                           T.C. Memo. 2002-5



                      UNITED STATES TAX COURT



               SIGITAS J. BANAITIS, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 4323-00.                   Filed January 8, 2002.



     Joseph Wetzel and Michael C. Wetzel, for petitioner.

     Shirley M. Francis, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION



     GERBER, Judge:   Respondent determined a $1,708,216

deficiency in income tax for petitioner’s 1995 taxable year.     The

issues for our consideration are:    (1) Whether petitioner is

entitled to exclude damages received in settlement of a lawsuit
                                - 2 -

under section 104(a)(2);1 (2) whether fees paid to petitioner’s

attorneys in accord with a contingent fee agreement are

excludable from petitioner’s gross income; and (3) whether

respondent’s determination violated petitioner’s Fifth Amendment

rights in the form of a Government taking without due process of

law or just compensation.

                          FINDINGS OF FACT2

     At all pertinent times, Sigitas J. Banaitis (petitioner)

resided in Clackamas County, Oregon.    From 1980 through December

30, 1987, petitioner was employed by the Portland branch of the

Bank of California, N.A. (BCal), as a loan officer and vice

president.   As such, petitioner solicited and maintained

customers, mostly businesses, to whom BCal made loans.    In so

doing, petitioner and BCal obtained sensitive and highly

confidential information, including information contained in

financial statements.    Loan customers were assured by both

petitioner and BCal of confidentiality through oral assurances

and written contracts.

     In 1984, Mitsubishi Bank, Ltd. (MBL), a member of the

Mitsubishi Group (MG), acquired a controlling interest in BCal.


     1
       Unless otherwise indicated, all section references are     to
the Internal Revenue Code in effect for the year in issue.
     2
       The parties have stipulated some of the facts. The
stipulation of facts and the attached exhibits are incorporated
herein by this reference.
                               - 3 -

Some of petitioner’s loan customers competed directly with firms

and enterprises of MG.   During 1986 and 1987, MBL employees asked

petitioner to provide confidential information about those

specific loan customers.   Adhering to his ethical and legal

duties, confidentiality agreements and BCal policy, petitioner

refused.

     Subsequent to his refusal, MBL employees gave petitioner

negative performance evaluations and attacked his integrity.

This situation grew so intolerable for petitioner that on

December 30, 1987, 1 day before his pension vested, petitioner

was forced to leave his job at BCal.

     Before and after petitioner left his job, he experienced

insomnia, headaches, stomach problems, back and neck pain, and

gum disease.   Petitioner did not consider himself disabled, nor

did he apply for disability insurance benefits.   After he left

BCal, petitioner actively searched for employment.   He

distributed resumes, went for job interviews, started businesses,

and offered and performed consulting services.

     On November 15, 1989, almost 2 years after petitioner was

forced to leave BCal, petitioner retained the law firm of Merten

& Associates to file a lawsuit against BCal and MBL.   In so

doing, petitioner signed an agreement entitled “Contingent Fee

Retainer Agreement” (Fee Agreement I).   Fee Agreement I provided

that petitioner’s attorneys would receive a percentage of
                               - 4 -

petitioner’s gross recovery.   They were to receive one-third in

the event that an agreement was reached before trial.     If a trial

commenced, the fee increased to 40 percent.   Settlement offers

had to be discussed with petitioner, and an offer could not be

accepted or rejected without his approval.    Merten & Associates

had an attorney’s statutory lien and a possessory lien on

petitioner’s property in its possession.

     Additionally, Fee Agreement I provided that if petitioner

(1) breached the agreement, (2) did not cooperate, (3)

unreasonably rejected a settlement offer, or (4) insisted on

pursuing a claim contrary to the attorney’s advice, the law firm

could terminate its services and would be entitled to payment at

an hourly rate for services rendered to date, plus costs.

Petitioner could fire Merten & Associates, at any time, which

would entitle it to a minimum payment of an hourly rate for their

services.   Fee Agreement I did not provide legal fees for the

pursuit or defense of an appeal.

     Having hired attorneys, petitioner filed a complaint in the

Multnomah County Circuit Court for the State of Oregon on

December 12, 1989.   Altogether, petitioner filed four amended

complaints, the last of which was filed on March 11, 1991.

     Petitioner’s complaints, as amended, contained two claims

for relief.   The first was against MBL for intentional

interference with contract and economic expectations.     The second
                               - 5 -

was against BCal for wrongful discharge from employment.    In both

claims, petitioner alleged that MBL and BCal acted maliciously

“with the intent to harm the plaintiff * * * [which was] socially

intolerable.”   Under this allegation, petitioner sought damages

of $3 million from MBL and $2 million from BCal.   Petitioner also

prayed for economic and noneconomic damages, as follows:    (1)

Economic damages of $647,389--$196,889 for lost salary and

benefits and $450,500 for lost future compensation; and (2)

noneconomic damages for “stress, anger, worry, and loss of life

enjoyment” in an amount to be determined by the jury after the

trial.

     On March 18, 1991, the jury returned a special verdict

against BCal and MBL.   The jury found that (1) petitioner did not

voluntarily resign his position at BCal, (2) MBL caused BCal to

constructively discharge petitioner, (3) BCal intended to make

working conditions so unacceptable that petitioner would resign,

(4) BCal forced petitioner to resign because petitioner refused

to disclose confidential information to MBL, and (5) petitioner’s

refusal was in furtherance of important public policy.    The jury

allocated fault 80 percent to MBL and 20 percent to BCal.

     The jury awarded petitioner the following damages:    (1)

$196,389 for his lost compensation to date, (2) $450,000 for his

lost future compensation, (3) $500,000 and $125,000 for emotional

distress from MBL and BCal, respectively.   Further, because they
                                 - 6 -

awarded petitioner compensatory damages, under Oregon law the

jury was allowed to consider punitive damages.    The jury found

that the employees of both MBL and BCal were “guilty of wanton

misconduct and acted within their employment.”    As such, the jury

awarded punitive damages from MBL and BCal in the amounts of

$3 million and $2 million, respectively.

     In summary, the money judgment against MBL was $500,000 for

noneconomic damages, $3 million for punitive damages and $646,389

for economic damages--$450,000 in lost future compensation and

$196,389 in wages.   The money judgment against BCal was $125,000

for noneconomic damages, $2 million for punitive damages, and

$646,389 for economic damages.    MBL and BCal were jointly and

severally liable for the economic damages and severally liable

for the noneconomic damages and the punitive damages.    Petitioner

was also entitled to postjudgment interest and costs of

litigation.

     Subsequently, MBL and BCal filed motions with the trial

court for judgment notwithstanding the verdict.    These motions

were granted in part and the judgment set aside.    At this point,

petitioner was still entitled to compensatory damages, but no

punitive damages.    Petitioner and the banks, separately, appealed

to the Oregon Court of Appeals.

     For the legal fees occasioned by the appeal, petitioner and

his attorney, Charles J. Merten (Merten), entered into a second
                               - 7 -

contingent fee agreement on July 22, 1991 (Fee Agreement II).     It

provided for various scenarios under which legal fees would be

payable. Generally, Fee Agreement II provided that the fees would

be computed as a percentage of petitioner’s recovery.

     Petitioner and Merten also entered into an agreement

entitled “Letter Interpretation” (Letter) which was intended to

govern the interpretation of Fee Agreement II.   It provided that

Merten’s fee would be paid out of petitioner’s punitive damages

recovery.   Again, it was clear that petitioner could fire his

attorneys at any time, thereby entitling them to a prescribed

amount of compensation.

     On August 3, 1994, the Oregon Court of Appeals reinstated

the jury verdict.   Consequently, MBL and BCal filed an appeal

with the Supreme Court of the State of Oregon.   Before the appeal

was completed, the parties reached a settlement.

     On October 26, 1995, petitioner entered into a confidential

settlement and a mutual release agreement with MBL and BCal.     The

total amount of the settlement was $8,728,559.   Pursuant to the

wording of the settlement agreement, MBL issued a cashier’s check

to petitioner for $4,864,547 and BCal issued a cashier’s check to

“[petitioner’s] attorney, Charles J. Merten,” for $3,864,012.

     Under Oregon State law , Or. Rev. Stat. sec. 18.540 (1991),

petitioner was required to pay a portion of his punitive damages

award to the State.   Petitioner initially disputed the
                                 - 8 -

applicability of this statute but later settled with the State

for $150,000.   The firm of Merten & Associates did not pay any

part of its $3,864,012 to the State of Oregon for this

statutorily imposed liability.

     Petitioner filed his 1995 Federal income tax return as

married filing separately.   He included a disclosure statement

with his 1995 return explaining that the compensatory damages,

the punitive damages, and the interest on the part of the award

used to pay his attorney’s fees were excludable from his gross

income under section 104(a)(2).    Accordingly, petitioner reported

as income only the interest on the part of the award disbursed

directly to him.

     Respondent made the following determination concerning the

litigation award:

     Total amount of damages awarded:           $8,728,559
     Less interest reported by the
          petitioner:                           (1,421,420)
     Less amount excluded, under I.R.C.,
          sec. 104(a)(2) for emotional
          distress:                               (625,000)
     Increase to income reported by
          petitioner:                            6,682,139

     Respondent allowed, as a miscellaneous itemized deduction,

$3,317,316 for attorney’s fees paid to Merten & Associates.

                              OPINION

     We consider three interrelated issues:   (1) Whether any

portion of damages received in settlement of petitioner’s legal

claim is excludable under section 104(a)(2); (2) whether the
                                 - 9 -

amount paid under the settlement directly to petitioner’s

attorney is excludable from petitioner’s gross income; and (3)

whether any portion of the tax burden placed on petitioner’s

settlement proceeds violates his constitutional rights as a

taking without due process of law or just compensation within the

meaning of the Fifth Amendment of the U.S. Constitution.

I.   Exclusion for Damages

      Section 61 defines gross income as “all income from whatever

source derived”.     While this definition of gross income is broad

in terms of what it includes, exclusions from gross income are

narrowly construed.     United States v. Burke, 504 U.S. 229, 248

(1992).     One such exclusion is provided for in section 104(a)(2):

“damages received (whether by suit or agreement and whether as

lump sums or as periodic payments) on account of personal

injuries or sickness” are excluded from gross income.

      A.    Economic Damages

      Petitioner received $646,389 in economic damages.

Petitioner contends that section 104(a)(2) applies to exclude

these economic damages from gross income.     In arguing that these

proceeds are excludable, petitioner points out that under Oregon

State law, his claims against BCal and MBL for wrongful discharge

and intentional interference with economic expectations are

torts.     As such, petitioner claims that damages received in

connection with these torts are excludable under section
                              - 10 -

104(a)(2).   However, petitioner’s argument assumes that the

origin of the claim is the only relevant inquiry.    A two-part

test for the section 104(a)(2) exclusion was established in

Commissioner v. Schleier, 515 U.S. 323, 333 (1995).    Schleier

requires that, in addition to the law suit’s being based upon a

tort claim, the damages received must have been “on account of

personal injuries or sickness”.   Id.

     The factual circumstances in this case reflect that

petitioner’s economic damages were not “on account of personal

injuries or sickness”.   Rather, petitioner’s economic damages

were intended to replace wages and other compensation lost when

he was forced to leave his job.   While in some circumstances

economic damages measured by lost wages can satisfy the second

prong of the Schleier test, petitioner’s economic damages do not.

For instance, if a taxpayer were unable to work as a direct

result of his physical injuries, the economic damages he received

to replace his lost wages would be excludable.   Id.; Rev. Rul.

85-97, 1985-2 C.B. 50.   In short, the taxpayer’s physical

injuries would have been the direct cause of his inability to

work.

     Although petitioner was forced to leave his job because of a

tort and he had manifestations of emotional distress, he was not

forced to leave his job because of those injuries.    Rather, he

was forced to leave because he refused to disclose confidential
                                - 11 -

information.    The damages were intended to replace salary and

benefits wrongfully taken from him “on account of” his

constructive discharge--not because of any personal injury.

Moreover, petitioner’s injuries did not prevent him from working

at all--at BCal or elsewhere.    We note that, after leaving BCal,

petitioner actively searched for employment and was self-

employed.

     Accordingly, petitioner’s economic damages are not “on

account of personal injury or sickness” and as such, do not meet

the Schleier test.     Petitioner’s economic damages are not

excludable from his gross income.

     B. Punitive Damages

     Petitioner also received $5 million in punitive damages.         As

with his economic damages, petitioner claims that section

104(a)(2) applies to exclude this amount from his gross income.

     Petitioner would have us accept his interpretation of the

following legislation added to section 104(a)(2) in 1989:

“Paragraph 2 [excluding from gross income any damages received on

account of personal injuries or sickness] shall not apply to any

punitive damages in connection with a case not involving physical

injuries.”     Petitioner contends that the use of a double negative

in this phrase creates a positive.       In other words, petitioner

believes that Congress intended for all punitive damages to be

excludable from gross income in any case involving physical
                                - 12 -

injuries or sickness.    Petitioner’s argument was addressed and

rejected by the Supreme Court in O’Gilvie v. United States, 519

U.S. 79, 89-90 (1996).

     Petitioner has gone to great lengths in his attempt to

support his interpretation, including citations and references to

judicial commentary, syntax doctrines, and comparisons to other

sections of the Internal Revenue Code.    However, the Supreme

Court has held that section 104(a)(2) does not exclude punitive

damages from income even if awarded in a case involving physical

injuries or sickness.     Id.

     Furthermore, petitioner’s award of punitive damages was not

intended to compensate for physical injuries.    The punitive

damages were intended to punish BCal and MBL and to deter them

from future misconduct.    When awarding petitioner punitive

damages, the jury found that the employees of BCal and MBL were

guilty of wanton misconduct and acted within the scope of their

employment. Accordingly, we find petitioner’s statutory

interpretation is flawed.

     To exclude his punitive damages from income, petitioner must

satisfy section 104(a)(2) and the two-prong Schleier test.

However, we have already held that while the damages arose from

tort-based claims, they were not on account of physical injuries

or sickness.   Therefore, petitioner’s punitive damages are not

excludable from his gross income.
                                - 13 -

      As such, we agree with respondent’s position in that the

noneconomic damages were the only damages excludable under

section 104(a)(2).   Petitioner must include his economic and

punitive damages within his gross income for taxable year 1995.

     II. Attorney Contingent Fee Agreements

     Petitioner also seeks to exclude from his gross income

$3,864,012, the portion of the settlement BCal paid directly to

Merten, his attorney, pursuant to the two contingent fee

agreements.   Here again, we consider the broad reach of section

61 and whether, under some theory, the amount paid to

petitioner’s attorney should be excluded from gross income.

Numerous taxpayers have attempted to find some approach for

excluding from income the portion paid to their attorneys from

judgment or settlement damages.    This Court has not approved any

such approach except where the case was appealable to a Court of

Appeals with a contrary view.

     This Court in Kenseth v. Commissioner, 114 T.C. 399 (2000),

affd. 259 F.3d 881 (7th Cir. 2001), held that a contingent fee

agreement did not result in an excludable assignment of income

from the taxpayer.   See Helvering v. Horst, 311 U.S. 112 (1940);

Lucas v. Earl, 281 U.S. 111 (1930).      In addition, we observed

that the right created in an attorney pursuant to a contingent

fee agreement was the right to be paid for services rendered--a

right created in any creditor-debtor relationship.     Under this
                                - 14 -

holding, proceeds of a judgment or settlement which would be

includable in the taxpayer’s income if paid directly to the

taxpayer, and which are instead paid to a taxpayer’s attorney

pursuant to an attorney contingent fee agreement are income to

the taxpayer.   Kenseth v. Commissioner, supra.    The Court of

Appeals for the Seventh Circuit recently affirmed this holding.

Kenseth v. Commissioner, 259 F.3d 881 (7th Cir. 2001).

     We recognize that there is a split among the Courts of

Appeals on this question.    The Court of Appeals for the Fifth

Circuit, in Cotnam v. Commissioner, 263 F.2d 119 (5th Cir. 1959),

affg. in part and revg. in part 28 T.C. 947 (1957), held that an

attorney’s lien under Alabama law provided the attorney with a

property right in the lawsuit.    Therefore, the court held that

the proceeds paid directly to the attorney pursuant to a

contingent fee agreement constituted the attorney’s property and

were not income to the taxpayer.    The Court of Appeals for the

Sixth Circuit, on a somewhat different theory, held that fees

paid to an attorney under a contingent fee agreement are not

income to the taxpayer.     Estate of Clarks ex rel. Brisco-Whitter

v. United States, 202 F.3d 854 (6th Cir. 2000).     On the other

hand, the Courts of Appeals for the Third, Seventh, Ninth and

Fourth Circuits have disagreed with the Fifth and Sixth Circuit’s

reasoning.   Kenseth v. Commissioner, 259 F.3d 881 (7th Cir.

2001); Young v. Commissioner, 240 F.3d 369 (4th Cir. 2001), affg.
                               - 15 -

113 T.C. 152 (1994); Coady v. Commissioner, 213 F.3d 1187 (9th

Cir. 2000), affg. T.C. Memo. 1998-291; O’Brien v. Commissioner,

319 F.2d 532 (3d Cir. 1963).

      In a recent case, the Court of Appeals for the Ninth

Circuit3 held that a defendant’s payment of a plaintiff’s

attorney’s fees under a fee shifting statute results in income to

the plaintiff.   Sinyard v. Commissioner, 268 F.3d 756 (9th Cir.

2001), affg. T.C. Memo. 1998-364.   That same result pertains even

though the attorney was hired under a contingent fee agreement.

Id.   In Sinyard, the court applied the discharge of indebtedness

and constructive receipt doctrines as the rationale for its

holding.

      We find nothing in the case at bar to cause us to differ

from our previous analyses in this regard.   The fact that the

attorney’s fees were paid directly from petitioner’s settlement

proceeds does not alter the amount of petitioner’s total

settlement recovery.   Petitioner settled the case for $8,728,559.

The defendants wrote one check to petitioner for $4,864,547 and

one check to petitioner’s attorney, Charles J. Merten, for

$3,864,012.   The fact that two checks were written does not

change the facts that (1) petitioner was owed $8,728,559 from the

defendants for the settlement amount and (2) Merten was



      3
       Petitioner’s case would be appealable to the Court of
Appeals for the Ninth Circuit.
                               - 16 -

owed $3,864,012 from petitioner for services rendered.   The

payment structure is immaterial.

     Petitioner has set forth an alternative argument.   He argues

that, in spite of Sinyard v. Commissioner, supra, the Court of

Appeals for the Ninth Circuit would not apply Federal tax law in

this case.   Instead, petitioner contends that Oregon law would

apply to determine whether a property right in the settlement

proceeds had been created in the attorney under the contingent

fee agreement.   Petitioner contends that as Oregon law gives the

attorney such a right, the Court of Appeals would disregard

Kenseth and Sinyard.

     In spite of petitioner’s argument, we find nothing in Oregon

law which provides an attorney hired under a contingent fee

agreement with anything more than a right to compensation for

services rendered.   When BCal directly paid petitioner’s

attorneys, it merely paid the fees petitioner already owed to

petitioner’s attorney.   Indeed, the settlement agreement

explicitly stated that BCal would pay “defendant’s attorney,

Charles Merten”.

     In addition, the Court of Appeals for the Ninth Circuit

explicitly rejected the reasoning in Cotnam v. Commissioner,

supra.   The court stated:   “We do not see how the existence of a

lien in favor of the taxpayer’s creditor [taxpayer’s attorney]

makes the satisfaction of the debt any less income to the
                              - 17 -

taxpayer whose obligation is satisfied.”   Sinyard v.

Commissioner, supra at 760.

     We also note that Merten did not pay any of his $3,864,012

to the State of Oregon under Or. Rev. Stat. sec. 18.540 (1991),

which claims a percentage of all punitive damages awards.   Under

Fee Agreement II, Merten’s fee was to come out of the punitive

damages.   The settlement proceeds replaced the jury verdict.

Therefore, if Merten were a real party in interest with respect

to that $3,864,012 settlement, and did not receive it instead to

discharge petitioner’s obligation to compensate him for services

rendered, Merten should have paid the State of Oregon a portion

of his proceeds.

     Consequently, we hold that the portion of the damages,

$3,864,012, paid directly to petitioner’s attorney is includable

within petitioner’s gross income.

     III. Constitutionality

     Petitioner claims that respondent’s determination violated

his constitutional right against a Government taking without due

process of law or just compensation.   Petitioner points out, that

after attorney’s fees, the Federal alternative minimum tax, and

the State of Oregon tax, he would be left with only $1,984,078.

This amount is 22.7 percent of the total settlement of
                                  - 18 -

$8,728,559.4      Petitioner claims that, as this is such a small

percentage of the total settlement, the application of the

alternative minimum tax is unconstitutional.

       However, the Court of Appeals for the Ninth Circuit, to

which petitioner’s case is appealable, has spoken on this

subject.      In Okin v. Commissioner, 808 F.2d 1338, 1342 (9th Cir.

1987), affg. T.C. Memo. 1985-199, the Ninth Circuit stated that

the Due Process Clause does not limit the congressional power to

tax.       Moreover, the Court specifically stated that the

“alternative minimum tax is a rational means of * * * tax, and *

* * is constitutional.”       See also Sinyard v. Commissioner, supra

at 760.

       To the extent not herein discussed, we have considered all

other arguments made by the parties and find them to be moot or

without merit.

       To reflect the foregoing,

                                        Decision will be entered

                                   for respondent.




       4
       We find it curious that petitioner claims his recovery was
$8,728,559 for purposes of making his constitutional argument
while he claims his recovery was only $4,864,547 for other
arguments in his brief.
