                       T.C. Memo. 2003-64



                     UNITED STATES TAX COURT



          ED AND PATRICIA A. MONTGOMERY, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 1816-00.             Filed March 5, 2003.



     David H. McQuaig, for petitioner.

     Felicia L. Branch, for respondent.



                       MEMORANDUM OPINION

     DINAN, Special Trial Judge:   Respondent determined

deficiencies in petitioners’ Federal income taxes of $2,975 and

$3,537, and accuracy-related penalties of $595 and $707.40, for

the taxable years 1996 and 1997.   By amended answer, respondent

pled increased deficiencies and penalties for each year in issue,

for deficiencies totaling $5,355 and $6,351, and penalties
                               - 2 -

totaling $1,071 and $1,270, in the respective years.   Unless

otherwise indicated, section references are to the Internal

Revenue Code in effect for the years in issue, and all Rule

references are to the Tax Court Rules of Practice and Procedure.

     The issues for decision are, with respect to each year in

issue:   (1) Whether certain damages received by petitioners from

a lawsuit are fully includable in gross income; (2) whether

Southern Financial Investment Services, Inc., an S corporation

wholly owned by petitioner husband, operated a trade or business

within the meaning of section 162 or conducted an activity not

engaged in for profit within the meaning of section 183; and (3)

whether petitioners are liable for the accuracy-related penalties

under section 6662(a).

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

The stipulations of fact and the attached exhibits are

incorporated herein by this reference.   Petitioners resided in

Jacksonville, Florida, on the date the petition was filed in this

case.

Lawsuit Proceeds

     Background

     In 1987, petitioner husband (petitioner) filed suit in the

United States District Court, Eastern District of Texas, against

his former employer, Leveretts Chapel Independent School District

(the district), and the individual school board members (the
                                - 3 -

defendants).    Petitioner and the district had an employment

contract under which petitioner was employed as superintendent of

the district.    After his employment was terminated prematurely

under the contract, petitioner filed a complaint setting forth

three causes of action, alleging (1) the defendants deprived

petitioner of his property interest in a written employment

contract without due process in violation of the Fourteenth

Amendment to the United States Constitution; (2) the defendants

conspired to deprive petitioner of his federally protected right

to due process in violation of 42 U.S.C. secs. 1983, 1985, and

1986; and (3) the defendants breached petitioner’s employment

contract, causing a loss of salary and various benefits.    The

complaint prayed for (1) lost wages, benefits, and compensatory

damages of $250,000; (2) punitive damages of $500,000; and (3)

costs and attorney’s fees.    The complaint alleged that

petitioner’s contract had been breached, and his rights violated,

after a meeting of the school board on or about January 13, 1986.

Petitioner claimed that he had sustained a loss of salary and

benefits “in excess of $40,000 per year”, a loss of participation

in a retirement system, and a loss of living quarters.     He also

claimed that the breach of the contract resulted in a loss of

continued employment beyond the term of the contract, causing

losses of future wages in the amount of $150,000.    A copy of the

contract attached to the complaint stated that the contract’s
                                - 4 -

term was from July 1, 1985, through June 30, 1988, and that

petitioner’s annual salary was set at $37,000.    The contract also

stated that petitioner was to receive certain other benefits,

including furnished housing.

     The final judgment in petitioner’s lawsuit was filed on July

20, 1989.   Petitioner received damages of $185,000, which had

been reduced by order of remittitur from a jury award of

$450,000, and costs and attorney’s fees of $15,556.70.

Petitioner was also awarded interest on these amounts.     On July

20, 1992, an order of execution of writ of mandamus was filed in

the district court compelling satisfaction of the “civil rights

judgment” filed 3 years earlier.    This order further provided

that, if necessary, the school district was to levy additional

taxes to satisfy the judgment; the court cited case law that such

measures were appropriate where needed “to vindicate

constitutional guarantees”.    In each of 1996 and 1997,

petitioners received a $30,000 payment towards the satisfaction

of this judgment.   In 1996, the payment consisted of $21,489 in

interest and $8,511 in principal.    In 1997, the payment consisted

of $19,966 in interest and $10,034 in principal.

     Petitioners filed joint Federal income tax returns for 1996

and 1997.   Petitioners reported as income on these returns the

portions of the yearly $30,000 payments representing interest

income, but they did not report the remaining portions of the
                                - 5 -

payments.   Respondent did not make an adjustment in the statutory

notice of deficiency with respect to this issue.      By amended

answer, respondent asserts that petitioners must include in gross

income the principal portions of the payments, $8,511 in 1996 and

$10,034 in 1997.

     Discussion

     Gross income generally includes income from whatever source

derived, unless excluded by statute.    Sec. 61(a).    The exclusion

upon which petitioners rely in this case is that of section

104(a)(2), which excludes from gross income “the amount of any

damages received (whether by suit or agreement and whether as

lump sums or as periodic payments) on account of personal

injuries or sickness.”1   The Supreme Court, in Commissioner v.

Schleier, 515 U.S. 323 (1995), summarized the requirements of

section 104(a)(2) as follows:

          In sum, the plain language of § 104(a)(2), the text of
     the applicable regulation, and our decision in Burke
     establish two independent requirements that a taxpayer must
     meet before a recovery may be excluded under § 104(a)(2).
     First, the taxpayer must demonstrate that the underlying
     cause of action giving rise to the recovery is “based upon
     tort or tort type rights”; and second, the taxpayer must
     show that the damages were received “on account of personal
     injuries or sickness.” * * *


     1
      Sec. 104(a)(2) was amended by the Small Business Job
Protection Act of 1996, Pub. L. 104-188, sec. 1605, 110 Stat.
1755, 1838. We apply the statute as it was in effect prior to
amendment because the payments in this case were received
pursuant to a court decree issued before September 13, 1995. Id.
sec. 1605(d)(2), 110 Stat. 1838.
                                 - 6 -

Id. at 336-337.   Amounts received as punitive damages are not

received “on account of personal injuries or sickness” and thus

are not excludable from gross income under section 104(a)(2).

O’Gilvie v. United States, 519 U.S. 79, 101 (1996).

     Prior to the Supreme Court’s decision in Schleier, this

Court had held that damages received under a 42 U.S.C. sec. 1983

(hereinafter referred to as sec. 1983) claim are excludable from

income under section 104(a)(2).     Bent v. Commissioner, 87 T.C.

236 (1986), affd. 835 F.2d 67 (3d Cir. 1987).    See also Metzger

v. Commissioner, 88 T.C. 834 (1987), affd. without published

opinion 845 F.2d 1013 (3d Cir. 1988).    In Bent, the taxpayer was

a high school teacher who had brought suit after the school board

had declined to rehire him.   He sued the school board for breach

of contract and various sec. 1983 claims.    After a court had

rejected all of the taxpayer’s claims except a sec. 1983 claim

based on a violation of the First Amendment right to free speech,

the taxpayer settled the case.    This Court held that the

settlement payment received by the taxpayer was excludable from

income under section 104(a)(2).    In so holding, the Court found

that, under the circumstances of the case, the taxpayer’s

recovery of lost wages was an element of the compensatory damages

available under sec. 1983 and was not an independent basis for

recovery.   The Third Circuit affirmed, expressing agreement with

our reasoning and conclusions.
                                - 7 -

     Respondent attempts to distinguish Bent from the present

case, arguing in part that Schleier stands for the proposition

that damages received for economic injury do not qualify for the

section 104(a)(2) exclusion, and that this Court’s holding in

Bent that lost wages may be a measure of personal injury “has

clearly lost its vitality” following Schleier.    We agree with

respondent insofar as damages received on account of economic

injury are not excludable under section 104(a)(2) pursuant to

Schleier.    Quantum Company Trust v. Commissioner, T.C. Memo.

2000-149.

     Respondent bears the burden of proof with respect to this

issue because it was raised by respondent for the first time in

his answer.    Rule 142(a).

     In the case at hand, neither party has attempted to break

down the $185,000 in damages into portions attributable to the

various categories of damages sought by petitioner in his

lawsuit.    We therefore examine each category of damages sought

therein.

     First, petitioner sought punitive damages of $500,000.      Any

portion of the amounts awarded to petitioner which represent

punitive damages is not excludable from income under section

104(a)(2).    O’Gilvie v. United States, supra.

     Second, petitioner sought compensatory damages of $250,000.

We are convinced that these damages sought by petitioner were for
                                 - 8 -

economic injury, not personal injury.     The complaint alleged lost

wages and benefits “in excess of $40,000 per year”.     Because the

contract was breached with approximately 2-1/2 years remaining

(from January 1986 through June 1988), this would result in

approximately $100,000 of lost wages and benefits.     The complaint

further alleged lost future wages of $150,000.     Because the total

amount of compensatory damages sought by petitioner was $250,000,

we find that the entire amount was sought as a result of the

economic injury suffered by petitioner.     Thus, regardless of

whether certain civil rights damages may be excluded from income

under other circumstances, they may not in this case because the

damages awarded to petitioner were not awarded on account of

personal injury or sickness.     Commissioner v. Schleier, supra.

Rather, they were to make petitioner whole economically as a

result of his lost employment.     Any portion of the amounts

awarded to petitioner which represent the requested compensatory

damages is not excludable from income under section 104(a)(2).

Id.; Quantum Company Trust v. Commissioner, supra.

S Corporation Loss

     Background

     During the years in issue, petitioner taught at Florida

Community College at Jacksonville and held several other part-

time positions.     Petitioner wife was employed by the Duval County

School Board.     On their joint Federal income tax returns, they
                                    - 9 -

reported combined taxable wage income of $43,251 in 1996 and

$52,187 in 1997.    In addition, petitioners received $30,000 of

income in each year representing the payments resulting from the

lawsuit discussed above.

     During the years in issue, petitioner was the sole

shareholder of an S corporation named Southern Financial

Investment Services, Inc. (SFIS).        SFIS was incorporated in

January 1990, and elected Subchapter S status in 1996.                From its

incorporation until the time of trial, SFIS had never generated

positive net income.      The following represents the “receipts” and

“deductions” of SFIS in each of the years for which the amounts

appear in the record:

                   1991      1993      1994      1995        1996       1997

     Receipts      $-0-      $-0-    $49,705     $3,829       $335       $292
     Deductions     -0-       -0-    (79,611)   (54,445)   (15,308)   (15,163)
     Net loss       -0-       -0-    (29,906)   (50,616)   (14,973)   (14,871)

In the years in issue, SFIS reported the following on its

corporate Federal income tax returns:

                                      1996           1997

     Gross receipts                    $335          $292
     Cost of goods sold                 -0-        (4,947)
     Rents                              -0-        (1,200)
     Taxes and licenses              (2,551)       (1,193)
     Interest                        (2,592)          (23)
     Depreciation                      (289)         (289)
     Advertising                       (372)         (114)
     Legal/professional              (2,577)       (2,577)
     Other expenses                  (6,927)       (4,820)
     Ordinary loss                  (14,973)      (14,871)

In each year, petitioners claimed a deduction for the entire loss

on their individual income tax return as petitioner’s 100 percent
                              - 10 -

share of SFIS’s loss.   In the statutory notice of deficiency,

respondent disallowed the deductions in full.     Respondent

determined that, because the activities of SFIS were not operated

with a profit motive during the years in issue, the allowable

deductions for expenses related thereto are limited to the amount

of SFIS’s income in each year.

     Discussion

     Under section 162(a), a taxpayer may deduct the ordinary and

necessary expenses paid or incurred during the taxable year in

carrying on its trade or business.     A taxpayer is engaged in a

trade or business if the taxpayer is involved in the activity

with continuity and regularity and with the primary purpose of

making a profit.   Commissioner v. Groetzinger, 480 U.S. 23, 35

(1987).

     If an activity of a taxpayer is not conducted for profit,

section 183(a) disallows all deductions related thereto, except

as provided by section 183(b).   An activity is not conducted for

profit if it is one with respect to which deductions are not

allowable under section 162 or section 212(1) or (2).2    Sec.

183(c).   If an activity of a taxpayer is not for profit, section

183(b) allows the taxpayer to deduct (1) expenses which otherwise

would have been allowable without regard to profit motive, and


     2
      Sec. 212 applies only to individuals and is therefore
inapplicable to SFIS.
                              - 11 -

(2) certain additional expenses to the extent of the gross income

derived from the activity, less those deductions of the first

type.

     A taxpayer must have an actual and honest profit objective

in order for an activity to be one which is for profit.     Surloff

v. Commissioner, 81 T.C. 210, 233 (1983); Dreicer v.

Commissioner, 78 T.C. 642, 644 (1982), affd. without published

opinion 702 F.2d 1205 (D.C. Cir. 1983); sec. 1.183-2(a), Income

Tax Regs.   This determination is made at the corporate level with

respect to the activities of an S corporation.   Baldwin v.

Commissioner, T.C. Memo. 2002-162; sec. 1.183-1(f), Income Tax

Regs.   However, we look to the intent of an S corporation’s sole

shareholder in deciding whether the corporation had the requisite

profit objective.   Baldwin v. Commissioner, supra.    In

determining whether the requisite intention to make a profit

exists, greater weight is given to objective facts than to the

taxpayer’s self-serving characterization of his intent.     Id.;

Dreicer v. Commissioner, supra at 645; sec. 1.183-2(a), Income

Tax Regs.   The regulations set forth a nonexclusive list of

factors to be considered in determining whether the taxpayer has

the requisite profit objective:   (1) The manner in which the

taxpayer carries on the activity; (2) the expertise of the

taxpayer or his advisers; (3) the time and effort expended by the

taxpayer in carrying on the activity; (4) the expectation that
                              - 12 -

the assets used in the activity may appreciate in value; (5) the

success of the taxpayer in carrying on other similar or

dissimilar activities; (6) the taxpayer’s history of income or

losses with respect to the activity; (7) the amount of occasional

profits, if any, which are earned; (8) the financial status of

the taxpayer; and (9) elements of personal pleasure or

recreation.   Section 1.183-2(b), Income Tax Regs.

     Petitioners bear the burden of proving that respondent’s

determinations in the notice of deficiency are in error.     Rule

142(a).3

     The parties’ stipulation states that SFIS and petitioner

were engaged in “multi-level marketing type activities” with

respect to the products of several companies, and that the 1996

and 1997 gross receipts were from commissions and the sale of

products.   However, petitioners have provided no reliable

evidence that any such activities conducted by SFIS or petitioner

had the requisite profit objective.    The tax returns filed by

SFIS are merely uncorroborated assertions, not evidence of any

activity.   Apart from the generic description in the parties’

stipulation, the only evidence in the record concerning the

purported activities is petitioner’s cursory testimony, which we


     3
      Sec. 7491(a) does not shift the burden of proof to
respondent in this case because petitioners have provided no
credible evidence with respect to the activities of SFIS. Sec.
7491(a)(1).
                               - 13 -

do not find to be reliable.4   Petitioners did not produce a

single item of corroborating evidence, such as a ledger, time

log, bank account record, receipt, or invoice.

     Petitioners have not shown that petitioner and SFIS were

involved in any activity with continuity and regularity, and they

have not shown that any of the objective factors enumerated above

demonstrate an intent to profit.   We therefore find that SFIS was

not engaged in a trade or business and is not entitled to any

business expense deductions.   Sec. 162(a); Commissioner v.

Groetzinger, supra.    With no underlying trade or business, SFIS

is limited to the deductions allowed by respondent pursuant to

section 183(b).   Sec. 183(a), (c).

Negligence

     In the notice of deficiency, respondent determined that

petitioners are liable for accuracy-related penalties under

section 6662(a) of $595 in 1996 and $704.40 in 1997.   This

determination is based upon the adjustments made with respect to

the disallowed SFIS losses.    By amended answer, respondent seeks

to increase the penalties to $1,071 in 1996 and $1,270 in 1997.

This increase is based upon the unreported income from the

litigation proceeds.


     4
      Petitioner testified that SFIS has been engaged in a
variety of activities, including real estate and sales of pre-
paid calling cards, gold coins, “a vitamin-type product that kind
of replaces Viagra”, and a “program for debt freedom”.
                                - 14 -

     Although respondent bears the burden of production with

respect to the determination of negligence in the notice of

deficiency, petitioners ultimately bear the burden of proof.

Sec. 7491(c); Rule 142(a).   Respondent bears the burden of proof

with respect to the increase in the penalties.    Sec. 7491(c).

     Section 6662(a) imposes a 20-percent penalty on the portion

of an underpayment attributable to any one of various factors,

one of which is negligence or disregard of rules or regulations.

Sec. 6662(b)(1).   “Negligence” includes any failure to make a

reasonable attempt to comply with the provisions of the Internal

Revenue Code, including any failure to keep adequate books and

records or to substantiate items properly.    Sec. 6662(c); sec.

1.6662-3(b)(1), Income Tax Regs.    Section 6664(c)(1) provides

that the penalty under section 6662(a) shall not apply to any

portion of an underpayment if it is shown that there was

reasonable cause for the taxpayer’s position and that the

taxpayer acted in good faith with respect to that portion.     The

determination of whether a taxpayer acted with reasonable cause

and in good faith is made on a case-by-case basis, taking into

account all the pertinent facts and circumstances.    Sec.

1.6664-4(b)(1), Income Tax Regs.    The most important factor is

the extent of the taxpayer’s effort to assess his proper tax

liability for the year.   Id.
                              - 15 -

     There is no evidence in the record relevant to ascertaining

petitioners’ liability for the accuracy-related penalties with

respect to the unreported lawsuit proceeds:   Their authority or

rationale for reporting only a portion of the $30,000 payments

received from the lawsuit is unknown.   The fact that petitioners

reported the bulk of the payments--the portions representing

interest--indicates they may have been advised to exclude the

amounts representing principal on the authority of Bent v.

Commissioner, 87 T.C. 236 (1986), affd. 835 F.2d 67 (3d Cir.

1987).   Regardless, because the record is devoid of any facts

concerning this issue, and because respondent bears the burden of

proof, we hold that petitioners are not liable for the increased

penalties sought by respondent in his amended answer.

     Petitioners, however, failed to show that SFIS was engaged

in a business, they did not produce books and records for SFIS,

they did not provide substantiation for any of the individual

expenses shown on the tax return of SFIS, and they did not show

any effort to assess their proper tax liability with respect to

the losses from SFIS claimed on their individual returns for the

years in issue.   We find petitioners to be negligent, and we

sustain respondent’s determination that petitioners are liable

for the accuracy-related penalties, with respect to the claimed

deductions for losses from SFIS.
                             - 16 -

     To reflect the foregoing,

                                      Decision will be entered

                                 for respondent.5




     5
      Decision will be entered for respondent for (1) the
deficiencies in the increased amounts pled by respondent in his
amended answer, and (2) the penalties in the amounts determined
in the statutory notice of deficiency.
