                        T.C. Memo. 2011-241



                      UNITED STATES TAX COURT



    HEALTHPOINT, LTD., DFB PHARMACEUTICALS, INC., TAX MATTERS
                      PARTNER, Petitioner v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 25736-09.                Filed October 3, 2011.



     Gregg R. Kosterlitzky and Gerald L. Brantley, for

petitioner.

     Daniel J. LaVassar and David Q. Cao, for respondent.



              MEMORANDUM FINDINGS OF FACT AND OPINION


     COHEN, Judge:   Respondent sent a notice of final partnership

administrative adjustment (FPAA) for 2004 to Healthpoint, Ltd.

(Healthpoint).   DFB Pharmaceuticals, Inc. (petitioner), the

designated tax matters partner for Healthpoint, filed a timely
                                 - 2 -

petition for readjustment with the Court.      The issues for

decision are:    (1) Whether the proceeds of a particular

settlement agreement are taxable as capital gains or ordinary

income; and (2) whether petitioner is liable for a penalty under

section 6662(a).    The Court requested that the parties in their

posttrial briefs address the jurisdiction of the Court with

respect to the section 6662(a) penalty.      The parties agree, and

the Court concludes, that we have such jurisdiction in this case.

See 106 Ltd. v. Commissioner, 136 T.C. 67 (2011).

     Unless otherwise indicated, all section references are to

the Internal Revenue Code (Code) in effect for the year in issue,

and all Rule references are to the Tax Court Rules of Practice

and Procedure.

                          FINDINGS OF FACT

     Some of the facts have been stipulated, and the stipulated

facts are incorporated in our findings by this reference.

Healthpoint is a Texas limited partnership.      At the time the

petition was filed, Healthpoint’s principal place of business was

in Texas.

     Healthpoint is a specialty pharmaceutical company which, at

all relevant times, had three primary divisions, including a

tissue management division.     Healthpoint sold the tissue

management division in 2008 but retained ownership of some of its

products, including Accuzyme.    Accuzyme is a prescription
                               - 3 -

ointment that uses a combination of urea and an enzyme called

papain to eliminate necrotic tissue from wounds, a process known

as debriding.   Healthpoint owns the exclusive rights to the

Accuzyme trademark and associated goodwill and spent millions of

dollars to promote successfully Accuzyme nationally.

Consequently, by 2001, Accuzyme had become the most prescribed

papain-urea debriding ointment on the market.

     Ethex Corporation (Ethex), a wholly owned subsidiary of KV

Pharmaceuticals, Inc., introduced a product, Ethezyme, which was

packaged and marketed as a generic form of Accuzyme.     Ethezyme,

however, contained an additional potentially harmful chemical and

more papain than Accuzyme.   Ethex’s marketing strategy, however,

caused practitioners and consumers to believe that Ethezyme was a

generic equivalent of Accuzyme and could be used as a substitute.

When patients had negative results after using Ethezyme,

practitioners did not order Accuzyme in place of Ethezyme because

Ethex had marketed Ethezyme as a generic version of Healthpoint’s

product.   Subsequently, many consumers were driven out of the

papain-urea debridement ointment market altogether.

     On August 3, 2000, Healthpoint filed suit (Ethex I) in the

U.S. District Court for the Western District of Texas (District

Court), claiming that Ethex was liable for false advertising,

unfair competition, and trademark dilution under the Lanham Act

and unfair competition, misappropriation, and business
                                 - 4 -

disparagement under Texas law.     The parties attempted to reach a

settlement agreement through mediation before trial, but were

unsuccessful.     At trial in Ethex I, Healthpoint presented expert

testimony that profits it lost as a result of Ethex’s conduct

caused $3,498,905 in actual damages.     Healthpoint’s vice

president of sales also testified that sales were approximately

$1 million lower than projected for 2000 and $5 million lower

than projected for 2001.

     On July 18, 2001, while the Ethex I litigation was ongoing,

Healthpoint filed another suit against Ethex (Ethex II) in the

District Court.     In Ethex II, Healthpoint alleged that Ethex was

marketing a new formulation of Ethezyme, Ethezyme 830, as a

generic equivalent to Accuzyme.     Healthpoint claimed Ethex was

liable for false advertising, unfair competition, and trademark

dilution under the Lanham Act and Texas law, as well as for theft

of trade secrets.    Healthpoint attempted to join the claims

related to Ethezyme 830 to Ethex I, but the District Court ruled

that it was too late to do so.

     On September 28, 2001, the jury in Ethex I returned a

verdict in favor of Healthpoint.     The jury found that Ethex had

engaged in false advertising under Federal law and acts of unfair

competition under Federal and Texas law and that Ethex had acted

with malice when it engaged in misconduct under Texas law.      The

jury did not find, however, that Ethex had knowingly or
                               - 5 -

intentionally diluted Healthpoint’s trademark or disparaged

Healthpoint’s business.

     On October 4, 2001, Healthpoint publicized this verdict via

a press release titled “Texas Jury Sends Strong Message to Ethex

Corporation”.   On December 10, 2002, the District Court released

its Findings of Fact and Conclusions of Law.   The jury awarded

$16.47 million, of which $16,163,545 went to Healthpoint.      The

damages were allocated as follows:

            Damage                         Amount

     Actual damages                      $5,000,000
     Disgorgement of Ethex’s profits
       from false advertising
       and unfair competition             1,640,000
     Punitive damages                     3,174,515
     Lanham Act enhanced damages          6,349,030

     Ethex filed an appeal with the Court of Appeals for the

Fifth Circuit, and Healthpoint and Ethex attempted to reach a

settlement in Ethex I through the required mediation procedure.

When this was unsuccessful, the parties attempted to resolve

Ethex II and the appeal of Ethex I in a second formal mediation

attempt that was also ultimately unsuccessful.

     In December 2003, Healthpoint and Ethex began direct

settlement negotiations.   At that time Healthpoint proposed

settling both cases for approximately $25 million, and Ethex

proposed settling both cases for $8 million.     Both offers were
                               - 6 -

rejected.   In December 2003, Ethex proposed settling the cases

with a royalty arrangement on profits from future sales of

Ethezyme.   Healthpoint rejected that offer and countered with an

offer of $13 million plus a royalty and some additional terms.

Ethex also rejected the counteroffer and offered $9 million

immediately, $250,000 payable over 4 years, and royalty payments

on increased sales of Ethezyme 830.     Healthpoint declined this

offer, and settlement negotiations ceased temporarily.

     In August 2004, shortly before the scheduled trial in Ethex

II and oral arguments in the appeal of Ethex I, Healthpoint and

Ethex resumed settlement discussions.     The parties agreed to

settle Ethex I for $12 million and Ethex II for $4.5 million.

     Though the parties had agreed to the amount of the

settlement, the discussion surrounding the nondisparagement and

confidentiality provisions remained contentious.    Ethex wanted

Healthpoint jointly to request a vacatur of the pleadings in

Ethex I to remove them from the public record, but Healthpoint

declined.   Ultimately, the parties agreed to a nondisparagement

clause that permitted Healthpoint to use public domain documents

(e.g., the pleadings, the findings of fact, etc.) to promote

Accuzyme and distinguish it from Ethezyme, coupled with terms

that prohibited Ethex from using the settlement agreement for

those same purposes.
                                - 7 -

     On August 29, 2004, Ethex sent Healthpoint a proposed

settlement agreement.    Out of the $16.5 million agreed upon, that

draft proposed allocating $12 million to “compensatory damages

arising out of alleged unintentional product disparagement” to

settle Ethex I and $4.5 million with the same description to

settle Ethex II.

     Healthpoint subsequently sent Ethex its proposed settlement

agreement.   Healthpoint’s tax counsel prepared an outline of the

categories of damages the agreement would include but did not

assign any amounts to those categories.   Without the aid of tax

counsel, Healthpoint then proposed allocating $15.8 million as

follows:

                Damage                            Amount

     Ethex I
       Lanham Act--false advertising:
         Damage to goodwill and reputation      $7,600,000
         Lost profits/disgorgement of
           profits                               1,250,000
       Unfair Competition:
         Damage to goodwill and reputation       1,750,000
         Lost profits/disgorgement of
           profits                                 100,000
         Punitive damages                        1,100,000

     Ethex II
       Lanham Act--false advertising:
         Damage to goodwill and reputation       2,350,000
         Lost profits/disgorgement of
           profits                                 450,000
       Unfair Competition:
         Damage to goodwill and reputation      1,200,000
                               - 8 -

Healthpoint also proposed allocating $500,000 to DPT

Laboratories, Ltd. (DPT), not a party to this case, to settle a

claim for misappropriation of trade secrets in Ethex II, $150,000

of the proceeds from Ethex I to DPT for damage to goodwill and

reputation, and $50,000 of the proceeds from Ethex I to DPT for

lost profits.   Ethex responded to that proposal with an email

stating that

     under no circumstances could * * * [Ethex] ever agree that
     any part of this settlement is for anything that might be
     associated with willful misconduct. We feel strongly that
     this characterization of our conduct is completely
     unjustified. These accusations have been injurious to our
     reputation, and we will not do anything that might be
     interpreted as conceding that we acted in a knowing manner.

Healthpoint believed that it would be unable to reach an

agreement without complying with this request and subsequently

acquiesced to Ethex’s demand to eliminate allocations to

misappropriation and punitive damages.   Ethex permitted

Healthpoint to reallocate the $500,000 payable to DPT

Laboratories to settle Ethex II and the $1.1 million punitive

damages to other categories without objection.

     On September 2, 2004, Ethex and Healthpoint signed the

settlement agreement resolving Ethex I and Ethex II.    The damages

were allocated under the settlement agreement as follows:
                                  - 9 -

                Damage                              Amount

     Ethex I
       Damage to goodwill and reputation          $10,450,000
       Lost profits/disgorgement of
         profits                                    1,350,000

     Ethex II
       Damage to goodwill and reputation            4,050,000
       Lost profits/disgorgement of
         profits                                      450,000

The $200,000 Healthpoint proposed allocating to DPT to settle

Ethex I remained in the final settlement agreement and is not at

issue in this case.   The settlement agreement also included the

statement that “no part of the sums paid pursuant to this

Agreement are for willful misconduct” or for punitive damages.

     Healthpoint did not maintain any business documentation

relating to goodwill or make any calculations during the

settlement negotiations to justify the allocations in the

agreement.   Healthpoint was aware that allocating money to items

of ordinary income rather than capital gain would generate a

higher tax burden.    Healthpoint’s tax counsel was not involved in

any discussion of the total amount of the settlement or the

amount of each individual allocation.

     Healthpoint filed a Form 1065, U.S. Return of Partnership

Income, on April 11, 2005.    With respect to the proceeds of the

settlement, it reported $14.5 million in long-term capital gain

and $1.8 million in ordinary income.      The Internal Revenue

Service examined Healthpoint’s 2004 tax return.     The FPAA
                              - 10 -

contained determinations that all proceeds of the settlement were

ordinary income to Healthpoint and that the section 6662(a)

penalty applied.   Respondent now concedes that Lanham Act

enhanced damages of $6,349,030 awarded by the jury for loss of

goodwill are taxable as long-term capital gain.

                              OPINION

     Petitioner argues that we should respect the allocations

made in the settlement agreement, and respondent argues that we

should apply the allocations made by the jury in Ethex I.     The

parties agree that proceeds of the settlement determined to be

for goodwill or damage to reputation are taxable as capital gain

and that proceeds determined to be lost or disgorged profits or

punitive damages are taxable as ordinary income.    See secs. 1221,

61(a); Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955).

     The parties agree that petitioner does not qualify for a

shift in the burden of proof under section 7491 because of the

net worth limitations of section 7491(a)(2)(C).    Thus petitioner

bears the burden of proving that respondent’s allocation of the

settlement proceeds is erroneous.   Rule 142(a); INDOPCO, Inc. v.

Commissioner, 503 U.S. 79 (1992).

Allocations by the Settlement Agreement

     Where damages are received pursuant to a settlement

agreement, the tax consequences of the settlement depend on the

nature of the claim that was the basis for the settlement, rather
                                - 11 -

than the validity of the claim.    United States v. Burke, 504 U.S.

229, 239 (1992).   The determination of the nature of the

underlying claim is a factual one and is generally made by

reference to the settlement agreement considered in the light of

the facts and circumstances surrounding the settlement.      Robinson

v. Commissioner, 102 T.C. 116, 126 (1994), affd. in part and

revd. in part and remanded on another issue 70 F.3d 34 (5th Cir.

1995).   Where there is an express allocation in the settlement

agreement between the parties, it will generally be followed in

determining the allocation for Federal income tax purposes if the

settlement agreement is entered into by the parties in an

adversarial context at arm’s length and in good faith.      Id. at

126-127.   However, an express allocation set forth in the

agreement is not necessarily determinative if other facts

indicate that the payment was intended by the parties to be for a

different purpose.   Bagley v. Commissioner, 105 T.C. 396, 406

(1995), affd. 121 F.3d 393 (8th Cir. 1997).   Thus, judicial

approbation of express settlement allocations for Federal income

tax purposes is not warranted where circumstantial factors reveal

that the designation of the settlement proceeds was not the

result of adversarial, arm’s-length and good faith negotiations

and is incongruous with the “economic realities” of the

taxpayer’s underlying claims.    See id. at 406-410.
                                - 12 -

     Petitioner relies primarily on McKay v. Commissioner, 102

T.C. 465 (1994), vacated on other grounds without published

opinion 84 F.3d 433 (5th Cir. 1996), to justify allocating the

settlement proceeds consistent with the written agreement for tax

purposes.   In McKay, the taxpayer received a settlement from his

employer in a lawsuit including, among other things, a claim for

breach of his employment contract and a wrongful discharge tort

claim.   Before the settlement, the taxpayer received a favorable

judgment of approximately $12 million on the contract claim and

$2 million on the tort claim.    Finding that the employer violated

the Racketeer Influenced and Corrupt Organizations Act (commonly

known as RICO), the jury applied treble damages and awarded $43

million to the employee.   The settlement agreement gave the

taxpayer similar actual damages of approximately $14 million,

excludable under section 104(a)(2), but expressly disclaimed any

payment of punitive or treble damages that would have been

taxable as ordinary income.    Because these allocations were

roughly the same as the jury verdict with respect to the contract

and tort claims and reflected an arm’s-length and adversarial

negotiation process, we determined that the allocations in the

settlement agreement were the “clearest embodiment of the payor’s

intent in the instant case.”    Id. at 484.

     Respondent cites Bagley v. Commissioner, supra, to support

his position that the allocations in the settlement agreement
                               - 13 -

should not be respected.    The Court of Appeals for the Eighth

Circuit affirmed our decision to disregard the express

allocations of the settlement agreement and stated that

     proof of a defendant’s desire or intent not to show an
     award of punitive damages does not establish that the
     defendant did not pay something to avoid punitive
     damages, where there is solid evidence that the
     prospect of punitive-damages liability necessarily
     increased the amount that the defendant paid in
     settlement.

Bagley v. Commissioner, 121 F.3d at 396.

     Petitioner argues that Ethex and Healthpoint were adverse

throughout the entire negotiating process and thus the agreement

must be respected.    Petitioner points out numerous instances

throughout the settlement negotiations where the parties

disagreed.   However, general adversity between the parties to a

lawsuit is to be expected.    The requirement that parties involved

in settlement negotiations be adverse is a factor in determining

whether the final agreement reflected the true intentions of the

parties involved.    If the parties were generally adverse but

ultimately allocated the funds in a way that did not represent

the claims they actually intended to settle, then we need not

respect the allocations made in the settlement agreement.

     Petitioner argues that Ethex refused to pay the punitive

damages Healthpoint had included in its first draft settlement

agreement, thus proving that the allocations were the product of

adverse negotiations.    However, the circumstances indicate not
                               - 14 -

that Ethex would not pay any amount relating to punitive damages,

but simply that they could not be labeled as such.    The amount of

the settlement was not disputed at the time Ethex objected to the

punitive damages allocation included in Healthpoint’s draft

settlement agreement.    Ethex was indifferent as to how

Healthpoint chose to allocate the funds so long as the allocation

did not imply intentional wrongdoing, and it permitted

Healthpoint to assign the same amount of damages to any other

category.    The limitations Ethex put on the labeling of damages

are insufficient to establish that the allocations in the

agreement are the product of adversity between the parties.

     Furthermore, it is unlikely that Healthpoint would have

desired to include punitive damages or additional items in the

settlement that would be taxed as ordinary income.    Healthpoint

was aware that the settlement allocations proposed by Ethex would

result in a more favorable tax rate.    Healthpoint may have

desired to demonstrate wrongdoing on the part of Ethex.    It is

unlikely, however, that referring to punitive damages in a

settlement agreement with a nondisparagement clause would have

affected Ethex’s reputation significantly more than the jury

verdict.    The expected tax benefits of characterizing the damages

as for loss of goodwill would be more beneficial to Healthpoint.

Healthpoint had proposed an allocation to punitive damages during

the settlement negotiations that was significantly less than the
                               - 15 -

amount of the jury award, thus suggesting that tax considerations

had greater importance than punitive motives.

     Petitioner also asserts that a statement in McKay v.

Commissioner, 102 T.C. at 484, specifically that “[McKay] was

never given the freedom to structure the settlement on his own”,

implies that, in the absence of the ability of one party to draw

the settlement allocations without objection, we must respect the

settlement for Federal income tax purposes.   If, as petitioner

argues, a “free hand” to draw the settlement allocation is a

necessary rather than a sufficient condition, we could only

disregard settlement allocations when the parties to the

agreement were completely nonadverse.   That result is not

justified by our Opinion in McKay.

Allocating According to Jury Verdict

     Respondent contends that the appropriate allocation of the

settlement proceeds is according to the jury verdict rendered in

Healthpoint’s favor.   “It is a tenet of federal tax law that

income received in settlement of a claim should be taxed in the

same manner as if it had been received on that claim in court.”

Francisco v. United States, 267 F.3d 303, 319 (3d Cir. 2001).

The Court of Appeals for the Fifth Circuit, to which our decision

here is appealable, has affirmed that a jury verdict is the best

indicator of the worth of a plaintiff’s claims.   Robinson v.

Commissioner, 70 F.3d at 38.
                               - 16 -

     We agree with respondent that, in the light of the

circumstances of the settlement and the verdict in Ethex I, the

allocations made by the jury should be applied to the settlement

of Ethex I for tax purposes.   However, we must still address the

allocations with respect to Ethex II.   “‘When assessing the tax

implications of a settlement agreement, courts should * * *

[not] engage in speculation’”, but should discern “‘the claim the

parties, in good faith, intended to settle for.’”   Green v.

Commissioner, 507 F.3d 857, 868 (5th Cir. 2007) (quoting Bagley

v. Commissioner, 121 F.3d at 395, and Dotson v. United States, 87

F.3d 682, 688 (5th Cir. 1996)), affg. T.C. Memo. 2005-250.     We

have previously used a jury verdict from one case to make a

determination as to the character of settlement proceeds for

another similar case brought by the same taxpayer, but without a

rendered verdict, where the two cases were jointly settled.     See

Miller v. Commissioner, 93 T.C. 330, 335 (1989) (holding that

because the jury did not award damages for emotional distress in

one case, the parties did not intend the settlement to include

payment for emotional distress in a similar case not yet brought

to verdict), revd. on other grounds 914 F.2d 586 (4th Cir. 1990).

     Although Healthpoint’s complaint in Ethex II alleged

misdeeds by Ethex slightly different from those alleged in Ethex

I, the cases were very similar.   In fact, the settlement
                               - 17 -

agreement allocated the damages in Ethex I in similar proportions

to Ethex II.

     Petitioner has not met its burden to show that the

allocations according to the settlement agreement in Ethex II

should be respected.   The amounts paid to settle Ethex II should

be allocated in the same proportions and classifications as those

in Ethex I, on the basis of the jury verdict, the above analysis,

and respondent’s concession.

Applicability of Accuracy-Related Penalty

     Section 6662(a) and (b)(1) and (2) imposes a 20-percent

accuracy-related penalty on any underpayment of Federal income

tax attributable to a taxpayer’s negligence or disregard of rules

or regulations or substantial understatement of income tax.

Section 6662(c) defines negligence as including any failure to

make a reasonable attempt to comply with the provisions of the

Code and defines disregard as any careless, reckless, or

intentional disregard.   Disregard of rules or regulations is

careless if the taxpayer does not exercise reasonable diligence

to determine the correctness of a return position that is

contrary to the rule or regulation.     Sec. 1.6662-3(b)(2), Income

Tax Regs.   A substantial understatement of income tax exists if

the understatement exceeds the greater of 10 percent of the tax

required to be shown on the return or $5,000.    Sec.

6662(d)(1)(A).   For penalties that relate to adjustments to
                               - 18 -

partnership items, the determination of tax motivation and

negligence depends on the state of mind of the general partner of

the partnership.    See Wolf v. Commissioner, 4 F.3d 709, 713 (9th

Cir. 1993), affg. T.C. Memo. 1991-212.

     Under section 7491(c), the Commissioner bears the burden of

production with regard to penalties and must come forward with

sufficient evidence indicating that it is appropriate to impose

penalties.   See Higbee v. Commissioner, 116 T.C. 438, 446 (2001).

However, once the Commissioner has met the burden of production,

the burden of proof remains with the taxpayer, including the

burden of proving that the penalties are inappropriate because of

reasonable cause or substantial authority.    See Rule 142(a);

Higbee v. Commissioner, supra at 446-447.    Considering the amount

of the resulting underpayment of tax, respondent has satisfied

the burden of producing evidence that the penalty is appropriate.

     Petitioner argues that substantial authority supports the

position taken.    As explained above, the arguments petitioner

offered are not adequately supported by the caselaw and do not

show substantial authority.    See sec. 1.6662-4(d)(2) and (3),

Income Tax Regs.    Furthermore, Healthpoint’s income tax return

did not adequately disclose the position taken with regard to the

settlement allocations.

     The accuracy-related penalty under section 6662(a) is not

imposed with respect to any portion of the underpayment as to
                              - 19 -

which the taxpayer acted with reasonable cause and in good faith.

Sec. 6664(c)(1); Higbee v. Commissioner, supra at 448.    The

decision as to whether a taxpayer acted with reasonable cause and

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

account all of the pertinent facts and circumstances.    See sec.

1.6664-4(b)(1), Income Tax Regs.   Taxpayers may satisfy their

burden of proof as to negligence by showing that they reasonably

relied on the advice of a competent professional adviser.    See

United States v. Boyle, 469 U.S. 241, 250-251 (1985); Freytag v.

Commissioner, 89 T.C. 849, 888 (1987), affd. 904 F.2d 1011 (5th

Cir. 1990), affd. 501 U.S. 868 (1991).   Reliance on professional

advice, standing alone, is not an absolute defense but rather is

a factor to be considered.   The Court of Appeals for the Fifth

Circuit has held that the reasonable cause/good faith defense is

available in a partnership-level proceeding in this Court,

provided that it is used as a defense by the partnership itself

rather than by an individual partner.    Klamath Strategic Inv.

Fund v. United States, 568 F.3d 537, 548 (5th Cir. 2009).

     Petitioner asserts that Healthpoint relied on the advice of

tax counsel hired to oversee the settlement agreement.

Petitioner has not proven, however, that tax counsel offered an

opinion as to the propriety of the allocations in the agreement.

Although Healthpoint’s tax counsel provided the outline of the

allocations for use in the settlement, he did not participate in
                                - 20 -

the negotiations with Ethex regarding the total amount of the

settlement or the amount of each individual allocation.

Petitioner’s counterargument that the negotiations were completed

between the parties without regard to tax consequences and

therefore their tax adviser was not involved, even if true, is

insufficient.   Petitioner has not otherwise shown that the tax

adviser considered the tax consequences of the final agreement.

Petitioner is therefore liable for a penalty under section

6662(a), which will be reduced to reflect respondent’s

concession.

     We have considered the other arguments of the parties, and

they either are without merit or need not be addressed in view of

our resolution of the issues.    For the reasons explained above,



                                         Decision will be entered

                                 under Rule 155.
