                      T.C. Memo. 2001-55



                      UNITED STATES TAX COURT



                  TAYLOR MILLER, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 12095-98.             Filed March 6, 2001.



     Patrick W. Martin, for petitioner.

     Timothy F. Salel, for respondent.



                        MEMORANDUM OPINION


     BEGHE, Judge:   Respondent determined a deficiency of $75,180

in petitioner’s 1992 Federal income tax.     The deficiency is

primarily attributable to respondent’s determination that the

proceeds of petitioner’s settlement of a sex discrimination class

action lawsuit, Kraszewski v. State Farm Gen. Ins. Co., 38 Fair

Empl. Prac. Cas. (BNA) 197 (N.D. Cal. 1985), affd. in part, revd.
                                - 2 -


in part and remanded 912 F.2d 1182 (9th Cir. 1990) (the State

Farm class action lawsuit), are included in her gross income.1

     Petitioner concedes that the gross proceeds of her

settlement of the State Farm class action law suit--$283,543--are

not excluded from her gross income under section 104(a)(2),2 but

she attacks the validity of respondent’s notice of deficiency on

multiple grounds:    That respondent violated his reopening

procedures, that respondent performed a second inspection of

petitioner’s books of account in violation of section 7605(b),

and that respondent is equitably estopped from issuing the notice

of deficiency.    Petitioner also claims, if the validity of the

notice should be sustained, that she is entitled to deduct, as

section 162 business expenses, two items she did not claim on her

1992 income tax return:    Her contribution to a private pension

plan and her attorney’s fees and costs in the State Farm class

action lawsuit.

     We sustain the validity of respondent’s notice and reject

petitioner’s claims to the private pension plan contribution



     1
       For a description of the State Farm class action lawsuit
in the context of the claimants’ income tax treatment, see Brewer
v. Commissioner, T.C. Memo. 1997-542, affd. without published
opinion 172 F.3d 875 (9th Cir. 1999).
     2
       Unless otherwise noted, all section references are to the
Internal Revenue Code in effect during the year in issue, and all
Rule references are to the Tax Court Rules of Practice and
Procedure.
                               - 3 -


deduction and above-the-line treatment of the deduction for her

attorney’s fees and costs, which respondent allowed in the notice

of deficiency as an itemized deduction subject to the 2-percent

limitation of section 67.

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

The stipulations of fact and accompanying exhibits are

incorporated by this reference.   For clarity and convenience,

findings of fact and discussion with respect to the validity of

respondent’s notice and petitioner’s deduction claims are

combined under two separate headings.    Monetary amounts have been

rounded to the nearest whole dollar.

     Petitioner resided in Poway, California, when the petition

in this case was filed.

     Issue 1:   Validity of Statutory Notice

     During 1975, petitioner sold insurance products as an

employee of Fidelity Union Life Insurance Company (Fidelity).

During 1976 and 1977, petitioner operated as a sole owner and

paid for the costs of operating her business as an independent

insurance salesperson with Fidelity.    Petitioner reported her

1976 and 1977 earnings from the sale of Fidelity insurance

products on Schedule C of her 1976 and 1977 Federal income tax

returns.   After 1977, petitioner never again sold insurance, but

worked off and on, sometimes as an employee and sometimes as an
                               - 4 -


independent contractor, in various selling jobs in, among other

things, the financial products, mortgage brokerage, and real

estate businesses.

     In fall 1976 or January 1977, petitioner applied to become a

State Farm trainee agent.   As part of her job application,

petitioner had a series of interviews and took a test with State

Farm.   Petitioner was never hired by State Farm, nor did she ever

provide services for State Farm.

     In 1988, petitioner applied to become a class member of the

State Farm class action lawsuit and thereafter became a class

member.   On March 6, 1992, petitioner executed a settlement

agreement and general release (settlement agreement), regarding

her claim in the State Farm class action lawsuit.   In the

settlement agreement, petitioner and State Farm characterized the

settlement as “the compromise of a claim for agent earnings”; by

entering into the settlement agreement, petitioner waived “any

and all right she might have * * * respecting instatement”.

     Petitioner received a $223,935 check from the law firm of

Saperstein, Mayeda, Larkin, and Goldstein as the net proceeds of

settlement of her claim in the State Farm class action lawsuit.

Petitioner has stipulated that she received $283,543 as the gross

proceeds of the settlement (not reduced by attorney’s fees and

costs) during the 1992 tax year.   Of that amount, State Farm

reported $283,178 on Form 1099-MISC and the remaining $425 on
                                - 5 -


Form W-2.   State Farm negotiated and reported the $283,178 of

settlement proceeds on Form 1099-MISC as the amount it would have

paid petitioner if she had become its independent insurance

agent.   State Farm negotiated and reported the $425 of settlement

proceeds on Form W-2 with payroll taxes properly withheld as the

amount it would have paid petitioner if it had initially hired

her as a trainee agent.

     Petitioner timely filed her Federal income tax return, Form

1040, for the 1992 tax year with the Internal Revenue Service

Center in Fresno, California.   Petitioner attached to her 1992

return a Schedule C and a Form 8275 disclosure statement

reporting her receipt of settlement proceeds of $1,383,118 from

State Farm companies in 1992 on account of personal injuries or

sickness from a “very serious auto accident and an intentional

personal discrimination claim”, which were excludable from gross

income under section 104(a)(2).   Of this total amount, petitioner

received approximately $1,100,000 from State Farm Mutual Auto

Insurance Company in settlement of a claim for personal injuries

suffered in an auto accident.   These personal injury settlement

proceeds are not at issue in this case.

     On October 7, 1993, respondent’s District Director mailed

petitioner a letter and Information Document Request (Form 4564)

informing her that her 1992 income tax return had been selected

for examination.   On April 8, 1994, petitioner’s counsel mailed
                               - 6 -


respondent a 16-page memorandum arguing that the State Farm class

action lawsuit settlement proceeds received by petitioner are

excluded from gross income under section 104(a)(2).   On April 25,

1994, respondent mailed petitioner a “no change” form letter

(Letter 590 (DO) (Rev. 4-92)) stating:   “We examined your tax

return for the above period and made no changes to the tax year

reported.”   Respondent’s form letter goes on to advert to the

possibility of a later change in the taxpayer’s tax if the

taxpayer is a shareholder of an S corporation, a beneficiary of a

trust, or a partner in a partnership whose return is changed on

examination.

     Respondent and petitioner never executed a closing

agreement, pursuant to section 7121, for petitioner’s 1992 tax

year.

     On March 29, 1995, respondent’s Fresno Service Center mailed

petitioner a 30-day letter regarding her alleged failure to

report bartering proceeds of $2,894 on her 1992 income tax return

for the 1992 tax year.   The 30-day letter regarding the bartering

proceeds was unrelated to the examination regarding the State

Farm class action lawsuit settlement proceeds.   On April 19,

1995, petitioner’s representative, David W. Stevenson, C.P.A.

(Stevenson), in response to this 30-day letter, mailed a letter

to respondent’s Fresno Service Center, attaching thereto copies

of the Schedule D of petitioner’s 1992 income tax return and the
                                 - 7 -


front page of the 30-day letter.    After receiving Stevenson’s

letter, respondent agreed that petitioner had properly reported

$2,894 in bartering proceeds on Schedule D of her 1992 income tax

return.

     On September 28, 1995, respondent’s District Director

mailed petitioner a 30-day letter for the 1992 tax year regarding

the State Farm class action lawsuit settlement proceeds.    The

statement of examination changes accompanying this 30-day letter

proposed to treat petitioner’s State Farm class action lawsuit

settlement proceeds, in the amount of $283,117, as income from

self-employment for the 1992 tax year, and to allow legal fees of

$56,623 paid to obtain the settlement as an above-the-line

Schedule C deduction.   This 30-day letter proposed no adjustment

related to bartering proceeds.

     In November 1995, petitioner and her counsel signed a

Consent to Extend the Time to Assess Tax (Form 872) that extended

the period of limitations on assessment for the 1992 tax year

until June 30, 1997.

     On July 17, 1996, a tax technician in respondent’s District

Director’s Office mailed petitioner’s counsel a letter enclosing

a revised examination report (not included in the record)

deleting self-employment tax on the settlement proceeds and

downgrading petitioner’s legal fees from an above-the-line

Schedule C deduction to a below-the-line itemized deduction.      The
                               - 8 -


letter also asserted that two criteria applied in respondent’s

decision “to reopen Ms. Miller’s case for re-examination”:

First, there had “been a substantial error both in amount and in

relation to total tax liability” and, second, “other

circumstances exist indicating that failure to reopen the case

would be a serious administrative omission”.

     On October 2, 1996, petitioner signed another Consent to

Extend the Time to Assess Tax (Form 872), which extended the

period of limitations on assessment for the 1992 tax year until

April 30, 1998.

     On January 16, 1997, petitioner’s counsel mailed

respondent’s Riverside, California, Appeals Office a 9-page

memorandum arguing two grounds on which the no change letter

should stand.   The first ground was that there was no justifiable

basis for reopening the case under Rev. Proc. 94-68, 1994-2 C.B.

803, and section 4023 of the Internal Revenue Manual (the

Manual), which in his view were binding on the Internal Revenue

Service.   The second ground was that respondent had conducted a

second investigation of petitioner’s 1992 return, without

notifying her of the need thereof, in violation of section

7605(b).

     On June 16, 1997, the Chief, Examination Division, Laguna

Niguel, California, mailed petitioner a letter stating, with

regard to the 1992 tax year:
                               - 9 -


          We are required by law to notify taxpayers in
     writing if we need to reexamine their books and records
     after previously examining them.

          Because information that may affect your tax
     liability has been developed since we last examined
     your books and records, please make them available to
     us for reexamination.

           Thank you for your cooperation.

     On October 14, 1997, petitioner signed another Consent to

Extend the Time to Assess Tax (Form 872), which extended the

period of limitations for assessment for the 1992 tax year until

December 31, 1998.

     On April 9, 1998, respondent issued the notice of deficiency

for the 1992 tax year to petitioner.   When respondent issued the

notice, the period of limitations for assessment for the 1992 tax

year had not expired.

     Petitioner claims she relied on respondent’s April 25, 1994,

no change letter for “a sense of security,” but she did nothing

in detrimental reliance thereon.   For some years, petitioner has

been her mother’s primary source of support; petitioner’s income

tax returns for the years 1989 through 1996 claim her mother as a

dependent.   Commencing early in the calendar year 1998,

petitioner became the primary source of support for one of her

nephews.

     To provide the context for respondent’s change of the

position evidenced by the no change letter, we make some
                              - 10 -


preliminary observations.   In 1993, when respondent notified

petitioner that her 1992 return had been selected for

examination, continuing through 1994, when respondent mailed

petitioner the no change letter, it was respondent’s stated

position that a payment in satisfaction of a sex discrimination

claim under Title VII of the Civil Rights Act of 1964, as amended

in 1991 to provide for compensatory and punitive damages and for

jury trials, was excluded from gross income as damages for “tort-

like personal injury” under section 104(a)(2).   See Rev. Rul. 93-

88, 1993-2 C.B. 61; see also Priv. Ltr. Rul. 94-48-014 (Aug. 30,

1994).   In taking this position, respondent relied on language in

United States v. Burke, 504 U.S. 229, 234-241 (1992), which held

that back-pay damages under the pre-1991 version of Title VII of

the Civil Rights Act of 1964 were taxable because that version of

the Act, which provided neither for damages other than backpay

nor for a jury trial, did not redress a tort-like injury.

     Petitioner’s counsel’s legal memorandum of April 8, 1994,

argued that petitioner’s settlement proceeds from the State Farm

class action lawsuit remedied a tort-like injury and were

excluded from gross income under section 104(a)(2), pursuant to

Rev. Rul. 93-88 and Priv. Ltr. Rul. 94-48-014.   In issuing the no

change letter, respondent apparently accepted petitioner’s

argument that petitioner’s claim in the State Farm class action
                                - 11 -


lawsuit was governed by the 1991 amendments to the Civil Rights

Act.3

        Any uncertainty about the significance in discrimination

cases of the 1991 amendments to the Civil Rights Act was laid to

rest by the Supreme Court’s opinion in Commissioner v. Schleier,

515 U.S. 323 (1995), published June 14, 1995.     Schleier held that

awards under the Age Discrimination in Employment Act (ADEA) were

taxable not only because the ADEA, like the pre-1991 version of

the Civil Rights Act, does not satisfy the requirement of tort-

like injury, but also because the claim must be “on account of

personal injuries or sickness”, and that termination on account

of age could not “fairly be described as a ‘personal injury’ or

‘sickness.’” Id. at 330.     Thus, the second ground of Schleier



        3
       If respondent accepted petitioner’s argument to this
effect, relying on the holding of the Court of Appeals for the
Ninth Circuit in Davis v. City of San Francisco, 976 F.2d 1536
(9th Cir. 1992) (cited by petitioner’s counsel in his memo of
April 8, 1994), that the provisions of the Civil Rights Act of
1991, Pub. L. 90-202, 81 Stat. 602, governing expert witness fees
applied retroactively, it turned out that respondent was
mistaken. The amendments made by the Civil Rights Act of 1991,
which provided for additional relief of compensatory and punitive
damages as well as back pay, and for a jury trial, were
subsequently held not to apply retroactively. See Landgraf v.
USI Films Prods., 511 U.S. 244, 249, 256, 286 (1994). Thus,
respondent should have considered petitioner’s claim in the light
of the pre-1991 version of the Act under which she made claim,
which arose in 1977. See Clark v. Commissioner, T.C. Memo. 1997-
156. Since United States v. Burke, 504 U.S. 229 (1992), held
that sec. 104(a)(2) did not apply to a settlement award under
Title VII of the 1964 Act, Burke was governing authority for
inclusion of petitioner’s settlement in gross income.
                                - 12 -


supports the proposition that back wages for what might be

regarded as a tort-like injury, e.g. discrimination on account of

age, race, disability, or sex, are taxable unless it can be shown

that (a) the discrimination caused physical or psychological

injury, and (b) the loss of pay was due to a physical or

psychological injury, not just the discriminatory action of the

employer.4

     Schleier became the law of the land applicable to all

pending cases.     When the U.S. Supreme Court announces a rule of

law and applies it to the litigants in the case announcing the

rule, that rule applies retroactively to all other pending cases

unless barred by the statute of limitations or res judicata.    See

Harper v. Virginia Dept. of Taxation, 509 U.S. 86, 97 (1993);

James B. Beam Distilling Co. v. Georgia, 501 U.S. 529, 540-541,

544 (1991).   Consistently with this view, the Tax Court has

applied Schleier to taxable years antedating the Supreme Court’s

opinion therein.    See, e.g., Bagley v. Commissioner, 105 T.C. 396

(1995), affd. 121 F.3d 393 (8th Cir. 1997); Green v.

Commissioner, T.C. Memo. 1998-274; Goeden v. Commissioner, T.C.

Memo. 1998-18; Wise v. Commissioner, T.C. Memo. 1998-4; Kroposki


     4
       It is noteworthy that the Supreme Court in Schleier v.
Commissioner, 515 U.S. 323, 336 n. 8 (1995) cast doubt on the
Commissioner’s reading of United States v. Burke, supra, in Rev.
Rul. 93-88, 1993-2 C.B. 61. In Notice 95-45, 1995-2 C.B. 330,
the Commissioner suspended Rev. Rul. 93-88; in Rev. Rul. 96-65,
1996-2 C.B. 6, the Commissioner obsoleted Rev. Rul. 93-88.
                              - 13 -


v. Commissioner, T.C. Memo. 1997-563; Moran v. Commissioner, T.C.

Memo. 1997-412; Fredrickson v. Commissioner, T.C. Memo. 1997-125.

     The Tax Court has also invariably held that recipients of

settlement proceeds from the State Farm class action lawsuit are

required to include the proceeds in gross income.   See, e.g.,

Westmiller v. Commissioner, T.C. Memo. 1998-140; Reiher v.

Commissioner, T.C. Memo. 1998-75; Easter v. Commissioner, T.C.

Memo. 1998-8; Brewer v. Commissioner, T.C. Memo. 1997-542, affd.

without published opinion 172 F.3d 875 (9th Cir. 1999); Gillette

v. Commissioner, T.C. Memo. 1997-301; Hayes v. Commissioner, T.C.

Memo. 1997-213; Hardin v. Commissioner, T.C. Memo. 1997-202;

Raney v. Commissioner, T.C. Memo. 1997-200; Clark v.

Commissioner, T.C. Memo. 1997-156; Berst v. Commissioner, T.C.

Memo. 1997-137; Martinez v. Commissioner, T.C. Memo. 1997-126,

affd. without published opinion 83 AFTR 2d 99-362, 99-1 USTC par.

50,168 (9th Cir. 1998); Fredrickson v. Commissioner, supra.

     Approximately 3 months after the Supreme Court’s opinion in

Schleier, respondent mailed petitioner the 30-day letter of

September 28, 1995, which proposed that the proceeds of her

settlement of the State Farm class action lawsuit be included in

her gross income.   Thereafter, petitioner signed a series of

consents extending the period of limitations on assessment for

the 1992 tax year; in due course, in 1998, respondent issued the

notice, which embodies respondent’s determination to give effect
                               - 14 -


to the proposal in respondent’s 30-day letter of September 28,

1995.

     Before turning to petitioner’s three arguments that

respondent’s statutory notice is invalid, we recite some events

in the administrative history of the case noted by the parties in

making their arguments.

     Before mailing the 30-day letter of September 28, 1995, in

which respondent first proposed, after mailing petitioner the no

change letter, that the State Farm class action lawsuit

settlement proceeds should be included in her gross income,

respondent issued a 30-day letter, on March 29, 1995, to the

effect that she had failed to include $2,894 of bartering

proceeds in her 1992 return.   Petitioner’s representative

resolved that issue simply by sending respondent a copy of the

Schedule D on which the bartering proceeds were reported.

Petitioner now claims that respondent’s raising of the bartering

proceeds issue was a prohibited second examination without

petitioner’s consent in violation of section 7605(b).

     On July 17, 1996, after the 30-day letter of September 28,

1995, and the parties’ execution of the first consent extending

the period of limitations, a tax technician in respondent’s

District Director’s Office mailed petitioner’s attorney a letter

that on balance was more unfavorable to petitioner than the 30-

day letter:   Although the new letter said the recovery was not
                             - 15 -


subject to self-employment tax, it downgraded her attorney’s fees

from an above-the-line Schedule C deduction to a below-the-line

itemized deduction, which increased her adjusted gross income and

limited her available exemptions.    The letter also recited the

two criteria justifying respondent’s change of the position

evidenced by the no change letter.

     In response to petitioner’s counsel’s second memo of

January 16, 1997, arguing that neither of those criteria had been

satisfied and that petitioner had not been notified of the need

for a second examination, respondent’s Chief, Examination

Division, on June 16, 1997, mailed petitioner a letter belatedly

acknowledging that “We are required by law to notify taxpayers in

writing if we need to reexamine their books and records after

previously examining them” and asking petitioner to “please make

them available to us for examination”.    There is no evidence in

the record that respondent ever actually reexamined petitioner’s

records or requested any additional documentation from petitioner

regarding the State Farm class action lawsuit settlement

proceeds.

     Although there may be some interrelationships among

petitioner’s arguments that the notice should be invalidated on

account of respondent’s asserted failure to follow his reopening

procedures, respondent’s asserted violation of section 7605(b),

and petitioner’s claim of equitable estoppel, see Saltzman, IRS
                               - 16 -


Practice and Procedure 8-42 (2d ed. 1991), we follow the lead of

the parties and address these arguments under separate

subheadings.

     a. Respondent’s Asserted Failure To Follow Reopening
        Procedures

     Respondent’s procedural rules for reopening cases closed

after examination to make an adjustment unfavorable to the

taxpayer are set forth in the latest of a long line of revenue

procedures, Rev. Proc. 94-68, 1994-2 C.B. 803, and in section

4023 of the Manual.

     The Service’s policy is not to reopen a closed case to make

an adjustment unfavorable to the taxpayer unless

          (1) there is evidence of fraud, malfeasance,
     collusion, concealment, or misrepresentation of a
     material fact;
          (2) the prior closing involved a clearly defined
     substantial error based on an established Service
     position existing at the time of the previous
     examination; or
          (3) other circumstances exist that indicate
     failure to reopen would be a serious administrative
     omission. [1 Audit, Internal Revenue Manual (CCH),
     sec. 4023.2 (Reopening Requirements), at 7063-7064.]5

     The revenue procedure and the Manual clarify the reopening

procedures.    The closing of a case by the Service is evidenced,

among other things, by issuance of a no change letter to the

taxpayer.   See Rev. Proc. 94-68, sec. 4.01(1), 1994-2 C.B. 803; 1



     5
        Rev. Proc. 94-68, sec. 5.01 (Policy), 1994-2 C.B. at 804,
is virtually identical.
                             - 17 -


Audit, Internal Revenue Manual (CCH), sec. 4023.4, at 7064-7065.

A no change letter is not a closing agreement under section 7121.

See sec. 301.7121-1(d), Proced & Admin. Regs.

     i. Violation of Respondent’s Reopening Procedures Does Not
        Invalidate a Notice of Deficiency.

     In the face of hornbook law that respondent’s procedural

rules, including the reopening procedures under Rev. Proc. 94-68

and section 4023.2 of the Manual, supra, are merely directory,

not mandatory, see Collins v. Commissioner, 61 T.C. 693, 700-701

(1974), and that compliance with directory procedural rules is

not essential to the validity of a statutory notice, so that an

alleged violation of these rules provides no basis for

invalidating a statutory notice of deficiency, id., petitioner

cites Chrysler Corp. v. Brown, 441 U.S. 281 (1979), for the

proposition that respondent’s reopening procedures in Rev. Proc.

94-68, 1994-2 C.B. 803, should have “the force and effect of

law”.

     Chrysler Corp. v. Brown, 441 U.S. at 302 (quoting Morton v.

Ruiz, 415 U.S. 199, 232, 235, 236 (1974)), establishes that a

regulation or procedure has the force and effect of law when it

is promulgated by an agency as a “‘substantive rule’” or a

“‘legislative-type rule’” pursuant to a mandate or delegation by

Congress “‘affecting individual rights or obligations.’”

Conversely, “interpretive rules, general statements of policy, or
                                - 18 -


rules of agency organization, procedure, or practice” are not

binding upon the agency.     Id. at 301.   Courts have long

recognized the distinction between mandatory procedures, which

are binding on the agency, and directory procedures, which are

not.    See Cleveland Trust Co. v. United States, 421 F.2d 475 (6th

Cir. 1970); Geurkink v. United States, 354 F.2d 629 (7th Cir.

1965); Luhring v. Glotzbach, 304 F.2d 560 (4th Cir. 1962);

Collins v. Commissioner, supra; Notaro v. United States, 71 AFTR

2d 93-659, 93-1 USTC par. 50,030 (N.D. Ill. 1992); First Fed.

Sav. & Loan Association v. Goldman, 58 AFTR 2d 86-5612, 86-2 USTC

par. 9624 (W.D. Pa. 1986).

       We are satisfied under the weight of authority that we need

not reexamine the well-established law to this effect.        However,

for purposes of completeness, we do address petitioner’s argument

that respondent violated respondent’s own reopening procedures,

so as to demonstrate the inapplicability of any isolated cases in

which the Commissioner’s notice was arguably held invalid for

failure to follow his own reopening procedures.     See, e.g.,

Estate of Michael ex rel. Michael v. Lullo, 173 F.3d 503 (4th

Cir. 1999).    We conclude that in the case at hand respondent

satisfied at least one of the criteria under his procedures for

reopening a closed case.
                              - 19 -


     ii. Respondent Did Not Violate His Reopening Procedures in
         Reopening Petitioner’s 1992 Tax Year.

     Whether respondent was justified under Rev. Proc. 94-68 and

section 4023 of the Manual, supra, in reopening petitioner’s

“closed” case would depend upon whether respondent’s original

position (1) was attributable to taxpayer or Service misconduct,

(2) constituted “substantial error,” or (3) whether respondent’s

failure to change the position would have constituted “a serious

administrative omission”.   Satisfaction of any of these three

tests would justify reopening under the Service’s own policy

pronouncements.   See supra p. 16.

     We focus on the third test, whether “failure to reopen

would” have been “a serious administrative omission.”   Reopening

because of a “serious administrative omission” covers situations

in which a failure to reopen could:

          (1) result in serious criticism of the Service’s
     administration of the tax laws;
          (2) establish a precedent that would seriously
     hamper subsequent attempts by the Service to take
     corrective action;
          (3) result in inconsistent treatment of similarly
     situated taxpayers who have relatively free access to
     knowledge as to how the Service treated items on other
     taxpayers’ returns. [1 Audit, Internal Revenue Manual
     (CCH), sec. 4023.5, at 7065.]

     With regard to “serious administrative omission”, we

conclude that respondent is on firm ground.   Whatever doubt there

might have been about the clarity of respondent’s established

position in 1994, those doubts were laid to rest and the position
                               - 20 -


clarified in mid-1995 by the Supreme Court’s opinion in

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

acknowledges that the State Farm class action lawsuit settlement

proceeds constitute gross income, and we are satisfied that

respondent was authorized to pursue all recipients of such

proceeds, including petitioner, for all open years.    For

respondent not to have done so might well have resulted “in

serious criticism of the Service’s administration of the tax

laws” and would have resulted “in inconsistent treatment of

similarly situated taxpayers”, thereby satisfying the first and

third criteria for application of the “serious administrative

omission” test.    Petitioner’s anecdotal testimony that some

members of the class got away with noninclusion of their

settlement proceeds because respondent failed to pursue them does

not change our conclusion that the third test was satisfied.

     Section 4023.5 of the Manual, in its “Definition of

Reopening Criteria”, contains neither the conjunction “and” nor

the disjunctive connector “or” between the second and third

criteria.    1 Audit, Internal Revenue Manual (CCH), sec. 4023.5,

at 7065.    We are satisfied that the three criteria are to be

interpreted and applied as setting forth their requirements in

the disjunctive.    What this means is that the satisfying of any

one of the three criteria suffices to satisfy respondent’s

“serious administrative omission” reopening test.    Inasmuch as at
                                - 21 -


least one of the criteria for a “serious administrative omission”

was satisfied, respondent’s self-imposed stated conditions for

reopening petitioner’s 1992 tax case were satisfied.

     b. Second Inspection

     Section 7605(b) provides:

          No taxpayer shall be subjected to unnecessary
     examination or investigations, and only one inspection
     of a taxpayer’s books of account shall be made for each
     taxable year unless the taxpayer requests otherwise or
     unless the Secretary or his delegate, after
     investigation, notifies the taxpayer in writing that an
     additional inspection is necessary.

     The purpose of section 7605(b) is not to limit the number of

examinations, but to shift the discretion for a reexamination of

the taxpayer’s books to higher management personnel from the

field agent; this serves “to emphasize the responsibility of

agents to exercise prudent judgment in wielding the extensive

powers granted to them by the Internal Revenue Code.”      United

States v. Powell, 379 U.S. 48, 56 (1964).     Section 7605(b) was

not meant to restrict the scope of respondent’s legitimate power

to protect the revenue.     See id.   Section 7605(b) is not to be

read so broadly as to defeat the powers granted to respondent to

examine the correctness of a taxpayer’s return.     See De Masters

v. Arend, 313 F.2d 79, 87 (9th Cir. 1963).

     There is no evidence in the record of a second inspection as

contemplated by section 7605(b), irrespective of whether

petitioner is arguing that respondent’s reopening of the
                                - 22 -


treatment of the State Farm class action lawsuit settlement

proceeds or the raising of the bartering proceeds issue was a

prohibited second inspection.    A second inspection would require,

at a minimum, that respondent have access to and physically view

petitioner’s books and records for the 1992 tax year.    See

Benjamin v. Commissioner, 66 T.C. 1084, 1098 (1976), affd. on

other grounds 592 F.2d 1259 (5th Cir. 1979).

     Petitioner argued, in her counsel’s memo of January 16,

1997, that respondent had failed to notify her in writing of the

need for a second inspection.    Respondent, through the Chief,

Examination Division, belatedly responded, in respondent’s letter

of June 16, 1997, reciting the section 7605(b) requirements and

asking petitioner to “please make [her books and records]

available to us for examination.”    Respondent’s response was

wholly unnecessary.   There is no evidence in the record that

respondent actually reexamined petitioner’s records or requested

or received any additional documentation from petitioner

regarding the State Farm class action lawsuit settlement proceeds

after issuance of the no change letter.

     Apparently recognizing the weakness of her original position

on the issue, petitioner on the day of trial chose to rely on

respondent’s inquiry raising the bartering proceeds issue as the

prohibited second examination.    On this score, petitioner fares

no better.   In resolving the bartering proceeds issue, respondent
                              - 23 -


merely reviewed Schedule D of petitioner’s 1992 income tax return

and the letter from petitioner’s representative.   Respondent’s

review of a taxpayer’s income tax return and accompanying

schedules does not constitute a second inspection of the

taxpayer’s books of account under section 7605(b).   See Curtis v.

Commissioner, 84 T.C. 1349, 1351 (1985); Pleasanton Gravel Co. v.

Commissioner, 64 T.C. 510, 528 (1975), affd. per curiam 578 F.2d

827 (9th Cir. 1978).   Since there was no second inspection or

examination, respondent’s inquiry, following the no change

letter, into the bartering proceeds issue without a prior written

justification did not violate section 7605(b).   See Digby v.

Commissioner, 103 T.C. 441, 451 (1994).

     Even if respondent should be deemed to have performed a

second inspection in raising the bartering proceeds issue, it was

done with the knowledge of petitioner, who raised no objection

thereto prior to the morning of trial.    Consequently, petitioner

waived the requirement of written notice prior to a second

inspection.   See Rife v. Commissioner, 41 T.C. 732, 747 (1964),

affd. on this issue 356 F.2d 883 (5th Cir. 1966); Rice v.

Commissioner, T.C. Memo. 1994-204.

     Moreover, even if respondent should be deemed to have

performed a second inspection on the bartering proceeds issue

without prior notification that petitioner did not waive,

invalidation of the notice of deficiency would not be the proper
                                - 24 -


remedy.   No remedy would be warranted.     There was no adjustment

in the deficiency notice related to the bartering proceeds issue;

petitioner suffered no injury as a result of the alleged

violation of section 7605(b).    See Rice v. Commissioner, supra at

note 11 and cases cited therein.

     c. Respondent Is Not Equitably Estopped From Issuing the
        Notice of Deficiency.

     “Equitable estoppel is a judicial doctrine that ‘precludes a

party from denying his own acts or representations which induced

another to act to his detriment.’”       Hofstetter v. Commissioner,

98 T.C. 695, 700 (1992) (quoting Graff v. Commissioner, 74 T.C.

743, 761 (1980), affd. 673 F.2d 784 (5th Cir. 1982)).      The

traditional elements of equitable estoppel--all of which must be

satisfied to invoke the doctrine--are:      (1) A false

representation or misleading silence by the party against whom

the doctrine is to be invoked; (2) an error in a statement of

fact and not an opinion or statement of law; (3) ignorance of the

fact by the representee; (4) reasonable reliance on the act or

statement by the representee; and (5) detriment to the

representee.   See Norfolk S. Corp. v. Commissioner, 104 T.C. 13,

60 (1995), affd. 140 F.3d 240 (4th Cir. 1998).

     Equitable estoppel may not be asserted against the

Government “‘on the same terms as any other litigant’”.      United

States v. Hatcher, 922 F.2d 1402, 1410 (9th Cir. 1991) (quoting
                                - 25 -


Heckler v. Community Health Servs., 467 U.S. 51, 60 (1984)).         The

doctrine of equitable estoppel is applied against respondent

“with utmost caution and restraint.”       Schuster v. Commissioner,

312 F.2d 311, 317 (9th Cir. 1962), affg. 32 T.C. 998 (1959),

affg. in part and revg. in part First W. Bank & Trust Co. v.

Commissioner, 32 T.C. 1017 (1959).       Estoppel may be successfully

invoked against the Commissioner only where a taxpayer would

otherwise sustain such a “profound and unconscionable injury in

reliance on the Commissioner’s action as to require, in

accordance with any sense of justice and fair play, that the

Commissioner not be allowed to inflict the injury.”       Id.   This

rarely happens; the policy in favor of the efficient collection

of public revenue usually outweighs the customary policy

considerations that justify invocation of equitable estoppel as

between private litigants.   See id.

     In addition to the traditional elements of equitable

estoppel, the Court of Appeals for the Ninth Circuit requires the

party seeking to apply the doctrine against the Government to

prove affirmative misconduct.    See Purcell v. United States, 1

F.3d 932, 939 (9th Cir. 1993), and cases cited.      The aggrieved

party must prove “‘affirmative misconduct going beyond mere

negligence’” and, even then, “‘estoppel will only apply where the

government’s wrongful act will cause a serious injustice, and the

public’s interest will not suffer undue damage by imposition of
                               - 26 -


the liability.’”    Purer v. United States, 872 F.2d 277, 278 (9th

Cir. 1989) (quoting Wagner v. Director, Fed. Emergency Mgmt.

Agency, 847 F.2d 515, 519 (9th Cir. 1988)).     Affirmative

misconduct requires “ongoing active misrepresentations” or a

“pervasive pattern of false promises,” as opposed to an isolated

act of providing misinformation.     Watkins v. United States Army,

875 F.2d 699, 708 (9th Cir. 1989).      Affirmative misconduct is a

threshold issue to be decided before determining whether the

traditional elements of equitable estoppel are present.       See

Purcell v. United States, supra at 939.

     Before beginning the inquiry into whether the no change

letter satisfied the conditions for invoking equitable estoppel

against respondent, we must isolate and characterize the

representation, if any, made by the no change letter.     The letter

says two things:    “We examined your * * * return * * * and made

no changes to the tax year reported”, and it alerts the taxpayer

to the possibility of a later change if the Service makes a

change on examination of an S corporation, trust, or partnership

of which the taxpayer is a shareholder, beneficiary, or partner.

The letter thereby creates an impression that the return will not

be changed in any other circumstances, but this is more a

possible inference from silence than an affirmative

representation.    In this respect, the letter is different from

the estate tax closing letters that were considered in Estate of
                              - 27 -


Michael ex rel. Michael v. Lullo, 173 F.3d 503 (4th Cir. 1999);

Trust Servs. of Am. v. United States, 885 F.2d 561 (9th Cir.

1989); Estate of Brocato v. Commissioner, T.C. Memo. 1999-424;

Law v. United States, 51 AFTR 2d 1343, 83-1 USTC par. 13,514

(N.D. Cal. 1982).   The format of the estate tax closing letter,

as described or quoted in these cases, is to state that the

estate tax return has either been accepted as filed or after

adjustment to which the taxpayer agreed, to recite that the

letter is not a closing agreement under section 7121, and to

state that “we will not reopen this case” unless the three-prong

test set forth in the revenue procedure currently in effect is

satisfied, either by quoting the test or citing the revenue

procedure.

     Petitioner fails to satisfy the strict standard for

equitable estoppel against the Government for at least three

reasons.   First, as a threshold matter, there is no evidence of

ongoing active misrepresentations, a pervasive pattern of false

promises, or any affirmative misconduct by respondent.   See Purer

v. United States, supra at 278.

     Second, however the statements in the no change letter might

be characterized, petitioner has not demonstrated reliance on the

no change letter in changing her behavior to her detriment.    In

order to satisfy the requirement of reliance, petitioner must

show that she changed her behavior as a result of the alleged
                               - 28 -


misrepresentation.    See Heckler v. Community Health Servs., 467

U.S. 51, 61 (1984).    While petitioner claims that she relied on

the no change letter for “a sense of security”, there is no

evidence that she changed her behavior or did anything in

reliance on the no change letter, much less that she did anything

to her detriment.    See Keaton v. Commissioner, T.C. Memo. 1993-

365; Nadler v. Commissioner, T.C. Memo. 1992-383.

     Petitioner’s claims that she relied on the no change letter

in continuing to save her investments, and in continuing to care

for her mother, do not hold water.      Petitioner continued to save

her investments and care for her mother after she received the no

change letter in the same ways she did before she received it.

Petitioner’s continued behavior does not establish the change in

position that petitioner must establish in order to prove

reliance.   See Heckler v. Community Health Servs., supra at 61.

     Petitioner also claims that petitioner relied on the no

change letter in deciding to take custody of her nephew shortly

before June 1998.    However, before petitioner took custody of her

nephew, she had signed consents extending the period of

limitations on assessment on November 4, 1995, on October 2,

1996, and on October 14, 1997.    Petitioner took custody of her

nephew shortly after respondent issued the notice of deficiency

for this case on April 9, 1998.    Since petitioner was aware of

the pending examination of her income tax return for 1992, and
                                - 29 -


had already received the notice when she accepted custody of her

nephew, petitioner’s claim of reliance on the no change letter is

not credible.     See Levin v. Commissioner, T.C. Memo. 1990-226

(taxpayer who executed two extensions of the period of

limitations did not establish reliance on a closing document).

        Third, any reliance on the no change letter was not

reasonable.     A no change letter, as distinguished from a closing

agreement under section 7121, does not resolve a tax controversy

with finality.     See Opine Timber Co. v. Commissioner, 64 T.C.

700, 712-713 (1975), affd. without published opinion 552 F.2d 368

(5th Cir, 1977); Kiourtsis v. Commissioner, T.C. Memo. 1996-534;

Fitzpatrick v. Commissioner, T.C. Memo. 1995-548.     Even after she

received the no change letter, petitioner was aware that the 1992

tax year remained open.     Petitioner signed three consents to

extend the time to assess tax (Form 872).     The period of

limitations on assessment for the 1992 tax year had not expired

at the time respondent issued the notice of deficiency in this

case.     Accordingly, even if petitioner did rely on the no change

letter, her reliance was not reasonable.

     We deny petitioner’s claim for the application of equitable

estoppel against respondent to invalidate the statutory notice.

     Issue 2:    Amount and Character of Allowable Deductions

        The validity of respondent’s statutory notice having been

upheld, the conclusion follows, as petitioner concedes, that the
                               - 30 -


proceeds of settlement of her claim in the State Farm class

action lawsuit must be included in her 1992 gross income.   We are

therefore faced with petitioner’s alternative arguments that she

is entitled to a substantial deduction in arriving at her 1992

taxable income for her contributions to the TJM pension plan and

that her attorney’s fees are an above-the-line Schedule C

deduction rather than an itemized deduction subject to the 2-

percent floor of section 67.   These two arguments have a common

thread, that petitioner should be allowed to treat her settlement

recovery as if it were earnings from rendering services as an

independent contractor insurance agent for State Farm.

     a. Deduction Disallowed for Private Pension Plan
        Contributions

     On October 30, 1992, petitioner adopted the Taylor J. Miller

Defined Benefit Pension Plan (TJM Pension Plan).

     According to the adoption agreement, petitioner adopted and

sponsored the TJM Pension Plan as a sole proprietorship in her

own name.   Petitioner did not operate a sole proprietorship

during 1992 or 1993.

     The Adoption Agreement for the TJM Pension Plan selected

November 1, 1991, as the effective date and defined the term

"plan year" as the fiscal period ending on October 31 of each

calendar year.
                              - 31 -


     The TJM Pension Plan was a volume-submitter plan known as

the Harrigan, Ruff, Ryder & Sbardellati Master Defined Benefit

Pension Plan and Trust Agreement.   On April 12, 1994, respondent

issued an opinion letter that the Harrigan, Ruff, Ryder &

Sbardellati Master Defined Benefit Pension Plan and Trust

Agreement documents satisfied the requirements of the Internal

Revenue Code (without opining on the qualified status of

individual plans using the document).

     In 1995, petitioner applied for a determination letter for

the TJM Pension Plan.   On February 8, 1996, respondent mailed

petitioner a favorable determination letter that the TJM Pension

Plan was qualified under section 401.

     Petitioner retained an enrolled actuary, Stephen L. Hawkins,

to prepare the Actuarial Information (Schedule B, Form 5500) for

the TJM Pension Plan for the plan years ending October 31, 1992,

and October 31, 1993.

     The first plan year for the TJM Pension Plan ended October

31, 1992.   Petitioner submitted TJM Pension Plan's Annual Return

of Fiduciary of Employee Benefit Trust (Schedule P Form 5500),

the Return/Report of Employee Benefit Plan (Form 5500-C/R), the

Actuarial Information (Schedule B, Form 5500), and the

Application for Extension of Time To File Certain Employee Plan

Returns for the plan fiscal year ending October 31, 1992.   On the

Return/Report of Employee Benefit Plan (Form 5500-C/R),
                                - 32 -


petitioner used business code No. 8999, meaning "other services

not classified."

     The second plan year for the TJM Pension Plan ended October

31, 1993.   At trial, petitioner submitted the TJM Pension Plan's

Annual Return of Fiduciary of Employee Benefit Trust (Schedule P,

Form 5500), the Return/Report of Employee Benefit Plan (Form

5500-C/R), the Actuarial Information (Schedule B, Form 5500), and

the Application for Extension of Time To File Certain Employee

Plan Returns for the plan fiscal year ending October 31, 1993.

     Petitioner made the following deposits into a trust bank

account at Wells Fargo Bank titled in the name of Taylor J.

Miller, Trustee, Taylor J. Miller Defined Benefit Pension Plan

(TJM Pension Plan Account):

            Date                         Amount
            December 31, 1992            $ 2,500
            January 8, 1993               88,594
                                          91,094

     On January 8, 1993, petitioner transferred $85,000 from the

TJM Pension Plan Account to Jack White & Company.   Schedule B for

the plan year ending October 31, 1992, showed that petitioner

made the following contributions to the TJM Pension Plan:

            Date                         Amount
            December 31, 1992            $ 2,500
            January 8, 1993               38,229
                                          40,729

     Based on the plan provisions and assumptions used by the

actuary for the TJM Pension Plan plan year ending October 31,
                               - 33 -


1992, the full funding limitation under sections 412 and 404 was

$40,729.    For purposes of this case, under section

404(a)(1)(A)(i), the full funding limitation would result in a

maximum deductible contribution of $40,729 for the plan year

ending October 31, 1992.

     Schedule B for the plan year ending October 31, 1993, showed

that petitioner made the following contribution to the TJM

Pension Plan:

            Date                          Amount
            January 8, 1993               $50,365

     Based on the plan provisions and assumptions used by the

actuary for the TJM Pension Plan plan year ending October 31,

1993, the full funding limitation under sections 412 and 404 was

$52,443.    For purposes of this case, under section 404(a)(1)

(A)(i) and section 1.404(a)-14(c), Income Tax Regs., the full

funding limitation would result in a maximum deductible

contribution of $52,443 for the plan year ending October 31,

1993.

     During 1975, petitioner earned $12,895 in wages from

Fidelity; petitioner earned no self-employment income.    During

1976 and 1977, respectively, petitioner earned $4,849 and $1,059

in net self-employment income from sales of Fidelity insurance

products.    Petitioner had no self-employment income for the 1989

tax year.    For the 1990 and 1991 tax years, petitioner reported
                             - 34 -


net losses from self-employment on Schedule C of $4,769 and

$3,981, respectively.

     The only receipts that petitioner reported on Schedule C of

her 1992 income tax return were the settlement proceeds of her

auto accident personal injury claim and the settlement proceeds

of the State Farm class action lawsuit.    She lumped these

together and reported the sum as subject to “exclusion under

section 104(a)(2) (see 8275)”.    On her 1992 income tax return,

petitioner reported her occupation as “Investor”.

     Petitioner earned no income from self-employment for the

1993, 1994, and 1995 tax years.    On her income tax returns for

these years, petitioner reported her occupation as “Investor”.

      On the Schedule C to her 1996 income tax return, petitioner

reported a $5,364 net loss from self-employment; she reported her

occupation as “Investor”.

     At no time did petitioner perform services for State Farm.

Petitioner did not work in the insurance industry after 1977.

Petitioner did not claim any deduction for contributions to a

pension plan on her income tax return for the 1992 tax year.

     In her petition, filed with this Court on July 7, 1998,

petitioner raised the issue of the deductibility of her pension

plan contributions for the first time.    In her petition,

petitioner claimed a deduction for her 1992 tax year for $91,094

in total contributions to the TJM Pension Plan.    The $91,094 in
                              - 35 -


total contributions consists of $40,729 in contributions for the

plan year ending October 31, 1992, and a $50,365 contribution for

the plan year ending October 31, 1993.   Petitioner concedes, if

we should hold that she had earned income in 1992 in respect of

which she could make a deductible contribution to the TJM Pension

Plan, that the contribution deduction would be limited to a

lesser amount as calculated under section 1.404(a)-14(c), Income

Tax Regs.

     The TJM Pension Plan was not in effect for the 1991 tax year

because petitioner did not have a written plan and trust in

existence in 1991.   The TJM Pension Plan continues to remain in

effect, although petitioner has not made any subsequent

contributions to the trust under the plan.

     A self-employed taxpayer may be entitled to deduct from

income her contributions to a qualified plan, provided that the

deduction does not exceed the earned income derived from the

taxpayer’s trade or business with respect to which the plan is

established.   See secs. 401(c), 404(a)(1), and (a)(8).   “Earned

income” is defined in section 401(c)(2)(A), which states in

relevant part:   “The term ‘earned income’ means the net earnings

from self-employment (as defined in section 1402(a)), but such

net earnings shall be determined * * * only with respect to a

trade or business in which personal services of the taxpayer are
                               - 36 -


a material income-producing factor.”    Sec. 401(c)(2)(A)

(emphasis added).

     Petitioner seeks to deduct her contributions to the TJM

Pension Plan on the ground that the settlement proceeds of the

State Farm class action lawsuit should be characterized as earned

income from self-employment.

     Petitioner argues that the definition of net earnings from

self-employment should be broadly construed, citing Wuebker v.

Commissioner, 110 T.C. 431 (1998), particularly with regard to

insurance agents, citing Jackson v. Commissioner, 108 T.C. 130

(1997), and Schelble v. Commissioner, 130 F.3d 1388 (10th Cir.

1997), affg. T.C. Memo. 1996-269.   Although Wuebker and Jackson

did not hold in favor of inclusion, Schelble did, and there are

other cases that lend support to the traditional justification

for a broad approach to promote the inclusion of self-employed

individuals in the Social Security system and to finance Social

Security benefits to be paid to them.   See, e.g., Milligan v.

Commissioner, 38 F.3d 1094 (9th Cir. 1994).

     In support of the application of the “origin of the claim”

test to hold that the settlement proceeds qualify as earnings

from self-employment, petitioner also cites Dye v. United States,

121 F.3d 1399, 1404 (10th Cir. 1997), which quoted the District

Court as follows:
                             - 37 -


     the object of the “origin of the claim” test is to find
     the transaction or activity from which the taxable
     event proximately resulted, United States v. Gilmore,
     372 U.S. 39, 47, * * * (1963), or the event that “led
     to the tax dispute.” Keller St. Dev. Co. v.
     Commissioner, 688 F.2d 681 (9th Cir. 1982). The origin
     is determined by analyzing the facts and determining
     what the nature of the transaction is. Keller, 688
     F.2d at 681.

     Although petitioner in the agreement settling her claim in

the State Farm class action lawsuit waived all rights to be hired

by State Farm, the agreement characterized the settlement as “the

compromise of a claim for agent earnings.”   Petitioner cites

McKay v. Commissioner, 102 T.C. 465 (1994), vacated and remanded

in an unpublished opinion 84 F.3d 433 (5th Cir. 1996); Metzger v.

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

845 F.2d 1013 (3d Cir. 1988); and Yates Indus., Inc. v.

Commissioner, 58 T.C. 961 (1972), for the propositions that this

Court, in making its facts and circumstances analysis of the

origin of a claim, not only gives great deference to the terms of

a settlement negotiated at arm’s length, but that in these cases

“this Court determined that the parties [sic] specific allocation

of the settlement proceeds should be respected as it accurately

reflected the origin of the claim and the settlement of those

proceeds.”

     We have here some tensions between the initial positions of

Congress and the Commissioner, restricting the availability of

qualified plans for the self-employed because of the tax shelter
                              - 38 -


they can provide for highly compensated individuals, such as

physicians and lawyers,6 with petitioner’s reminder that the

Court has more recently recognized that highly compensated self-

employed individuals are entitled to use such plans, including

properly structured defined benefit plans, to shelter their

earned income and provide for retirement within the limits

established by Congress.   See Vinson & Elkins v. Commissioner, 99

T.C. 9 (1992).   Petitioner couples her reminder with the argument

that, as a victim of invidious discrimination that prevented her

from achieving an independent contractor relationship in the

insurance industry, she should be allowed to treat her

compensatory recovery as self-employment income and thereby

shelter a portion of the recovery by making deductible

contributions to her qualified plan.   Cf. Sager & Cohen, “How the




     6
       See Staff of the Joint Comm. on Taxation, General
Explanation of the Revenue Provisions of the Tax Equity and
Fiscal Responsibility Act of 1982, at 301-308 (J. Comm. Print
1982), setting forth the various restrictions in prior statutory
law on qualified plans for the self-employed. See also Bittker &
Lokken, Federal Taxation of Income, Estates and Gifts S90-4-S90-5
(Cum. Supp. No. 2, 2000) for a brief summary, with citations to
relevant authorities, of the Commissioner’s efforts to limit the
use by the erstwhile self-employed of professional corporations
as vehicles to obtain the tax benefits of qualified pension and
profit-sharing plans.
                               - 39 -


Income Tax Undermines Civil Rights Law”, Tax Notes 1643

(Sept. 25, 2000).

     Unfortunately for petitioner, the governing statutory

language does not allow us to disregard its plain meaning.    The

problem with petitioner’s arguments and authorities is that they

derive no support from and indeed are contradicted by the

statutory and regulatory language as construed by the Tax Court.

     Section 1.401-10(c)(1), Income Tax Regs., interprets “earned

income,” as used in section 401(c)(2)(A), quoted supra p. 35, and

section 1402(a).    The regulation provides that an individual who

renders no personal services has no “earned income” even though

such an individual may have net earnings from self-employment

from a trade or business.   Earned income includes professional

fees and other amounts received as compensation for personal

services “actually rendered” by the individual.    Id.

Accordingly, if a self-employed taxpayer has not rendered

personal services in the trade or business for which a plan is

established, then the taxpayer has no earned income and is not

entitled to deduct contributions to the plan.   See S. Rept. 992,

87th Cong., 1st Sess. 12 (1961), 1962-3 C.B. 303, 314 (“the

measuring rod for deductible contributions for self-employed

* * * [taxpayers] is ‘earned income’ * * *.   This means that

contributions by or for a proprietor or partner may be made under
                                - 40 -


a qualified retirement plan only if he performs personal

services”).

     We have found no case in which a person’s desire,

willingness, or intent to render personal services satisfied the

earned income requirement.   Instead, we have upheld the

requirement that personal services be actually performed in order

to yield earned income that will support a deduction under

section 404.

     In Kramer v. Commissioner, 80 T.C. 768 (1983), Jack Kramer,

a former U.S. tennis champion, received royalty payments from

Wilson Sporting Goods, a tennis racquet manufacturer, which were

attributed to the use of his name and reputation, and for

services actually rendered in promoting Wilson’s premier tennis

racquet, which bore his name.    We made an allocation between the

royalties paid for the use of Kramer’s name and reputation, which

were not earned income, and royalties paid for promotional

services actually rendered on Wilson’s behalf, which were earned

income.   We held that, to the extent the royalties did not

qualify as earned income, Kramer was not entitled to take them

into account in computing his deductible contributions to his

Keogh plan.

     Similarly, in Frick v. Commissioner, T.C. Memo. 1983-733,

affd. without published opinion 774 F.2d 1168 (7th Cir. 1985),

the Court denied Mr. Frick’s claimed Keogh plan contribution
                               - 41 -


deduction to the extent his contributions were from investment

income.   This was because the investment income was not derived

from personal services.    In so ruling, we quoted the legislative

history of section 401(c), which states:   “Since the objective of

* * * [a qualified plan for the self-employed] is to provide

retirement benefits based on personal services, inactive owners

who derive their income entirely from investments would not be

allowed to participate.”    S. Rept. 992, 87th Cong., 1st Sess. 12

(1961), 1962-3 C.B. 303, 314; see also Frick v. Commissioner,

T.C. Memo. 1985-542, affd. without published opinion 808 F.2d 837

(7th Cir. 1986); Frick v. Commissioner, T.C. Memo. 1989-86, affd.

without published opinion 916 F.2d 715 (7th Cir. 1990).

     In the case at hand, petitioner applied to become a State

Farm trainee agent in fall 1976 or January 1977.    However,

petitioner never performed any services for State Farm, either as

employee or as independent contractor.   After 1977, she never

worked in the insurance industry, although from time to time

thereafter she worked in various selling jobs, sometimes as

employee and sometimes as independent contractor.    As in the

Kramer and Frick cases, the income paid by State Farm to

petitioner in the case at hand cannot be earned income because it
                              - 42 -


was not paid as compensation for personal services actually

rendered.7

     The settlement proceeds received by petitioner do not meet

the personal service requirements for earned income set forth in

section 401(c)(2), section 1.401-10(c)(1), Income Tax Regs., and

the relevant case law.

     Inasmuch as the State Farm settlement proceeds do not

constitute income from self-employment within the meaning of

section 401(c)(2) or section 1402(a), petitioner is not entitled

to deduct the contributions to her defined benefit plan, the TJM

Pension Plan.   We therefore need not address the question briefed

by the parties regarding the limitations on the contribution

deduction.

     b. Character of Deduction for Legal Fee

     Petitioner presented no evidence and requested no findings

of fact on this issue and pays scant attention to it in her

briefs.   In her briefs, petitioner concludes by doing no more

than asserting:   “petitioner should be entitled to a deduction

* * * of $58,459.24 for attorneys’ fees and costs without regard

to the limitation under I.R.C. § 67.”


     7
       Because the State Farm settlement proceeds were not the
result of personal services actually rendered by petitioner, we
need not determine the precise nature of the settlement proceeds
or specifically characterize the settlement proceeds as a
particular type of income. See Gump v. United States, 86 F.3d
1126, 1130 (Fed. Cir. 1996).
                              - 43 -


     In so asserting, petitioner has conceded that she is not

entitled to exclude her share of the attorney’s fees in the State

Farm class action lawsuit in computing her gross income from the

settlement.   Petitioner’s concession is well taken.   Both the

Court of Appeals for the Ninth Circuit and this Court have

consistently held that contingent fees paid to recover a claim to

income are not excluded in computing the gross income from the

recovery, not even in a class action such as in the case at hand,

where the claimant retains even less control over the prosecution

and settlement of the claim than she would in ordinary one-on-one

litigation.   Compare Estate of Clarks v. United States, 202 F.3d

854 (6th Cir. 2000), and Cotnam v. Commissioner, 263 F.2d 119

(5th Cir. 1959), with Benci-Woodward v. Commissioner, 219 F.3d

941, 943 (9th Cir. 2000), affg. T.C. Memo. 1998-395; Coady v.

Commissioner, 213 F.3d 1187 (9th Cir. 2000), affg. T.C. Memo.

1998-291; Kenseth v. Commissioner, 114 T.C. 399 (2000); Brewer v.

Commissioner, T.C. Memo. 1997-542, affd. without published

opinion 172 F.3d 875 (9th Cir. 1999); Martinez v. Commissioner,

T.C. Memo. 1997-126, affd. without published opinion 83 AFTR 2d

99-362, 99-1 USTC par. 50,168 (9th Cir. 1998).   See also Banks v.

Commissioner, T.C. Memo. 2001-48.

     Although the legal expenses of an independent contractor in

prosecuting a claim arising from the conduct of his Schedule C

trade or business are entitled to above-the-line treatment as
                              - 44 -


business expenses, see Guill v. Commissioner, 112 T.C. 325

(1999), we have denied petitioner’s pension contribution

deduction on the ground that the recovery in her settlement of

the State Farm class action lawsuit did not constitute earned

income from services actually rendered by her in conducting a

Schedule C business.   There was no nexus between the recovery and

the rendering of any personal services by petitioner to the

payor.   The nexus was different; the recovery was connected to,

had its origin in, and arose out of State Farm’s invidious

discrimination, which deprived her of the opportunity to perform

any such services.

     Our denial of petitioner’s claim to a pension plan

contribution deduction on that ground forecloses her claim that

she is entitled to an above-the-line Schedule C deduction for

legal fees, rather than the itemized deduction subject to the 2-

percent limitation of section 67 that respondent allowed in the

statutory notice.

     To give effect to all the foregoing,


                                    Decision will be entered for

                               respondent.
