                          T.C. Memo. 2006-13



                      UNITED STATES TAX COURT



         CHRISTINE KENTON & GREG BRADEN, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 5535-04.                Filed January 31, 2006.



     Edward T. Perry, for petitioners.

     Catherine G. Chang, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION

     SWIFT, Judge:   Respondent determined a deficiency in

petitioners’ 2001 Federal income tax and a penalty as follows:


               Deficiency       Sec. 6662(a) Penalty

                $32,804                $6,561
                               - 2 -
     Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the year in issue, and

all Rule references are to the Tax Court Rules of Practice and

Procedure.   All references to petitioner in the singular are to

petitioner Christine Kenton.

     The primary issue remaining for decision is whether

petitioner’s legal fees relating to an employment discrimination

lawsuit are deductible by petitioners on a Schedule A, Itemized

Deductions, or on a Schedule C, Profit or Loss From Business, of

petitioners’ 2001 joint Federal income tax return.   If deductible

on petitioners’ Schedule C, the deduction for the legal fees

would avoid being reduced by the pernicious alternative minimum

tax (AMT) and by the 2-percent floor generally applicable to

miscellaneous itemized deductions.


                         FINDINGS OF FACT

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

     At the time the petition was filed, petitioners resided in

Covelo, California.

     Beginning in the fall of 1995, petitioner was employed for

2 years by a television production company (Company).   On or

about January 23, 1998, petitioner was terminated by the Company.

     On May 28, 1998, petitioner entered into a contingent fee

agreement with an attorney under which petitioner was obligated

to pay the attorney 40 percent of amounts recovered in connection
                               - 3 -
with a lawsuit to be filed against the Company relating to

petitioner’s termination.

     On January 21, 1999, petitioner’s lawsuit was filed against

the Company in the Superior Court of the State of California,

seeking compensatory damages for wrongful termination, for

discrimination, and for intentional infliction of emotional

distress and seeking punitive damages.

     On December 27, 2000, after binding arbitration in the

lawsuit, $756,392 in damages was awarded to petitioner,

consisting of $284,367 for backpay, $322,025 for frontpay, and

$150,000 for emotional distress.   Petitioner was not awarded

punitive damages.

     On March 15, 2001, petitioner and the Company agreed that

the Company would pay petitioner the $756,392 arbitration award

in installments over a period of 3 years.

     During 2001, the Company, as installment payments on the

damage award, issued checks in favor of petitioner in the total

amount of $148,744 and mailed the checks to petitioner’s

attorney.   After subtracting therefrom $59,498 for legal fees, in

2001 petitioner’s attorney transferred to petitioner a net of

$89,246.

     In early 2002, on a 2001 Form 1099-MISC, Miscellaneous

Income, the Company reported to petitioner and to respondent that
                                 - 4 -
the Company had paid petitioner in 2001 the above $148,744 as

nonemployee compensation.

     On April 3, 2002, petitioners signed and filed with

respondent their 2001 joint Federal income tax return on which

petitioners reported no income and no legal fees with respect to

petitioner’s employment discrimination lawsuit and the

arbitration award.

     On October 6, 2003, respondent mailed to petitioners a 30-

day letter proposing to include in petitioners’ income for 2001

the $148,744 reflected by the payments made by the Company in

2001 on the arbitration award.    Also, in the 30-day letter,

respondent, apparently for lack of substantiation, proposed to

deny petitioners any deduction for legal fees relating to the

arbitration award.

     On February 2, 2004, respondent mailed to petitioners a

notice of deficiency in which respondent treated as petitioner’s

“other income,” not as Schedule C income, the $148,744 the

Company paid in 2001 on the arbitration award and in which

respondent, for apparent lack of substantiation, did not allow

any deduction for legal fees relating to the arbitration award.

     On February 3, 2004, petitioners signed and filed with

respondent an amended joint Federal income tax return for 2001 on

which petitioners reported as income on a Schedule C the $148,744
                               - 5 -
paid on the arbitration award in 2001.   Petitioners do not now

contest that the $148,744 constitutes income to petitioner.

     Also, on the Schedule C to petitioners’ amended 2001 joint

Federal income tax return, petitioners claimed a business expense

deduction of $65,676 in legal fees relating to the lawsuit and

the arbitration award.

     Further, on petitioners’ amended 2001 joint Federal income

tax return, petitioners claimed additional itemized deductions in

the total amount of $8,520 relating to business use of

petitioners’ home, travel expenses, business expenses, real

estate taxes, and charitable contributions.

     Respondent now concedes that petitioner incurred $59,498 in

legal fees relating to the arbitration award, and respondent

would treat the $59,498 as miscellaneous itemized deductions, not

as Schedule C business expenses, and as subject to the AMT and to

the 2-percent floor.

     Respondent also determined against petitioner an accuracy-

related penalty of $6,561.1


                              OPINION

     Generally, legal fees are deductible on a Schedule C only if

the matter with respect to which the fees were incurred



     1
        The tax treatment by petitioners and by respondent of
portions of the $756,392 arbitration award which were paid by the
Company in 2002 and 2003 are not in issue in this case.
                               - 6 -
originated in the taxpayer’s trade or business and only if the

claim is sufficiently connected to that trade or business.   See

United States v. Gilmore, 372 U.S. 39 (1963); Biehl v.

Commissioner, 118 T.C. 467, 479 (2002), affd. 351 F.3d 982, 985

(9th Cir. 2003); Test v. Commissioner, T.C. Memo. 2000-362, affd.

49 Fed. Appx. 96 (9th Cir. 2002).

     Generally, expenses not incurred in a trade or business

activity but in the production or collection of income are

deductible only as miscellaneous itemized deductions on a

Schedule A.   Secs. 67(b), 212(1).

     Also, miscellaneous itemized deductions of individuals, as

defined by section 67(b), are not allowable for purposes of the

AMT and are subject to a 2-percent floor.   Secs. 56(b)(1)(A)(i),

67(a).

     In seeking to avoid application of the AMT and the 2-percent

floor to the 2001 legal fees relating to petitioner’s arbitration

award, petitioners argue that the $148,744 in income relating to

petitioner’s arbitration award should be treated as income from a

trade or business, reportable on petitioners’ Schedule C, and

therefore that the related legal fees also should be deductible

on the Schedule C and not be subject to the AMT and to the 2-

percent floor.

     It is well established, however, that, even though a

taxpayer’s employee status may be regarded as a trade or
                                - 7 -
business, legal fees stemming from a taxpayer’s employee status

are not deductible in computing adjusted gross income but are to

be treated only as miscellaneous itemized deductions, subject to

the AMT and to a 2-percent floor.    See sec. 62(a)(1); see also

McKay v. Commissioner, 102 T.C. 465, 493 (1994), revd. on other

grounds 84 F.3d 433 (5th Cir. 1996); Test v. Commissioner, supra;

Alexander v. Commissioner, T.C. Memo. 1995-51, affd. 72 F.3d 938

(1st Cir. 1995).

     It is undisputed that the origin of the claim with respect

to which the Company paid the $148,744 relating to the

arbitration award stemmed from petitioner’s status as an employee

of the Company.    Therefore, the related legal fees incurred by

petitioner are not deductible on petitioners’ Schedule C.

     We conclude that the legal fees of $59,498 petitioner paid

to her attorney relating to the arbitration award are deductible

only on petitioners’ Schedule A, are subject to the AMT, and are

subject to the 2-percent floor on miscellaneous itemized

deductions.2


     2
        We understand that the application of the alternative
minimum tax (AMT) and the 2-percent floor effectively will
eliminate most of the tax benefit of petitioners’ Schedule A
deduction for the legal fees. Sec. 56(b)(1)(A)(i). We also note
that, under the American Jobs Creation Act of 2004, Pub. L. 108-
357, sec. 703, 118 Stat. 1546, sec. 62(a) was amended, effective
Oct. 22, 2004, and legal fees relating to certain discrimination
lawsuits (including lawsuits similar to petitioner’s lawsuit
against the Company) paid after Oct. 22, 2004, with respect to
any judgment or settlement occurring after that date are allowed
                                                   (continued...)
                              - 8 -
     As indicated, petitioners also claim that petitioner paid a

total of $65,676, not $59,498, in legal fees to her attorney

relating to the arbitration award that should be deductible.

Respondent argues that petitioner has substantiated only $59,498

(resulting in a difference of $6,178).

     Generally, taxpayers bear the burden of proving that they

are entitled to deductions claimed.   See New Colonial Ice Co. v.

Helvering, 292 U.S. 435 (1934); Hradesky v. Commissioner, 65 T.C.

87, 90 (1975), affd. per curiam 540 F.2d 821 (5th Cir. 1976).

     Petitioners herein offered no credible evidence to

substantiate that the legal fees paid in 2001 relating to the

arbitration award exceeded $59,498.   The burden of proof with

respect to the additional $6,178 in legal fees is not shifted to

respondent and remains on petitioners.   Sec. 7491(a)(1) and (2);

Rule 142(a).

     Also, petitioners provided neither records nor any credible

evidence relating to the $8,250 in additional itemized deductions

claimed on their 2001 amended tax return.   The burden of proof

with respect thereto remains on petitioners.




     2
      (...continued)
as a deduction in computing adjusted gross income, with the
result that they are not subject to the AMT, and are not subject
to the 2-percent floor. Unfortunately for petitioners, however,
amended sec. 62(a) is not retroactive and does not apply to
petitioners’ 2001 Federal income tax. See Commissioner v. Banks,
543 U.S. 426, ___, 125 S. Ct. 826, 831 (2005).
                                - 9 -
     We sustain respondent’s disallowance of the $6,178 in

additional legal fees relating to the arbitration award and the

$8,520 in additional itemized deductions.

     Respondent has asserted against petitioners a substantial

understatement penalty with respect to the failure of petitioners

to report as income on their original 2001 joint Federal income

tax return the $148,744 that was paid on the arbitration award in

2001.

     Under section 6662, a substantial understatement of tax

exists if the amount of the understatement of income tax exceeds

the greater of:   (1) 10 percent of the tax required to be shown

on the return; or (2) $5,000.   Sec. 6662(d)(1)(A).

     Respondent has satisfied his burden of production under

section 7491(c) because respondent has shown that petitioners, on

their 2001 joint Federal income tax return, understated their tax

by more than 10 percent and by more than $5,000 by failing to

report the $148,744 arbitration award as income.

     Under sections 6662(d)(2)(B)(i) and 6664(c)(1), the amount

of a tax understatement may be reduced by the portion thereof

that is attributable to substantial authority or to reasonable

cause and good faith.

     Although petitioners now concede that the entire $148,744 is

includable in income, we find that petitioners had reasonable

cause for the treatment of the portion thereof (namely, $59,498)
                              - 10 -
that represents the contingent legal fees paid to petitioner’s

attorney.   In Commissioner v. Banks, 543 U.S. 426 (2005), the

Supreme Court just recently concluded that legal fees incurred by

taxpayers under contingent fee agreements could not be excluded

from gross income.

     Also, in Test v. Commissioner, T.C. Memo. 2000-362, we

relieved a taxpayer of an accuracy-related penalty relating to

the taxpayer’s erroneous placement of legal costs on a Schedule

C, instead of on a Schedule A.

     On the facts of this case and in our discretion, we believe

it inappropriate to apply the section 6662(a) accuracy-related

penalty to the $59,498 portion of the arbitration award that was

used to pay legal fees.

     With regard to the accuracy-related penalty applicable to

the $89,246 balance of the arbitration award paid by the Company

in 2001 ($148,744 less $59,498 equals $89,246), petitioners claim

that an enrolled agent advised them in 2001 that the arbitration

award was not includable in their income.   Petitioners, however,

failed to call the enrolled agent as a witness.   See Hann v.

Venetian Blind Corp., 111 F.2d 455 (9th Cir. 1940); Wichita

Terminal Elevator v. Commissioner, 6 T.C. 1158, 1165 (1946),

affd. 162 F.2d 513 (10th Cir. 1947).

     Respondent’s imposition of the section 6662(a) accuracy-

related penalty with respect to the $89,246 portion of the

arbitration award in excess of the 2001 legal fees is sustained.
                              - 11 -
     Petitioners also argue that, for purposes of section

6662(a), any understatement of tax should be calculated with

respect to their amended tax return, not their original tax

return.   Under section 1.6664-2T(c)(2), Temporary Income Tax

Regs., 56 Fed. Reg. 67505 (Dec. 31, 1991), however, an amended

tax return can be used to determine a taxpayer’s underpayment for

purposes of section 6662(a) only if the amended return is filed

before the taxpayer is first contacted by respondent with respect

to the year involved.   As we have found, respondent contacted

petitioners no later than October 6, 2003, and petitioners did

not file their amended 2001 joint Federal income tax return until

February 3, 2004.

     We have considered all arguments made herein, and, to the

extent not addressed, we conclude that they are without merit or

are irrelevant.

     To reflect the foregoing,


                                       Decision will be entered

                                 under Rule 155.
