T.C. Memo. 1998-240

UNITED STATES TAX COURT

WALTER E. HESS AND HELEN L. HESS, Petitioners v. 

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 8857-97. Filed July 2, 1998.

Milton J. Schubin and Sydney E. Unger, for petitioners.

John Aletta, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

LARO, Judge: Walter E. Hess and Helen L. Hess petitioned

the Court to redetermine respondent's determination of the

following deficiencies in Federal income tax and accuracy-related

penalties under section 6662(a):
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 Accuracy-Related Penalty

 Sec.

Year Deficiency 6662(a)

 1992 $17,970 $3,594

 1993 167,629 33,526

Following the parties' concessions, we must decide:

1. Whether section 104(a)(2) excludes from Walter E. Hess's

(Mr. Hess) 1993 gross income $425,000 of settlement proceeds he

received during that year. We hold it does not.

2. Whether Mr. Hess may deduct for 1993 a $170,040

long-term capital loss on his separation from employment with

L.G. Balfour Co. (Balfour). We hold he may not.

 3. Whether Mr. Hess is liable for the accuracy-related

penalty determined by respondent under section 6662(a) for 1993. 

We hold he is.

Unless otherwise indicated, section references are to the

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

references are to the Tax Court Rules of Practice and Procedure. 

Dollar amounts are rounded to the nearest dollar. Although

Helen L. Hess (Mrs. Hess) is a copetitioner, for simplicity and

clarity, we refer to Mr. Hess as the sole petitioner.

FINDINGS OF FACT

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

The stipulations of fact and the exhibits submitted therewith are

incorporated herein by this reference. Petitioner and Mrs. Hess
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resided in Darien, Connecticut, when they petitioned the Court. 

They filed 1992 and 1993 Forms 1040, U.S. Individual Income Tax

Returns, using the filing status of "Married filing joint

return". Petitioner graduated from Duke University with a

bachelor of arts degree in business.

Balfour employed petitioner from November 10, 1969, through

June 14, 1991, as a commercial representative. Balfour

manufactured and sold award items, such as jewelry, plaques, and

trophies, and petitioner had the exclusive right to sell

Balfour's products in New York City and certain surrounding

areas. For each Balfour product sold in petitioner's sales

territory, Balfour paid him a commission equal to the difference

between the price paid by the purchaser and the price charged

petitioner. Balfour issued petitioner Forms W-2, Wage and Tax 

Statements, listing the total commissions that it paid him during

each year.

Balfour let its retiring salesmen sell their sales

territories to other Balfour salesmen. On January 1, 1971,

Louis S. Myers (Mr. Myers), a retiring salesman, sold petitioner

the exclusive right to service Balfour's New York City sales

territory. Pursuant to the sale, Mr. Myers transferred his sales

accounts to petitioner from January 1, 1971, through December 31,

1973, and petitioner received credits to his commission account
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for sales on these accounts after their transfer. Mr. Myers

received payments (known as equity payments) equal to the sum of

(1) the commissions credited to his account for orders entered on

the transferred accounts in the year before their transfer to

petitioner and (2) the commissions credited to petitioner's sales

account during 1970 from accounts transferred to him before 1970.

The equity payments were made in five equal annual installments

by way of offsetting debits and credits that Balfour posted to

the commission accounts that it maintained for petitioner and

Mr. Myers. Balfour did not include the debited commissions in

the commissions shown on petitioner's Forms W-2.

Sometime during 1989 or 1990, petitioner and Balfour entered

into a dispute over petitioner's commissions. The dispute

centered mainly on petitioner's accounts with AT&T, Prudential,

and the New York Giants and on a $281,773 commission that Balfour

had mistakenly paid petitioner during 1990. Petitioner also was

unhappy with the way Balfour manufactured and delivered its

products to customers in his sales territory.

During May 1991, petitioner talked to Robbins, Inc.

(Robbins), a competitor of Balfour, about leaving Balfour to work

for Robbins. One month later, on June 14, 1991, petitioner

resigned from Balfour and began working for Robbins as a sales

representative. Petitioner continued to work for Robbins through
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1993 and beyond, and he continued to sell award products to

customers which he had previously serviced for Balfour.

Also on June 14, 1991, petitioner filed suit in Federal

District Court (the District Court) against Balfour and its

parent corporation, Town & Country Corp. (T&C). Petitioner's

complaint and amended complaint asserted claims mainly for: 

(1) Breach of contract, (2) destruction of his equity in his

sales territory, (3) failure to pay wages under Connecticut law,

(4) unlawful deductions from wages in violation of Connecticut

law, (5) conversion, and (6) constructive discharge. Neither the

complaint nor the amended complaint alleged that Balfour or T&C

caused petitioner to suffer a physical or emotional injury, and

neither pleading prayed for damages from such an injury. In

their answers, Balfour and T&C denied the material allegations

set forth in petitioner's pleadings, and they asserted various

affirmative defenses and counterclaims against him for breach of

contract, conversion, replevin, unjust enrichment, breach of duty

of loyalty, tortious interference, and unfair competition.

On March 13, 1992, petitioner served Balfour with

interrogatory responses identifying and describing his requested

damages to include: (1) $3,012,793 for breach of contract,

(2) $1.2 million for lost equity, (3) $9,359,849 for failure to

pay wages; (4) $1,262,448 for unlawful deduction from wages,
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(5) $12,594,636 for conversion of commissions, (6) $1,756,147 for

equity in sales territory, and (7) $4,108,158 for constructive

discharge. Petitioner alleged that his damages for constructive

discharge were: (1) $2,352,011 in commissions owed him for

Prudential, AT&T, the New York Giants, and NBA contracts and

(2) lost equity payments of $1,756,147 from not being allowed to

retire under Balfour's equity program. Petitioner did not assert

any claim for damages for a physical or emotional injury

purportedly caused by Balfour.

Balfour and petitioner both moved for summary judgment on

petitioner's claims of lost equity, statutory wage violations,

and conversion, and petitioner also moved for summary judgment on

all of Balfour's counterclaims. On December 16, 1992,

petitioner, through his attorney, submitted a document to the 

District Court explaining his position on his claims. This

document addressed petitioner's claims for: (1) Commissions owed

on the AT&T, Prudential, and the New York Giants contracts,

(2) lost commissions on NBA accounts removed from his sales

territory, (3) lost equity in his sales territory, (4) violations

of Connecticut wage statutes, (5) conversion, (6) wrongful

discharge, and (7) Balfour's counterclaims. The document did not

address any physical or emotional injury purportedly suffered by

petitioner.
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On April 26, 1993, Balfour offered petitioner $500,000 to

settle the litigation. The offer was made to compensate

petitioner for his alleged lost commissions and equity.

Petitioner rejected Balfour's offer, and he made a counteroffer

of $1.86 million based on the following claims: (1) AT&T

contract commissions of $465,000, (2) Prudential contract

commissions of $122,000, (3) the New York Giants contract

commissions of $50,000, (4) NBA accounts of $15,000, (5) All-Star

game commissions of $5,000, (6) pipeline commissions of $14,400,

(7) chargebacks of $5,000, (8) lost equity of $660,000, and

(9) litigation costs of $125,000.

Later, on or about May 5, 1993, the District Court granted

summary judgment in Balfour's favor on petitioner's claims that

equity in his sales territory had been destroyed and that Balfour

violated Connecticut's wage laws. The wage claims were denied

because the court concluded that Massachusetts, rather than

Connecticut, law applied. In denying the equity claim, the court

held that petitioner had not suffered a loss because he continued

to service his former accounts after leaving Balfour. The

District Court also denied petitioner's motion for summary

judgment on his claims of breach of contract, conversion, and

constructive discharge, and it denied his motion for summary

judgment on all of Balfour's counterclaims except for replevin. 
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On June 30, 1993, after petitioner had moved the District Court

to reconsider and clarify its rulings, the court affirmed its

rulings stating that petitioner's claims for lost equity, whether

explicitly or implicitly raised, were all dismissed.

On June 2, 1993, after receiving the court's ruling on the

summary judgment motions, Balfour rejected petitioner's $1.86

million offer and offered to settle the litigation for $200,000. 

This offer included compensation for lost commissions; it did not

include any compensation for a purported constructive discharge

or physical or emotional injury. Petitioner rejected this offer.

On or about August 26, 1993, petitioner served additional

interrogatory responses upon Balfour's attorney identifying his

damages as follows: (1) $2,118,180 for breach of contract,

(2) $5,848,501 for failure to pay wages, (3) $294,136 for

unlawful deduction from wages, (4) $5,317,121 for conversion of

commissions, (5) $2,497,734 for equity in sales territory, and

(6) $7,968,252 for constructive discharge. Petitioner alleged

that his damages for constructive discharge were: (1) $152,092

for commissions earned before June 14, 1991, (2) $421,440 for

commissions earned after July 1, 1991, through December 31, 1993,

under the AT&T contract, (3) $88,478 for commissions earned from

June 15 through December 31, 1991, under the Prudential contract,

(4) $2,497,734 in earned equity payments, (5) $2,812,508 in lost
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future earnings representing the amount petitioner would have

earned if he had worked for Balfour until age 65, and (6) $2

million in emotional distress.

Shortly after the additional interrogatory responses were

served on Balfour's attorney, but before she had read them,

Balfour and petitioner agreed to settle the litigation by having

Balfour pay petitioner $550,000. Balfour intended that this

payment would compensate petitioner for commissions purportedly

owed him, primarily on the AT&T account; it was not intended to

compensate petitioner for a purported constructive discharge or

physical or emotional injury. At the time of settlement, neither

Balfour nor its attorney knew that petitioner was claiming

damages for an emotional injury, and petitioner had never given

Balfour any reports detailing such an injury.

Beginning in mid-September 1993, the attorneys for Balfour

and petitioner began discussing the language to be used in the

settlement agreement, and the attorneys exchanged drafts of the

agreement. Petitioner's attorney asked that the agreement

allocate $425,000 of the $550,000 settlement payment to a claim

for constructive discharge and that the remaining $125,000 be

allocated to attorney's fees. Petitioner's attorney made this

request because petitioner's accountant had advised the attorney

that such an allocation would render the settlement proceeds
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nontaxable. To satisfy the concerns of Balfour's attorney that

such an allocation could expose Balfour to liability,

petitioner's attorney agreed to insert language in the agreement

stating that petitioner would indemnify Balfour for any Federal

income tax liability asserted against Balfour for unpaid Federal,

State, or local taxes owed on the settlement payment to

petitioner.

On November 30, 1993, petitioner and Balfour signed a

settlement agreement. Paragraph 1 stated that petitioner would

receive $425,000 and that his attorneys would receive $125,000. 

The agreement stated that the $425,000 payment settled

claims for compensatory damages arising out of alleged

wrongful discharge, * * * [and]

* * * * * * *

Neither this Agreement nor any action on the part of

Balfour or Town & Country required by the Agreement,

nor the allocation or description of the Settlement

Amount as recited in paragraph 1 hereof, constitutes an

admission by Balfour or Town & Country of any unlawful

or tortious action.

The latter language was placed in the agreement as a caveat to

the statement in paragraph 1 that the settlement payment was made

to compensate petitioner for his claim of wrongful discharge. 

The agreement also let petitioner represent Balfour's competitors

and sell non-Balfour products or services to Balfour's customers

in the New York City territory.
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On December 6, 1993, Balfour issued petitioner a check for

$425,000, and it issued his attorneys a check for $125,000.

Balfour later issued petitioner a Form 1099-MISC, Miscellaneous

Income, reflecting the settlement payment, and it deducted the

settlement amount on its Federal income tax return as a

commission expense.

Petitioner's 1992 Form 1040 claimed a deduction for legal

fees of $95,274 from the Balfour litigation. His 1993 Form 1040

did not report any of the settlement payment as income, claiming

that it was nontaxable. The 1993 Form 1040 claimed a long-term

capital loss of $170,040 in connection with petitioner's

termination of employment from Balfour.

Respondent determined that section 104(a)(2) did not apply

to exclude the $425,000 payment from petitioner's 1993 gross

income. Respondent also determined that petitioner could not

deduct the claimed loss because: (1) He had not established his

basis in the underlying asset and (2) he had not established that

his right to sell products in New York City became worthless

during 1992 or 1993.

OPINION

1. Taxability of Settlement Proceeds

We must decide whether petitioner received any of the

settlement proceeds on account of a personal injury. To the
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extent that he did, the funds are excludable from his gross

income. Sec. 104(a)(2). To the extent that he did not, the

funds are includable in his gross income. Sec. 61(a). Because

respondent determined that none of the proceeds are excludable

from petitioner's gross income under section 104(a)(2),

petitioner must prove otherwise. Rule 142(a); Welch v.

Helvering, 290 U.S. 111, 115 (1933); Robinson v. Commissioner,

102 T.C. 116, 124 (1994), affd. in part, revd. in part on an

issue not relevant herein and remanded 70 F.3d 34 (5th Cir.

1995).

Petitioner argues that the settlement proceeds are

excludable from his gross income because the settlement agreement

states explicitly that he received the proceeds for a personal

injury. Petitioner alleges that his litigation with Balfour was

adversarial and that he entered into the allocation set forth in

the settlement agreement to "maximize his relatively meager

recovery". Petitioner alleges that his cause of action against

Balfour for constructive discharge was real. Respondent argues

that none of the $425,000 is excludable from petitioner's gross

income because none of it was paid to him for a personal injury. 

Respondent argues that the allocation set forth in the settlement

agreement should be disregarded because it was not the product of

arm's-length negotiations between Balfour and petitioner.
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We agree with respondent that the allocation in the

settlement agreement does not control our decision herein, and

that none of the settlement proceeds are excludable from

petitioner's gross income under section 104(a)(2). Under

section 104(a)(2), settlement proceeds are excluded from gross

income to the extent that: (1) The cause of action underlying

the recovery of the proceeds is based upon tort or tort type

rights and (2) the proceeds are received on account of a personal

injury or sickness. Section 104(a)(2) is inapplicable when

either of these requirements is not met. Sec. 104(a)(2);

Commissioner v. Schleier, 515 U.S. 323, 336-337 (1995);

United States v. Burke, 504 U.S. 229, 233 (1992); sec. 1.104-

1(c), Income Tax Regs. 

The nature of the claim underlying a damage award, rather

than the validity of the claim, determines whether damages fall

within this two-part test. United States v. Burke, supra at 237;

Robinson v. Commissioner, supra at 125-126. Ascertaining the

nature of the claim is a factual determination that is generally

made by reference to the settlement agreement, in light of the

facts and circumstances surrounding it. Key to this

determination is the "intent of the payor" in making the payment. 

Knuckles v. Commissioner, 349 F.2d 610, 613 (10th Cir. 1965),

affg. T.C. Memo. 1964-33; Agar v. Commissioner, 290 F.2d 283, 284
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(2d Cir. 1961), affg. per curiam T.C. Memo. 1960-21; Seay v.

Commissioner, 58 T.C. 32, 37 (1972). We ask ourselves: "In lieu

of what were the damages awarded?" Robinson v. Commissioner,

102 T.C. at 126-127, and the cases cited thereat. Although the

payee's belief is relevant to this inquiry, the ultimate

character of the payment rests on the payor's dominant reason for

making the payment. See Agar v. Commissioner, supra at 284;

Fono v. Commissioner, 79 T.C. 680 (1982), affd. without published

opinion 749 F.2d 37 (9th Cir. 1984). A payor's intent may

sometimes be found in the characterization of the payment in a

settlement agreement (or other executed document), but such a

characterization is not always dispositive, for example, when the

record proves the characterization inconsistent with the

realities of the settlement. Bagley v. Commissioner, 105 T.C.

396, 406 (1995), affd. 121 F.3d 393 (8th Cir. 1977); Robinson v.

Commissioner, supra; Threlkeld v. Commissioner, 87 T.C. 1294,

1306-1307 (1986), affd. 848 F.2d 81 (6th Cir. 1988); see Knuckles

v. Commissioner, supra at 613; Eisler v. Commissioner, 59 T.C.

634, 640 (1973).

Petitioner argues that the settlement agreement in issue

characterizes Balfour's reason for making the settlement payment

to petitioner as compensation for a personal injury. We read the

record, however, not to support this characterization. In
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contrast with petitioner's argument that Balfour paid him the

settlement as compensation for a personal injury, we find that

Balfour's dominant reason for paying the settlement was to

compensate petitioner for commissions which Balfour could be

called upon to pay him in the event he prevailed in the District

Court suit.

Petitioner focuses only on the settlement agreement and asks

the Court to do likewise. We decline to do so. In Robinson v.

Commissioner, supra, the taxpayers sued a State bank for failing

to release a lien on their property. After the jury returned a

verdict in their favor for approximately $60 million, including

$6 million for lost profits, $1.5 million for mental anguish, and

$50 million in punitive damages, the parties to that proceeding

settled. In the final judgment reflecting the settlement, which

was drafted by the parties and signed by the trial judge,

95 percent of the settlement proceeds was allocated to mental

anguish and 5 percent was allocated to lost profits. We held

that this allocation did not control the taxability of the

proceeds to the taxpayers. We noted that the allocation was

"uncontested, nonadversarial, and entirely tax motivated", and

that it did not accurately "reflect the realities of * * * [the

parties'] settlement." Id. at 129.
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The same is true here. While the underlying litigation was

certainly adversarial, the parties were no longer adversaries

after they agreed on a settlement in principle. Petitioner

wanted the settlement payment connected to a tort so that he

could maximize his recovery by avoiding taxes on his recovery. 

Balfour, on the other hand, did not care whether the settlement

proceeds were allocated to tortlike personal injury damages

vis-a-vis other damages. Balfour's only concerns were that all

of petitioner's claims be settled, that nothing be done to

compromise its right to deduct the settlement, and that it be

indemnified for any tax liability resulting from a

mischaracterization of the settlement payment. Balfour, in

effect, gave petitioner the green light to allocate the proceeds

unilaterally in the manner that he desired, and petitioner did

so, allocating the payment in a way that would maximize his

recovery to the neglect of the fisc. Petitioner and Balfour did

not prepare the settlement agreement by realistically evaluating

the damages claimed in the lawsuit and allocating petitioner's

recovery accordingly. Nor did the attorneys for the parties

there ever discuss the merits of petitioner's constructive

discharge claim. As a matter of fact, neither Balfour nor its

attorney was even aware that petitioner had just recently made a

new claim for $2 million in emotional distress. 
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In a setting such as this, where the parties to a settlement

agreement fail to reflect their agreement accurately in a written

document, we will not accept the allocation set forth in that

document. That petitioner may have wanted the payment to be

characterized as compensation for a tortlike personal injury does

not govern the taxation of the payment for purposes of section

104(a)(2). The taxability of the payment, as discussed above,

turns on the payor's intent. Because none of the $425,000

payment compensated petitioner for a tortlike personal injury, we

hold for respondent on this issue. None of the $425,000 payment

is excludable under section 104(a)(2); i.e., the payment is fully

taxable under section 61(a). As conceded by respondent as a

result of this holding, petitioner may deduct for 1992 $95,274 of

legal expenses connected with the lawsuit.

2. Deduction of Long-Term Capital Loss

Petitioner must disprove respondent's determination that he

may not deduct his reported capital loss of $170,040. Rule

142(a); Welch v. Helvering, 290 U.S. at 115. Deductions are a

matter of legislative grace, and petitioner must show that his

claimed loss falls within the terms of the statute. New Colonial

Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). Petitioner

argues that he may deduct the loss because he lost the exclusive

sales territory that he purchased from Mr. Myers.
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We disagree with petitioner's claim that he may deduct his

reported loss of $170,040. An individual may deduct an uninsured

loss sustained during the taxable year if the loss was incurred: 

(1) In a trade or business or a for-profit transaction or (2) on

account of a casualty or theft. Sec. 165(a), (c). A loss "must

be evidenced by closed and completed transactions, fixed by

identifiable events, and * * * actually sustained during the

taxable year." Sec. 1.165-1(b), Income Tax Regs; see also

sec. 1.165-1(d)(1), Income Tax Regs. The deduction for a loss is

limited to the individual's basis in the underlying asset, as

determined under section 1011, see sec. 165(b); Leighton v.

Commissioner, T.C. Memo. 1995-515, affd. without published

opinion 108 F.3d 332 (5th Cir. 1997); Fisher v. Commissioner,

T.C. Memo. 1986-141; sec. 1.165-1(c), Income Tax Regs., and the

individual bears the burden of proving his or her basis,

Millsap v. Commissioner, 46 T.C. 751, 760 (1966), affd. 387 F.2d

420 (8th Cir. 1968). A loss cannot be computed where the

individual's basis in the asset is not proven. Towers v.

Commissioner, 24 T.C. 199, 239 (1955), affd. on other grounds sub

nom. Bonney v. Commissioner, 247 F.2d 237 (2d Cir. 1957); Heckett

v. Commissioner, 8 T.C. 841 (1947); see also Fisher v.

Commissioner, supra.
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Petitioner has not established that his separation from

employment with Balfour caused him to incur a loss during 1993 on

his New York City sales territory. In fact, a similar claim by

petitioner was rejected by the District Court when it ruled that

petitioner incurred no loss of equity in his sales territory

because he continued to service accounts in that territory after

leaving Balfour. As the court stated:

Hess argues that even though he has taken his accounts

to a Balfour competitor, Balfour must compensate him

for his equity. In reality, what Hess bought in 1971

from Mr. Myers was the right to service accounts in a

specific territory. To now take those accounts from

that territory, yet demand payment from Balfour for the

value of the territory, flies in the face of contract

law, not to mention common sense. 

Petitioner also has not proven that he has a basis in the

sales territory. Petitioner "paid" Mr. Myers for this territory

with income that was not previously taxed to petitioner. 

Petitioner's "payments" were made through debits to his sales

account, and these debits were not included as taxable income on

the Forms W-2 that Balfour issued to him. Nor does the record

reveal that petitioner otherwise reported these debits as income

on his returns. Because petitioner's "payments" for his sales

territory were not included in his gross income, he lacks a basis

therein which, in turn, precludes him from deducting a loss on

its alleged destruction.

3. Accuracy-Related Penalty

Respondent determined that petitioner is liable for an

accuracy-related penalty for negligence under section 6662(a) for
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1993. Section 6662 imposes an accuracy-related penalty equal to

20 percent of any portion of an underpayment of tax that is

attributable to negligence or disregard of rules or regulations. 

See sec. 6662(a) and (b). The term "negligence" means "any

failure to make a reasonable attempt to comply with the

provisions of [the Code]". Sec. 6662(c). This includes any

failure to exercise due care or to do what a reasonable and

ordinarily prudent person would do under the circumstances. 

See Rybak v. Commissioner, 91 T.C. 524, 565 (1988); Neely v.

Commissioner, 85 T.C. 934, 947 (1985). The term "disregard"

includes any careless, reckless, or intentional disregard. 

Sec. 6662(c). 

Petitioner must prove respondent's determination of

negligence wrong. Rule 142(a); Bixby v. Commissioner, 58 T.C.

757, 791 (1972). Petitioner's complete argument against this

penalty is: "As the foregoing discussion and Proposed Findings

demonstrate, * * * [petitioner] had a solid basis for * * * [his]

tax position. No grounds exist for imposing penalties under IRC

§ 6662(a)." We disagree; we are unable to find that petitioner

had a solid basis for his positions herein. Petitioner is a

sophisticated and longtime businessman who holds a business

degree from Duke University. Yet he deliberately painted his

settlement agreement with Balfour to appear that he received the

settlement payment for a personal injury although he knew that

the payment was intended to compensate him for taxable
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commissions. He also claimed a deduction for a $170,040 loss on

his sales territory, knowing that he had no basis therein, that

he still worked in this territory after leaving Balfour, and that

the District Court had rejected his claim to have suffered such a

loss. We conclude that petitioner is liable for the accuracyrelated penalty determined by respondent under section 6662(a)

for 1993. 

In reaching all our holdings herein, we have considered all

arguments made by petitioner and, to the extent not discussed

above, find them to be without merit. To reflect the foregoing,

Decision will be entered

under Rule 155.