Stadnyk v. Comm'r

T.C. Memo. 2008-289
UNITED STATES TAX COURT
DANIEL J. AND BRENDA J. STADNYK, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 11296-05. Filed December 22, 2008.
Michael D. Kalinyak, for petitioners.
Alisha M. Harper, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
GOEKE, Judge: The issue for decision arises from petitioner
wife’s receipt of settlement proceeds of $49,000. Respondent
determined a deficiency of $13,119 for 2002 and an accuracy-
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related penalty of $2,624 under section 6662.1 The issues for
decision are: (1) Whether petitioners may exclude the settlement
proceeds received by petitioner wife from their gross income
pursuant to section 104(a)(2). We hold the settlement award is
gross income and not excludable; and (2) whether petitioners are
liable for an accuracy-related penalty under section 6662 for
their failure to report the settlement proceeds. We hold they
are not.
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 they filed
the petition, petitioners resided in Kentucky.
On December 11, 1996, petitioners purchased a used 1990 Geo
Storm from Nicholasville Road Auto Sales, Inc. (Nicholasville
Auto), for their son for $3,430. Petitioner wife tendered two
checks to Nicholasville Auto in partial payment for the car,
check No. 1080 for $100 and check No. 1087 for $1,100, from a
checking account with Bank One, Kentucky, N.A. (Bank One).
Petitioner husband had visited Nicholasville Auto on multiple
occasions to search for a used car for his son. On one visit to
the dealership petitioner husband attempted to test drive the Geo
1
Unless otherwise indicated, all section references are to
the Internal Revenue Code.
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Storm, but it was not running. Petitioner husband returned to
the dealership, and a salesman informed him that the car had been
repaired. Petitioner husband test drove the car around the lot,
found that it was working, and decided to purchase the car.
Unfortunately, the car broke down within minutes of leaving
Nicholasville Auto, approximately 7 miles from the dealership.
Petitioners had the car repaired at a cost of $479.78.
Petitioners attempted to contact Nicholasville Auto about the Geo
Storm. However, their calls were ignored, placed on hold for
long periods of time, and not returned.
Because of their dissatisfaction with the car, petitioner
wife contacted Bank One to place a stop payment order on the
$1,100 check. The stop payment order indicated “dissatisfied
purchase” as the reason for the stop payment order. After the
stop payment order, Bank One incorrectly stamped the check “NSF”
for insufficient funds and returned the check to Nicholasville
Auto. On February 4, 1997, Nicholasville Auto filed a criminal
complaint against petitioner wife for issuing and passing a
worthless check in the amount of $1,100. At approximately 6 p.m.
on February 23, 1997, officers of the Fayette County Sheriff’s
Department arrested petitioner wife at her home in the presence
of her husband, her daughter, and a family friend. Petitioner
wife was taken to the Fayette County Detention Center. She was
handcuffed, photographed, and confined to a holding area. At
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approximately 11 p.m., petitioner wife was handcuffed and
transferred to the Jessamine County Jail, where she was searched
via pat-down and with the use of an electric wand. She was
required to undress to her undergarments, remove her brassiere in
the presence of police officers, and wear an orange jumpsuit.
Petitioner wife was released on bail at approximately 2 a.m. on
February 24, 1997. On April 23, 1997, petitioner wife was
indicted for “theft by deception over $300.00” as a result of the
returned check marked for insufficient funds. These charges were
subsequently dropped.
Petitioner wife did not suffer any physical injury as a
result of her arrest and detention, except that she was
physically restrained against her will and subjected to police
arrest procedures. Petitioner wife has stated that she was not
grabbed, jerked around, bruised, or physically harmed as a result
of her arrest or detention. Petitioner wife visited a
psychologist approximately eight times over 2 months as a result
of this incident. The costs of these visits were covered by
petitioner wife’s insurance and employer. She did not have any
out-of-pocket medical expenses for physical injury or mental
distress suffered as a result of her arrest and detention.
On August 25, 1999, petitioner wife filed a complaint
against (1) J.R. Maze, the sole owner of Nicholasville Auto; (2)
Nicholasville Auto; and (3) Bank One. On July 5, 2000, she filed
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a first amended complaint. She alleged that Bank One breached a
fiduciary duty of care owed to her by improperly and negligently
marking check No. 1087 “NSF” for insufficient funds. The first
amended complaint alleges damages against Bank One as follows:
including, but not limited to, nominal damages,
compensatory damages and special damages, including,
but not limited to, attorney’s fees to defend, lost
time and earnings, mortification and humiliation,
inconvenience, damage to reputation, emotional
distress, mental anguish, and loss of consortium.
As against J.R. Maze and Nicholasville Auto, the first
amended complaint seeks the above damages in addition to punitive
damages for their actions relating to alleged fraudulent
misrepresentations relating to the condition of the Geo Storm and
filing the criminal case against petitioner wife. The first
amended complaint bases its claim for damages against J.R. Maze
and Nicholasville Auto on the following counts: Malicious
prosecution, abuse of process, false imprisonment, defamation,
and outrageous conduct. The first amended complaint repeats and
incorporates by reference these allegations with respect to Bank
One.
On March 7, 2002, petitioner wife entered into a mediation
agreement with Bank One, under which Bank One agreed to pay
petitioner wife the sum of $49,000 in settlement of the complaint
against it and to provide a letter of apology to petitioner wife.
Petitioner wife agreed to the dismissal of her complaint against
Bank One. On March 14, 2002, Bank One issued a check to
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petitioner wife for $49,000. On May 3, 2002, petitioner wife’s
complaint against Bank One was dismissed with prejudice pursuant
to an agreed order. Petitioner wife’s claims against J.R. Maze
and Nicholasville Auto had been dismissed with prejudice pursuant
to an agreed order entered on June 8, 2001. There is no
information in the record relating to the terms of the agreed
order dismissing the counts against Nicholasville Auto or J.R.
Maze.
During the mediation discussions, petitioner wife’s attorney
informed petitioners that the settlement proceeds would not be
taxed. The mediator and the attorney for Bank One also stated
that the settlement proceeds would not be subject to Federal
income tax. Petitioner husband prepared petitioners’ 2002 Form
1040, U.S. Individual Income Tax Return, as he had done for over
40 years, using a commercial tax software program. Petitioner
husband understood that settlement proceeds were not taxable and
was not aware that a distinction was made for tax purposes for
different types of settlements. Petitioners did not obtain any
professional tax advice beyond the statements made by their
attorney, the mediator, and the attorney for Bank One regarding
whether or not the settlement proceeds were taxable. Petitioner
wife received Form 1099-MISC, Miscellaneous Income, from Bank One
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reporting the payment of the $49,000 settlement for the 2002 tax
year. Petitioners did not report the settlement proceeds on
their 2002 tax return.
Respondent issued a notice of deficiency to petitioners on
March 14, 2005, determining that for their 2002 tax year
petitioners were liable for a tax deficiency of $13,119 and an
accuracy-related penalty under section 6662(a) of $2,624.
OPINION
I. Settlement Proceeds
The issue for decision requires an analysis of whether the
settlement proceeds petitioner wife received qualify for the
statutory exclusion from gross income under section 104(a)(2).
Except as otherwise specifically provided, gross income includes
“all income from whatever source derived”. Sec. 61(a). Section
61(a) is broadly construed; conversely, statutory exclusions from
income, such as section 104(a)(2), are narrowly construed.
Commissioner v. Schleier, 515 U.S. 323, 327 (1995).
Section 104(a)(2) excludes from gross income damages
received on account of personal physical injury or physical
sickness. In order to qualify for income exclusion under section
104(a)(2), taxpayers must satisfy a two-prong test: (1) The
underlying cause of action giving rise to the settlement award
must be based upon tort or tort type rights, and (2) the damages
must be received on account of personal physical injuries or
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physical sickness. Sec. 104(a)(2); Commissioner v. Schleier,
supra at 336-337; sec. 1.104-1(c), Income Tax Regs. The Small
Business Job Protection Act of 1996, Pub. L. 104-188, sec. 1605,
110 Stat. 1838, amended section 104(a)(2) to require that
personal injuries or sickness be physical for the taxpayer to
qualify for the section 104(a)(2) income exclusion. For purposes
of section 104(a)(2), emotional distress is not treated as a
physical injury or physical sickness, except for damages not in
excess of the cost of medical care attributable to emotional
distress. Sec. 104(a) (flush language). Damages received in
settlement of economic rights arising out of a contract are not
excludable under section 104(a)(2). Robinson v. Commissioner,
102 T.C. 116, 126 (1994), affd. in part and revd. in part on
another issue 70 F.3d 34 (5th Cir. 1995); Stocks v. Commissioner,
98 T.C. 1, 9 (1992). The parties dispute whether the settlement
proceeds satisfy either prong of this two-part test.
Where damages are received pursuant to a settlement
agreement, the tax consequences of the settlement depend on the
nature of the claim that was the basis for the settlement, rather
than the validity of the claim. United States v. Burke, 504 U.S.
229, 239 (1992); Robinson v. Commissioner, supra at 126. The
determination of the nature of the underlying claim is a factual
one and is generally made by reference to the settlement
agreement considered in the light of the facts and circumstances
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surrounding the settlement. Robinson v. Commissioner, supra at
126; Knoll v. Commissioner, T.C. Memo. 2003-277. When the
settlement agreement allocates the damage award to the underlying
claims, that allocation is generally binding for tax purposes to
the extent the parties entered into the agreement in an
adversarial context, at arm’s length, and in good faith.
Threlkeld v. Commissioner, 87 T.C. 1294, 1306-1307 (1986), affd.
848 F.2d 81 (6th Cir. 1988). When the settlement agreement lacks
express language that identifies the basis for the settlement
award, the Court considers the details surrounding the underlying
proceedings, the allegations in the complaint, the arguments made
by the parties, and the settlement discussions between the
parties. Robinson v. Commissioner, supra at 127; Threlkeld v.
Commissioner, supra. The most important factor in determining
the nature of the claim is the intent of the payor in making the
payment. Stocks v. Commissioner, supra at 10.
A. The Nature of Petitioner Wife’s Claims
The first requirement for the section 104(a)(2) income
exclusion is the existence of a claim based upon tort or tort
type rights. The term “tort” has been defined broadly as “A
civil wrong, other than breach of contract, for which a remedy
may be obtained, usu. in the form of damages” or “a breach of a
duty that the law imposes on persons who stand in a particular
relation to one another.” Black’s Law Dictionary 1526 (8th ed.
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2004). The limitation of the exclusion to claims arising in tort
or tort type rights necessitates a consideration of State law.
Threlkeld v. Commissioner, supra at 1305-1306. State law
determines whether the nature of the legal claim is a tort or
tort type right, and Federal law controls the Federal tax
consequences. Bland v. Commissioner, T.C. Memo. 2000-98.
The parties disagree as to what legal claims petitioner wife
asserted against Bank One and whether the asserted claims were
based on tort or tort type rights. The mediation agreement did
not state the basis for the award or allocate the award in any
way. The record does not contain any information concerning the
mediation process to assist us in determining the basis of the
mediation award. Rather, the parties focus on petitioner wife’s
allegations in her complaint. Respondent contends that the only
claim that petitioner wife asserted against Bank One was for
breach of a fiduciary duty of care based on its erroneous marking
of the $1,100 check for insufficient funds. Petitioners contend
that the settlement proceeds were paid on account of petitioner
wife’s physical restraint and detention, which constituted the
tort of false imprisonment.
As respondent points out, petitioner wife asserted only one
count against Bank One alone. However, petitioner wife asserted
numerous counts against codefendants J.R. Maze and Nicholasville
Auto, including false imprisonment, malicious prosecution, abuse
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of process, and defamation. The first amended complaint
specifically repeats and incorporates by reference each of these
counts against Bank One. This incorporation by reference is
sufficient for us to find that petitioner wife alleged a claim of
false imprisonment against Bank One.
Although petitioners rely heavily on the false imprisonment
claim to support the applicability of section 104(a)(2),
petitioner wife also alleged the torts of negligence and breach
of fiduciary duty against Bank One. Respondent characterizes
those claims as based on contract under State law, citing Bank of
Louisville Royal v. Sims, 435 S.W.2d 57, 58 (Ky. Ct. App. 1968).
However, it is not as clear as respondent would have us believe
that a lawsuit arising from a bank and customer relationship is
based on contract alone. The Kentucky banking statute recognizes
elements of both contract and tort in the bank-depositor
relationship. See Bullitt County Bank v. Publishers Printing
Co., 684 S.W.2d 289, 291-292 (Ky. Ct. App. 1984). The banking
statute imposes a duty on banks to exercise good faith and
ordinary care in handling customer accounts, a duty which
inherently incorporates common law rules of negligence. Pulliam
v. Pulliam, 738 S.W.2d 846, 849 (Ky. Ct. App. 1987). The remedy
for a breach of a duty imposed by law is not necessarily confined
to a contract claim. Am. Natl. Bank v. Morey, 69 S.W. 759, 760
(Ky. Ct. App. 1902). Specifically, Morey recognizes that a bank
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customer may have a tort claim for a wrongful dishonor of a
check. Id. Negligence in the performance of a contract can give
rise to a tort where the negligence breached a duty owed by the
defendant independent of the contract. Mims v. W.-S. Agency,
Inc., 226 S.W.3d 833, 836 (Ky. Ct. App. 2007). Petitioner wife
had a right under the State banking statute to stop payment on
the check. See Ky. Rev. Stat. Ann. sec. 355.4-403(1) (LexisNexis
2008). Thus, Bank One owed petitioner wife certain duties
imposed under the State banking statute. Negligence in the
performance of those duties could give rise to a tort claim
sufficient to satisfy the first prong of the section 104(a)(2)
income exclusion.
Respondent contends that Bank One’s liability to petitioner
wife is based on Ky. Rev. Stat. Ann. sec. 355.4-402 (LexisNexis
2008). That section provides a cause of action by a customer
against a bank that wrongfully dishonors the customer’s check.
The statute does not specify a theory for a bank’s liability for
wrongful dishonor. See also U.C.C. sec. 4-402, Official Comment
2 (2008) (recognizing dishonor may be based on contract, tort, or
both). Courts have recognized that a depositor’s claim for
wrongful dishonor of a check may give rise to a cause of action
in contract or tort, or both. Schwartz, Annotation, “Liability
of Bank to Depositor for Dishonoring a Check”, 126 A.L.R. 206
(1940). Thus, this statute does not provide conclusive support
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for respondent’s characterization of petitioner wife’s complaint
against Bank One as a contract claim. Moreover, neither the
complaint nor the first amended complaint cites this statute as
the basis for petitioner wife’s cause of action against Bank One.
Wrongful dishonor occurs when a bank refuses to pay a check drawn
upon it by a customer with sufficient funds to cover the check.
By placing a stop payment order, petitioner wife asked Bank One
not to honor the $1,100 check. The similarity between Bank One’s
failure to adhere to the stop payment order and a wrongful
dishonor is that Bank One’s mistake exposed petitioner wife to
arrest and prosecution. Ky. Rev. Stat. Ann. sec. 355.4-402
specifically recognizes that a wrongful dishonor may proximately
cause the customer’s arrest, which is a reasonably foreseeable
consequence of the wrongful dishonor. Thus, it recognizes that
while Bank One may not have initiated the criminal action against
petitioner wife, its handling of the $1,100 check may have
proximately caused her arrest.
It is incorrect to characterize petitioner wife’s complaint
against Bank One as a contract claim or merely a dispute over the
wrongful dishonor of a check. Rather, petitioner wife decided to
sue Bank One because of the ordeal she suffered as a result of
her arrest and detention. Petitioner wife did not suffer an
economic loss from Bank One’s alleged mishandling of her check.
She did not sue Bank One to recover on economic rights arising
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from a contract with Bank One. Petitioner wife sought damages
against Bank One that resulted from her arrest, detention, and
indictment. She alleged damages associated with tort type
rights: Emotional distress, mental anguish, mortification,
humiliation, and damage to reputation. Although Bank One did not
initiate the criminal proceedings against petitioner wife, the
erroneous marking of the check for insufficient funds
precipitated the arrest. Bank One entered into the settlement
agreement with an intent to resolve claims for tort type rights.
Accordingly, we find that petitioner wife received the settlement
for claims based on tort or tort type rights.
B. Physical Injury or Physical Sickness
The second requirement for income exclusion under section
104(a)(2) is that the settlement proceeds be paid on account of
physical injury or physical sickness. Congress amended section
104(a)(2) in 1996 to distinguish between physical injuries and
nonphysical injuries and specifically limited the availability of
the section 104(a)(2) income exclusion to physical injuries for
payments made after August 20, 1996. The amendment overruled
court decisions that exempted payments for nonphysical injuries
from gross income. H. Conf. Rept. 104-737, at 301 (1996), 1996-3
C.B. 741, 1041. Before the 1996 amendment, the Court of Appeals
for the Sixth Circuit, to which this case is appealable, held
that damages received on account of a personal nonphysical injury
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were excludable under section 104(a)(2). See Threlkeld v.
Commissioner, 848 F.2d 81 (6th Cir. 1988). The terms “physical
injuries” and “physical sickness” do not include emotional
distress, except for damages not in excess of the cost of medical
care attributable to emotional distress. Sec. 104(a) (flush
language).
Petitioner wife has admitted that she did not suffer
physical harm during the course of her arrest and detention. She
was not grabbed, jerked around, or bruised. Rather, petitioners
argue that physical restraint and detention constitute a physical
injury for purposes of section 104(a)(2). Petitioners contend
that a person does not have to be cut or bruised for physical
injury to occur under tort law.
Physical restraint and physical detention are not “physical
injuries” for purposes of section 104(a)(2). Being subjected to
police arrest procedures may cause physical discomfort. However,
being handcuffed or searched is not a physical injury for
purposes of section 104(a)(2). Nor is the deprivation of
personal freedom a physical injury for purposes of section
104(a)(2). Physical injury is not required for the tort of false
imprisonment to occur. Kentucky courts define false imprisonment
as “any deprivation of the liberty of one person by another or
detention for however short a time without such person’s consent
and against his will, whether done by actual violence, threats or
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otherwise.” Grayson Variety Store, Inc. v. Shaffer, 402 S.W.2d
424, 425 (Ky. Ct. App. 1966). The tort of false imprisonment
protects personal interest in freedom from physical restraint;
such an interest is “in a sense a mental one”. Banks v. Fritsch,
39 S.W.3d 474, 479-480 (Ky. Ct. App. 2001). Injury from false
imprisonment is “in large part a mental one” where the plaintiff
can recover for mental suffering and humiliation. Id. at 479.
The alleged false imprisonment against petitioner wife did not
cause her to suffer physical injury as required for relief under
section 104(a)(2).
It seems likely, as petitioners contend, that Bank One
agreed to pay the $49,000 settlement to compensate for the ordeal
that petitioner wife suffered as a result of her arrest,
detention, and indictment. The damages sought by petitioner wife
against Bank One are stated in terms of recovery for nonphysical
personal injuries: Emotional distress, mortification,
humiliation, mental anguish, and damage to reputation. These
types of injuries are not excludable under section 104(a)(2).
See Sanford v. Commissioner, T.C. Memo. 2008-158 (settlement
award for emotional distress relating to sexual harassment and
discrimination claims is not excludable); Polone v. Commissioner,
T.C. Memo. 2003-339 (settlement award for defamation claim is not
excludable), affd. 505 F.3d 966 (9th Cir. 2007); Venable v.
Commissioner, T.C. Memo. 2003-240 (settlement payment for mental
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anguish and loss of reputation relating to malicious prosecution
claim is not excludable), affd. 110 Fed. Appx. 421 (5th Cir.
2004). Petitioner wife did not experience a “physical injury” as
required for relief under section 104(a)(2). For this reason,
the settlement proceeds were not excludable from income under
section 104(a)(2).
C. Sixteenth Amendment and Section 61(a) Arguments
In the alternative, petitioners argue that settlement
proceeds for personal injuries are not gross income within the
meaning of section 61(a) where (A) the settlement was not paid
for lost earnings and (B) petitioners were not enriched by the
settlement. Petitioners further argue that section 104(a)(2)
conflicts with section 61(a) and violates the Sixteenth Amendment
to the extent that it taxes compensatory damages received for
personal injuries.
Petitioners’ arguments are similar to those previously
rejected. See Murphy v. IRS, 493 F.3d 170, 179-180 (D.C. Cir.
2007); Ballmer v. Commissioner, T.C. Memo. 2007-295. Gross
income includes “all economic gains not otherwise exempted.”
Commissioner v. Banks, 543 U.S. 426, 433 (2005). Thus,
petitioner wife’s settlement award for personal injury is gross
income under section 61(a). Section 104(a)(2) does not conflict
with section 61(a) by subjecting damage awards for nonphysical
personal injury to tax. As this Court has explained in Ballmer,
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for the flush language of section 104(a) to make sense (defining
emotional distress as a nonphysical injury), the definition of
gross income in section 61(a) must first include damages for
nonphysical injuries. Section 104(a)(2) does not conflict with
section 61(a).
Moreover, petitioners’ argument with respect to the
unconstitutionality of section 104(a)(2) is without merit. See
Murphy v. IRS, supra at 186; Ballmer v. Commissioner, supra. In
Murphy, the Court of Appeals examined at length the
constitutionality of taxing damage awards for nonphysical
personal injuries. The court held that the taxation of awards
received for personal, nonphysical injury was within the power of
Congress and that such a tax was not subject to the apportionment
requirement and was uniform. We see no reason to revisit this
issue here. See Hawkins v. Commissioner, T.C. Memo. 2007-286.
II. Section 6662 Penalty
Respondent determined that petitioners are liable for an
accuracy-related penalty under section 6662 for substantial
understatement of income tax for the 2002 tax year. Section
6662(a) and (b)(2) imposes a 20-percent penalty on an
underpayment of tax that results from a substantial
understatement of income tax. An understatement is substantial
if it exceeds the greater of 10 percent of the tax required to be
shown on the return, or $5,000. Sec. 6662(d)(1)(A).
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The section 6662 penalty is inapplicable to the extent the
taxpayer had reasonable cause for the understatement and acted in
good faith. Sec. 6664(c)(1). The determination of whether the
taxpayer acted with reasonable cause and in good faith is made on
a case-by-case basis, taking into account the relevant facts and
circumstances. Sec. 1.6664-4(b)(1), Income Tax Regs.
“Circumstances that may indicate reasonable cause and good faith
include an honest misunderstanding of fact or law that is
reasonable in the light of all the facts and circumstances,
including the experience, knowledge, and education of the
taxpayer.” Id. Generally, the most important factor is the
extent of the taxpayer’s efforts to assess the proper tax
liability. Id. An honest misunderstanding of fact or law that
is reasonable in the light of the experience, knowledge, and
education of the taxpayer may indicate reasonable cause and good
faith. Remy v. Commissioner, T.C. Memo. 1997-72.
Petitioners relied on statements made by their attorney, Bank
One’s attorney, and the mediator during the course of the
mediation conference that the settlement award would not be
subject to Federal income tax. The mediation agreement did not
contain any statements with respect to the tax treatment of the
settlement. Petitioners did not seek additional advice regarding
the proper tax treatment of the settlement after receiving the
Form 1099-MISC from Bank One reporting the $49,000 settlement
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award. Petitioners received unsolicited advice from three
separate and independent individuals that the settlement would
not be taxed. At least two of those individuals were
disinterested parties with no relationship with petitioners.
This advice confirmed petitioners’ previous understanding of the
taxation of settlement awards. Although none of those
individuals had specialized knowledge in tax law, they were
experienced in personal injury lawsuits and settlements.
Petitioners acted reasonably and in good faith when following
their advice and preparing their own return as they have done for
over 40 years. We find that reasonable persons could disagree as
to whether additional advice was required in this instance. The
receipt of Form 1099 should not preclude a finding of reasonable
cause. See Kidd v. Commissioner, T.C. Memo. 2004-135; sec.
1.6662-3(b)(1)(i), Income Tax Regs. Accordingly, we find that
petitioners are not liable for the section 6662 penalty.
On the basis of the foregoing,
Decision will be entered
for respondent as to the
deficiency and for petitioners
as to the penalty.