April 25, 1996,

edition under the headline “UTA apologizes, pays off

Polone”. The first two sentences of the press release

were reported by Daily Variety in its April 25, 1996,

edition.”

Documenting the Settlement

After UTA and petitioner reached the settlement

on Wednesday, April 24, 1996, Mr. Dunham was

involved in the drafting of the final documents. On

Friday, April 26, 1996, Mr. Dunham delivered to Mr.

Ostroff a draft of a comprehensive settlement and

general release agreement with respect to petitioner’s

claims against UTA.

* The article immediately to the right of the article on UTA

and petitioner's settlement (on the front page) reported that Ms.

Jones had joined CAA.

58a

Mr. Ostroff and Ms. Dillman asked Gary Cohen, a

tax attorney at Sidley Austin, to document the

settlement reached between petitioner and UTA. Mr.

Cohen proposed the use of two settlement agree-

ments to Mr. Dunham. Mr. Cohen believed that two

documents, rather than one, were advisable from a

tax perspective. He felt that the employment claim

and defamation claim should be kept separate. On

April 29, 1996, Mr. Cohen sent Mr. Dunham drafts

of two settlement agreements with respect to

petitioner's claims against UTA (two settlement

agreements).

On May 1, 1996, Mr. Cohen sent Mr. Dunham

revised pages of the two settlement agreements

that were blacklined to show corrections made by

Mr. Dunham to the versions sent to him on April 29,

1996.

That same day Ms. Dillman also sent a separate

letter to Mr. Berkus and Mr. Dunham. The letter

was sent at Mr. Berkus’s and Mr. Dunham’s request

to confirm that the April 24, 1996, letter, as

countersigned and slightly amended by Mr. Berkus,

represented a binding settlement agreement.

On May 2, 1996, Mr. Dunham delivered to

Mr. Ostroff revised drafts of the two settlement

agreements, both in unmarked and redlined versions,

with changes from the versions sent to Mr. Dunham

on May 1, 1996. Mr. Dunham made changes to

eliminate language he thought was unnecessary, not

part of the agreement reached between UTA and

petitioner (i.e., inconsistent with the agreement that

was detailed in the April 24, 1996, letter), overbroad,

and/or redundant.

59a

On May 3, 1996, Mr. Dunham faxed Mr. Cohen and

Mr. Ostroff further revised drafts of the two

settlement agreements. That same day, petitioner

and UTA executed two agreements-the Employment

Termination Agreement and Mutual General Release

(employment termination agreement) and the Defa-

mation Agreement and Mutual General Release

(defamation agreement).

The employment termination agreement provided

UTA would pay petitioner $2 million in five install-

ments ($475,000 by June 30, 1996, and December 31,

1996, and $350,000 by June 30, 1997, December 31,

1997, and January 1, 1998) and the back-end pay-

ments received after March 31, 1998. .

The defamation agreement provided UTA would

pay petitioner $4 million in four $1 million install-

ments. The first payment was to be made on May 1,

1996. The last three payments were to be made by

November 1, 1996, May 1, 1997, and November 1,

1997. The defamation agreement specifically pro-

vided that these payments would be: paid to peti-

tioner as compensation to him for the alleged

personal injuries he suffered on account of the

defamation. UTA entered into the defamation agree-

ment, and agreed to pay petitioner $4 million pur-

suant to the defamation agreement, in order to settle

petitioner’s defamation claim. UTA would not have

agreed to settle with petitioner if petitioner had not

agreed to release UTA from his defamation and other

legal claims.

'* We note that this payment was due 2 days before the

execution of the defamation agreement.

60a

Petitioner’s Career After His Termination By UTA

Before his termination by UTA, petitioner was a

top-earning talent agent at UTA, had numerous well-

known and prestigious clients, was considered a

“partner” at UTA, and was considered very successful

within the entertainment industry. After being fired

by UTA, petitioner did not receive any calls from

CAA or William Morris. ICM specifically would not

hire petitioner because of the concern expressed by

some of ICM’s partners regarding the adverse public-

ity surrounding petitioner’s dismissal from UTA.

After his termination and the conclusion of the

settlement negotiations, petitioner felt he had no

viable career as a talent agent. He also did not

believe he could start his own talent agency. Peti-

tioner thus decided to pursue a career as a talent

manager and as a film and television producer.

Talent managers are not allowed to procure em-

ployment on behalf of clients and do not benefit from

the fixed commission rates that talent agents are

entitled to receive under their agreements with the

talent guilds.

Around May 1996, he started Hofflund Polone with

Judy Hofflund (a former partner at UTA). During

2001 or 2002, petitioner formed a_ production

company named Pariah Productions.

As of the time of trial, petitioner had at least two

television shows on the air-Family Affair and Hack.

Several pilots he produced had not yet been picked up

as series, and he had not produced any feature films.

6la

Payments Made to Petitioner Pursuant to _ the

Settlement Agreements

Pursuant to the employment termination agree-

ment, UTA paid petitioner $950,000 in 1996

and $1,050,000 in 1998. Petitioner included these

amounts on his respective Federal income tax returns

for 1996 and 1998.

Pursuant to the defamation agreement, UTA paid

petitioner $1 million on or about: (1) May 1, 1996

(May 1996 payment), (2) November 11, 1996 (Novem-

ber 1996 payment), (3) May 5, 1997 (May 1997

payment), and (4) November 11, 1998 (November

1998 payment).

UTA did not withhold any taxes from the $4

million it paid petitioner pursuant to the defamation

agreement (i.e., with respect to petitioner’s defa-

mation claim). Petitioner never attempted to sell his

anticipated stream of income from the settlement.

Petitioner’s Tax Returns

In April and May 1996, petitioner consulted with

tax accountants and tax attorneys to discuss the

state of the tax law as it related to the settlement

with UTA. Petitioner was told that the $4 mil-

lion allocated to the defamation claim would be

nontaxable.

Petitioner advised his business manager, from the

firm of Kessler Schneider, to disclose the settlement

with UTA on his tax returns in the most clear and

proper way possible. Petitioner’s business manager

‘* Sometime after the settlement was executed, UTA ceased

making payments provided for in the settlement agreement. A

lawsuit ensued, and payments eventually resumed.

62a

prepared petitioner’s tax returns in consultation with

petitioner’s tax attorneys.

On his Federal income tax returns for 1992

through 1996, petitioner reported the following total

salary and bonus received from UTA: $450,000

in 1992, $954,000 in 1993, $1,190,229 in 1994,

$1,956,408 in 1995, and $1,768,681 in 1996.

Hofflund Polone, a partnership, allocated to peti-

tioner or petitioner's wholly owned corporation the

following taxable income: $84,416 in 1996, $1,300,423

in 1997, $1,624,867 in 1998, $1,684,024 in 1999,

$2,395,145 in 2000, and $2,377,146 in 2001.

On or about October 10, 1997, petitioner filed his

1996 Federal income tax return. Petitioner did not

include the May 1996 payment in income on his 1996

return. Petitioner reported, under other income on

his 1996 return, a $1 million payment from UTA on

his 1996 return. This amount, which represented the

November 1996 payment, was in addition to the

wages he reported from UTA in 1996. Statement 1 of

petitioner’s 1996 return stated: “Taxpayer received

$1 million from United Talent Agency (UTA), repre-

senting settlement of claims by taxpayer for personal

injury against UTA, pursuant to an agreement as of

May 1, 1996. The lump-sum payment received does

not constitute income subject to self-employment

tax.”

On his 1997 return, petitioner reported, under

other income, $2,000. Petitioner did not include the

May 1997 payment in income. On the line for other

income “See Statement 1” was typed in. Statement 1

of petitioner’s 1997 return listed $2,000 from Conde

Nast Publications and $1 million from UTA as

“miscellaneous income” and subtracted out $1 million

63a

as UTA settlement proceeds to arrive at a total of

$2,000. Below the subtraction were the words “see

footnote”. The footnote, contained in statement 2,

stated:

Taxpayer settled a lawsuit with his prior

employer for defamation on May 1, 1996, by

entering into a settlement agreement. In the

settlement agreement, the taxpayer released his

former employer from any liability related to his

claims for defamation and, in exchange, received

$4 million. This $4 million was comprised of the

former employer’s promise to pay $1 million at

the time the settlement agreement was executed,

$1 million in November 1996, $1 million in May

1997 and $1 million in November 1997.

During the tax year 1997, the taxpayer received

the lawsuit settlement installment in May 1997.

The former employer failed to make payment in

November 1997.

Under Warren Jones v. Commissioner, 524 F. 2nd

788 (9th Cir. 1975), rev’g 60 T.C. 663, 1973 WL 2570

(1973), and Heller Trust v. Commissioner, 382 F.2d

675.(9th Cir. 1967), the taxpayer is required to treat

his receipt of his former employer’s promise to pay $4

million as an amount realized in the 1996 taxable

year at the time of his receipt of the promise to pay,

in May 1996. Under IRC section 104, amounts re-

ceived in May 1996 on account of claims for defa-

mation and other tort type rights were excludable

from gross income. (Reg. sec. 1.104-1(c)).

Accordingly, the taxpayer’s receipt of his: former

employer’s promise to pay was excludable from gross

income.

64a

Petitioner’s 1997 return also included a Form 8275,

Disclosure Statement. The disclosure statement

cross-referenced the above footnote.

On his 1998 return, petitioner reported his other

income in substantially the same manner as it was

reported on his 1997 return-i.e., petitioner did not

include the November 1998 payment in income and

included a statement and a footnote similar to those

on his 1997 return. The footnote on the 1998 return

also noted that petitioner received the payment he

was supposed to receive in November 1997 in

November 1998. Petitioner’s 1998 return also in-

cluded a Form 8275. The disclosure statement cross-

referenced the footnote in Statement 2.

On or about April 16, 1998, petitioner filed an

amended 1996 Federal income tax return. On the

amended return, among other things, petitioner

decreased his adjusted gross income by $1 million.

Essentially, petitioner sought to exclude the

November 1996 payment from income and sought a

refund of Federal income taxes paid with respect to

the November 1996 payment. Petitioner’s amended

return also included a Form 8275. The disclosure

statement referred to an attached explanation. The

explanation was substantially similar to paragraphs

1 and 3 of the footnote contained in his 1997 return.

The explanation also stated: “The taxpayer’s original

1996 Form 1040, however, erroneously reported $1

million of the amounts received under the settlement

agreement as income. As a result, taxpayer is now

filing this amended return to correct the error in his

original return.”

65a

Examination of Petitioner’s 1996, 1997, and 1998 Tax

Returns

Revenue Agent Marcelle Colline (RA _ Colline)

conducted the examination of petitioner’s 1996, 1997,

and 1998 returns. RA Colline has worked at the

Internal Revenue Service (IRS) for approximately

20 years. During most of that time, she has been a

revenue agent. In 2001, she was promoted to

manager.

John Alan Harbin represented petitioner during

the examination of petitioner’s 1996, 1997, and 1998

returns. Mr. Harbin is an attorney and a certified

public accountant.

RA Colline met with Mr. Harbin several times

during the examination. RA Colline issued several

Information Document Requests (IDR) to petitioner.

Mr. Harbin was professional, but he delayed several

times in responding to the IRS.

RA Colline requested that petitioner sign a Form

12180, Third Party Authorization. RA Colline

requested permission to interview a third party—

Mr. Berkus. Mr. Harbin stated that he would sign

the Form 12180; however, over a month passed and

he never signed the form. RA Colline summoned Mr.

Berkus and interviewed him.

On July 26, 1999, RA Colline issued an IDR (July

26 IDR) to petitioner. She received none of the

requested documents. All three items requested

concerned the settlement documents for the litigation

between petitioner and UTA regarding UTA’s

termination of petitioner. RA Colline did not obtain

the information requested in the July 26 IDR from

petitioner. In October 1999, she obtained this in-

formation from Mr. Berkus.

66a

On November 8, 1999, RA Colline issued an [DR

(November 8 IDR) to petitioner.” The November 8

IDR requested tax return information regarding

petitioner from Hofflund Polone and Bedford Falls

Investors, L.P.,"° for 1996, 1997, and 1998. RA

Colline did not receive any information regarding

Hofflund Polone from petitioner, and Mr. Harbin

provided information only for 1998 regarding Bedford

Falls Investors, L.P.

In the November 8 IDR, RA Colline also requested

copies of petitioners 1997 and 1998 income tax

returns. Mr. Harbin eventually sent petitioner’s

1998 return after RA Colline advised him that she

had obtained copies of petitioner’s 1997 return.

During the examination, RA Colline requested an

interview with petitioner to gather information

about, and petitioner’s explanation of, items on

petitioner's returns that were under examination.

Mr. Harbin absolutely refused to allow petitioner to

be interviewed. Petitioner testified for over 4-1/2

hours during the trial of this case.

Respondent’s Determination and Denial of Petitioner’s

Refund Claim

On or about February 15, 2000, respondent denied

petitioner’s claim for refund for 1996 (relating to the

November 1996 payment). The reason for disallow-

ance was that the $1 million payment associated with

°° This document also informed petitioner that his 1997 and

1998 tax years were under examination.

'* Bedford Falls Investors, L.P., was listed as a partnership

petitioner received income or loss from on Schedule D of his

1996, 1997, and 1998 returns.

67a

petitioner’s refund request did not qualify as tax-free

income.

In the notice of deficiency, respondent determined

that the May 1996 payment, the May 1997 payment,

and the November 1998 payment were includable in

petitioner’s taxable income for 1996, 1997, and 1998,

respectively."’ Respondent also determined a penalty

pursuant to section 6662 for all 3 years.

Refund Litigation

On February 14, 2002, petitioner filed a complaint

in U.S. District Court seeking a refund of the Federal

income taxes attributable to his including the

November 1996 payment in income on his 1996

return.

OPINION

I. Burden of Proof

The parties vigorously dispute who bears the

burden of proof. Section 7491(a) places the burden of

proof on the Commissioner with regard to certain

factual issues if certain conditions are met. Higbee v.

Commissioner, 116 T.C. 438, 440, 2001 WL 617230

(2001). Section 7491 applies to examinations com-

menced after July 22, 1998. Id. Respondent concedes

that the examination of petitioner’s 1996, 1997, and

1998 tax years began after the effective date of

section 7491.

" Respondent also reduced petitioner’s itemized deductions

for 1996, 1997, and 1998 because of the increase tn petitioner’s

income. This adjustment is purely computational.

68a

Section 7491(a)(2) provides that the Commissioner

will bear the burden of proof with respect to an issue

pursuant to section 7491(a) if:

(A) the taxpayer has complied with the re-

quirements under this title to substantiate any

item;

(B) the taxpayer had maintained all records

required under this title and has cooperated with

reasonable requests by the Secretary for wit-

nesses, information, documents, meetings, and

interviews; and

or trust, the taxpayer is described in section

7430(c)(4)(A)G2).

The burden is on the taxpayer to show that he

satisfied these prerequisites. H. Conf. Rept. 105-599,

at 240, 242 (1998), 1998-3 C.B. 747, 994, 996.

Respondent contends, among other things, that

petitioner did not cooperate with respondent’s rea-

sonable requests for information, documents, and

interviews; therefore, the burden of proof does not

shift to respondent. Respondent’s IDRs and request

to interview petitioner were requests for information,

documents, and an interview. Thus, we must decide

whether respondent’s requests were reasonable and

whether petitioner failed to cooperate.

A. Reasonable Request

We consider all the surrounding facts and cir-

cumstances of this case in deciding whether re-

spondent’s request for witnesses, information, docu-

ments, meetings, and interviews is_ reasonable.

Respondent requested information concerning the

settlement documents regarding UTA’s termination

69a

of petitioner and regarding petitioner’s tax return

information for the years in issue. This information

was relevant to the determination of the taxable

amount of the May 1996 payment, the November

1996 payment, the May 1997 payment, and the

November 1998 payment, and to the bottom line

amount of taxable income petitioner had during the

years in issue. Respondent requested an interview

with petitioner to gather information about, and

petitioner's explanation of, items on _ petitioner’s

returns that were being examined. On the basis

of the facts and circumstances, we hold that

respondent’s requests in the July 26th IDR, in the

November 8th IDR, and to interview petitioner were

reasonable requests for information, documents, and

interviews.

B. Cooperation

Whether the taxpayer cooperated with reasonable

requests by the Commissioner for witnesses,

information, documents, meetings, and interviews is

based on all the surrounding facts and circumstances

of the case. The statute itself does not state what

constitutes “cooperation”. The conference commit-

tees’s report states that the House bill provided:

[T]he taxpayer must fully cooperate at all times

with the Secretary (including providing, within a

reasonable period of time, access to and in-

spection of all witnesses, information, and

documents within the control of the taxpayer, as

reasonably requested by the Secretary). Full

cooperation also includes providing reasonable

assistance to the Secretary in obtaining access to

an inspection of witnesses, information, or

documents not within the control of the taxpayer

(including any witnesses, information, or docu-

70a

ments located in foreign countries). A necessary

element of fully cooperating with the Secretary is

that the taxpayer must exhaust his or her

administrative remedies (including any appeal

rights provided by the IRS). The taxpayer is not

required to agree to extend the statute of

limitations to be considered to have fully coop-

erated with the Secretary. [H. Conf. Rept 105-

599, supra at 239,1998-3 C.B. at 993; fn. refs.

omitted; emphasis added.]

The conference committees’s report further states

that the Senate amendment provided: [T]he

taxpayer must cooperate with reasonable requests by

the Secretary for meetings, interviews, witnesses,

information, and documents (including providing,

within a reasonable period of time, access to and

inspection of all witnesses, information, and docu-

ments within the control of the taxpayer, as

reasonably requested by the Secretary). Cooperation

also includes providing reasonable assistance to the

Secretary in obtaining access to an inspection of

witnesses, information, or documents not within the

control of the taxpayer (including any witnesses,

information, or documents located in foreign coun-

tries). A necessary element of cooperating with the

Secretary is that the taxpayer must exhaust his or

her administrative remedies (including any appeal

rights provided by the IRS). The taxpayer is not

required to agree to extend the statute of limitations

to be considered to have cooperated with the

Secretary. Cooperation also means that the taxpayer

must establish the applicability of any privilege.

** * Td. at 240,1998-3 C.B. at 994; fn. refs. omitted;

emphasis added. ]

Jla

Thus, the Senate Amendment changed “full coop-

eration” to “cooperation”, “fully cooperate” to “coop-

erate”, and “fully cooperate at all times with the

Secretary” to “cooperate with reasonable requests by

the Secretary for meetings, interviews, witnesses,

information, and documents”. The conference agree-

ment followed the Senate Amendment except for

some changes not relevant to the definition of

cooperation.

Petitioner failed to provide documents within his

control requested in the July 26 IDR and November 8

IDR. Petitioner argues that because the documents

contained in the July 26 IDR were publicly available

(i.e., at a courthouse) and from UTA (the opposing

party in the dispute involving petitioner’s termi-

nation), and because respondent eventually received

some of these documents from Mr. Berkus, albeit

several months later, the fact that petitioner did not

provide this information to respondent does not mean

petitioner was uncooperative. Petitioner also argues

that, because petitioner’s 1997 return was available

from the service center, the fact that petitioner did

not provide his 1997 return to respondent does not

indicate that petitioner was uncooperative. We

disagree.

The fact that respondent could obtain documents

and/or information from another source, and/or did

eventually obtain the documents and/or information

from another source, does not relieve petitioner from

his obligation to cooperate if petitioner desires the

benefit of the provisions of section 7491(a). If this

‘* We note that it takes the Commissioner between 6 and 8

weeks to obtain return information from his internal record-

keeping centers. Additionally, the information contained on a

transcript of account is not as clear as the actual return.

72a

were not the case, taxpayers could be affirmatively

uncooperative but still gain the benefit of section

7491(a) so long as the Commissioner was able to

obtain the information that he sought.

Mr. Harbin’s conclusory statements that he was

cooperative on behalf of Mr. Polone are unpersuasive.

Mr. Harbin stated that in cases involving celebrities,

it is his business practice to decline interviews with

the taxpayer. The fact that Mr. Harbin thought

petitioner was “world famous” in Hollywood does not

entitle petitioner to preferential treatment when it

comes to section 7491(a)-petitioner still needed to

cooperate with respondent in order to secure the

benefits of section 7491(a).””

Petitioner’s actions impeded respondent’s exami-

nation of petitioner’s 1996, 1997, and 1998 returns.

Petitioner, by failing to provide respondent with the

information and documents requested in the July 26

IDR and in the November 8 IDR, and by refusing to

be interviewed, did not provide respondent with

reasonable assistance in obtaining access to wit-

nesses, documents, and/or information. On the basis

of the facts and circumstances of this case, we hold

that petitioner failed to cooperate with respondent’s

reasonable request for information, documents, and

’° Petitioner argues that the legislative history of sec. 7491

demonstrates that the intent of the section is only to require

sharing documents and other information with respondent. We

disagree. The legislative history specifically mentions cooper-

ating with requests for interviews and access to all witnesses.

H. Conf. Rept. 105-599, at 240 (1998), 1998-3 C.B. 747, 994.

More importantly, the statute specifically provides that the

taxpayer has to cooperate with reasonable requests for inter-

views. Sec. 7491(a)(2)(B).

73a

interviews. Accordingly, petitioner bears the burden

of proof.” Sec. 7491(a); Rule 142(a).

II. Exclusion pursuant to Section 104(a)(2)

Respondent determined that the May 1996 pay-

ment, the May 1997 payment, and the November

1998 payment are not excludable pursuant to section

104(a)(2). Respondent also denied petitioner’s refund

claim (relating to the November 1996 payment) for

the same reason. Petitioner challenges respondent’s

determination and the denial of his refund claim.”

A. Section 104

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

Supreme Court has long reiterated the sweeping

scope of section 61. Commissioner v. Schleier, 515

U.S. 323, 327, 115 S.Ct. 2159, 132 L.Ed.2d 294

(1995); Commissioner v. Glenshaw Glass Co., 348

U.S. 426, 429-431, 75 S.Ct. 473, 99 L.Ed. 483 (1955).

Section 104, in contrast, provides an exception with

respect to compensation for injuries or sickness.

Such exclusions from gross income are construed

narrowly. Commissioner v. Schleier, supra at 328;

” We note it appears that petitioner did not exhaust his

administrative remedies. This is an alternative reason to hold

that the burden of proof does not shift in this case. H. Conf.

Rept. 105-599, supra at 240, 1998-3 C.B. at 994.

“We note that we have jurisdiction to determine whether

there was an overpayment of tax for 1996. Secs. 6512(b),

7422(e).

74a

United States v. Burke, 504 U.S. 229, 248, 112 S.Ct.

1867, 119 L.Ed.2d 34 (1992) (Souter, J., concurring in

judgment); Banaitis v. Commissioner, 340 F.3d 1074,

1079 (9th Cir. 2003), affg. in part and revg. in part

T.C. Memo. 2002-5. 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

(pre-SBJPA section 104):

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 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, repu-

tation, or character”. United States v. Burke, supra

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

at 329-331; Roemer v. Commissioner, 716 F.2d 693

(9th Cir. 1983) (holding that compensation paid for

defamation, as defined by California law, is exclud-

able from income pursuant to pre-SBJPA section

104), revg. 79 T.C. 398, 1982 WL 11142 (1982); see

also Threlkeld v. Commissioner, 87 T.C. 1294, 1986

WL 22061 (1986) (aligning the Court with the

decision in Roemer), affd. 848 F.2d 81 (6th Cir. 1988).

75a

The SBJPA then amended section 104, as relevant

here, to provide (post-SBJPA section 104):

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), emo-

tional distress shall not be treated as a

physical injury or physicai sickness. The pre-

ceding sentence shall not apply to an amount

of damages not in excess of the amount paid

for medical care * * * attributable to emotional

distress.

The 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. Post-SBJPA

section 104 is effective for amounts received after

August 20, 1996. SBJPA, sec. 1605(d), 110 Stat. 1839.

Regulations promulgated under section 104 fur-

ther 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

76a

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 before the SBJPA, the U.S.

Supreme Court in Commissioner v. Schleier, supra at

336-337, established a two-pronged test for ascertain-

ing a taxpayer’s eligibility for the section 104(a)(2)

exclusion. “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; Banaitis Commissioner, supra

at 1079. This test has since been extended to apply

to post-SBJPA section 104, with the corresponding

change that the second prong now requires proof

that the personal injuries or sickness for which the

damages were received were physical. Shaltz v.

Commissioner, T.C. Memo. 2003-173; Henderson uv.

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

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

B. Did Petitioner Make a Tort Claim?

Respondent argues that petitioner’s claims regard-

ing his termination did not sound in tort.

The determination of whether a settlement pay-

ment is exempt pursuant to section 104 depends on

the nature of the claim settled and not on the validity

of the claim. Robinson v. C

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