                         T.C. Memo. 1996-465



                       UNITED STATES TAX COURT



  DIAMOND CLAIMS & INVESTIGATION SERVICES, INC., Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 5736-93.                   Filed October 16, 1996.



     Merritt S. Yoelin and Michael D. Walker, for petitioner.

     Shirley M. Francis, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION

     CHIECHI, Judge:    Respondent determined a deficiency of

$234,870.48 in petitioner's Federal income tax for its taxable

year ended September 30, 1988.

     The only issue remaining for decision is whether petitioner

must include in its income for the year at issue all, or only a

portion, of the amount awarded by the U.S. District Court for the
                                - 2 -

District of Oregon (District Court) to the plaintiffs in a law-

suit in which petitioner and two individuals, Peter J. Diamond

(Mr. Diamond) and Shirley Diamond (Ms. Diamond), were identified

as the plaintiffs.   We hold that petitioner must include in its

income only the portion stated herein.

                           FINDINGS OF FACT

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

     Petitioner, Diamond Claims & Investigation Services, Inc.

(DCI), is an Oregon corporation that was incorporated on August

21, 1979, and that had its principal place of business in Coos

Bay, Oregon, at the time the petition was filed.

     During the years 1980 through 1988, Mr. Diamond and Ms.

Diamond, who were married, each owned 50 percent of the outstand-

ing stock of DCI.    They also were its only officers, serving as

president and secretary, respectively.    (Mr. Diamond and Ms.

Diamond are sometimes referred to as the Diamonds.)    As of the

time of the trial herein, DCI was not actively engaged in a trade

or business, was in existence in name only, and was wholly owned

by Mr. Diamond, who inherited Ms. Diamond's stock in DCI after

she died on May 6, 1990.

     Throughout the years 1980 through 1988, DCI's principal

business activity was the investigation of insurance claims and

other insurance-related matters.    During the years 1980 through

1984, DCI derived approximately 90 percent of its business from a

group of related companies that were collectively known as
                                 - 3 -

Farmers Insurance Group (FIG).1    That business consisted princi-

pally of (1) investigating suspected criminal and fraudulent

activities of FIG's agents, clients, and third-party claimants

and (2) training FIG personnel in the conduct of such investiga-

tions so as to enable FIG to establish an internal workforce with

that investigative capability.

     During the years at issue, DCI sent FIG invoices for ser-

vices rendered that were prepared in accordance with FIG's

specifications and that pertained to different types of services

rendered, including investigative services and office and cleri-

cal services related to those investigative services.    Pursuant

to FIG's specifications, DCI's invoices also billed FIG for costs

that FIG agreed to reimburse (e.g., meals and lodging).

Evergreen Typing Service

     Throughout all relevant periods, DCI required various

secretarial and clerical support services in order to conduct its

business operations.   During the years 1980 through 1982, DCI

first employed Ms. Diamond and then Headquarters, Inc. to provide

such services.   During the summer of 1982, DCI formed its own

secretarial and clerical support services business known as

Evergreen Typing Service (ETS) for the principal purpose of

providing such services to DCI in connection with the work that


1
   DCI provided its services to a division within the legal
department of FIG known as the Criminal Investigations Division
(CID).
                               - 4 -

it was performing for FIG and other customers.2   During the early

part of 1983, DCI sold ETS to the Diamonds, who thereafter owned

and operated it as a sole proprietorship.3

     During 1983 and all relevant periods thereafter, ETS was the

exclusive provider to DCI of secretarial and clerical support

services, such as typing, photocopying, transcribing, and answer-

ing the telephone, with DCI providing approximately 95 to 99

percent of ETS' business.   During those periods, ETS also made

its clerical staff available to DCI for DCI's investigative work

and permitted DCI's surveillance vans to be marked with ETS'

logo.   During 1983 and 1984, virtually all of the services that

ETS provided to DCI were related to the work that DCI was per-

forming for FIG, and ETS provided certain of those services, such

as the preparation of clerical reports, in accordance with FIG's

specifications.

     During 1983 and 1984, ETS sent DCI invoices for services

rendered that identified, inter alia, the name of the case with

respect to which it provided the service, the type of service

rendered (e.g., typing or copying), and the charge for such




2
   DCI informed certain FIG officials of its plans to form ETS.
Those officials, who were concerned about the security of docu-
ments containing confidential information relating to the inves-
tigative work that DCI was conducting for FIG, assisted DCI in
executing those plans.
3
   At the time that DCI transferred the ownership of ETS to the
Diamonds, Mr. Diamond informed FIG officials of that transfer.
                               - 5 -

service.4   At no time during those years did ETS submit invoices

directly to FIG for the services that it provided to DCI in

connection with DCI's work for FIG.     Rather, DCI billed FIG for

those services, charging FIG the same amount that ETS had charged

it.

      The Diamonds reported the financial results of ETS in

Schedule C of the Federal income tax return (return) that they

filed for each of the years 1983, 1984, and 1985, as follows:

                                     1983       1984       1985

    Gross receipts              $180,787      $199,355    $39,875
    Less: Cost of goods sold      62,201         --          --
    Plus: Other income             2,312         --          --
       Gross income              120,898       199,355     39,875
    Less: Expenses                23,945        92,537       --
       Net profit                 96,953       106,818     39,875

The Farmers Lawsuit

      The Parties and Their Claims

      In September 1984, DCI and the Diamonds, who were repre-

sented by the law firm of Markowitz & Herbold (Markowitz &

Herbold), commenced a lawsuit (Farmers lawsuit) against FIG in

the District Court.   The plaintiffs named in the Farmers lawsuit

were "DIAMOND CLAIMS & INVESTIGATION SERVICES, INC., an Oregon

corporation, and PETER J. DIAMOND and SHIRLEY DIAMOND, husband

and wife" (plaintiffs).   The plaintiffs filed an initial com-

4
   The particular information that ETS included in the invoices
that it submitted to DCI during the years 1983 and 1984 was based
on certain requirements specified by FIG in order to enable FIG
to identify the costs associated with the particular investiga-
tive projects that it had assigned to DCI.
                                - 6 -

plaint (initial complaint), an amended complaint (amended com-

plaint), and a second amended complaint (second amended com-

plaint), and the plaintiffs and FIG submitted a pretrial order

(pretrial order).   In those submissions, the plaintiffs raised

claims against FIG for breaches of contract, indemnity, and

fraudulent misrepresentations and sought damages from FIG with

respect to those claims.5   The District Court ruled that the

pretrial order (1) superseded the various complaints that the

plaintiffs had filed in the Farmers lawsuit and (2) controlled

the determination of any damages to be awarded to the plaintiffs.

     In the pretrial order, the plaintiffs alleged, inter alia:

     VI.       Contentions of Fact

              *      *      *    *      *    *     *

          2.   In December, 1980, Michael Conn, acting as
     Director of CID and on behalf of all defendants, and
     plaintiffs, agreed as follows (these promises are
     hereinafter jointly referred to as "the agreement"):

               a)   That CID would assign to plaintiffs all
     investigations which were assigned to outside investi-

5
   In the initial complaint and in the amended complaint, the
plaintiffs alleged that the parties to the agreement at issue in
the Farmers lawsuit were FIG and "Diamond Claims" and that, as a
result of FIG's breaches of contract and fraudulent misrepresen-
tations, "plaintiff Diamond Claims has suffered lost revenue from
investigation, consultation and clerical services; lost profits *
* * all to plaintiff Diamond Claims' damage in the amount of
$5,000,000", and requested, inter alia, that the District Court
enter a judgment against FIG and in favor of "Diamond Claims" in
the amount of $5 million on account of its claims against FIG for
breaches of contract and fraudulent misrepresentations. In the
second amended complaint and in the pretrial order, references to
"Diamond Claims" in the foregoing allegations were changed to
references to "plaintiffs".
                         - 7 -

gators by CID on behalf of any defendant, for a period
of five years from December, 1980, in Oregon, Washing-
ton, Idaho, Utah and Montana.

        *     *     *     *      *     *     *

          c)    That plaintiffs would perform investiga-
tions of suspected criminal and fraudulent activities
among defendants' insureds, employees, agents and
brokers in connection with CID's investigation and
attempted prosecution of insurance fraud; provide
equipment necessary thereto; and provide consulting
services, training and assistance necessary to enable
CID to establish and develop internal units with per-
sonnel capable of conducting such investigations on an
in-house basis.

        *     *     *     *      *    *     *

     4.   From 1980-1984, plaintiffs performed investi-
gations described in paragraph VI-2(c) on behalf of
defendants.

        *     *     *     *      *    *     *

     6.   * * * During 1980 to 1984, plaintiffs as-
sisted in training CID's regional (in-house) Criminal
Investigators. Plaintiffs built their own organization
capable of handling the defendants' investigation
needs. * * * Plaintiffs Peter and Shirley Diamond
devoted substantial time, effort and resources to their
performance of their agreement with defendants. * * *

     7.   In the summer of 1982, DCI started a business
called Evergreen Typing Service (hereinafter ETS) for
the purpose of providing transcription services to
defendants in connection with investigations. Owner-
ship of the business was later transferred to Peter and
Shirley Diamond. From time to time, plaintiffs in-
vested in new equipment for ETS and hired employees for
the purpose of dealing with CID's workload. From 1982
to 1984, ETS provided services to defendants.

     8.   Plaintiffs' actions in performance of their
agreement with defendants were done at the request of
defendants and with their knowledge, and were necessary
to the performance of plaintiffs' agreement with defen-
dants. Plaintiffs have performed all of their obliga-
tions under their agreement with defendants.
                         - 8 -

     9.   Sometime in 1981 or 1982, CID began using
outside investigators other than plaintiffs in Oregon,
Washington, Idaho, Utah and Montana for cases which
should have been assigned to plaintiffs under the
agreement. This practice continued up to the present.
This practice was in breach of defendants' agreement
with plaintiffs.

        *     *     *     *      *    *     *

     16. In May, 1984, Mr. Conn on behalf of all
defendants promised plaintiffs that agreements between
plaintiffs and defendants would be extended for a
period of two years. * * *

        *     *     *     *      *    *     *

     18. On November 9, 1984, Ronald Burlison wrote a
letter to plaintiffs stating that they should "cease
all work" on defendants' files. Since that time defen-
dants have assigned no cases to plaintiffs.

        *     *     *     *      *    *     *

     20. Defendants breached their agreements with
plaintiffs as follows:

          a)   CID failed to assign to plaintiffs all
of its investigations done by outside investigators in
Oregon, Washington, Utah, Montana and Idaho, from
December 1980 to May, 1986.

         *     *     *     *     *     *     *

     21. Plaintiffs were damaged by defendants'
breaches as follows:

         *     *     *     *     *     *     *

          b)   They lost profits on investigations
defendants assigned to other investigators from 1981 to
May, 1986, in the approximate amount of $5.5 million.

         *     *     *     *     *     *     *

     22. Defendants repeatedly made false misrepresen-
tations to plaintiffs and concealed the true state of
affairs from plaintiffs with the knowledge and intent
that plaintiffs would rely on the representations to
                                       - 9 -

       their detriment, as follows:

                 a)   Defendants repeatedly represented to
       plaintiffs that plaintiffs were receiving and would
       continue to receive all of CID's assignments to outside
       investigators in Oregon, Washington, Idaho, Montana and
       Utah, when plaintiffs were not receiving all such
       assignments, defendants had no intention of giving
       plaintiffs all such assignments, and CID's policy
       expressed to its regional Criminal Investigators was
       that assignments would be made on a case-by-case basis.

               *       *       *       *       *       *       *

                 d)   Defendants repeatedly represented to
       plaintiffs that plaintiffs would be indemnified and
       held harmless by defendants when defendants never
       intended to indemnify plaintiffs, and never did indem-
       nify plaintiffs or reimburse plaintiffs for plaintiffs'
       legal fees, costs, and expenses.

                   *       *    *       *       *       *       *

            28. As a result of defendants' fraudulent acts as
       described above, plaintiffs were damaged as set out * *
       * [in connection with their claim for breaches of
       contract]; plaintiffs Peter and Shirley Diamond suf-
       fered embarrassment, humiliation, emotional distress
       and mental pain and suffering to their damage in the
       amount of $500,000 each; plaintiff DCI is entitled to
       punitive damages of $25 million; and plaintiffs Peter
       and Shirley Diamond are entitled to punitive damages of
       $25 million.

                   *       *    *       *       *       *       *

VII.        Contentions of Law

                   *       *    *       *       *       *       *

            1.   All of the named defendants are liable to
       plaintiffs for the damages described above.

            2.   All defendants and all plaintiffs were par-
       ties to and are bound by the agreement, and are enti-
       tled to the benefits thereof.

                   *       *       *       *       *       *       *
                             - 10 -

          9.   Plaintiffs Peter and Shirley Diamond are
     entitled to recover their lost income, including loss
     of profits from ETS, and increased expenses, arising
     from defendants' fraud and breach of their agreement
     with plaintiffs.

     In the pretrial order, FIG denied all of the plaintiffs'

allegations, including the foregoing, and alleged, inter alia,

that the Diamonds were not entitled to recover any damages on

account of claims against FIG that properly belonged to DCI.

     Proceedings Before and Rulings
     By the District Court

          Imposition of Sanctions

     At the conclusion of the pretrial discovery period in the

Farmers lawsuit, the plaintiffs filed a motion (motion for

sanctions) in which they alleged that FIG had committed various

discovery abuses and requested that the District Court enter

sanctions against FIG by striking FIG's amended answer and

counterclaims, entering a judgment in favor of the plaintiffs,

and awarding attorneys' fees and costs to the plaintiffs.    On

September 9, 1986, the District Court issued an order (order)

granting the plaintiffs' motion for sanctions and indicating that

it would enter a default judgment in favor of the plaintiffs

following an evidentiary hearing (damages hearing) to determine

the amount of damages that they suffered.

          Damages Hearing

     On October 21 and 22, 1986, the District Court held a

damages hearing at which the plaintiffs presented evidence with
                              - 11 -

respect to their claims for damages for lost profits on account

of FIG's breaches of contract and fraudulent misrepresentations.

That evidence included the testimony of Donald Wharton (Mr.

Wharton), a certified public accountant whom the plaintiffs had

retained for the purpose of determining the profits lost by DCI

and by the Diamonds as a result of those actions of FIG.

     At the damages hearing, Mr. Wharton testified that, in

determining lost profits, he took account of the profits lost by

DCI, as well as the profits lost by ETS, and that he treated ETS

as a division of DCI.   In this connection, Mr. Wharton testified

that it was his understanding that ETS was owned by the Diamonds,

that it was formed sometime during 1982, and that it provided

services almost exclusively for DCI.

     Mr. Wharton further testified at the damages hearing that he

and others working under his supervision had prepared several

analyses of the profits lost by DCI and by ETS as a result of

FIG's breaches of contract and fraudulent misrepresentations and

that, in determining those profits, he relied principally on one

of those analyses referred to as Analysis 1 (Analysis 1) that was

entitled "Additional Profits due to DCI - 1981-1985, Measure

number one - Using historical hourly rates for investigators'

services and historical markups on other revenues".6   Analysis 1


6
   Although the title of Analysis 1 referred only to DCI, as
stated above, in reaching the conclusions shown in Analysis 1,
Mr. Wharton aggregated the operations of DCI and ETS.
                              - 12 -

reflected the following conclusions of Mr. Wharton about the lost

revenue, the direct costs, the variable overhead costs, and the

lost profits of both DCI and ETS:

     Additional revenues
       Service . . . . . . . . . . .   . $1,957,613
       Mileage . . . . . . . . . . .   .    169,420
       Office . . . . . . . . . . .    .    553,745
       Photo, phone, and
         reimbursable items . . . .    .      309,574   $2,990,352
     Less: Direct costs
       Service . . . . . . . . . . .   .    738,420
       Mileage . . . . . . . . . . .   .    145,212
       Office . . . . . . . . . . .    .    174,939
       Photo, phone, and
         reimbursable items . . . .    .     281,430    1,340,001
     Less: Variable overhead costs     .                  155,132
     Additional profits . . . . . .    .                1,495,219

     Mr. Wharton explained at the damages hearing the approach

that he used in preparing Analysis 1 and in arriving at the

conclusions set forth therein, as follows:

     (1)   Mr. Wharton first determined that DCI and ETS lost the

following amounts of additional revenue during the years indi-

cated:

                Year                       Amount

                1981                     $56,993
                1982                     488,522
                1983                     865,182
                1984                     983,918
                1985                     595,737
                Total lost revenues    2,990,352

Mr. Wharton made the foregoing determinations by examining

certain invoices that private investigative agencies other than

DCI had submitted to FIG during the period 1981 through 1985 for

work that he determined should have been assigned to DCI under
                               - 13 -

the agreement at issue in the Farmers lawsuit and by examining

certain other records that were obtained from FIG containing the

charges for such work.

     (2)   Mr. Wharton next analyzed certain historical financial

data of DCI and ETS that showed the categories, and the amounts

in each category, of revenues received by DCI and by ETS during

the years 1981 through 1984.   Based on that analysis, Mr. Wharton

concluded there were the following four categories of revenues

received by DCI or ETS during those years, (a) service, (b) mile-

age, (c) office, and (d) photo, phone, and reimbursable items.

He allocated the total lost revenues of $2,990,352 among those

four categories in proportions that reflected the historical data

relating to those years that he had analyzed.

     (3)   Mr. Wharton next analyzed certain historical financial

data of DCI and ETS that indicated the relationship of costs to

revenues within each of the four categories of revenues shown in

Analysis 1.   Based on that analysis, Mr. Wharton determined the

direct costs that DCI or ETS would have incurred in generating

the lost revenues within each of those categories.

     (4)   Mr. Wharton next conducted "a study of the general

administrative-type expenses" to determine the additional vari-

able overhead costs (variable overhead) that DCI or ETS would

have incurred on an annual basis during 1981 through 1985 in

generating the $2,990,352 of total lost revenues for that period.

     (5)   Mr. Wharton next reduced the total lost revenues by the
                                - 14 -

total direct costs and the variable overhead to arrive at the

total profits that DCI and ETS lost during the period 1981

through 1985, which he labeled in Analysis 1 as "Additional

Profit due DCI".

     With respect to the portion of the total lost profits

reflected in Analysis 1 that was attributable to ETS, Mr. Wharton

testified at the damages hearing that although he was unable to

determine that portion precisely, "the bulk of what is in the

office profitability would have been from Evergreen."     In that

regard, Mr. Wharton further testified with respect to Analysis 1

that:     (1) The lost revenues of $553,745 that he allocated to the

office category were lost revenues from clerical and secretarial

services such as typing, photocopying, and transcribing; (2) the

direct costs of $174,939 that he allocated to the office category

were costs that would have been associated with the lost revenues

in that category including variable office costs, such as hourly

rates charged by typists; and (3) the variable overhead of

$155,132 included additional costs that would have been associ-

ated with the lost revenues in the office category.

             The District Court's Award of Damages

        On January 20, 1987, the District Court issued an opinion

(opinion) in the Farmers lawsuit.     In that opinion, the District

Court concluded that the effects of the entry of default in favor

of the plaintiffs and against FIG were (1) to treat as estab-

lished the plaintiffs' factual allegations in the pretrial order
                                - 15 -

relating to their claims against FIG for breaches of contract,

indemnity, and fraudulent misrepresentations and (2) to hold FIG

liable to the plaintiffs on each of those claims.    Based on the

plaintiffs' allegations in the pretrial order, the District Court

specifically found in its opinion, inter alia, that DCI started a

business during 1982 known as ETS for the purpose of providing

transcription services to FIG and that DCI later transferred

ownership of that business to the Diamonds.

        In its opinion, the District Court awarded the plaintiffs,

viz., Diamond Claims & Investigation Services, Inc., and Peter J.

Diamond and Shirley Diamond, the following types of damages in

the amounts and for the claims indicated:

                                  Type of              Amount of
    Plaintiffs' Claims        Damages Awarded       Damages Awarded

Breaches of contract        Lost profits damages     $1,497,015.51
Indemnity                   Indemnity damages            63,159.00
Fraudulent                  Punitive damages and        290,715.00
   misrepresentations7         reliance damages          35,746.00
     Total                                            1,886,635.51

        On February 26, 1987, the District Court entered a judgment

(District Court's judgment) that "plaintiffs shall recover from

defendants the sum of $1,886,635.51, together with interest at

the rate of 6.09 percent from the date of entry of judgment".8

        With respect to the lost profits damages, the District Court

7
   The District Court did not award the Diamonds any damages for
the emotional distress that they claimed they suffered as a
result of FIG's fraudulent misrepresentations.
8
     Hereinafter, all dollar amounts are rounded.
                             - 16 -

relied on Analysis 1 and Mr. Wharton's testimony at the damages

hearing, finding that, with a few minor exceptions, Mr. Wharton's

determinations set forth in Analysis 1 were reasonable.   The

District Court made the following minor adjustments to Mr.

Wharton's determinations in Analysis 1 in order to reflect

certain additional evidence presented at the damages hearing:

(1) It increased lost revenue for the period 1984 and 1985 by

$21,593 and the total lost revenues for the period 1981 through

1985 by that same amount; (2) it increased direct costs for the

period 1984 and 1985 by $10,797 to reflect the cost of generating

that additional revenue and the total direct costs for the period

1981 through 1985 by that same amount; and (3) it increased

variable overhead by $9,000 of additional monthly rents that

would have been incurred during an unspecified period of time

during the period 1981 through 1985 to generate the total lost

revenues reflected in Analysis 1 during those years.

          The District Court's Award
          of Attorneys' Fees and Costs

     The plaintiffs sought $240,137 in attorneys' fees, and the

District Court scheduled an evidentiary hearing on that request.

In June 1987, the District Court awarded the plaintiffs attor-

neys' fees and costs in the total amount of $220,360.

     FIG's Appeal of the District Court's Judgment

     FIG appealed the District Court's judgment to the U.S. Court

of Appeals for the Ninth Circuit.   In June 1988, the Court of
                              - 17 -

Appeals affirmed the imposition of sanctions and the award to the

plaintiffs of lost profits damages, indemnity damages, and

punitive damages and reversed the award of reliance damages.

     Satisfaction of the District Court's
     Judgment in the Farmers Lawsuit

     On or about August 4, 1988, the attorneys representing FIG

in the Farmers lawsuit delivered to the plaintiffs' attorneys,

Markowitz & Herbold, a check issued by FIG, dated August 3, 1988

(FIG check), in the amount of $2,254,983 (proceeds of the Farmers

lawsuit) and a letter attached thereto (FIG letter).    The FIG

check was made payable to the plaintiffs in the Farmers lawsuit

(viz., DCI, Peter Diamond, and Shirley Diamond) and to Markowitz

& Herbold.   The FIG letter stated, inter alia, that the check

represented full payment by FIG of the plaintiffs' claims, as

follows:

           Amount of judgment            $1,850,8909
           Interest on judgment             161,821
           Attorneys' fees                  220,36010

9
   This amount consisted of all the damages that the District
Court awarded to the plaintiffs, except reliance damages.
10
   Although the District Court awarded the plaintiffs $220,360
in attorneys' fees and costs, the FIG letter indicated that the
proceeds of the Farmers lawsuit included a total of $226,212 in
attorneys' fees and costs. Moreover, although the District
Court's judgment awarding attorneys' fees and costs to the
plaintiffs does not indicate that the plaintiffs were also
awarded interest on those fees and costs, the FIG letter indi-
cated that the proceeds of the Farmers lawsuit included a total
of $15,369 in interest on those fees and costs. The record does
not explain the reasons for those discrepancies, and the parties
do not advance any argument about them. Despite the foregoing
                                                   (continued...)
                              - 18 -

           Interest on attorneys' fees       15,369
           Costs                              5,62611
           Appeal costs                         22612
           Per diem interest                    691
              Total                       2,254,983

The FIG check was endorsed by (1) Peter Diamond as president of

DCI, (2) Peter Diamond as an individual, (3) Shirley Diamond as

an individual, and (4) David Markowitz and Barrie Herbold and was

deposited into the client trust account of Markowitz & Herbold.

Minutes of Certain DCI Meetings
and Certain Correspondence of DCI
With Respect to the Farmers Lawsuit

      The minutes of a special meeting of DCI, dated December 12,

1984 (December 12, 1984 minutes) and signed by the Diamonds in

their capacity as shareholders of DCI, made reference to the

Farmers lawsuit and stated in pertinent part:

      As is already known, the corporation is engaged in
      litigation against Farmers Insurance. Resulting ef-
      fects to the corporation are going to be a continued
      drain of its financial capability * * *. * * * Ever-
      green Typing Service, Peter Diamond and Shirley Diamond
      will continue to provide the support services that
      formerly were given by Evergreen Typing Service.

      In light of this, they have agreed to not bill for
      their services rendered during the course of the liti-
      gation if DCI will assume the litigation expenses,
      court costs, attorneys [sic] fees, etc.

10
 (...continued)
discrepancies, since the parties proceed on the assumption that
the District Court awarded damages, attorneys' fees and costs,
and interest to the plaintiffs in amounts stated in the FIG
letter, we shall also proceed on that assumption.
11
     See supra note 10.
12
     See supra note 10.
                             - 19 -

     Additionally, they have agreed that they will also be
     compensated for the loss of Evergreen Typing Service
     profits as a result of the breach of contract in [sic]
     case giving rise to the Farmers litigation engaged in
     by the corporation. They will be deferring those
     profit dollars, however, until such time as the litiga-
     tion has been successful. The Diamonds have also
     agreed that they will not bring a separate lawsuit
     against the corporation (DCI) for any breach of con-
     tract that the corporation would have been responsible
     for to Evergreen Typing Service.

     A letter on DCI's stationery that was signed by Mr. Diamond,

addressed to the Diamonds and to ETS, and dated December 12, 1984

(December 12, 1984 letter) also made reference to the Farmers

lawsuit and stated in pertinent part:

     This will confirm the corporation's agreement to extend
     any and all expenses with regard to the litigation
     engaged in by ourselves as against Farmers Insurance.
     Since this litigation is to our mutual benefit, there
     is no need to reiterate its content as we are all
     parties. However [sic] the purpose of this letter is
     to affirm that all litigation expenses, attorneys [sic]
     fees, trial costs, etc., will be paid for by the corpo-
     ration in exchange for your continued support services
     throughout the litigation and your refraining from
     bringing any separate [sic] litigation against the
     corporation for any liabilities owed to Evergreen
     Typing Service or yourselves, individually.

     This will also aknowledge [sic] that our arrangement
     indicated above will have no effect on your company's
     recovery at time of settlement or judgement as against
     Farmers Insurance, et al. Nor will the litigation
     expenses extended by DCI have any offsetting effect as
     against any judgement due Evergreen Typing Service or
     yourselves individually as proprietors.

     The minutes of a meeting of DCI, dated December 30, 1984

(December 30, 1984 minutes) and signed by the Diamonds in their

capacity as shareholders of DCI, also made reference to the

Farmers lawsuit and to certain rental payments that DCI owed the
                              - 20 -

Diamonds and stated in pertinent part:

     the Diamonds have agreed to forestall collection of
     rent until such time as judgement has been rendered in
     the litigation ongoing. This is also in consideration
     of the risk that litigation may be unsuccessful, and
     the Diamonds would be out their rent due. They are
     willing to extend this credit as further consideration
     to avoid personal litigation expenses in the ongoing
     suit.

Allocation by DCI and the Diamonds of
the Proceeds of the Farmers Lawsuit

     On August 9, 1988, the Diamonds, in their capacity as the

officers and shareholders of DCI and in their capacity as the

owners of ETS, met with attorneys from Markowitz & Herbold in

order to discuss how the proceeds of the Farmers lawsuit should

be divided or allocated between DCI and the Diamonds as the

owners of ETS.   On that date, Markowitz & Herbold issued a check

to DCI in the amount of $1,162,780, which contained a notation

indicating that that check was in "settlement of claims" and

which was endorsed by Mr. Diamond as president of DCI.   On that

same date, Markowitz & Herbold also issued a check to Mr. Diamond

in the amount of $400,000, which contained a notation indicating

that that check was in "settlement of personal claim", was

endorsed by Mr. Diamond as an individual, and represented the

Diamonds' share of the proceeds of the Farmers lawsuit as the

owners of ETS.   The law firm of Markowitz & Herbold retained

$692,203 of the proceeds of the Farmers lawsuit as attorneys'

fees and costs that were incurred in the Farmers lawsuit (attor-
                               - 21 -

neys' fees and costs actually incurred in the Farmers lawsuit).13

       Sometime after the damages hearing, DCI and/or the Diamonds

retained James Donnelly (Mr. Donnelly), a certified public

accountant, to analyze how the proceeds of the Farmers lawsuit

should be allocated between DCI and ETS.   Mr. Donnelly made seven

alternative analyses.    In making those various analyses, he had

access to, and relied on, inter alia, the following that he

received from Mr. Diamond:   (1) A copy of the District Court's

opinion and (2) copies of certain evidence presented at the

damages hearing, including copies of Analysis 1 and portions of

the transcript containing Mr. Wharton's testimony, historical

financial records of DCI and ETS, and Federal income tax returns

filed by DCI and by the Diamonds.    Mr. Donnelly recommended, and

the board of directors of DCI and the Diamonds in their capacity

as owners of ETS approved, the use of one of those analyses

(selected allocation analysis).

       Under the selected allocation analysis, Mr. Donnelly recom-

mended that $446,981 of the lost profits damages be allocated to

ETS.    That amount, which was approximately 29.86 percent of those

damages (selected allocation ratio), represented Mr. Donnelly's

estimate of the profits that ETS would have earned during each of


13
   Although the attorneys' fees and costs actually incurred in
the Farmers lawsuit were $692,203, the District Court awarded the
plaintiffs $220,360 in attorneys' fees and costs, and FIG paid
the plaintiffs $226,212 in attorneys' fees and costs. See supra
note 10.
                               - 22 -

the years 1985 through 1988 if it had continued to operate as it

had during the years 1983 and 1984, reduced by any profits that

ETS actually earned during each of the years 1985 through 1988.

Mr. Donnelly used the following approach to estimate what those

profits would have been:   (1) He calculated ETS' average net

profits for the years 1983 and 1984 (viz., $110,248); (2) he used

a constant annual inflation rate of 4 percent; (3) he concluded

that if ETS had continued to operate during the years 1985, 1986,

1987, and 1988 as it had during 1983 and 1984, it would have

earned profits of $114,658, $119,245, $124,015, and $128,976,

respectively; (4) he determined that ETS actually earned profits

of $39,875 during 1985 and reduced the 1985 estimated profits

figure of $114,658 by that amount; and (5) he reduced the forego-

ing estimated profits figures for the years 1985 through 1988 by

$38 to reflect certain rounding adjustments for all four years.

      Under the selected allocation analysis, Mr. Donnelly also

recommended (1) that his selected allocation ratio of 29.86

percent be applied to the punitive damages, the interest, and

the attorneys' fees and costs components of the proceeds of the

Farmers lawsuit and (2) that the resulting amounts be allocated

to ETS.   He also recommended that his selected allocation ratio

of 29.86 percent be applied to the attorneys' fees and costs

actually incurred in the Farmers lawsuit14 and that the resulting

14
     In applying his selected allocation ratio to the attorneys'
                                                     (continued...)
                               - 23 -

amount be allocated to ETS and reduce the proceeds of the Farmers

lawsuit that he had otherwise allocated to ETS under the selected

allocation analysis.

     Under the selected allocation analysis, Mr. Donnelly recom-

mended that the proceeds of the Farmers lawsuit and the attor-

neys' fees and costs actually incurred in the Farmers lawsuit be

allocated between DCI and ETS, as follows:

                         Total Amount   Recommended   Recommended
       Item                of Item      Allocation    Allocation
     Allocated             Allocated       to ETS        to DCI

Lost profits damages      $1,497,016     $446,981     $1,050,035
Punitive damages             290,715       86,714        204,001
Indemnity damages             63,159        -0-           63,159
Interest                     177,881       53,115        124,766
Attorneys' fees
  and costs                  226,212         67,547      158,665
    Total proceeds of
      the Farmers lawsuit 2,254,983       654,357      1,600,626
Less:
  Attorneys' fees and
  costs actually incurred
  in the Farmers lawsuit     683,556      204,112        479,444
    Amount allocated       1,571,427      450,245      1,121,182

     Sometime after August 9, 1988, and prior to September 30,

1988, in reliance on Mr. Donnelly's recommendation under the

selected allocation analysis, an additional allocation of $50,245

of the proceeds of the Farmers lawsuit was made to the Diamonds

as the owners of ETS, thereby increasing the amount of the



14
 (...continued)
fees and costs actually incurred in the Farmers lawsuit, Mr.
Donnelly used $683,556 as the amount of such fees and costs.
However, the actual amount of such fees and costs was $692,203.
The record does not explain that discrepancy, and the parties
make no argument about it.
                              - 24 -

proceeds of the Farmers lawsuit allocated to, and received by,

the Diamonds as the owners of ETS from $400,000 to $450,245.

Tax Return Treatment

     In the return that it filed for its taxable year ended

September 30, 1988, and that Mr. Donnelly signed as return

preparer, DCI included in gross income the entire amount of the

proceeds of the Farmers lawsuit (viz., $2,254,983).    DCI claimed

a $450,245 deduction for "CONTRACT SERVICES".   DCI also claimed

various other deductions, including deductions for legal and

accounting fees in the amounts of $715,814 and $9,708, respec-

tively.

     The Diamonds filed a joint return for 1988 that Mr. Donnelly

signed as return preparer.   In Schedule C of that return, the

Diamonds reported $450,245 of gross receipts, $9,600 of other

income, $1,696 of expenses that included $880 of legal and

accounting fees, and $458,149 of net profits from the operations

of ETS.

Notice of Deficiency

     In the notice of deficiency (notice), respondent determined,

inter alia, that DCI's taxable income for the taxable year ended

September 30, 1988, must be increased by $411,086.    The notice

stated in pertinent part:

     It is determined that for the taxable year ended 9-30-
     88 your gross income is understated in the amount of
     $411,086.00 which represents a portion of the lawsuit
     income received from Farmers Insurance Company and
     improperly allocated to your sole shareholder. This
                             - 25 -

     income is determined to be includible in your gross
     income and it has not been established that such amount
     is anything other than income to you. Accordingly,
     taxable income is increased $411,086.00 for the taxable
     year ended 9-30-88.

     On May 3, 1993, respondent filed with the Court an answer

(answer) to the petition that DCI had filed with the Court, in

which respondent alleged, inter alia, (1) that respondent mis-

characterized the adjustment in the notice to DCI's taxable

income as an adjustment to its gross income, rather than as a

disallowance of a claimed deduction for contract services in the

amount of $411,086 and (2) that DCI is not entitled to that

deduction because it constitutes a dividend or an attempted

assignment of income to the Diamonds.

                             OPINION

     The District Court awarded the proceeds of the Farmers

lawsuit15 to the plaintiffs (viz., DCI and the Diamonds) without

15
   The components of the proceeds of the Farmers lawsuit were:
(1) Lost profits damages of $1,497,016, (2) indemnity damages of
$63,159, (3) punitive damages of $290,715, (4) attorneys' fees
and costs of $226,212, and (5) interest of $177,881. Despite the
District Court's awarding indemnity damages of $63,159 to all the
plaintiffs (viz., DCI and the Diamonds), DCI does not contend
that any portion of those indemnity damages is allocable to the
Diamonds and thus not includible in its income for the year at
issue. In contrast, although a portion of the interest component
of the proceeds of the Farmers lawsuit was awarded with respect
to indemnity damages, neither petitioner nor respondent contends
that that portion of such interest component is not at issue. We
conclude that the indemnity damages component of the proceeds of
the Farmers lawsuit is not at issue in this case, but that all of
the interest component of such proceeds is at issue. Accord-
ingly, the amount of the proceeds of the Farmers lawsuit that
remains at issue is $2,191,824. Hereinafter, any reference to
                                                   (continued...)
                              - 26 -

specifying how much of those proceeds it was awarding to each of

those plaintiffs.   In its return for the year at issue, DCI

included in its gross income all the proceeds of the Farmers

lawsuit and deducted as "CONTRACT SERVICES" $450,245.   In their

joint return for 1988, the Diamonds included that $450,245 as

gross receipts.

     DCI contends that it is entitled to the full amount (i.e.,

$450,245) of the deduction that it claimed for "CONTRACT SER-

VICES" because:   (1) The Diamonds were the plaintiffs in the

Farmers lawsuit in their capacity as the owners of ETS; (2) the

proceeds of the Farmers lawsuit included damages that the Dis-

trict Court awarded to the Diamonds in that capacity; and (3) the

proceeds of the Farmers lawsuit that were allocated to the

Diamonds represented their share of the total proceeds of that

lawsuit.   In the alternative, DCI contends that it is entitled to

the full amount of the deduction in question because DCI and the

Diamonds entered into an agreement under which the Diamonds

agreed, inter alia, to refrain from instituting a lawsuit against

DCI for breach of contract in return for DCI's agreement to pay

the Diamonds their share of the proceeds of the Farmers lawsuit.

     Respondent counters that DCI is not entitled to $411,086 of

the deduction that DCI claimed for "CONTRACT SERVICES" because


15
 (...continued)
the proceeds of the Farmers lawsuit shall be to those proceeds
that remain at issue.
                               - 27 -

DCI paid that amount to the Diamonds as a dividend.16

     The parties frame the central issue that we must resolve as

necessarily implicating section 162.17   We assume that that is

because, in its return for the year at issue, DCI included in its

gross income all the proceeds of the Farmers lawsuit and deducted

as "CONTRACT SERVICES" $450,245.   We disagree with the parties'

framing of the main issue that we must resolve as necessarily

implicating section 162.18   As we see it, the critical question

that we must decide is the factual issue of whether the District

Court awarded all, or only a portion, of the proceeds of the

Farmers lawsuit to DCI.   If we were to find that the District

Court awarded a portion, and not all, of the proceeds of the

Farmers lawsuit to DCI, only that portion would be includible in

DCI's gross income for the year at issue; the remaining portion



16
   Although respondent does not offer any explanation as to why
she conceded $39,159 of the $450,245 deduction that DCI claimed
in its return for the year at issue, we shall not disturb that
concession.
17
   All section references are to the Internal Revenue Code in
effect for the year at issue. All Rule references are to the Tax
Court Rules of Practice and Procedure.
18
   Nor are we bound by DCI's treatment of the proceeds of the
Farmers lawsuit in its return for the year at issue. Although,
as respondent suggests, DCI's inclusion in that return of all of
those proceeds might be construed as an admission by DCI that the
Diamonds were not awarded any damages in the Farmers lawsuit in
their capacity as the owners of ETS, we do not take it as such.
This is because, inter alia, DCI also claimed in that return a
deduction of $450,245, the portion of those proceeds received by
the Diamonds in their capacity as the owners of ETS pursuant to
Mr. Donnelly's recommendation.
                               - 28 -

of such proceeds would not be includible in DCI's gross income,

but would be includible in the gross income of the person to whom

the District Court awarded such portion; and DCI would not be

entitled to deduct any portion of the proceeds of the Farmers

lawsuit that is at issue.19   If we were to find that the District

Court awarded all of the proceeds of the Farmers lawsuit to DCI,

all of those proceeds would be includible in DCI's gross income

for the year at issue.   In that event, we would have to address

DCI's alternative contention that, because of a purported agree-

ment entered into between DCI and the Diamonds pursuant to which

DCI was to pay a portion of the proceeds of the Farmers lawsuit

to the Diamonds, it is entitled to the deduction that it claimed

under section 162 for the year at issue.

     We turn first to whether the District Court awarded all, or

only a portion, of the proceeds of the Farmers lawsuit to DCI.20

In deciding that question, we shall focus on the District Court's

opinions and judgments in the Farmers lawsuit, the pretrial order

submitted in that lawsuit, and certain evidence presented at the

19
   See supra note 16. We acknowledge that, for a given taxable
year, including an item in gross income and then deducting a
portion of it will generally produce the same result reached by
excluding that portion from gross income and deducting no portion
of the item in question. However, we must reach that result by
following the path mandated by the facts that we have found and
the applicable law.
20
   Although there was a dispute at trial as to whether respon-
dent's answer raised a new matter and altered the burden of
proof, our determinations are made on the record without regard
to that question.
                               - 29 -

damages hearing on which the District Court expressly relied in

awarding damages to the plaintiffs in that lawsuit.    Cf. Furrer

v. Commissioner, 566 F.2d 1115, 1116 (9th Cir. 1977), affg. T.C.

Memo. 1976-331; Church v. Commissioner, 80 T.C. 1104, 1107

(1983).

     In September 1984, DCI and the Diamonds commenced the

Farmers lawsuit in the District Court by filing an initial

complaint.   Thereafter, they filed an amended complaint and a

second amended complaint, and the plaintiffs and FIG submitted a

pretrial order.    In those submissions, the plaintiffs raised

claims against FIG for breaches of contract, indemnity, and

fraudulent misrepresentations and sought damages from FIG with

respect to those claims.    At the conclusion of the pretrial

discovery period, the plaintiffs filed a motion for sanctions

against FIG, and on September 9, 1986, the District Court issued

an order granting that motion and indicating that it would enter

a default judgment in favor of the plaintiffs following the

damages hearing.

     On January 20, 1987, the District Court rendered an opinion

in which it concluded (1) that the pretrial order (a) superseded

the various complaints that the plaintiffs had filed in the

Farmers lawsuit and (b) controlled the determination of any

damages to be awarded to the plaintiffs and (2) that the effects

of the entry of default in favor of the plaintiffs and against

FIG were to treat as established the plaintiffs' factual allega-
                             - 30 -

tions in the pretrial order relating to their claims against FIG

for breaches of contract, indemnity, and fraudulent misrepresen-

tations.

     In the pretrial order, the Diamonds, as well as DCI, were

identified as the plaintiffs in the Farmers lawsuit.21    In that

order, those plaintiffs raised claims against FIG for, inter

alia, breaches of contract and fraudulent misrepresentations and

sought damages from FIG with respect to those claims.22

     With respect to the plaintiffs' claims against FIG for

breaches of contract, the pretrial order alleged, inter alia:

(1) That the plaintiffs were parties to, bound by, and entitled

to the benefits of the agreement at issue in the Farmers lawsuit;

(2) that DCI had started ETS during 1982 for the purpose of

providing transcription services to FIG in connection with the

investigative work that it was performing for FIG; (3) that DCI

had thereafter transferred ownership of ETS to the Diamonds;


21
   Respondent contends that ETS was not identified as a plain-
tiff in the Farmers lawsuit. That ETS was not so identified does
not preclude our finding that the Diamonds were the plaintiffs in
the Farmers lawsuit in their capacity as the owners of ETS or
that they were awarded damages in that capacity.
22
   We note that, at an early stage in the Farmers lawsuit, the
plaintiffs apparently recognized that the initial complaint and
the amended complaint were deficient insofar as those complaints
indicated that the allegations in support of their claims of
breaches of contract and fraudulent misrepresentations and in
support of the damages sought on account of those claims were
made solely by DCI, and not by the Diamonds, and they corrected
those deficiencies in the second amended complaint and in the
pretrial order.
                             - 31 -

(4) that DCI and the Diamonds periodically invested in new equip-

ment for ETS and hired employees for the purpose of providing

services to FIG; (5) that ETS provided services to FIG during the

years 1982 through 1984; and (6) that FIG breached the agreement

at issue in the Farmers lawsuit.

     With respect to the plaintiffs' claims against FIG for

fraudulent misrepresentations, the pretrial order alleged, inter

alia, that FIG repeatedly made false misrepresentations to the

plaintiffs and concealed the true state of affairs from the

plaintiffs with the knowledge and intent that the plaintiffs

would rely on such misrepresentations to their detriment.

     With respect to the lost profits damages that the plaintiffs

sought from FIG for breaches of contract and for fraudulent mis-

representations, the pretrial order alleged, inter alia:

(1) That the plaintiffs suffered damages as a result of those

actions of FIG; (2) that the plaintiffs lost profits on the

investigative work that FIG assigned to investigative agencies

other than DCI; and (3) that "Plaintiffs Peter and Shirley

Diamond are entitled to recover their lost income, including loss

of profits from ETS, and increased expenses, arising from defen-

dants' fraud and breach of their agreement with plaintiffs."

     With respect to the punitive damages that the plaintiffs

sought from FIG for fraudulent misrepresentations, the pretrial

order alleged that the Diamonds, as well as DCI, were entitled to

punitive damages in the amount of $25 million.
                              - 32 -

     Based on the plaintiffs' factual allegations in the pretrial

order that the District Court treated as established, that Court

held in its opinion that FIG was liable to the plaintiffs for

breaches of contract, indemnity, and fraudulent misrepresenta-

tions.

     The District Court then proceeded in its opinion to deter-

mine the damages to be awarded to the plaintiffs as a result of

FIG's liability.   In making that determination, the District

Court relied on evidence that the plaintiffs presented at the

damages hearing with respect to their claims for damages for lost

profits due to FIG's breaches of contract and fraudulent

misrepresentations, including Analysis 1 and the testimony of Mr.

Wharton regarding that analysis.   Mr. Wharton testified at the

damages hearing (1) that it was his understanding that ETS was

owned by the Diamonds; (2) that it was formed sometime during

1982; (3) that it provided services almost exclusively to DCI;

(4) that, in determining lost profits, he took account of the

profits lost by DCI, as well as the profits lost by ETS, and that

he treated ETS as a division of DCI; (5) that he and others

working under his supervision prepared several analyses of the

profits lost by DCI and by ETS as a result of FIG's breaches of

contract and fraudulent misrepresentations and that, in determin-

ing those profits, he relied principally on Analysis 1; (6) that,

in reaching the conclusions shown in Analysis 1, he aggregated

the operations of DCI and ETS; and (7) that although he was
                              - 33 -

unable to determine precisely the portion of the total lost

profits reflected in Analysis 1 that was attributable to ETS,

"the bulk of what is in the office profitability would have been

from Evergreen."   In that regard, Mr. Wharton further testified

with respect to Analysis 1 that (1) the lost revenues of $553,745

that he allocated to the office category in Analysis 1 were lost

revenues from clerical and secretarial services such as typing,

photocopying, and transcribing; (2) the direct costs of $174,939

that he allocated to the office category were costs that would

have been associated with the lost revenues in that category

including variable office costs, such as hourly rates charged by

typists; and (3) the variable overhead of $155,132 included

additional costs that would have been associated with the lost

revenues in the office category.

     Based upon the pretrial order and evidence presented at the

damages hearing, in its opinion, the District Court awarded to

all the plaintiffs in the Farmers lawsuit (viz., DCI and the

Diamonds), and not just to DCI, damages in the total amount of

$1,886,63623 for FIG's liability for breaches of contract, indem-

nity, and fraudulent misrepresentations.   On February 26, 1987,

it entered a judgment reflecting that opinion in favor of all the

plaintiffs, and not just DCI, and for interest on those damages.


23
   This amount included the District Court's award to the plain-
tiffs of reliance damages, which was reversed by the U.S. Court
of Appeals for the Ninth Circuit.
                               - 34 -

       Thereafter, the plaintiffs sought attorneys' fees, and the

District Court awarded attorneys' fees and costs to all the

plaintiffs in the Farmers lawsuit, and not just to DCI.

       Respondent points to the following language in the District

Court's opinion to support her position that the District Court

awarded all of the lost profits damages to DCI and did not award

any portion of those damages to the Diamonds as the owners of

ETS:

       Deducting the above costs and overhead items of
       $1,514,929.52 from the $3,011,945.03 total additional
       revenue that Diamond Claims would have received if
       Farmers had not breached their investigation services
       contract, I find that Diamond Claims' lost profits for
       the period 1981-1985 were $1,497,015.51.

We acknowledge that the foregoing language in the District

Court's opinion, standing alone, appears to lend support to

respondent's position.    However, that language does not stand

alone and should not be read in a vacuum without regard to all

the other relevant facts relating to the District Court's award

in the Farmers lawsuit that we have found.    We believe that the

reason that the District Court referred to the lost profits

damages as "Diamond Claims' lost profits" is that it relied on

and adopted Mr. Wharton's approach that was reflected in his

testimony at the damages hearing and in Analysis 1 of treating

ETS as a division of DCI for purposes of calculating the lost

profits damages to be awarded to the plaintiffs in the Farmers

lawsuit.    Mr. Wharton testified at that hearing that, in deter-
                             - 35 -

mining lost profits, he took account of the profits lost by DCI,

as well as the profits lost by ETS, that he treated ETS as a

division of DCI, and that although he was unable to determine

precisely the portion of the total lost profits attributable to

ETS, "the bulk of what is in the office profitability would have

been from Evergreen."

     The following actions taken by the parties to the Farmers

lawsuit subsequent to the District Court's opinions and judgments

are consistent with those opinions and judgments:   (1) FIG made

the FIG check in payment of the proceeds of the Farmers lawsuit

payable to all the plaintiffs in the Farmers lawsuit (viz., DCI,

Peter Diamond, and Shirley Diamond), as well as their attorneys

Markowitz & Herbold; (2) FIG prepared the FIG letter that

accompanied the FIG check in which it stated, inter alia, that

that check represented full payment by FIG of the plaintiffs'

claims, without drawing any distinction between DCI and the

Diamonds; and (3) Peter Diamond as president of DCI, Peter

Diamond as an individual, Shirley Diamond as an individual, and

David Markowitz and Barrie Herbold endorsed the FIG check.24


24
   We note that certain statements by DCI and the Diamonds in
the Dec. 12, 1984 minutes, the Dec. 12, 1984 letter, and the Dec.
30, 1984 minutes also are consistent with the District Court's
opinions and judgments in the Farmers lawsuit. Those documents
all indicate that at an early stage in the Farmers lawsuit DCI
and the Diamonds recognized that the Diamonds, in their capacity
as the owners of ETS, were parties to the Farmers lawsuit and
would be entitled to a portion of any amount that the District
Court decided to award in that lawsuit.
                               - 36 -

      Based on our examination of the entire record in this case,

we find that the District Court awarded a portion of the proceeds

of the Farmers lawsuit to DCI and a portion of those proceeds to

the Diamonds as the owners of ETS.25    Consequently, only the

portion of such proceeds that the District Court awarded to DCI

is includible in its gross income for the year at issue.26

      The remaining question that we must resolve, which also is

factual, is what are the respective amounts of the proceeds of

the Farmers lawsuit that the District Court awarded to DCI and to

the Diamonds as the owners of ETS.27    In resolving that question,

25
   Respondent contends that no portion of the proceeds of the
Farmers lawsuit was awarded to the Diamonds as the owners of ETS
because there is no indication that there was a contractual
relationship between FIG and the Diamonds as the owners of ETS.
We reject that contention. The pretrial order alleged that the
plaintiffs were parties to the agreement at issue in the Farmers
lawsuit, that the Diamonds were entitled to lost profits from the
operations of ETS as a result of FIG's breaches of contract and
fraudulent misrepresentations, and that the Diamonds were enti-
tled to punitive damages as a result of FIG's fraudulent misrep-
resentations. The District Court entered a default judgment in
favor of, and awarded damages to, all the plaintiffs (viz., DCI
and the Diamonds) on account of their claims against FIG for
breaches of contract and fraudulent misrepresentations.
26
   In light of our finding that the District Court awarded a
portion of the proceeds of the Farmers lawsuit to DCI and a
portion of such proceeds to the Diamonds as the owners of ETS, we
shall not address DCI's alternative contention, which we under-
stand DCI would advance only in the event that we had not made
such a finding, that it is entitled to deduct the $450,245 of the
proceeds of the Farmers lawsuit that it claimed in its return for
the year at issue because that is the amount that DCI was obli-
gated to pay the Diamonds under an agreement entered into between
them.
27
     We disagree with petitioner's suggestion on brief that re-
                                                     (continued...)
                              - 37 -

we shall address each of the following components of the proceeds

of the Farmers lawsuit:   (1) Lost profits damages of $1,497,016,

(2) punitive damages of $290,715, (3) attorneys' fees and costs

of $226,212, and (4) interest of $177,881.   DCI contends that

$1,121,18228 should be allocated to DCI and that $450,245 should

be allocated to the Diamonds as the owners of ETS.   To support

that contention, DCI relies on the selected allocation analysis

that was (1) prepared by Mr. Donnelly, the certified public

accountant who was retained to analyze how the proceeds of the

Farmers lawsuit should be divided between DCI and the Diamonds as

the owners of ETS and (2) relied on by DCI and the Diamonds when

they allocated $1,121,182 of the proceeds of the Farmers lawsuit

to DCI and $450,245 of those proceeds to the Diamonds as the

owners of ETS.   According to petitioner, those amounts represent

the respective shares of DCI and the Diamonds (viz., $1,600,626

and $654,357, respectively) of the proceeds of the Farmers

lawsuit as determined by Mr. Donnelly under the selected alloca-

tion analysis, reduced by their respective shares (viz., $479,444

and $204,112, respectively) of the attorneys' fees and costs

actually incurred in the Farmers lawsuit as determined by Mr.


27
 (...continued)
spondent conceded that issue. In fact, respondent states on
brief that she made no concession with respect to "the disallowed
contract services expense."
28
   That amount includes the indemnity damages of $63,159 that
are not at issue in this case. See supra note 15.
                                - 38 -

Donnelly under that analysis.

     We are unwilling to rely on Mr. Donnelly's selected alloca-

tion analysis because the District Court did not use that analy-

sis (or any of Mr. Donnelly's other analyses) in determining the

amount of damages that it awarded to the plaintiffs in the Farm-

ers lawsuit.29   Instead, we shall rely on the District Court's

order, opinions, and judgments in the Farmers lawsuit and on

certain evidence presented at the damages hearing on which the

District Court expressly relied in awarding damages to the

plaintiffs.   Cf. Thomson v. Commissioner, 406 F.2d 1006, 1010

(9th Cir. 1969), affg. T.C. Memo. 1965-237; Niles v. United

States, 520 F. Supp. 808, 813 (N.D. Cal. 1981), affd. 710 F.2d

1391 (9th Cir. 1983).

     We turn first to the lost profits damages component of the

proceeds of the Farmers lawsuit.    In determining the respective

portions of the lost profits damages awarded to DCI and to the

Diamonds as the owners of ETS, we have examined the entire record

in this case and have focused on the following:   (1) The District

Court's order granting the plaintiffs' motion for sanctions and

the District Court's opinions and judgments awarding damages,

attorneys' fees and costs, and interest to the plaintiffs;

29
   We note that Mr. Donnelly's selected allocation analysis was
(1) based on data different than those relied on by the District
Court, (2) applied a methodology different than that applied by
the District Court, and (3) focused on profits lost by ETS for
years that were not the same years for which lost profits damages
were awarded by the District Court.
                                 - 39 -

(2) Analysis 1 on which the District Court relied in awarding the

lost profits damages; (3) Mr. Wharton's testimony at the damages

hearing regarding Analysis 1 on which the District Court relied

in awarding those damages; (4) other evidence presented at the

damages hearing on which the District Court relied in making a

few minor adjustments to Mr. Wharton's determinations in Analysis

1; (5) those minor adjustments; and (6) the facts that DCI formed

ETS in 1982 and operated it until sometime during the early part

of 1983 at which time the Diamonds acquired and operated ETS as a

sole proprietorship.      We find on the record before us that, of

the total amount of lost profits damages (viz., $1,497,016) that

the District Court awarded to the plaintiffs in the Farmers

lawsuit, $1,222,948 was awarded to DCI and $274,068 was awarded

to the Diamonds as the owners of ETS.

      As for the remainder of the proceeds of the Farmers lawsuit

at issue, viz., punitive damages of $290,715, attorneys' fees and

costs of $226,212,30 and interest of $177,881, we believe that it

is reasonable to assume that each of the foregoing components of

those proceeds that were awarded to DCI and to the Diamonds as

the owners of ETS were awarded in the same proportions as the

lost profits damages were awarded, i.e., 81.69 percent to DCI and

18.31 percent to the Diamonds.      Accordingly, we find that the

District Court awarded each of the following components of the


30
     See supra note 10.
                              - 40 -

proceeds of the Farmers lawsuit to DCI and to the Diamonds as the

owners of ETS:

                              Amount               Amount
         Item                 Awarded            Awarded to
        Awarded               to DCI            the Diamonds

     Punitive damages        $237,485             $53,230
     Attorneys' fees
        and costs             184,792              41,420
     Interest                 145,311              32,570

     Based on our review of the entire record in this case, we

find that, of the proceeds of the Farmers lawsuit that are at

issue (viz., $2,191,824), $1,790,536 was awarded to DCI and

$401,288 was awarded to the Diamonds as the owners of ETS.

Accordingly, only $1,790,536 of those proceeds is includible in

DCI's gross income for the year at issue.31

     To reflect the foregoing and the concessions of the parties,


                                   Decision will be entered

                              under Rule 155.



31
   The remaining portion of such proceeds, or $401,288, is not
includible in DCI's gross income for the year at issue, and DCI
is not entitled to the deduction of $411,086 on which the parties
focus their arguments. In this connection, petitioner concedes
on brief that, by allowing petitioner to deduct $39,159 of the
total deduction claimed in its return for the year at issue with
respect to the proceeds of the Farmers lawsuit, respondent did
not include in petitioner's taxable income for that year $39,159
of those proceeds that are at issue and that the District Court
awarded to the Diamonds as the owners of ETS. Consequently, in
the Rule 155 computation, the parties shall take account of
petitioner's concession so that the maximum amount of the pro-
ceeds of the Farmers lawsuit that are at issue and that are not
includible in the taxable income of DCI is $401,288.
