T.C. Memo. 1998-18

UNITED STATES TAX COURT

WILLIAM J. GOEDEN AND CAROL S. GOEDEN, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 21994-94. Filed January 14, 1998.

John W. Hein, for petitioners.

J. Paul Knap, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

WRIGHT, Judge: Respondent determined deficiencies in

petitioners' Federal income taxes, an addition to tax for

substantial understatement of tax and accuracy-related penalties,

as follows:
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1 Respondent has conceded that the value of health and

life insurance coverage received by petitioner from State Central

Credit Union during the years in issue is excludable from gross

income. Respondent has also conceded that, to the extent

attorney's fees were paid in 1988 for the purpose of obtaining

taxable income, petitioners are entitled to deduct such fees as a

miscellaneous itemized deduction in that year.

 Addition to Tax Penalty

Year Deficiency Sec. 6661 Sec. 6662(a)

1988 $8,760 $2,190 ---

1989 2,423 --- $485

1990 7,532 --- 1,506

Petitioners have alleged and claimed in their petition that,

based on their amended Federal income tax returns for 1988, 1989,

and 1990, they are entitled to refunds for those years in the

amounts of $896, $1,567, and $1,574, respectively.

Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the years in issue. All

Rule references are to the Tax Court Rules of Practice and

Procedure. 

After concessions by respondent,1 the issues to be decided

are: (1) Whether all or any part of the payments received in the

years 1988 through 1990 by petitioner William J. Goeden from

State Central Credit Union, pursuant to a settlement agreement,

is excludable from gross income under section 104(a)(2) as

damages received on account of personal injuries; (2) whether

petitioners are entitled to deduct any part of attorney's fees
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paid in 1988 in connection with the settlement agreement; (3)

whether petitioners are liable for the addition to tax for

substantial understatement of tax under section 6661 for 1988;

and (4) whether petitioners are liable for the accuracy-related

penalties under section 6662(a) for 1989 and 1990.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. 

The stipulation of facts and the attached exhibits are

incorporated herein by this reference.

Petitioners resided in Brookfield, Wisconsin, at the time

their petition was filed in this case.

William J. Goeden (petitioner) was employed in several

positions by State Central Credit Union (the credit union) from

January 14, 1957, until he resigned on September 15, 1988,

serving as its president since April 1, 1981. Petitioner did not

have a written employment contract with the credit union at any

time during his employment.

On February 29, 1988, at an executive session of the credit

union's board of directors, a majority of the board (by a 4 to 3

vote) passed a resolution authorizing and directing its chairman

to:

(1) Provide written notice to Mr. William J. Goeden,

President of State Central Credit Union, that the Board

may remove him as an officer and director of State

Central Credit Union for violation of applicable law,

the Articles of Incorporation of State Central, the
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Bylaws and/or for any other good and sufficient cause

including but not limited to the following:

(a) The NCUA's [National Credit Union

Association] expressed concerns over

management practices including underwriting

policies and collection policies;

(b) Mismanagement associated with Dale Armstrong

and Cemetery Services, Inc.;

(c) Mismanagement associated with the purchase of

automobile conditional sales contracts;

(d) Mismanagement associated with the failure to

follow applicable FHA regulations in

connection with its home improvement loan

program;

(e) Mismanagement associated with employee

problems and concerns; and

(f) Failure to follow Board policies and Bylaws

in connection with the foregoing.

(2) Set forth in writing the reasons for the proposed

removal;

(3) Establish a time and location at which Mr. Goeden

may appear before the Board to rebut allegations

made against him which such time to be not less

than five (5) business days subsequent to mailing

to Mr. Goeden the Written notice described herein.

Various matters pertaining to petitioner's employment were

discussed at nine board meetings held between April 8, 1988, and

September 15, 1988. Although some of the allegations of

petitioner's mismanagement were challenged by some board members

as being false, neither petitioner nor his attorney, as reflected

in the board's minutes, specifically indicated at board meetings

that a suit based entirely on libel, injury to professional

reputation, or defamation would be brought by petitioner against
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the credit union. Petitioner never filed suit against the credit

union for libel, defamation, or any other cause of action.

Members of the board expressed serious concern at some

meetings about their possible personal liability as directors and

about a potential breach of petitioner's implied employment

contract. A claim of age discrimination was also a concern of

the board, as well as avoiding a possible suit for "wrongful

termination" under Wisconsin laws. In at least two board

meetings the members' discussion related to a settlement based on

retirement pay for petitioner.

At the May 4, 1988, board meeting petitioner's attorney

argued that petitioner committed no wrongs, that his proposed

termination would be unfair, and that he was being used as a

scapegoat for the credit union's problems. He charged that

petitioner's proposed termination was not in keeping with the

employee relations policies of the credit union. Consequently,

he stated that petitioner's proposed termination would be

regarded as a breach of his employment contract and that board

members who voted in favor of termination would be exposed to

personal liability. He stated that there would be extensive

discovery and litigation if petitioner were discharged.

In the board's executive session on May 4, 1988, a member

stated that it was necessary to determine whether the board

needed "just cause" to terminate petitioner and whether the
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discharge could be considered a "wrongful termination". A member

also expressed concern that the board could be sued by petitioner

and inquired whether the board's indemnity policy would pay for

any damages which might result.

The charges of mismanagement made against petitioner caused

damage to his professional reputation in the credit union

industry and prevented him from obtaining another responsible

position in his profession at the management level. He was asked

to resign as a member of the board of directors of the Tyme

Corporation.

On or about September 15, 1988, petitioner and the credit

union entered into a written settlement agreement which provided,

in pertinent part, as follows:

WHEREAS, the Board of Directors of the Credit Union 

instituted proceedings on February 29, 1988, to consider the

removal of Goeden from his positions as President and 

Director of the Credit Union.

WHEREAS, Goeden has indicated litigation would be 

commenced against the Credit Union and any directors who 

participated in his removal as President and Director and it

is anticipated such litigation would be protracted, 

complicated and time-consuming for the parties;

WHEREAS, it is the mutual intent of the parties that 

the payments made pursuant to this Settlement Agreement are 

made by or on behalf of the Credit Union and received by 

Goeden in settlement of any and all claims Goeden may have 

against the Credit Union or any of its officers and/or 

directors, either individually or in combination with 

others, including but not limited to any and all claims for 

defamation, libel, slander, age discrimination, tortious 

interference with Goeden's trade, profession and right to 

earn a living, injury to Goeden's business and professional 

reputation and standing in the business community and 
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tortious interference with Goeden's right to be free from 

interference with his employment or other claims entitling 

Goeden to seek compensatory damages for personal injuries, 

injury to Goeden's feelings and humiliation and damages for 

alleged violations of his civil and statutory rights;

 * * * * * * * 

NOW, THEREFORE, in consideration of the promises 

contained herein, the parties agree as follows;

1. The parties to this Agreement will execute the

General Mutual Release and Statement that is

attached as Exhibit A and incorporated herein.

2. Goeden will receive the sum of Fifty Thousand

Dollars ($50,000) immediately upon execution of

this Settlement Agreement.

3. The Credit Union will be responsible for the

payment to Goeden of monthly monetary sums as

follows:

(a) Three Thousand Five Hundred Dollars ($3,500)

commencing as of September 15, 1988, and

thereafter paid monthly with the final

payment to be made on or by October 15, 1992.

(b) Three Thousand Four Hundred Sixty Seven

Dollars ($3,467) paid on or by November 15,

1992, and Three Thousand Dollars ($3,000)

thereafter paid monthly with the final

payment to be made on or by October 15, 1995,

in the amount of Three Thousand Four Hundred

Dollars ($3,400);

(c) Taxes, if any, with regard to the payments

are Goeden's responsibility.

(d) The above payments are to be made to Goeden

on or by the 15th day of each month.

(e) In the event of Goeden's death, the payments

will be paid to his spouse, if living, or to

his estate if not. Payments to Mrs. Goeden

would be made to her estate if she were to

die after Goeden and during the period when

such payments are required hereunder.
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(f) Earnings from other sources will not serve to

reduce or be offset against any payments or

benefits due to or received by Goeden, Mrs.

Goeden or their estates hereunder.

(g) The above payments may not be reduced,

eliminated or set-off against future claims,

if any, the Credit Union might bring against

Goeden unless and until a final nonappealable judgment or court order has been

entered against Goeden with respect to such

claim or claims.

4. Goeden will resign as President and terminate his

employment with the Credit Union as of September

15, 1988. Goeden's employment termination will be

recorded as a Board approved early retirement. 

Goeden will not seek or accept any future

relationship with the Credit Union as an officer,

director or employee.

The settlement agreement also provided that the credit union

would continue to pay group health and dental insurance for

petitioner and his family until he reached age 65 (he was then

57), and to pay certain premiums on his life insurance. The

credit union agreed to provide petitioner with Medicare

Supplement Insurance after he reached age 65.

The settlement agreement did not allocate the payments

received by petitioner to any particular cause of action.

On September 15, 1988, petitioner and the credit union

signed a general mutual release and statement. In it, petitioner

agreed to discharge from liability the credit union and its

directors and officers for any and all causes of action,

including age discrimination, breach of contract whether express
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or implied, and libel, slander, defamation, damage to reputation,

and intentional or negligent infliction of emotional distress.

Pursuant to the settlement agreement, petitioner received

from the credit union a lump-sum payment of $50,000 on September

15, 1988, and monthly payments totaling $14,000 in 1988, $42,000

in 1989, and $42,000 in 1990.

In an attachment to their Federal income tax returns for

each of the years 1988, 1989, and 1990, relying on the advice of

their certified public accountant from KPMG Peat Marwick, the

firm which prepared them, petitioners reported an amount under

"miscellaneous other income" which was 25 percent of the monthly

payments as the "taxable portion of settlement with State Central

Credit Union". They also reported in 1988 an amount that was 25

percent of the $50,000 lump-sum payment. They claimed a

deduction of $13,750 for attorney's fees paid in 1988. The

returns did not disclose the full amount of the payments received

by petitioner or the percentage reported. The returns did not

report as income any part of the value of petitioner's health and

life insurance coverage.

On or about December 9, 1991, petitioners filed amended

Federal income tax returns for 1988, 1989, and 1990, containing

the following explanation:

On the return as originally filed the taxpayer had included

in Other Income the "taxable portion" of settlement proceeds

received from State Central Union. The settlement proceeds

arose from an employment discrimination claim.
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At the time the returns were prepared, there were a few

court cases which supported an allocation of the proceeds

between personal injury damages (nontaxable) and contracttype claims (taxable). Based on such decisions, the

taxpayer allocated 25% of the proceeds to contract-type

claims and allocated the remaining 75% of the proceeds as

nontaxable personal injury payments.

Recently, the courts have reversed earlier cases and have

ruled favorably for the taxpayers, as they have ruled that

100% of the payments in similar fact cases should be

excludible from taxable income. Specifically, the Downey v.

Commissioner, 97 T.C. 10 (1991) case recently overruled its

prior decision in Rickel v. Commissioner, 90-1 USTC Para

50,200 (3rd Cir. 1990).

Thus, petitioners claimed in the amended returns that all of the

payments received by petitioner were excludable from gross income

under section 104(a)(2). Consequently, they adjusted their

itemized deductions by claiming that the attorney's fees are not

deductible. The amended returns claimed refunds of $896 for

1988, $1,567 for 1989, and $1,574 for 1990.

In the notice of deficiency dated August 30, 1994,

respondent increased petitioners' gross income by $48,437 in

1988, $31,500 in 1989, and $31,500 in 1990, including in their

gross income all of the monthly payments petitioner received from

the credit union and all of the $50,000 lump-sum payment. The

notice allowed an additional itemized deduction of $41,250 in

1988 for attorney's fees.

The petition filed in this case on November 28, 1994, prior

to the Supreme Court's decision in Commissioner v. Schleier, 515
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U.S. 323 (1995), alleged that petitioner had causes of action

against the credit union for libel and age discrimination. 

OPINION

Issue 1. Excludability of Settlement Payments

Petitioners contend that the payments received by petitioner

from the credit union pursuant to the terms of the settlement

agreement were based entirely on tort or tort type claims and

therefore all of the payments are excludable from gross income

under section 104(a)(2). To the contrary, respondent contends

that all of the payments received by petitioner are includable in

his gross income because they were made by the credit union for

reasons which rendered them subject to tax. We agree with

petitioners in part and with respondent in part. Based on this

record, we conclude that an allocation should be made.

Section 61(a) provides that, except as otherwise provided in

the Code, gross income means "all income from whatever source

derived". The Supreme Court has stated that the statutory

definition of gross income is broad and reflects Congressional

intent to exert the full measure of its taxing power and to bring

within the definition of income any accession to wealth. United

States v. Burke, 504 U.S. 229, 233 (1992). Thus, any receipt of

funds or other accession to wealth received by a taxpayer is

presumed to be gross income unless the taxpayer can establish

that the accession fits into one of the specific exclusions
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created by other sections of the Code. Commissioner v. Glenshaw

Glass Co., 348 U.S. 426, 430-432 (1955).

One exclusion is contained in section 104(a)(2). It permits

a taxpayer to exclude from gross income "the amount of any

damages received (whether by suit or agreement and whether as

lump-sums or periodic payments) on account of personal injuries

or sickness". Section 1.104-(1)(c), Income Tax Regs., defines

the term "damages received (whether by suit or agreement)" as an

amount received (other than workmen's compensation) through

prosecution of a legal suit or action based upon tort or tort

type rights, or through a settlement agreement entered into in

lieu of such prosecution.

The Supreme Court, in addressing the scope of section

104(a)(2), has applied the default rule of statutory

interpretation that exclusions from income must be narrowly

construed. Commissioner v. Schleier, 515 U.S. at 328. Thus, a

taxpayer seeking the exclusion must demonstrate not only that the

underlying claim giving rise to the recovery was based on tort or

tort type rights but also that the damages were received on

account of personal injuries or sickness. Id. at 336-337.

In the absence of express language in the settlement

agreement stating how the payments made to petitioner should be

allocated "on account of personal injuries", the intent of the

payor (the credit union) in making the payments is a key factor
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to consider in applying section 104(a)(2). Knuckles v.

Commissioner, 349 F.2d 610, 612 (10th Cir. 1965), affg. T.C.

Memo. 1964-33; Stocks v. Commissioner, 98 T.C. 1, 10 (1992).

As indicated in our findings of fact, the credit union's

board of directors had several motives for making the payments to

petitioner. The documentary or testimonial evidence shows that

such motives were to avoid (1) a suit for libel, defamation, or

damage to petitioner's professional reputation; (2) a suit for

age discrimination or wrongful discharge; (3) expenses of

litigation; and (4) claims for breach of an implied employment

contract. In addition, the board wanted to provide petitioner

with retirement pay. Because the intent of the credit union in

making payments to petitioner is derived from all of the above

motives, we think an allocation of the payments is appropriate

and necessary under these facts and circumstances. Stocks v.

Commissioner, supra at 16-17.

In view of the testimony of Hugo W. Wandt, Jr., and Richard

H.E. Smith, who were members of the credit union's board of

directors, and William French, an attorney who represented

petitioner in negotiations with the board, we are persuaded that

the claim for defamation and damage to professional reputation

was the predominant reason motivating the credit union's payments

to petitioner. Respondent did not attempt to rebut this

testimony by calling witnesses, especially other members of the
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credit union's board of directors. Instead, respondent countered

with the assertion that petitioners failed to carry their burden

of proof as to the intent of the payor credit union. We reject

this assertion.

Respondent does not dispute that payments received on

account of traditional causes of action for libel, slander,

personal embarrassment, or defamation are excludable from gross

income, whether the damage is to the taxpayer's personal or

professional reputation. See Threlkeld v. Commissioner, 87 T.C.

1294 (1986), affd. 848 F.2d 81 (6th Cir. 1988).

Other evidence shows that some of the payments were

motivated by claims that were not "on account of personal

injuries" within the scope of section 104(a)(2) and,

consequently, are includable in petitioner's gross income.

Accordingly, it is our best judgment, based on the record as

a whole, that 60 percent of the payments are allocable to the

potential claim for defamation and damage to professional

reputation and 40 percent to the other potential claims. 

Therefore, we hold that 60 percent of the payments received by

petitioner are excludable from his gross income under section

104(a)(2), and the remainder is includable in his gross income.

Issue 2. Deductibility of Attorney's fees

Having concluded that 60 percent of the payments to

petitioner are excludable from gross income and 40 percent are
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includable, it follows that the attorney's fees should be

allocated in the same proportion as the excludable and includable

portions of the settlement payments. Section 265(a)(1) precludes

a deduction for an amount paid for legal fees if it is allocable

to a class of income exempt from taxation. See also Stocks v.

Commissioner, 98 T.C. at 18; Metzger v. Commissioner, 88 T.C.

834, 860 (1987), affd. without published opinion 845 F.2d 1013

(3d Cir. 1988); sec. 1.265-1(c), Income Tax Regs. We so hold.

Issue 3. Section 6661 Addition to Tax

Respondent determined that petitioners are liable for an

addition to tax under section 6661 for substantial understatement

of tax for 1988. Petitioners contend that they are not liable

for the addition to tax because (1) there was substantial

authority for reporting as taxable only part of the settlement

payments received in that year, and (2) their Federal income tax

return adequately disclosed the settlement with the credit union. 

We agree with petitioners.

Section 6661(a), for returns due on or before December 31,

1989, provided for an addition to tax if there was a substantial

understatement of income tax for the taxable year. In the case

of additions to tax assessed after October 21, 1986, the amount

of the addition to tax is equal to 25 percent of the amount of

any underpayment attributable to such understatement. Omnibus

Budget Reconciliation Act of 1986, Pub. L. 99-509, sec. 8002(c),
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100 Stat. 1874, 1951; Licari v. Commissioner, 946 F.2d 690, 692

(9th Cir. 1991), affg. T.C. Memo. 1990-4; Pallottini v.

Commissioner, 90 T.C. 498 (1988).

Section 6661(b)(1)(A) provided that a substantial

understatement of income tax exists if the amount of the

understatement exceeds the greater of 10 percent of the tax

required to be shown on the return or $5,000. An understatement

was defined as the excess of the amount of tax required to be

shown on the return for the taxable year over the amount of tax

imposed which is shown in the return, reduced by any rebate. 

Sec. 6661(b)(2)(A).

In general, section 6661(b)(2)(B) provided that the

understatement is deemed to be reduced to the extent it is

attributable to: (1) The tax treatment of an item for which

there was substantial authority; or (2) any items with respect to

which the relevant facts affecting the item's tax treatment are

adequately disclosed in the return or in a statement attached to

the return.

At the time petitioners timely filed their Federal income

tax return for 1988 there was substantial authority for treating

some of the settlement payments petitioner received from the

credit union as excludable from his gross income. Damages to

professional or business reputation were excludable under section

104(a)(2) as being based on tort or tort type claims. Threlkeld
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v. Commissioner, supra (involving a civil lawsuit for malicious

prosecution); Roemer v. Commissioner, 716 F.2d 693 (9th Cir.

1983), revg. 79 T.C. 398 (1982) (involving a civil suit for

injury to a person's reputation caused by defamatory statements

constituting libel). The law was unsettled with respect to the

excludability of claims based on age discrimination. See Downey

v. Commissioner, 97 T.C. 150 (1991), supplemented by 100 T.C. 634

(1993), revd. and remd. 33 F.3d 836 (7th Cir. 1994).

It is problematic whether petitioners adequately disclosed

the item regarding the settlement payments in their 1988 return. 

While it was not a full and detailed disclosure, we are inclined

to view it as adequate because respondent was alerted to the fact

that petitioner had received settlement payments from the credit

union, some taxable and some nontaxable. The disclosure in the

attachment to the return led to respondent's audit of the item

which in turn resulted in the principal adjustment contained in

the notice of deficiency.

Accordingly, we hold that petitioners are not liable for the

addition to tax under section 6661(a) for 1988.

Issue 4. Section 6662(a) Accuracy-Related Penalties

Respondent determined that petitioners are liable for

accuracy-related penalties for negligence under section

6662(a)(1) for 1989, and for a substantial understatement of

income tax under section 6662(a)(2) and negligence under section
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6662(a)(1) for 1990. Petitioners contend that they are not

liable for the accuracy-related penalties for either year. We

agree with petitioners.

The facts and circumstances as to whether there was a

substantial understatement of income tax for 1990 are similar to

those pertaining to 1988. We have previously concluded that for

1988 there was substantial authority for petitioners' treatment

of the settlement payments received from the credit union and an

adequate disclosure of the item's tax treatment in their return. 

We reach the same conclusion with respect to 1990 and hold that

there was not a substantial understatement of income tax for that

year. See also sec. 6664(c) (relating to reasonable cause and

good faith).

For the years 1989 and 1990 we also conclude that

petitioners were not negligent in filing their returns.

Taxpayers are liable for a penalty equal to 20 percent of

the part of the underpayment to which section 6662(a) applies. 

Negligence is a lack of due care or failure to do what a

reasonable and ordinarily prudent person would do under the

circumstances. Zmuda v. Commissioner, 731 F.2d 1417, 1422 (9th

Cir. 1984), affg. 79 T.C. 714 (1982); Neely v. Commissioner, 85

T.C. 934, 947 (1985). For purposes of section 6662(a),

negligence is a failure to reasonably attempt to comply with the

provisions of the Internal Revenue Code. Sec. 6662(c). The
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accuracy-related penalty under section 6662(a) does not apply to

any part of an underpayment if the taxpayer shows that there is

reasonable cause for that part of the underpayment and that the

taxpayer acted in good faith based on the facts and

circumstances. Section 6664(c).

Mr. French, petitioner's attorney during the negotiations

with the credit union, was a trial lawyer, not a tax lawyer. 

Because he thought petitioner needed competent tax advice about

how the settlement payments should be reported for Federal income

tax purposes, he recommended that petitioner consult James L.

Mohr, a certified public accountant and tax specialist with KPMG

Peat Marwick. He introduced petitioner to Mr. Mohr, who was

hired to advise petitioner with respect to the tax aspects of the

settlement. KPMG Peat Marwick prepared petitioners' Federal

income tax returns for 1988, 1989, and 1990. Petitioner

consulted with Mr. Mohr and provided him with all the necessary

and relevant information required for the preparation of the

returns. The information was complete and accurate. Mr. Mohr

did the tax research to determine the then current status of the

law under section 104(a)(2). Although he thought the settlement,

for the most part, was based on tort type claims that resulted in

the payments' being excludable from gross income, he advised

petitioner to report 25 percent of the settlement payments as

taxable in an attempt to be reasonable and to avoid future

problems in dealing with the issue if questioned on audit by the
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Internal Revenue Service. Later, after this Court's first

opinion in Downey v. Commissioner, 97 T.C. 150 (1991), KPMG Peat

Marwick prepared amended Federal income tax returns for 1988,

1989, and 1990, which petitioners filed on December 9, 1991,

claiming that all of the settlement payments were excludable from

petitioner's gross income.

Under some circumstances a taxpayer may avoid liability for

negligence if reasonable reliance on a competent professional

adviser is shown. United States v. Boyle, 469 U.S. 241 (1985);

Freytag v. Commissioner, 89 T.C. 849, 888 (1987), affd. 904 F.2d

1011 (5th Cir. 1990), affd. 501 U.S. 868 (1991). Here it is

clear that petitioners made a good faith effort and acted

reasonably and prudently in attempting to comply with section

6662 by supplying their certified public accountant with all the

information necessary to correctly report the item subject to

adjustment. Petitioners hired an experienced accountant and tax

expert, and they relied on his advice. Therefore, we hold that

the imposition of the accuracy-related penalties for negligence

for 1989 and 1990 was improper and that petitioners are not

liable for them. 

To reflect concessions and our conclusions with respect to

the contested issues,

Decision will be entered

under Rule 155.
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