                  T.C. Summary Opinion 2009-99



                      UNITED STATES TAX COURT



          PAUL J. AND ALLEN C. PRINSTER, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 15675-07S.             Filed June 30, 2009.



     Paul J. and Allen C. Prinster, pro sese.

     Michael W. Berwind, for respondent.



     GERBER, Judge:   This case was heard pursuant to the

provisions of section 7463 of the Internal Revenue Code in effect

when the petition was filed.1   Pursuant to section 7463(b), the

decision to be entered is not reviewable by any other court, and


     1
      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.
                                -2-

this opinion shall not be treated as precedent for any other

case.

     Respondent determined for 2005 an income tax deficiency of

$18,392 and an accuracy-related penalty under section 6662(a) of

$3,678.   At trial respondent moved to amend the pleadings in

order to seek a deficiency of $33,616 and a section 6662(a)

penalty of $6,723.20.   The issues for decision are:   (1) Whether

to grant respondent’s motion to amend the pleadings; (2) whether

payments that Paul Prinster (Mr. Prinster) and his attorney

received from his former employer are excludable from

petitioners’ gross income under section 104(a)(2); (3) whether

petitioners are entitled to deductions for travel, meals,

entertainment, and “listed property” expenses claimed on their

2005 return; and (4) whether petitioners are liable for the

section 6662(a) accuracy-related penalty.

                            Background

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

The stipulations of facts and the attached exhibits are

incorporated herein by this reference.   Petitioners resided in

California when they filed their petition.   Portions of the

record have been sealed at the request of petitioners.

     The controversy underlying this case involves the

termination of Mr. Prinster’s employment.    Mr. Prinster believed

the firing to be wrongful, and thereafter he suffered mental
                                -3-

distress.   He also experienced hyperlipidemia, hypertension, and

other ailments, which he believed to be caused by that mental

distress.   Petitioners hired an attorney, Mr. Lyon, who

represented Mr. Prinster in the controversy.    Mr. Lyon filed suit

against the employer.   The employer paid $76,500 to settle Mr.

Prinster’s claim in 2005.   At Mr. Prinster’s request, $28,716.50

of that amount was paid directly to Mr. Lyon.    The employer

accordingly issued Mr. Prinster and Mr. Lyon Forms 1099-MISC,

Miscellaneous Income, in the respective amounts paid to each of

them.   Mr. Prinster asked Mr. Lyon whether the settlement was

taxable and was advised that it was not because it was

attributable to personal injuries.

     Petitioners timely filed a joint Form 1040, U.S. Individual

Income Tax Return, for the 2005 tax year.   They did not report

any of the former employer’s payments as income.    They did report

$18,506 of income on Schedule C, Profit or Loss From Business,

from Mr. Prinster’s educational service business.    They also

claimed Schedule C expenses of $494 for meals and entertainment,

$4,245 for travel, $1,876 for vehicles/machinery/equipment, and

$13,975 for car and truck expenses.

     On April 26, 2007, respondent issued a notice of deficiency

in which he determined that petitioners had an income tax

deficiency of $18,392 for their 2005 tax year.    In calculating

the deficiency respondent assumed that the income petitioners
                                 -4-

reported on their Schedule C ($18,506) was attributable to the

payment from the former employer ($47,783.50) and thus mistakenly

believed that petitioners had underreported that payment by

$29,277.    Respondent disallowed petitioners’ Schedule C expenses

for lack of substantiation, and other items were disallowed as a

result of computational limitations.      Respondent also determined

a section 6662(a) accuracy-related penalty of $3,678.

      Petitioners filed a petition with the Court on July 11,

2007.    Respondent has conceded that petitioners have adequately

substantiated $960 of Schedule C rent or lease expenses.

However, during preparation for trial respondent discovered that

the $28,716.50 payment from the employer to Mr. Lyon was related

to the payment the employer made to Mr. Prinster.     Respondent

also learned that the $18,506 of Schedule C income petitioners

reported was not from Mr. Prinster’s former employer.     Respondent

subsequently moved to amend his answer to conform to the proof to

seek an increased deficiency and an increased penalty that

accounted for all of the payments from the employer.

                             Discussion

I.   Respondent’s Motion To Amend the Pleadings

      A party may amend a pleading only by leave of the Court, and

leave shall be given freely when justice so requires.     Rule

41(a).    When issues not raised by the pleadings are tried by

express or implied consent of the parties, the Court may allow
                               -5-

such amendment of the pleadings as necessary to cause them to

conform to the evidence presented at trial.    Rule 41(b)(2).

Prejudice to the other party is a key factor in deciding whether

to allow an amendment to the pleadings.    See Kroh v.

Commissioner, 98 T.C. 383, 389 (1992).

     Petitioners stipulated, for purposes of trial, that Mr.

Prinster’s former employer paid him a total of $76,500.2    At

trial respondent moved to amend the pleadings to conform with the

evidence regarding the payments.    Respondent seeks an increased

income tax deficiency and an increased section 6662(a) accuracy-

related penalty for petitioners’ 2005 tax year.

     The notice of deficiency placed petitioners on notice that

respondent considered the payments from the employer to be

includable in their gross income.    The extent of the payments,

including the payment to Mr. Prinster’s attorney, was known to

petitioners when respondent issued the notice of deficiency.     The

amendment to the pleadings does not cause prejudice to

petitioners because they knew the correct amount of those

payments and of the potential for tax liability.

     Accordingly, respondent’s motion to amend the pleadings will

be granted.




     2
      The stipulation renders moot respondent’s burden of proving
the increased deficiency under Rule 142(a).
                                  -6-

II.   Section 104(a)(2) Exclusion

      Section 104(a)(2) provides an exclusion from gross income

for damages received on account of personal physical injury or

physical sickness.    To qualify under section 104(a)(2), as

amended and in effect for amounts received after August 20, 1996,

taxpayers must show:    (1) The underlying cause of action was

based upon tort or tort type rights; and (2) the damages were

received on account of personal physical injuries or physical

sickness.    Commissioner v. Schleier, 515 U.S. 323, 336-337

(1995); sec. 1.104-1(c), Income Tax Regs.

      A.   Tort-Based Claim

      The section 104(a)(2) requirement that petitioners’ claim

arise from a tort or tort type rights obligates us to examine

State law, because State law determines the nature of the claim.

Venable v. Commissioner, T.C. Memo. 2003-240, affd. 110 Fed.

Appx. 421 (5th Cir. 2004).

      Under California law an employer’s right to fire an at-will

employee is limited by public policy considerations.     Tameny v.

Atl. Richfield Co., 610 P.2d 1330, 1332-1333 (Cal. 1980).      At-

will employees may recover tort damages from employers if they

can show they were discharged in contravention of fundamental

public policy.    Id. at 1336.   To prevail, employees must show

that important public constitutional or statutory interests were
                                  -7-

contravened.     Silo v. CHW Med. Found., 45 P.3d 1162, 1166 (Cal.

2002).

     Mr. Prinster did have a tort-based wrongful termination

claim against his employer.     He alleged his termination violated

the public policy concerning:     (1) Making false statements (False

Statements Accountability Act of 1996, 18 U.S.C. sec. 1001

(2006); Holmes v. Gen. Dynamics Corp., 22 Cal. Rptr. 2d 172 (Ct.

App. 1993)); (2) whistleblowing (Cal. Lab. Code secs. 98.6,

1102.5, and 1105 (West 2003 & Supp. 2009); Cal. Govt. Code secs.

8547.3, 8547.8, 19683 (West 2005 & Supp. 2009)); (3) refusal to

commit illegal acts (Cal. Lab. Code sec. 2856 (West 2003)).

     B.     Physical Injury or Physical Sickness

     For payments made after August 20, 1996, Congress amended

section 104(a)(2) to limit the exclusion to amounts received only

for physical injuries or physical illness.     Small Business Job

Protection Act of 1996, Pub. L. 104-188, sec. 1605, 110 Stat.

1838.     To determine whether the payment received was for a

physical injury or sickness, we must again examine the taxpayer’s

underlying claim.     Connolly v. Commissioner, T.C. Memo. 2007-98.

The determining factor is the payor’s intent or dominant reason

for making the payment.     Vincent v. Commissioner, T.C. Memo.

2005-95.     This is generally determined by reference to the stated

reasons for the payment and the accompanying factual setting.

Stocks v. Commissioner, 98 T.C. 1, 11 (1992); Knoll v.
                                -8-

Commissioner, T.C. Memo. 2003-277.    Generally, courts have

respected the allocation made when it is an arm’s-length

agreement made in good faith.   Stadnyk v. Commissioner, T.C.

Memo. 2008-289; see Fono v. Commissioner, 79 T.C. 680 (1982),

affd. without published opinion 749 F.2d 37 (9th Cir. 1984).

     Petitioners contend that Mr. Prinster suffered physical

sickness in the form of headaches, vomiting, diarrhea,

hypertension, hyperlipidemia, and diabetes.

     Mr. Prinster’s ailments are not of the type contemplated by

section 104(a)(2).   Emotional distress is not treated as a

physical injury or physical sickness except to the extent of

amounts paid for medical care attributable to the emotional

distress.   Sec. 104(a) (flush language).   “Physical

manifestations of emotional distress such as fatigue, insomnia,

and indigestion do not transform emotional distress into physical

injury or physical sickness.”   Connolly v. Commissioner, supra.

In Lindsey v. Commissioner, T.C. Memo. 2004-113, affd. 422 F.3d

684 (8th Cir. 2005), the taxpayer also suffered from hypertension

and stress-related symptoms, and we held that these symptoms

related to emotional distress rather than physical sickness.

Absent proof of medical care expenses, petitioners have not

demonstrated any physical injury or physical sickness that gives

rise to the section 104(a)(2) exclusion.
                                -9-

     Furthermore, petitioners have not sufficiently shown that

Mr. Prinster’s ailments resulted from his termination.     The

record reflects that Mr. Prinster had already been suffering from

hyperlipidemia, and the record further suggests that Mr.

Prinster’s posttermination symptoms could also have been the

product of his diet and lifestyle.    The record thus fails to

establish the cause of Mr. Prinster’s sickness.

     Petitioners also failed to demonstrate that the payments

from his employer were for physical injuries.    Though the sealed

portion of the record indicates that the payments were “for

alleged emotional and related physical injuries”, there is no

specificity about the amount, if any, that could be allocated to

either.   In the absence of a basis for allocation, we presume the

entire amount is not excludable.   See Taggi v. United States, 35

F.3d 93, 96 (2d Cir. 1994); Connolly v. Commissioner, supra;

Sodoma v. Commissioner, T.C. Memo. 1996-275, affd. without

published opinion 139 F.3d 899 (5th Cir. 1998).

     C.   Payment to Mr. Lyon

     Petitioners contend that Mr. Prinster received only

$47,783.50 from his employer and that the $28,716.50 paid

directly to Mr. Lyon should therefore not be included in

petitioners’ gross income.

     Gross income includes “all income from whatever source

derived” unless specifically excluded.    Sec. 61(a).   Section
                                -10-

61(a) is broadly interpreted, but exclusions from income are

narrowly defined.    Commissioner v. Schleier, 515 U.S. at 327-328.

A taxpayer cannot exclude economic gain from gross income by

assigning that gain in advance to another party because gains are

taxed to those who earn them.   Commissioner v. Banks, 543 U.S.

426 (2005); Lucas v. Earl, 281 U.S. 111, 114-115 (1930).

     Mr. Prinster’s former employer agreed to pay him $76,500.

Petitioners were entitled to the $76,500 and the $28,716.50

payment therefore belonged to petitioners.   Accordingly,

petitioners cannot avoid the incidence of tax on that payment

simply because that portion of the settlement was redirected to

Mr. Lyon.   The cause of action generating the $76,500 payment

belonged to Mr. Prinster.   Mr. Lyon was owed the amount of

$28,716.50 by Mr. Prinster for legal services rendered to Mr.

Prinster.   Moreover, Mr. Prinster and his employer agreed that

“Each Party shall bear his or its own costs and attorneys’ fees.”

The employer made the $28,716.50 payment directly to Mr. Lyon

solely because Mr. Prinster requested it to do so.   The

transaction is thus treated as if Mr. Prinster had received the

payment from his employer and then paid that amount over to Mr.

Lyon.   The fact that Mr. Prinster arranged to have his employer

make a portion of the payment directly to Mr. Lyon does not

change the result.
                                -11-

       Accordingly, we hold that petitioners must include in their

gross income the $76,500 paid by the former employer, even though

a portion was paid to Mr. Lyon.

       D.   Conclusion

       Although petitioners have demonstrated that Mr. Prinster had

a tort-based claim, they have not established that any of the

payments from his employer were for physical injury or physical

sickness.

       Petitioners therefore cannot exclude these payments from

their gross income.

III.    Schedule C Expenses

       Deductions are a matter of legislative grace, and taxpayers

bear the burden of establishing entitlement to claimed

deductions.    Rule 142(a); INDOPCO, Inc. v. Commissioner, 503 U.S.

79, 84 (1992).    Taxpayers are required to maintain adequate

records to establish the amount of their income and deductions.

Sec. 6001; sec. 1.6001-1(a), (e), Income Tax Regs.

       When a taxpayer establishes that he has incurred deductible

expenses but is unable to substantiate the exact amounts, we

generally can estimate the deductible amount if sufficient

evidence exists to provide a rational basis for the estimate.

Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930);

Vanicek v. Commissioner, 85 T.C. 731, 742-743 (1985).    However,

section 274(d) prohibits us from estimating a taxpayer’s travel,
                               -12-

entertainment, and “listed property” (e.g., automobiles and other

property used for transportation) expenses.   Sanford v.

Commissioner, 50 T.C. 823, 827 (1968), affd. per curiam 412 F.2d

201 (2d Cir. 1969); sec. 1.274-5T(a), Temporary Income Tax Regs.,

50 Fed. Reg. 46014 (Nov. 6, 1985).

     To deduct the items in dispute, all of which are subject to

strict substantiation requirements, petitioners must substantiate

either by adequate records or by sufficient evidence

corroborating their own statements:   (A) The amount of each

expense; (B) the time and place the expense was incurred; (C) the

business purpose of the expense; and (D) the business

relationship to them of each expense incurred.   Sec. 274(d);

Beale v. Commissioner, T.C. Memo. 2000-158.   Expenses subject to

section 274 requirements may be substantiated by adequate records

where the taxpayer maintains an account book, a diary, a log, a

statement of expenses, trip sheets, or similar records prepared

contemporaneously with the expenditure supplemented by other

documentary evidence.   Sec. 1.274-5(c)(2)(iii), Income Tax Regs.;

sec. 1.274-5T(c)(2), Temporary Income Tax Regs., 50 Fed. Reg.

46017 (Nov. 6, 1985).   Substantiation by other sufficient

evidence requires the production of corroborative evidence in

support of a taxpayer’s statement specifically detailing the

required elements.   Sec. 1.274-5T(c)(3), Temporary Income Tax

Regs., 50 Fed. Reg. 46020 (Nov. 6, 1985).
                                 -13-

      Mr. Prinster has failed to substantiate his Schedule C

expenses.   The only evidence supporting the deductions he claimed

is his testimony that the expenses were incurred.   He did not

produce adequate records or other sufficient evidence to

corroborate that testimony, and he therefore has not established

the amounts of these expenses.    With the exception of the $960 of

rent or lease expenses that respondent has conceded, Mr. Prinster

is not entitled to deductions for his Schedule C expenses.

IV.   Section 6662(a) Penalty

      Section 6662(a) and (b)(1) and (2) imposes an accuracy-

related penalty of 20 percent on the portion of an underpayment

attributable to negligence, disregard of rules or regulations, or

a substantial understatement of income tax.   Negligence includes

any failure to keep adequate books and records or to substantiate

items properly.   Sec. 1.6662-3(b)(1), Income Tax Regs.   An

understatement is substantial if it exceeds the greater of: (1)

10 percent of the tax required to be shown on the return for the

taxable year, or (2) $5,000.    Sec. 6662(d)(1)(A); Neely v.

Commissioner, 85 T.C. 934, 947 (1985).

      Petitioners had a substantial understatement of income tax

because their tax liability was understated by $33,616.

Petitioners were also negligent in that they failed to properly

substantiate their claimed Schedule C deductions.
                                 -14-

     Petitioners contend they should not be liable for the

section 6662(a) penalty on the portion of the deficiency

attributable to the payments from Mr. Prinster’s former employer

because Mr. Lyon advised Mr. Prinster that the payments were not

taxable.

     Section 6664(c)(1) provides a defense to the section 6662

penalty for any portion of an underpayment where reasonable cause

existed and the taxpayers acted in good faith.      In determining

whether a taxpayer reasonably relied in good faith on

professional advice, all facts and circumstances must be

considered, including the taxpayer’s education, sophistication,

and business experience.    Sec. 1.6664-4(c)(1), Income Tax Regs.

Generally, the most important factor is the extent of the

taxpayer’s effort to assess the taxpayer’s proper tax liability.

Sec. 1.6664-4(b)(1), Income Tax Regs.

     Mr. Prinster asked his attorney, Mr. Lyon, whether the

settlement was taxable.    Mr. Lyon incorrectly advised that it was

not taxable because Mr. Prinster’s ailments were considered

physical injuries.    Petitioners are not tax sophisticated, and

they relied on Mr. Lyon’s advice.       It is generally reasonable for

the taxpayer to rely on an attorney’s tax advice as to a matter

of tax law, and the taxpayer is ordinarily not required to

challenge that advice.     United States v. Boyle, 469 U.S. 241, 251

(1985).    Here the reliance was in good faith and it was
                                 -15-

reasonable for petitioners to rely on their adviser’s advice on

the transaction.   Sec. 1.6664-4(c)(1), Income Tax Regs.

     Accordingly, petitioners are not liable for the section

6662(a) penalty on the portion of the underpayment attributable

to their failure to report the $76,500 settlement.      With respect

to petitioners’ claimed Schedule C expenses, however, petitioners

were negligent in failing to maintain proper substantiating

records and are liable for the section 6662(a) accuracy-related

penalty.   We leave to the parties the computation of the correct

amount of the section 6662(a) penalty.

     To reflect the foregoing,


                                        An appropriate order will be

                                 issued, and decision will be

                                 entered under Rule 155.
