                        T.C. Memo. 2009-51



                      UNITED STATES TAX COURT



      THOMAS ANTHONY BACHMANN AND KATHLEEN HELEN BACHMANN,
   Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent


     Docket No. 21179-07.                Filed March 11, 2009.




     John E. Ellsworth, for petitioners.

     George W. Bezold, for respondent.



                        MEMORANDUM OPINION


     MORRISON, Judge: The petitioners (the Bachmanns) and the

respondent (the IRS) agreed to submit this case for decision

under Rule 122.   The IRS determined a deficiency of $283,882 for

the taxable year 2004 and a penalty under section 6662(a) and

(b)(2) of $56,776.
                               - 2 -

     The issues for decision are: (1) whether a $1,369,729 net

arbitration award against Salomon Smith Barney in favor of Mr.

Bachmann is includable in the Bachmanns’ gross income for the

taxable year 2004; and (2) whether the Bachmanns are liable for

the penalty under section 6662(a) and (b)(2).   Unless otherwise

indicated, all section references are to the Internal Revenue

Code in effect for the year at issue.

                            Background

     We adopt as findings of fact all statements contained in the

stipulation of facts.   The stipulation of facts and the attached

exhibits are incorporated here by this reference.   As the time

they filed the petition, the Bachmanns resided in New Jersey.

     Mr. Bachmann had been employed in the financial services

industry for more than 30 years before he commenced employment

with Salomon Smith Barney, Inc. (Smith Barney), against which he

would later lodge an arbitration claim.   The IRS has stipulated

that the copy of the arbitration claim is authentic.   The IRS has

not stipulated that the facts alleged in the claim are true.    In

this opinion we frequently cite the arbitration claim.   We are

stating only that the relevant assertion has been made in the

arbitration claim, not that we find the fact to be true.

     Mr. Bachmann was a senior vice president at Tucker Anthony

in its financial institution service group before he joined Smith

Barney.   Mr. Bachmann had spent most of his career “servicing the
                                - 3 -

needs of community banks.”    Bachmann developed a novel idea for

smaller community banks to issue “trust preferred stock” as a

group and thereby lower the cost of the issuance of such stock to

each individual bank.    In a trust preferred stock arrangement,

the banks issue debt to a trust, which in turn issues preferred

securities to investors and thereby raises cash for the banks.

Eveson & Schramm, “Bank Holding Company Trust Preferred

Securities: Recent Developments”, 11 N.C. Banking Inst. 105, 117

n.74 (2007); Eveson, “Financial and Bank Holding Company Issuance

of Trust Preferred Securities”, 6 N.C. Banking Inst. 315, 327

(2002); Gergen & Schmitz, “The Influence of Tax Law on Securities

Innovation in the United States: 1981-1997”, 52 Tax L. Rev. 119,

133-134 n.58 (1997).    Bachmann’s claim asserts the following

reasons why trust preferred stock is more advantageous than other

financial instruments:

     13. For each dollar a bank generates of so-called
     “Tier I Capital” (consisting of items including stock,
     undivided profits, and surplus), the bank is permitted
     to take in several dollars of deposits. Thus, it is
     advantageous for banks to increase their amount of
     “Tier I Capital” – since such capital enables a bank to
     take in more deposits, which can then be invested
     through loans or other instruments to generate further
     “Tier I Capital.” In sum, “Tier I Capital” enables a
     bank to leverage such capital to take in many more
     dollars of deposits, and thus, to grow.
     14. In 1992, while Bachmann was employed by Tucker
     Anthony, certain regulatory changes were announced
     which allowed, for the first time, certain non-bank
     entities to use the issuance of trust preferred stock
     (“Trust Preferreds”) as “Tier I Capital.” Thereafter,
     in 1996, further regulatory changes allowed Trust
                               - 4 -

     Preferreds to be counted as Tier I Capital for the
     banks.
     15. Authorizing Trust Preferreds to be treated as
     “Tier I Capital” allowed banks to create such capital
     more cheaply than through the issuance of common stock.
     Additionally, since Trust Preferreds have a debt
     component, banks could deduct from their taxable income
     the interest paid to Trust Preferreds holders. Thus,
     Trust Preferreds were an inexpensive way to increase a
     bank’s capital base and profitability.

According to the claim, Mr. Bachmann’s “intention was ultimately

to profit from marketing his idea, through a brokerage firm, to

such banks [i.e. community banks].”    The claim does not indicate

when Mr. Bachmann developed the idea.

     Mr. Bachmann joined Smith Barney in April 1997 to become a

senior vice president in Smith Barney’s institutional financial

group.   During his employment, Mr. Bachmann disclosed to Smith

Barney the group-issuance idea.   In exchange, Mr. Bachmann

understood that Smith Barney would “properly compensate him for

its use, as well as for any additional contributions of his

specialized knowledge and longstanding experience with community

banks (as well as his existing employment agreement with [Smith

Barney]).”   The claim characterizes one of the terms of Mr.

Bachmann’s March 5, 1997 employment agreement as follows:

     he would receive (for the first two years – although
     never subsequently modified): (a) a monthly draw of
     $20,000 versus commissions (not to exceed a deficit of
     $160,000, at which point the deficit would be
     reviewed); and (b) a 40 percent payout.

This is the description found in Mr. Bachmann’s arbitration

claim.   The employment agreement itself has not been submitted
                                 - 5 -

into the record before this Court.       The record does not reveal

whether the monthly draws were paid and what the amounts of the

yearly payouts were, if paid at all.

     Mr. Bachmann would later claim that he should have been

compensated $1.5 million for Smith Barney’s “use of his novel

idea” and “contributions of specialized knowledge, skills, and

labor.”   According to the claim, Smith Barney paid Mr. Bachmann

only $191,000 (in two installments in 2000) while Smith Barney

earned over $6 million in fees from use of the idea.

     Mr. Bachmann’s claim recounts that in December 1997 he met

with James Harasimowicz, a director of Smith Barney, to plan an

upcoming presentation that Smith Barney would make to Merchant’s

Bank.   Mr. Harasimowicz supposedly expressed enthusiasm for

Bachmann’s group-issuance idea and said he would seek permission

to pursue it from the appropriate Smith Barney managers.       In

February 1998 there was a further meeting between Bachmann and

Harasimowicz.   This meeting was also attended by Steven Rehms,

Managing Director in the Financial Institutions Department.

Harasimowicz stated that Bachmann’s group-issuance idea had been

approved by the necessary Smith Barney officials.      At a later

meeting, Bachmann was charged with preparing a list of banks that

might be potential participants in the group-issuance idea.

Bachmann supposedly created this list, and also contacted the

banks to gauge their interest.    During 1998 to 2000, the claim
                               - 6 -

recounts, Bachmann and Smith Barney expended substantial effort

in marketing the group-issuance idea to community banks.   These

efforts consumed 5 to 6 hours of Bachmann’s personal working day.

Eventually, Smith Barney engineered a transaction in which 29

banks issued $230 million worth of stock pursuant to the group-

issuance idea.   Smith Barney earned at least $6 million of fees

from this deal, which closed in March of 2000.

     On November 9, 2001, apparently after leaving employment

with Smith Barney, Mr. Bachmann filed an arbitration claim with

the New York Stock Exchange against Smith Barney alleging breach

of contract, unjust enrichment, misappropriation and conversion

of Mr. Bachmann’s novel idea, breach of fiduciary duty,

misrepresentation, and tortious interference with prospective

economic advantage.   Bachmann’s claim against Smith Barney is

summarized in paragraphs 4 and 5 of his NYSE arbitration claim:

     4. While employed at SSB, Bachmann disclosed his novel
     idea to SSB [Smith Barney] -- based on the
     understanding that SSB would properly compensate him
     for its use, as well as for any additional
     contributions of his specialized knowledge and
     longstanding experience with community banks (as well
     as his existing employment agreement with SSB [Smith
     Barney]).
     5. SSB [Smith Barney] utilized Bachmann’s novel idea,
     specifically requested and received significant
     additional assistance from him, and exploited his
     specialized knowledge and longstanding experience with
     community banks. However, despite such SSB [Smith
     Barney] actions -- as well as its having ultimately
     profited from Bachmann’s idea, making more than $6
     million in net fees in its first use alone -- it
     nevertheless refused to properly compensate him.
     Although Bachmann appropriately was entitled to an
                              - 7 -

     amount not less than $1.5 million, SSB [Smith Barney]
     paid him $191,000.

Paragraph 45 lists the legal theories asserted by Mr. Bachmann:

     45. Accordingly, as a result of SSB’s [Smith Barney]
     improper acts, Bachmann has been damaged in an amount
     to be determined at the hearing, but not less than
     $1,500,000, plus interest, including the following:
     a. Breach of contract, unjust enrichment, and quantum
     meruit, including: (1) SSB’s [Smith Barney] failure to
     comply with its employment agreement and other
     understandings with Bachmann; (2) SSB [Smith Barney]
     having (a) accepted the value of Bachmann’s novel idea
     and having requested and accepted the contribution of
     his specialized knowledge, skills, and labor in the
     execution of that idea; (b) economically enriched
     itself from its usurpation of Bachmann’s novel idea
     and the use of his specialized knowledge, skills, and
     labor knowing that Bachmann expected to be reasonably
     compensated therefor; and (c) failed to reasonably
     compensate him for his idea or for his contribution of
     specialized knowledge, skills, and labor; and (3)
     engaging in the other activities summarized herein;
     b. Misappropriation and conversion of Bachmann’s novel
     idea, including: (1) SSB [Smith Barney] having used
     Bachmann’s novel idea despite the understanding that it
     would be treated confidentially and not used by SSB
     [Smith Barney] unless he was properly compensated for
     it; (2) SSB [Smith Barney] having led Bachmann to
     believe that he would be reasonably compensated for the
     use of such a novel idea; (3) SSB [Smith Barney] having
     used the novel idea, as well as having requested and
     utilized Bachmann’s specialized knowledge, skills, and
     labor to make a substantial profit with the idea; (4)
     SSB [Smith Barney] having not reasonably compensated
     Bachmann either for his novel idea or his contribution
     of specialized knowledge, skills, and labor; and (5)
     engaging in the other activities summarized herein.
     c. Breach of fiduciary duty, misrepresentation, and
     tortious interference with prospective economic
     advantage, including: (1) improperly inducing Bachmann
     to disclose his novel idea to SSB [Smith Barney] by
     creating the false understanding that he would be
     appropriately compensated; (2) improperly usurping to
     itself the value and economic benefits of Bachmann’s
     novel idea and specialized services; and (3) engaging
     in the other activities summarized herein.
                               - 8 -

Smith Barney apparently lodged a counterclaim against Mr.

Bachmann, but the counterclaim is not in the record.

     The arbitrators conducted 19 hearings, but Mr. Bachmann did

not introduce transcripts of any of them into the record.   On

March 19, 2004, the arbitrators awarded Mr. Bachmann $1,576,360

for his claim and awarded Smith Barney $206,631 for its

counterclaim, with each party to pay its own attorney’s fees and

costs.   The decision is succinct:

     The undersigned arbitrator(s) have decided and
     determined that in full and final settlement of all
     claims between the parties that: Respondent [Smith
     Barney] shall pay to claimant [Mr. Bachmann]
     $1,576,360.00. Claimant shall pay $206,631 to
     Respondent. Parties shall bear their own attorney’s
     fees and forum fees.

The decision resulted in a net award of $1,369,729, which Smith

Barney paid to Mr. Bachmann in 2004.1   Smith Barney issued a Form

1099-MISC, Miscellaneous Income, for the net award to Mr.

Bachmann, but the Bachmanns did not report such amount on their

2004 income tax return, which they filed on August 16, 2005.

     On June 18, 2007, the IRS timely mailed the Bachmanns a

notice of deficiency for the taxable year 2004, determining a

deficiency in income tax of $283,882 and a penalty due to

substantial understatement of income tax of $56,776 pursuant to



     1
      The Bachmanns stipulated that “the award [he] received and
the amounts paid by [Smith Barney] did not compensate him for any
physical injury.”
                               - 9 -

section 6662(a) and (b)(2).   The notice of deficiency included

the entire net award of $1,369,729 in the Bachmanns’ gross income

while allowing an itemized deduction for attorney’s fees and

costs totaling $572,063.2   The notice of deficiency also included

     2
      The net payment from Smith Barney to Mr. Bachmann is
composed of two cross-payments: the payment by Smith Barney of
$1,576,360 on account of Mr. Bachmann’s claim, and the payment by
Mr. Bachmann of $206,631 to Smith Barney on account of Smith
Barney’s counterclaim. It seems to us that the tax treatment of
each payment should be analyzed separately. Thus, at least in
theory, the IRS could have taken the position that the $1,576,360
should be included in the gross income of the Bachmanns, and that
the $206,631 payment by the Bachmanns is not deductible.
However, the IRS appears to have conceded on brief that the
$206,631 payment should be deducted by the Bachmanns. The brief
says:

     Counsel for respondent notes that the allowed itemized
     deduction is overstated by $15,000 due to the double
     counting of the retainer fee paid to Mr. Bachmann’s
     counsel. Respondent’s counsel also notes that the
     proper reporting of the award and counter award
     requires inclusion of Mr. Bachmann’s full award of
     $1,576,360 in income and allowance of the counter award
     to [Smith Barney] of $206,631 as an itemized deduction.
     Respondent is raising neither point as an issue.

     For their part, the Bachmanns submit on brief that the
$1,576,360 gross award is not includable in their income. The
Bachmanns do not expressly go further and argue that in the event
they are allowed to exclude the $1,576,360 gross award from their
income, they are also entitled to a deduction for the $206,631
payment. We consider that the Bachmanns have waived the argument
that they are entitled to a deduction if the larger payment is
excluded.
     In summary, we construe the IRS’s position to be that the
$1,576,360 payment should be included in the Bachmanns’ income,
with the $206,631 as a deduction from income. We construe the
Bachmanns’ position to be that the $1,576,360 payment should be
excluded from their income, but that they are not entitled to the
$206,631 deduction if the larger payment is excluded. Thus, the
issue for us to consider is whether the $1,576,360 payment should
                                                   (continued...)
                              - 10 -

in the Bachmann’s gross income, unreported dividends of $1,227

and unreported unemployment compensation of $850, both of which

the Bachmanns conceded in their pre-trial memorandum as

includable in their gross income and are therefore not addressed

here.

     The parties agreed to submit their case without a trial

under Rule 122.   In their opening brief, the Bachmanns argue that

their claim against Smith Barney was for “an illegal taking of

something of value” and does not mention lost wages or income.

Therefore, they assert that the arbitration award is a

“nontaxable return of capital.”

     In its briefs, the IRS argues that Mr. Bachmann’s claims

against Smith Barney “all arise from Mr. Bachmann’s employment

contract requiring * * * [Smith Barney] to pay him compensation

for the services he rendered through application of his

knowledge, experience, expertise, and creative talents in

performance of those services.”   The IRS argues that portions of

Bachmann’s claim seek lost profits or royalties, and that lost

profits and royalties are treated as ordinary income.    The IRS

argues further that Mr. Bachmann “sought to profit from

implementing his idea; that profit constitutes ordinary income.”

     2
      (...continued)
be included in gross income. If it is includable, then the IRS
concedes the $206,631 is deductible. If it is not includable,
then the Bachmanns have conceded that the $206,631 is not
deductible.
                                - 11 -

Finally, the IRS argues that Bachmann has produced no evidence

that he had cost basis in his idea.

                              Discussion

I. Income Tax Deficiency

     Section 61(a) provides that “Except as otherwise provided in

this subtitle * * * all income from whatever source derived” is

included in gross income.    The concept of gross income is to be

broadly construed while statutory exceptions are to be narrowly

construed.   Commissioner v. Schleier, 515 U.S. 323, 328 (1995);

see also United States v. Burke, 504 U.S. 229, 248 (1992)

(Souter, J., concurring in judgment).      The taxpayer generally has

the burden of proving any amount excludable from gross income

pursuant to an applicable statutory exception or general

principles of tax law.     Rule 142(a), Tax Court Rules of Practice

and Procedure; Welch v. Helvering, 290 U.S. 111, 115 (1933);

Parrish v. Commissioner, 168 F.3d 1098, 1101 (8th Cir. 1999),

affg. T.C. Memo. 1997-474; Weiss v. Commissioner, 221 F.2d 152,

155 (8th Cir. 1955), affg. T.C. Memo. 1954-51.      The burden of

proof shifts to the IRS when a taxpayer introduces relevant

credible evidence with respect to any factual issue provided that

the taxpayer has met the substantiation, record-keeping and

administrative cooperation requirements of the Internal Revenue

Code.   Sec. 7491(a).
                               - 12 -

     When an amount is received by a taxpayer as a result of a

legal dispute, the tax treatment of the payment is determined by

asking “In lieu of what were the damages awarded?”    Raytheon

Prod. Corp. v. Commissioner, 144 F.2d 110, 113 (1st Cir. 1944),

affg. 1 T.C. 952 (1943).   The Bachmanns assert in their opening

brief that the arbitration award is excludable from gross income

because it represents a return of capital for Mr. Bachmann’s

transfer to Smith Barney of his group-issuance idea, and not

compensation for services.    The Bachmanns bear the burden of

proving that the award should be treated in a manner other than

the treatment claimed by the IRS in the deficiency notice unless

the burden shifts to the IRS pursuant to section 7491(a).

     As to the Smith Barney payment, the Bachmanns’ effort to

exclude it from their gross income faces several problems.    One

such problem--an insurmountable one in our view--is that the

Bachmanns have not shown that they have a tax basis in the idea.

There is no evidence in the record of what Mr. Bachmann paid to

create or develop the idea.    The burden of proof remains with the

Bachmanns because they have failed to produce credible evidence

of tax basis to shift the burden under section 7491(a).

Therefore, the Court is unable to find that the idea has a tax

basis of anything greater than zero.    This alone causes us to

reject the Bachmanns’ theory that the Smith Barney payment is not

taxable.
                             - 13 -

     Furthermore, it is questionable whether a payment by Smith

Barney to Bachmann for his business ideas could be considered

anything other than a payment for services.3   One of the services

that managers perform is that they come up with useful ideas.

For all we know, this is what the payment was for.     We do not

know whether Mr. Bachmann came up with the group-issuance idea

while working for Smith Barney.   We do not know what Mr. Bachmann

was required to do for Smith Barney under his employment

agreement, or the full extent of the provisions in the employment

agreement with respect to Mr. Bachmann’s business ideas.     In

short, there is no evidence for us to find that the “idea” should

be considered the property of Mr. Bachmann, rather than part of

the services provided by Mr. Bachmann.   Once again, the burden of

proof remains with Mr. Bachmann because of his failure to produce

credible evidence that the idea was his property.

     Also, even if some of the arbitration award can be

considered to have been paid for Mr. Bachmann’s idea, and that

this is different from Mr. Bachmann’s services, we could not say

how much of the payment is in exchange for the idea.    The NYSE

arbitration claim states that Mr. Bachmann



     3
      See Ofria v. Commissioner, 77 T.C. 524, 539 n.8 (1981) (“In
such a case where ideas have not been reduced to concrete
inventions, there might well be a basis for questioning whether
payments for such ideas could be considered anything more than
compensation for services.”).
                               - 14 -

     operated on the understandings (and reasonably
     expected) that: (a) his idea would be treated
     confidentially; and (b) if it were pursued by [Smith
     Barney], he would be appropriately compensated (i) for
     the value of his novel idea, (ii) for the labor he
     performed in its development and marketing, including
     specialized knowledge he contributed, and the
     longstanding experience with community banks he
     utilized to make the idea successful, and (iii) under
     his existing employment agreement.

Any portion of the arbitration award attributable to Mr.

Bachmann’s services, including his marketing efforts, is within

the scope of taxable compensation for services as defined in

section 61(a)(1).   There is nothing in the record allowing us to

determine what portion of the payment is allocable to the idea,

as opposed to services.   The Bachmanns have failed to shift the

burden of proving this allocation under section 7491(a) because

they produced no credible evidence showing which part of the

payment should be so characterized; as previously stated, they

produced no evidence of tax basis in the idea nor any evidence of

ownership of the idea.    We therefore conclude that the amount of

the gross award must be included in the Bachmanns’ income for the

2004 at ordinary income tax rates.4




     4
      The Bachmanns argued that the payment from Smith Barney
should be excluded from their income. They did not raise the
issue of whether the payment should be treated as capital gain
income and taxed at capital gains tax rates. We therefore
decline to address the issue.
                                - 15 -

II.   Penalty

      A. Penalty Under Section 6662(a) and (b)

      Section 6662(a) and (b)(2) imposes a penalty upon any

portion of an underpayment attributable to a substantial

understatement of income tax.     A substantial understatement of

income tax occurs if the tax required to be shown on the return

for the taxable year exceeds the reported tax by the greater of

(a) $5,000 or (b) 10 percent of the correct tax.     Sec.

6662(d)(1)(A).   In this case, the difference between the correct

and reported taxes is $283,693, which exceeds 10 percent of the

tax required to be shown of $290,693.     Thus, the Bachmanns can

avoid the penalty only if the understatement is reduced under

section 6662(d)(2)(B) or 6664(c).

      Under section 6662(d)(2)(B), the amount of the

understatement for purposes of determining the amount of the

penalty is reduced by that portion of such understatement

attributable to (a) the tax treatment of an item by the taxpayer

if there was substantial authority for such treatment at the time

the return is filed or on the last day of the applicable taxable

year, or (b) any item if relevant facts affecting the item’s tax

treatment are adequately disclosed on the return (or in a

statement attached to the return) and the taxpayer has a

reasonable basis for such treatment.     Sec. 6662(d)(2)(B);   sec.

1.6662-4(d)(3)(iv)(C), Income Tax Regs.     The Bachmanns did not
                               - 16 -

disclose relevant facts on their return despite having received a

Form 1099-MISC from Smith Barney and had no substantial authority

for their failure to include the award in their reported gross

income.   The section 6662(d)(2)(B) exception is therefore

inapplicable to the Bachmanns.

     B. Reasonable Cause and Good Faith Exception Under Section
     6664(c)

     No penalty may be imposed under section 6662 with respect to

any portion of an underpayment if the taxpayer had reasonable

cause for the tax treatment of such portion and the taxpayer

acted in good faith with respect to such portion.   Sec. 6664(c).

The determination is made on a case-by-case basis taking into

account all relevant facts and circumstances, including “honest

misunderstanding of fact or law that is reasonable in light of

all the facts and circumstances, including the experience,

knowledge and education of the taxpayer.”   Sec. 1.6664-4(b)(1),

Income Tax Regs.   The most important factor is “the taxpayer’s

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

Reliance on an information return or professional advice

constitutes reasonable cause and good faith if under all the

circumstances, such reliance was reasonable and the taxpayer

acted in good faith.   Id.   The Bachmanns made no showing that

they consulted a paid tax preparer or lawyer before filing their

return despite having received a Form 1099-MISC from Smith
                               - 17 -

Barney.   Mr. Bachmann was a sophisticated finance professional

employed by a large financial services firm and had the requisite

educational level to understand his need to seek professional tax

advice regarding the treatment of his award, especially after his

receipt of the Form 1099-MISC; the law requires some diligence on

the part of the taxpayer.    See Vezey v. United States, 84 AFTR 2d

6192, 99-2 USTC par. 50,863 (9th Cir. 1999).    The Bachmanns’ mere

claim that their return was accurate as filed and no underpayment

exists to penalize is insufficient to avoid a penalty. See

Sparkman v. Commissioner, 509 F.3d 1149, 1161 (9th Cir. 2007),

affg. T.C. Memo. 2005-136.   Therefore, the reasonable cause and

good faith exception does not apply and the Bachmanns are liable

for the full amounts of both the underlying tax liability and

penalty determined by the IRS.

     To reflect the foregoing,

                                      Decision will be entered for

                                 respondent.
