DocketNumber： Docket No. 18000-94.
Citation Numbers： 73 T.C.M. 2178, 1997 Tax Ct. Memo LEXIS 120, 1997 T.C. Memo. 113
Judges： FAY
Filed Date： 3/5/1997
Status： Non-Precedential
Modified Date： 4/18/2021
Decision will be entered under Rule 155.
P owned stock in Corp. A. Corp. A operated numerous restaurants under a franchise arrangement with Corp. B. P sued both Corp. A and Corp. B, alleging two contract claims and a tort claim. Corp. B and P entered into a settlement agreement, whereby Corp. B purchased P's stock in Corp. A and, in return, P released his claims against Corp. B. P used some of the proceeds received as a result of the agreement with Corp. B to settle a loan made to P by Bank X. The loan balance consisted of both principal and accrued interest. P also wrote off an investment in Company Y.
MEMORANDUM FINDINGS OF FACT AND OPINION
FAY,
| Penalty | ||||
| Year | Deficiency | Sec. 6663 1990 | $ 815,589 | $ 611,692 |
| 1991 | 1,069 | 802 |
All section references are to the Internal Revenue Code in effect for the taxable years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure, unless otherwise indicated.
A trial was held to resolve the following issues for decision:
(1) Whether any of the amount received from PepsiCo, Inc. (PepsiCo), on the sale of petitioner's *122 substantiated amounts included in the basis of his failed investment in a T.J. Cinnamons Bakery franchise. We hold that the amounts have not been substantiated.
(4) Whether petitioners are entitled to deduct the investment interest expense claimed on their 1990 Federal income tax return related to loans from the United Bank of Fort Collins (the bank). We hold that they are, in the amounts set out herein.
(5) Whether 1991 deductions claimed for attorney's fees have been substantiated by petitioners. We hold that the fees have not been substantiated.
(6) Whether petitioners are subject to the accuracy-related penalty under section 6662(a) in connection with the filing of their 1990 and 1991 Federal income tax returns. We hold that 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 the petition was filed, petitioners resided in Fort Collins, Colorado. At all times relevant, petitioners used the cash receipts and disbursements method of accounting.
In the *123 1960's and early 1970's, petitioner owned a number of Pizza Hut, Inc. (Pizza Hut), restaurants as a sole proprietor under a franchise arrangement between petitioner and Pizza Hut. In 1975, petitioner was approached by several other individual Pizza Hut franchisees who had formed a corporation called Pizza Management, Inc. (PMI). Petitioner transferred his restaurants to PMI in exchange for stock in the PMI corporation. Petitioner believed that PMI had a special contractual right to issue its shares to the public notwithstanding any terms or limitations of the Pizza Hut franchise agreements. As a result of petitioner's transferring his restaurants to PMI, petitioner received approximately 11 percent of the stock in PMI. By the mid-1980's, PMI was the franchisee of approximately 200 Pizza Hut restaurants.
In the spring of 1986, PMI developed plans for a public offering of PMI stock. Pizza Hut successfully prevented PMI from issuing shares in PMI to the public. Pizza Hut asserted that a public offering of PMI stock would violate the terms of the franchise agreements between Pizza Hut and PMI.
In May 1988, petitioner, as a shareholder of PMI, and his children, as shareholders of PMI, brought a civil action against PepsiCo, Pizza Hut, PMI, and other PMI shareholders. Petitioner alleged that he suffered damages as a result of Pizza Hut's refusal to allow the public offering to go forward. Specifically, petitioner made three claims against Pizza Hut and PepsiCo. First, petitioner alleged that PMI and PepsiCo had entered into agreements, after petitioner had transferred his sole proprietorship restaurants to PMI, which restricted PMI's right to "go public" and that the agreements between PepsiCo and PMI constituted a breach of obligations owed to petitioner as a third-party beneficiary under the original agreements between Pizza Hut and PMI. Second, petitioner *125 urged that Pizza Hut be estopped from claiming that the PMI shareholders' rights had been modified by the later agreements between PMI and PepsiCo. Finally, petitioner alleged that the conduct by Pizza Hut in preventing the public offering constituted a tortious interference with petitioner's contractual rights and prospective business advantages.
In 1990, petitioner and Lawrence F. Dickie, a representative of PepsiCo, entered into settlement negotiations, resulting in an agreement whereby PepsiCo would acquire all of petitioner's PMI stock, and petitioner would release his claims against PepsiCo and Pizza Hut. During these negotiations, petitioner and Mr. Dickie discussed the damages suffered by petitioner as a result of PepsiCo's actions, including the damage to his relationship with the bank and the harm to his business reputation through adverse publicity in the press. On March 28, 1990, in compliance with the settlement agreement, petitioner transferred 393,948 *126 petitioner $ 3,250,071. Of this amount, petitioner paid $ 300,000 to the attorneys handling the lawsuit against PepsiCo.
In preparing his 1990 Federal income tax return, petitioner allocated the $ 3,250,071 payment between two amounts. Petitioner treated $ 1,969,740 *127 of $ 1,469,309 in his PMI stock, consisting of the following: Original basis $ 200,000 Miscellaneous expenses 100,000 Received from children Travel expenses 5,797 Misc. legal fees 1,637 Legal fees paid 300,000 Contingent legal fees Total 1,469,309
The difference between $ 1,969,740 (amount received for shares of PMI stock) and $ 1,469,309 was reported in petitioner's 1990 Federal income tax return as a long-term capital gain of $ 500,431.
Respondent, in her notice of deficiency, determined that the $ 3,250,071 *128 received from PepsiCo was paid as consideration for petitioner's PMI stock, and no amounts were excludable under section 104(a)(2). Further, respondent limited petitioner's basis in the PMI stock to the $ 200,000 initially invested by petitioner.
Petitioner deducted $ 156,441 as investment interest expense in his 1990 Federal income tax return and reported $ 1,224,395 as an investment interest expense carryforward. These amounts related to petitioner's various loans from the bank.
Petitioner borrowed money from the bank on various dates throughout the 1980's. In return, petitioner executed promissory notes in favor of the bank, secured by petitioner's PMI stock and the assets of several other business ventures controlled by him. One of these entities operated a restaurant and was called Out of Bounds, Inc. Another entity was Noel Exploration, Inc., a corporation engaged in the oil and gas business. The bank used separate customer numbers for Noel Exploration, Inc. (Cust. No. 10408), Out of Bounds, Inc. (Cust. No. 10626), and petitioner (Cust. No. 10398). Typically, the loans from the bank were for terms of 1 year. At the end of the term, petitioner typically *129 rolled the outstanding principal and accrued interest into a new 1-year loan.
On December 3, 1984, the bank lent petitioner $ 549,312 from an unsecured line of credit (loan No. 10398/100160), On December 19, 1986, the bank lent petitioner $ 1,570,000 (loan No. 10398/111752). The bank applied $ 102,155 to pay off loan No. 10398/105886, the balance owed on the unsecured line of credit ($ 97,779 principal and $ 4,376 interest). *130 The bank applied $ 168,978 to pay off loan No. 10626/68956, an outstanding loan to Out of Bounds, Inc. The bank disbursed $ 30,000 to petitioner, and the bank charged petitioner $ 681 in fees. Finally, $ 1,154,545 was applied to pay off loan No. 10398/102971 ($ 1,107,123 for principal and $ 47,422 for interest). The remaining available balance of the note was to be used as a reserve for future interest accruals. On September 8, 1987, the bank renewed loan No. 10398/111752 in the amount of $ 1,750,000. The increase of $ 180,000 was designated to satisfy accrued interest. On August 15, 1988, the bank renewed loan No. 10398/111752, in the amount of $ 2 million with a maturity date of August 15, 1989. Again, the increase in the amount of the note represents accrued interest on the note. The note was secured by 160,000 shares of PMI stock. By August 23, 1989, the bank began demanding payment of the $ 2 million note of August 15, 1988. As of March 22, 1990, the amount due on the note was $ 2,204,210, inclusive of principal and interest. On March 28, 1990, petitioner and the bank entered into a settlement agreement. Pursuant to the agreement, petitioner agreed to pay the bank $ 1,800,000 *131 in full satisfaction of principal and interest due on loan No. 10398/111752. No amount was separately designated for principal or interest. As of March 28, 1990, the principal portion of the note was as follows: Principal balance from loan No. 10398/100160 $ 439,323 Amount advanced for Overland Trail property 650,000 Payoff of loan No. 10626/68956 168,978 Payoff of principal of loan No. 10398/105886 97,779 Funds advanced to petitioner 30,000 Loan fees 681 Total 1,386,761
Petitioner, in his 1990 Federal income tax return, deducted investment interest expense in the amount of $ 156,441. The T.J. Cinnamons Bakery Franchise
On November 30, 1987, petitioner entered into an agreement to purchase the assets of a T.J. Cinnamons Bakery franchise located in San Antonio, Texas. T.J. Cinnamons Bakery is a company that specializes in bakery products. Petitioner paid $ 60,000 to acquire the business and *132 assumed a note in the amount of $ 181,058.
Shortly after the transaction was consummated, petitioner discovered that the seller had given him inaccurate financial information and that the seller was unable to transfer certain business assets to petitioner. After petitioner initiated steps to rescind the transaction, the seller filed for bankruptcy. In 1990, the bankruptcy court discharged petitioner's claims against the seller. As a result of the bankruptcy court's decision, petitioner claimed a long-term capital loss of $ 357,356 in his 1990 Federal income tax return related to the T.J. Cinnamons Bakery franchise. The items that constitute the $ 357,356 were not separately identified in petitioner's Federal income tax return. Respondent limited the loss to petitioner's original basis of $ 241,058.
OPINION
Petitioner did not report $ 1,280,331 of the $ 3,250,071 received from PepsiCo as income on his 1990 Federal income tax return. Petitioner's C.P.A. advised him that the amount was excludable, pursuant to section 104(a)(2), as damages received on account of personal injuries. Respondent argues that petitioner has failed to establish that any portion *133 of the amount received is excludable under section 104(a)(2). We disagree with respondent.
Section 61 provides that "gross income means all income from whatever source derived". Sec. 61(a). Unless the Internal Revenue Code specifically provides otherwise, all accessions to wealth must be included in gross income.
Section 104(a)(2) provides an exclusion from income for "the amount of any damages received * * * on account of personal injuries or sickness". The term "damages" in section 104(a)(2) encompasses amounts received pursuant to settlement agreements.
The tax consequences of a settlement agreement depend on the nature of the litigation and on the origin of the claim but not on the validity of those claims. *134
In his 1990 Federal income tax return, petitioner allocated some of the proceeds received from PepsiCo to nontaxable amounts received in settlement of a lawsuit under section 104(a)(2). Petitioner, in connection with the transfer of PMI stock to PepsiCo, signed a release which discharged his claims against Pizza Hut and PepsiCo (release). The release states, in pertinent part: The undersigned, Wallace R. Noel, does hereby release and forever discharge Pizza Hut, Inc., PepsiCo, Inc., and all of their subsidiaries, divisions and related companies, and all of their employees, officers and agents, from any and all claims, actions, and causes of action, now existing or that may arise hereafter, known and unknown, and including, in particular but without limitation, all claims that have been asserted or that could be asserted in that certain action pending in Sedgwick County District Court, Sedgwick County, *135 Kansas, captioned: The undersigned agrees that, as a part of this Release, the referenced action, as it relates to Pizza Hut, Inc. and PepsiCo, Inc., shall be dismissed, with prejudice, forthwith and agrees further that he shall take whatever action is necessary to bring about such a dismissal. * * *
The release lacks any language concerning the amount of money petitioner received, if any, as consideration for signing this release. Further, the stock transfer agreement states: Upon delivery to me or my designee of (i) $ 3,250,071 in immediately available funds and (ii) your release of claims against me, I will transfer to Pizza Hut, Inc. (by delivery of the Shares and the Powers) good, valid and marketable title to all of the Shares * * *.
At trial, Mr. Dickie, PepsiCo's representative in the transaction, testified that the amount paid to petitioner was based solely on PepsiCo's valuation of the PMI corporation. *137 is not merely a general release of claims. Rather, the release specifically identifies petitioner's claims asserted against PepsiCo and Pizza Hut in the action pending in Sedgwick County District Court. Second, it is evident from the documents presented at trial that PepsiCo would not have purchased petitioner's stock in PMI without also receiving his release of claims. It is apparent that PepsiCo paid petitioner $ 3,250,071, both to purchase his stock and to settle his claims. Accordingly, we must allocate the $ 3,250,071 between the value of the stock in PMI and the value of settling petitioner's claims.
It would serve no purpose to delve into detailed discussions concerning the weight of specific testimony or the credibility of certain evidence. We make this allocation based on the totality of the evidence before the Court, while allowing for a certain amount of overstatement, or understatement, in the assertions contained in the testimony before us. See
To exclude under section 104(a)(2) the proceeds from the settlement of a claim, the claim (1) must be based on tortlike rights and (2) must be "on account of" personal injuries.
In his 1990 Federal income tax return, petitioner included the following amounts in the basis of his PMI stock: $ 100,000 of miscellaneous expenses, $ 5,797 in additional travel costs, $ 1,637 in miscellaneous legal fees, and $ 800,000 in legal costs related to the PepsiCo litigation ($ 300,000 actually paid and $ 500,000 in contingent fees; see
The Commissioner's determinations are presumed correct. Rule 142(a);
At trial, petitioner and his C.P.A. testified that the $ 100,000 in miscellaneous expenses and the $ 5,797 in travel expenses were paid by petitioner as a stockholder of PMI. However, petitioner did not produce any records at trial to substantiate these claimed expenses. A determination of basis is a factual one, for which the burden of proof rests with petitioner.
Petitioner argues on brief that $ 8,800 in accounting fees should be included in the basis of his PMI stock. *142
Petitioner paid $ 300,000 to his lawyers upon the settlement of claims against PepsiCo and increased the basis of his PMI stock. Again, respondent, in her notice of deficiency, allowed petitioner these fees as a miscellaneous itemized deduction. For the reasons set out below, we hold that $ 219,000 of these fees is a proper addition to the basis of petitioner's stock, $ 54,000 of the fees is deductible as a miscellaneous itemized deduction, and $ 27,000 of the fees is nondeductible. Section 265 precludes a deduction for legal expenses attributable to a class of income that is exempt from taxation. Expenses and amounts otherwise allowable which are directly *143 allocable to any class or classes of exempt income shall be allocated thereto; and expenses and amounts directly allocable to any class or classes of nonexempt income shall be allocated thereto. If an expense or amount otherwise allowable is indirectly allocable to both a class of nonexempt income and a class of exempt income, a reasonable proportion thereof determined in the light of all the facts and circumstances in each case shall be allocated to each.
Ordinarily, we allocate the legal expenses in the same proportion as the settlement payment. See
Next, we must decide whether the legal fees allocated to the sale of petitioner's stock, or $ 219,000, were properly added to the basis in petitioner's stock, as argued by petitioner, or whether the fees are deductible as miscellaneous itemized deductions, as respondent contends. In litigation involving the acquisition or disposition of capital assets, the origin and character of the claim control in deciding whether or not legal expenses should be capitalized.
Petitioner transferred his Pizza Hut franchises in exchange for PMI stock because he was under the impression that PMI possessed the right to issue its stock in a public offering without restrictions from Pizza Hut. When PepsiCo contested PMI's public offering, petitioner instituted *145 a lawsuit to enforce these rights. The litigation involved the transferability of PMI's stock, thereby implicating the "perfection of title" by petitioner, and the litigation culminated in the sale of the stock to PepsiCo. Thus, 73 percent of the legal expenses, or $ 219,000 of the $ 300,000 legal fees paid, was properly included in the basis of petitioner's stock and treated as an offset against the sale price. See
In addition to the $ 300,000 of legal fees paid to the attorneys, petitioner included $ 500,000 in the basis of his PMI stock. The $ 500,000 related to a contingent note, executed by petitioner, payable to the law firm involved in the litigation. Payment on the note was contingent upon any future awards from the PMI litigation.
Generally, a contingent liability may not be added to basis.
In his 1990 Federal income tax return, petitioner deducted $ 357,356 as a long-term capital loss from his failed investment in a T.J. Cinnamons Bakery franchise. On brief, however, petitioner argues that the basis of the franchise consisted of the following amounts:
| Cash paid by petitioner | $ 60,000 |
| Note assumed by petitioner | 181,058 |
| Capitalized expenses | 86,175 |
| Total | *147 327,233 |
Respondent contends that the basis is limited to the amount allowed in the notice of deficiency, $ 241,058, representing the cash paid and the note assumed by petitioner. Thus, the expenses of $ 86,175 remain in dispute. For the reasons set forth herein, we conclude that the basis is $ 241,058.
Petitioner included $ 86,175 of expenses in the basis of his T.J. Cinnamons Bakery investment. A taxpayer is responsible for maintaining sufficient records to substantiate the propriety of a deduction.
Respondent, in her notice of deficiency, disallowed petitioner's claimed investment interest expense deduction of $ 156,441 and determined that petitioner realized $ 404,210 of income from debt forgiveness. *149 On brief, respondent abandoned this argument because she calculated that the principal balance of petitioner's borrowings was something less than the $ 1,800,000 he ultimately paid to the bank. Respondent therefore concluded that the remaining balance of petitioner's payment represented interest accrued by the bank. Specifically, respondent determined that $ 1,386,761 of petitioner's $ 1,800,000 payment to the bank constituted payment of principal, and $ 413,239 related to interest. Respondent calculated the principal balance by tracing payments through the bank's "Loan Commitment" sheets to determine how the funds were actually disbursed. This analysis was detailed, credible, and persuasive.
Petitioner relies on "Interest Paid" statements he received from the bank to support his contention that more than $ 413,239 of the $ 1,800,000 payment to the bank related to interest. Included in these statements was a $ 71,321.97 amount of interest "paid" for 1990. However, a bank "Charge Off Authorization" form indicates that the $ 71,321.97 amount was actually written off by the bank. Therefore, the Court finds that the bank's "Interest Paid" statements do not reflect interest actually "paid" by petitioner. Petitioner failed to introduce any other evidence at trial concerning the principal balance on the notes *150 or the interest paid to the bank. Accordingly, we sustain respondent's determination that petitioner paid $ 413,239 in interest charges for 1990.
In her notice of deficiency, respondent disallowed $ 19,975 in legal expenses claimed as a deduction in 1991. Since petitioner failed to address this issue either at trial or in his brief, we treat this as a concession by petitioner and find for respondent.
In her notice of deficiency, respondent determined that petitioners were liable for penalties for fraud pursuant to section 6663. Prior to trial, respondent conceded that no amounts were due for fraud. In her answer to the petition, respondent asserted an accuracy-related penalty against petitioners pursuant to section 6662(a) for their 1990 and 1991 Federal income tax returns. Since the accuracy-related penalty was first raised in her answer to the petition, respondent has the burden of proof on this issue.
An accuracy-related penalty equaling 20 percent of the underpayment may be imposed for any one of five reasons. Sec. 6662(a). One such reason exists where the taxpayer is negligent in completing his return. Sec. 6662(b)(1). Negligence includes "any failure *151 to make a reasonable attempt to comply with the provisions" of the Internal Revenue Code. Sec. 6662(c). This Court has defined negligence as the "lack of due care or failure to do what a reasonable and ordinarily prudent person would do under the circumstances."
A taxpayer can avoid liability for the accuracy-related penalty if he engages a competent professional to prepare his return, and he reasonably relies on the advice of that professional.
Petitioner engaged Wayne Hoover, a C.P.A. with over 20 years of experience, to prepare his 1990 and 1991 Federal income tax returns. Petitioner was a longtime client of Mr. Hoover's and heavily relied on Mr. Hoover's advice. After discussing the facts with petitioner, Mr. Hoover advised petitioner to exclude income under section 104(a)(2) and include the contingent legal fees *152 in his PMI stock basis. Since the burden of proof is on respondent, she must prove that petitioner failed to provide relevant information to Mr. Hoover and that petitioner's reliance on Mr. Hoover was improper. Respondent has failed to meet this burden. The penalties for 1990 and 1991 are not sustained.
1. Prior to trial, respondent conceded that no amounts were due to fraud. In her answer to the petition, respondent asserted an accuracy-related penalty against petitioners pursuant to sec. 6662(a).↩
1. All references to petitioner are to Wallace R. Noel.↩
2. By the spring of 1986, PepsiCo had purchased all of the stock of Pizza Hut, and Pizza Hut became a wholly owned subsidiary of PepsiCo.↩
3. Petitioner owned 386,448 shares of Pizza Management, Inc. (PMI). Additionally, petitioner controlled 7,500 shares that were beneficially owned by his wife and children. The total of these two amounts constitutes the 393,948 shares transferred to PepsiCo, Inc. (PepsiCo).↩
4. Petitioner's allocation comports to the $ 5 per share book value reflected in the 1990 financial statements of PMI.↩
1. Petitioner, in his 1990 Federal income tax return, reduced his gain by $ 61,875, which represents the amount received which is attributable to his wife's and children's stock. Respondent concedes that this amount is not taxable to petitioner.↩
2. In his 1990 Federal income tax return, petitioner included $ 800,000 in contingent legal fees in the basis of his stock. In the brief, petitioners admit that this was in error, and that the contingent portion of the fees amounted to only $ 500,000; thus, the $ 300,000 actually paid by petitioner was reported twice on his Federal income tax return. Accordingly, we will discuss this issue using the $ 500,000 amount as conceded by petitioner.↩
5. The number preceding the slash identifies the customer, and the number following the slash identifies the specific loan.↩
6. The amount of the deduction was limited to petitioner's net investment income.↩
7. In his testimony Mr. Dickie explained that a retail food franchise is usually valued based on either a percentage of sales income or a multiplier of income before depreciation and taxes. According to Mr. Dickie, these methods were applied to PMI in order for PepsiCo to arrive at the $ 8.25 per share price paid by PepsiCo to petitioner.↩
8. When contracts are interfered with in a tortious manner, a litigant may recover damages for emotional distress.
9. Petitioner reported $ 1,637 of miscellaneous legal fees in the basis of his PMI stock. Respondent, in her notice of deficiency, allowed these expenses as miscellaneous itemized deductions. Petitioner, in his reply brief, agreed that these fees were properly accounted for in the notice of deficiency.↩
1. Petitioner's counsel, in his trial brief, admits that petitioner was not able to reconstruct the $ 357,356 amount reported in the 1990 Federal income tax return. Therefore, our discussion will focus on the $ 327,233 amount testified to by petitioner's accountant, Mr. Hoover.
10. The letter from petitioner's attorneys was sent to the sellers of the T.J. Cinnamons Bakery franchise. It was written as part of petitioner's attempts to rescind the transaction and recover his money.↩
11. Petitioner, in his 1990 Federal income tax return, reported $ 1,224,395 as investment interest expense carry forward. This amount was also disallowed by respondent in her notice of deficiency. This disallowance affected the deficiency determined for 1991. Petitioner concedes on brief that the 1990 Federal income tax return inaccurately reported interest accrued in prior years, because none of that interest was actually paid until 1990. Accordingly, the interest carried forward will consist only of the interest expense the Court determines has been "paid" in 1990 but not deducted by petitioner due to sec. 163(d) limitations.
Freytag v. Commissioner , 111 S. Ct. 2631 ( 1991 )
Commissioner v. Schleier , 115 S. Ct. 2159 ( 1995 )
Mason K. Knuckles and Bernice A. Knuckles v. Commissioner ... , 349 F.2d 610 ( 1965 )
Albany Car Wheel Company, Inc. v. Commissioner of Internal ... , 333 F.2d 653 ( 1964 )
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Maxwell v. SOUTHWEST NAT. BANK, WICHITA, KAN. , 593 F. Supp. 250 ( 1984 )
Carlos and Jacqueline Marcello v. Commissioner of Internal ... , 380 F.2d 499 ( 1967 )
Dana A. Hinckley and Adelaide Hinckley v. Commissioner of ... , 410 F.2d 937 ( 1969 )
thomas-l-freytag-and-sharon-n-freytag-v-commissioner-of-internal , 904 F.2d 1011 ( 1990 )