Carranza v. Comm'r

T.C. Summary Opinion 2009-28
UNITED STATES TAX COURT
LUIS H. AND MARGARITA M. CARRANZA, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 7969-06S. Filed February 26, 2009.
Luis H. and Margarita M. Carranza, pro sese.
Jonathan H. Sloat, for respondent.
GERBER, Judge: This case was heard pursuant to the
provisions of section 74631 of the Internal Revenue Code in
effect when the petition was filed. Pursuant to section 7463(b),
the decision to be entered is not reviewable by any other court,
1
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for 2003, the taxable year
under consideration, and all Rule references are to the Tax Court
Rules of Practice and Procedure.
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and this opinion shall not be treated as precedent for any other
case.
Respondent determined a $19,714 income tax deficiency for
petitioners’ 2003 tax year and a $3,943 accuracy-related penalty
under section 6662(a). Respondent, pursuant to section 6214(a),
filed an answer and an amended answer in which he sought a
$15,503 increase in the income tax deficiency and a $3,100.40
increase in the accuracy-related penalty, for a total deficiency
of $35,217 and a total accuracy-related penalty of $7,043.40.
The initial income tax deficiency was based on petitioners’
failure to report, as income, Social Security benefits and
settlement proceeds of a wrongful termination action brought by
Luis Carranza. The increased deficiency also stems from the
settlement of the wrongful termination action. The questions
remaining for our consideration are whether any of the proceeds
of the wrongful termination action are includable in petitioners’
gross income and whether petitioners are liable for an accuracy-
related penalty.
Background
Petitioners resided in California at the time their petition
was filed. Luis H. and Margarita M. Carranza received Social
Security benefits of $13,710 and $12,294, respectively, for the
taxable year 2003 but failed to report these amounts as income on
their joint return for that year. Mr. Carranza worked for Spears
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Manufacturing Co. (Spears) as a foreman/supervisor 6 days a week
and 10 hours per day. Spears manufactured mainly plastic, but
also some brass, pipe fittings used for plumbing. Mr. Carranza
was in charge of Spears’s production operation, and these
responsibilities burdened him greatly and caused him to come home
exhausted. Spears’s employees worked three shifts, and Mr.
Carranza supervised the foremen of all three shifts. He was
often called at home to deal with problems that occurred during
the night shift. Mr. Carranza had worked for Spears for 25 years
and was well liked by the owner, Wayne Spears. The pressure of
his job led to anxiety and hypertension, which, in turn, may have
caused a central arterial occlusion and loss of sight in Mr.
Carranza’s left eye during 1999.
Sometime before 2000 Mr. Carranza developed a hematoma in
his leg which affected nerves and muscles so that it was
difficult for him to walk. In time his leg atrophied, and he
lost the ability to control it. He became unable to walk stairs
and to function effectively in his supervisory position at
Spears. On or about November 5, 2001, upon the advice of a
doctor, he was assigned lighter responsibilities at Spears. Mr.
Spears and others made demands on Mr. Carranza that were beyond
his lessened physical capabilities, expecting his performance to
be at the same level as before his physical problems. In
addition, comments were made about his lessened physical
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capabilities that caused him great humiliation. On April 29,
2002, he was dismissed from his position at Spears. His anxiety
became more severe after he was dismissed. Mr. Carranza was in
the care of three different psychiatrists and because of his
mental and physical condition was unable to obtain another job.
After Mr. Carranza was dismissed, Mrs. Carranza negotiated a
severance agreement with Spears under which he was paid $1,000
per week for 19 weeks. Around this time Mr. Carranza contacted
an attorney. On or about July 11, 2002, Mr. Carranza commenced
an action against Spears in Los Angeles County Superior Court.
The complaint sought damages for violations of the California
Fair Employment and Housing Act, including disability
discrimination, age discrimination, wrongful termination in
violation of public policy, and breach of implied contract due to
wrongful termination of employment.
In the complaint Mr. Carranza alleged that he was “disabled”
because of the medical conditions of vascular embolic disease,
hypertension, and glaucoma and that he had been suffering from
these conditions since June 1999. He also specifically alleged
he was disabled because of the hematoma in his left leg. Mr.
Carranza sought judgment against Spears for all medical expenses,
general damages for emotional distress and mental suffering,
exemplary and punitive damages, and attorney’s fees.
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Mr. Carranza also applied for disability payments from the
Social Security Administration, and on December 1, 2002, he was
advised of his entitlement to a monthly disability check. He
also filed a claim for workers compensation with the State of
California, which on August 9, 2005, resulted in a $49,000
settlement, with $45,000 being paid to him and a net recovery of
$38,250 after the payment of $6,750 in legal fees.
During 2003 the suit against Spears was settled for
$162,500. Of the $162,500, $97,500 was paid directly to Mr.
Carranza “for personal injury in the form of emotional distress
damages”. The remaining $65,000 was paid directly to his
attorney as “a payment for the attorney’s fees incurred on
* * * [Mr. Carranza’s] behalf”. The parties agreed that the
$97,500 “in settlement of claims for personal injury in the form
of emotional distress damages resulting from the conduct that is
the subject of tort or tort-like claims” was to be reported on a
Form 1099-MISC, Miscellaneous Income, but that no withholding tax
would be taken from the payment. With respect to the $65,000
paid to Mr. Carranza’s attorney, a Form 1099-MISC would be sent
only to the attorney. Of the $97,500 settlement amount, Mr.
Carranza received a net amount of $93,554.24 after reduction of
$3,945.76 for costs assessed against him.
Petitioners’ 2003 Form 1040, U.S. Individual Income Tax
Return, was prepared by a professional income tax return preparer
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(preparer) who had been preparing their income tax returns for a
few years before 2003. Petitioners provided the preparer with
the Form 1099-MISC and other information about the settlement of
the suit with Spears and with all of the medical records. The
preparer concluded that the $97,500 settlement amount Mr.
Carranza received was not includable in income, and petitioners
relied upon his judgment with respect to that decision.
Petitioners provided their preparer with information about the
receipt of Social Security payments during 2003, but no part of
it was reported on their tax return. Even if it had been, it
would not have been taxable according to the amount of income the
preparer reported on the return. Petitioners’ 2003 income tax
return did not include their Social Security payments, the
$97,500 settlement proceeds they received, or the $65,000 Mr.
Carranza’s attorney received.
Discussion
In general the Commissioner’s determination in a notice of
deficiency is presumed correct. Welch v. Helvering, 290 U.S.
111, 115 (1933). In pertinent part, Rule 142(a)(1) provides the
general rule that “The burden of proof shall be upon the
petitioner”. Petitioners bear the burden of showing the
settlement is not includable in income as respondent determined
it is. There is no dispute about the burden of proof or the
shifting of same under section 7491. Respondent bears the burden
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of proof with respect to the increased deficiency and the
increased accuracy-related penalty. See Rule 142(a)(1).
Respondent also bears the burden of production with respect to
the section 6662(a) accuracy-related penalty. See sec. 7491(c).
Petitioners have stipulated that they received Social
Security payments during 2003 that were not included in their
income on their return. Such payments have been held to be
taxable and are includable in income in an amount determined
under a statutory formula. Sec. 86(a), (b), and (c); see, e.g.,
Green v. Commissioner, T.C. Memo. 2007-217. The remaining issues
we consider are whether any portion of the settlement with Spears
is includable in petitioners’ 2003 income and whether they are
liable for an accuracy-related penalty with respect to any
portion of a resulting understatement.
Mr. Carranza became progressively unable to perform his
duties at Spears. His physical problems began during 1999 and
became progressively worse until his dismissal during 2003. He
also suffered emotionally because of his physical problems and
from humiliation experienced at Spears. Mr. Carranza sued Spears
and alleged that he was “disabled” because of the medical
conditions of vascular embolic disease, hypertension, hematoma in
his left leg, and glaucoma and that he had been suffering from
these conditions since June 1999. In the complaint Mr. Carranza
sought judgment against Spears for all medical expenses, general
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damages for emotional distress and mental suffering, exemplary
and punitive damages, and attorney’s fees.
Mr. Carranza and Spears settled the suit and entered into a
settlement agreement laying out the basis for the settlement.
Although Mrs. Carranza testified that Mr. Carranza’s settlement
and recovery from Spears were for physical injuries caused by his
working conditions, the settlement agreement unambiguously
attributed the settlement to his “personal injury in the form of
emotional distress damages resulting from conduct that is the
subject of tort or tort-like claims”. Section 104, as is
pertinent to this case, provides:
SEC. 104. COMPENSATION FOR INJURIES OR SICKNESS.
(a) In General.--Except in the case of amounts
attributable to (and not in excess of) deductions
allowed under section 213 (relating to medical, etc.,
expenses) for any prior taxable year, gross income does
not include–-
(1) amounts received under workmen's
compensation acts as compensation for personal
injuries or sickness;
(2) the amount of any damages (other than
punitive damages) received (whether by suit or
agreement and whether as lump sums or as periodic
payments) on account of personal physical injuries
or physical sickness;
Section 104(a)(2) makes it clear that for damages to be
excluded from gross income, they must be received “on account of
personal physical injuries or physical sickness”. Section 104(a)
also specifically provides that “For purposes of paragraph (2),
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emotional distress shall not be treated as a physical injury or
physical sickness.” The circumstances in this case are somewhat
convoluted because Mr. Carranza received Social Security benefits
because of physical disability. He also sought California
workers compensation and received a settlement for his physical
disability. With respect to his suit against Spears, however, he
did not seek damages for physical disability caused by his
working conditions. Instead, he sought damages for emotional
distress and mental suffering. Likewise, the settlement of the
litigation with Spears was for emotional distress damages.
In order for the Spears settlement proceeds to qualify for a
section 104(a)(2) exclusion, petitioners must show that: (1) The
underlying cause of action giving rise to the recovery was
“‘based upon tort or tort type rights’”; and (2) the “‘damages
were received * * * on account of personal [physical] injuries or
[physical] sickness.’” See Commissioner v. Schleier, 515 U.S.
323, 336-337 (1995) (adjusted to comport with subsequent
legislation) (quoting United States v. Burke, 504 U.S. 229, 234
(1992)).
There is no question about whether the damages were for
“tort or tort type rights”. The question we consider is whether
the damages were for a physical injury. When damages are paid
under a settlement agreement, courts generally first look to the
express language of the agreement. Rivera v. Baker West, Inc.,
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430 F.3d 1253, 1257 (9th Cir. 2005). Mr. Carranza’s agreement
with Spears expressly attributes the settlement to emotional
distress and mental suffering. Moreover, he did not allege in
his complaint initiating the settled litigation that Spears
employees or work conditions had caused him physical injury.
There is some evidence in this record that could support a
finding that his work conditions were a contributing factor to
some of his physical problems, but that was not the focus of the
litigation and, clearly not the purpose of the settlement. See
id. at 1257-1258. With such compelling and explicit language, we
cannot find otherwise. Accordingly, we find that Mr. Carranza’s
settlement with Spears was not for physical injury.
We now consider the portion of the settlement that
petitioners are required to include in income. The total
settlement, agreed to between Mr. Carranza and Spears, was
$162,500. The $162,500 constituted “the entire monetary
consideration provided to” Mr. Carranza, as agreed to by the
parties. Of that amount, $97,500 was paid directly to Mr.
Carranza for personal injury due to emotional distress, and a
Form 1099-MISC was issued to him for $97,500. The remaining
$65,000 was paid directly to Mr. Carranza’s attorney for his
services, and a Form 1099-MISC was issued to the attorney in that
amount. Accordingly, the parties intended by their settlement
that the attorney be accountable for the $65,000.
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Respondent, in the deficiency notice and on the basis of the
Form 1099-MISC, initially included only $97,500 in petitioners’
income for 2003. That adjustment, along with the unreported
Social Security benefits, was the basis for the $19,714 income
tax deficiency and the $3,943 accuracy-related penalty.
Respondent, by an answer and amended answer, sought a total
increase in the income tax deficiency of $15,503 and a total
increase in the accuracy-related penalty of $3,100.40. Those
increases are attributable to inclusion of the $65,000 in
petitioners’ gross income for 2003.2
Until 2005 there had been differing treatment by courts with
respect to the attorney’s fees portion of damage settlements
and/or litigation. Some courts treated the attorney’s fees
portion as the taxpayer’s income, even though paid directly to
the attorney. Others treated the attorney’s fees portion as not
includable in the taxpayer’s income. In Commissioner v. Banks,
543 U.S. 426 (2005), the Supreme Court resolved those differences
and held that the portion of the settlement paid to attorneys was
income to the taxpayer under the anticipatory assignment of
income doctrine established in Lucas v. Earl, 281 U.S. 111
(1930).
2
Respondent also allowed petitioners an offsetting
miscellaneous itemized deduction for the $65,000 attorney’s fees
subject to the 2-percent threshold and the alternative minimum
tax limitations on certain deductions, which are computational
issues. See secs. 56(b), 67.
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The increased income tax deficiency is based on both the
inclusion of the $65,000 paid directly to Mr. Carranza’s attorney
and the alternative minimum tax that is generated, in part, by
the attorney’s fees itemized deduction not being allowed for
computation of the alternative minimum tax. See, e.g., Benci-
Woodward v. Commissioner, 219 F.3d 941, 944 (9th Cir. 2000),
affg. T.C. Memo. 1998-395.
The facts of this case reflect that Mr. Carranza was
entitled to the entire $162,500 and that the $65,000 paid
directly to his attorney was money to which Mr. Carranza was
entitled under the settlement. Under these circumstances and
because of the current state of the law, petitioners are liable
for the determined income tax deficiency and an increased
deficiency in income tax based on the inclusion of the $65,000,
the deduction for attorney’s fees, and the application of the
alternative minimum tax provisions.
Respondent also determined a 20-percent accuracy-related
penalty under section 6662(a) on the entire underpayment of tax.
Respondent determined that petitioners are liable for the penalty
because they substantially understated their income tax within
the meaning of section 6662(b)(2) and (d)(1).
In order for the penalty to apply, the understatement must
exceed the greater of 10 percent of the tax required to be shown
on the income tax return or $5,000. Sec. 6662(d)(1)(A).
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Petitioners’ 2003 income tax return reported no (zero) income tax
liability. Accordingly, the understatement of tax decided in
this case is substantial.
An accuracy-related penalty is not imposed on any portion of
the understatement as to which the taxpayer acted with reasonable
cause and in good faith. Sec. 6664(c)(1). Reliance on the
advice of a tax professional may constitute reasonable cause and
good faith if under all the facts and circumstances the reliance
is reasonable and in good faith. Neonatology Associates, P.A. v.
Commissioner, 115 T.C. 43, 98 (2000), affd. 299 F.3d 221 (3d Cir.
2002); sec. 1.6664-4(c)(1), Income Tax Regs. To qualify for this
exception, a taxpayer must prove by a preponderance of the
evidence that: (1) The adviser was a competent professional who
had sufficient expertise to justify reliance, (2) the taxpayer
provided necessary and accurate information to the adviser, and
(3) the taxpayer actually relied in good faith on the adviser’s
judgment. Neonatology Associates, P.A. v. Commissioner, supra at
98-99.
Petitioners, who have no expertise in or understanding of
the tax laws, used and relied upon a professional preparer to
prepare their 2003 income tax return. They had used the same
preparer for prior years’ returns. The preparer was called by
respondent to testify at trial about the circumstances under
which he prepared petitioners’ income tax return. Considering
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Mrs. Carranza’s testimony and that of the preparer, we conclude
that he was a competent professional with sufficient expertise to
prepare petitioners’ tax return. We also conclude that the
preparer had accurate and sufficient information from which to
evaluate whether petitioners’ Social Security benefits and the
Spears settlement proceeds were includable in petitioners’ gross
income. Finally, we conclude, under the circumstances of this
case, that it was reasonable for petitioners to rely on their
preparer.
The evidence shows that Mr. Carranza was physically disabled
and unable to work. It also shows that he suffered anxiety and
severe mental distress. Mr. Carranza received Social Security
benefits because of his disability. Mrs. Carranza provided the
preparer with Mr. Carranza’s substantial medical records that
reflected a pattern of illness and physical conditions that could
have been related to his working conditions. The preparer’s
conclusion, which was based upon the information petitioners
provided, was that Mr. Carranza’s disability and hence the Spears
settlement were due to physical injury and that the settlement
proceeds were excludable from gross income under section 104.
The preparer reached this conclusion in view of a Form 1099-MISC
reflecting miscellaneous income of $97,500. We also note that
Mr. Carranza did not receive a Form 1099-MISC for the $65,000
paid to the attorney. As noted earlier in this opinion, there is
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a reasonable amount of evidence that could support the conclusion
that Mr. Carranza’s physical condition (injury) was work related.
With respect to the Social Security benefits, once the
preparer concluded that the $97,500 settlement Mr. Carranza
received was excluded from petitioners’ 2003 income, the Social
Security benefits would not have been includable in petitioners’
income. Although the preparer’s failure to report the benefits
does not strictly follow usual reporting protocol, it was
reasonable for petitioners, who were not versed in such matters,
to rely on the preparer’s judgment in the preparation of their
income tax return.
We therefore hold that petitioners are not liable for an
accuracy-related penalty under section 6662(a).
To reflect the foregoing,
Decision will be entered
under Rule 155.