                        T.C. Memo. 2005-250



                      UNITED STATES TAX COURT



                 GEORGE G. GREEN, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 178-02, 12108-03.    Filed October 31, 2005.



     Gregg R. Kosterlitzky and Kenton E. McDonald, for

petitioner.

     Gerald L. Brantley and Bruce Wilpon, for respondent.



              MEMORANDUM FINDINGS OF FACT AND OPINION


     COHEN, Judge:   Respondent determined deficiencies in these

consolidated cases of $2,636,238, $128,792, $79,135, $52,583, and

$1,868,443 in petitioner’s Federal income taxes for 1995, 1996,

1997, 1998, and 1999, respectively.   Respondent also determined

accuracy-related penalties under section 6662(a) of $527,247.60,
                                - 2 -

$25,748.40, $15,827, $10,516, and $373,688.60 for the years in

issue, respectively.    Additionally, respondent determined an

addition to tax under section 6651(a) of $93,422.15 for failure

to file timely for 1999.    At the time of trial, respondent

asserted that the correct deficiencies were in the amounts of

$1,518,890, $119,466, $78,839, $113,255, and $1,865,426 for 1995,

1996, 1997, 1998, and 1999, respectively, with accuracy-related

penalties under section 6662(a) of $303,778, $23,893, $15,768,

$22,651, and $373,085 for the years in issue, respectively.      The

correct addition to tax under section 6651(a) for failure to file

timely in 1999 was recomputed as $93,271.

       After concessions by the parties, the issues for decision

are:

       (1) Whether petitioner, a cash basis taxpayer, must report

the damages received under a release and settlement agreement

into which he entered with the State of Texas, and, if so, what

amounts must be reported as taxable income;

       (2) whether deductions that petitioner substantiated are

allowable under section 162 or 212;

       (3) whether respondent may amend the answer to include

petitioner’s attorney’s fees in his reportable gross income;

       (4) whether petitioner is liable for section 6662(a)

accuracy-related penalties for each of the years in issue; and
                                - 3 -

     (5) whether petitioner is liable for the section 6651(a)

addition to tax for failure to file timely his 1999 tax return.

     Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the years 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.

Petitioner resided in Horseshoe Bay, Texas, at the time that he

filed his petition.

Whistleblower Lawsuit and Settlement Agreement

     Petitioner worked for the Texas Department of Human Services

(TDHS) as an architect from 1983 until December 12, 1989.    His

duties included reviewing TDHS construction contracts and

advising his supervisors as to the contractors’ compliance with

contractual terms.    While working for TDHS, petitioner believed

that officials with TDHS were engaged in a pattern of fraud and

corruption.   Petitioner discussed the misconduct with his

supervisors, and, when they failed to act, he advised numerous

TDHS employees that he intended to report the misconduct to

authorities outside of the department.

     In September 1989, TDHS began an investigation of

petitioner’s long-distance telephone use.    The investigation
                               - 4 -

revealed that, of all of the telephone calls placed from

petitioner’s extension for 2-1/2 years, one 13-cent telephone

call was alleged to be improper.    Additionally, in October 1989,

TDHS began to investigate petitioner’s use of sick leave.

Investigators audited petitioner’s sick leave records and placed

him under surveillance to monitor his activities during those

working hours when he was excused to receive physical therapy.

The investigators alleged that on one occasion petitioner left

work and failed to attend a therapy session and that on several

occasions no record existed to show his attendance at a therapy

session.   On December 12, 1989, petitioner was fired for

allegedly abusing his sick leave, falsifying official documents,

and misusing his business telephone.   TDHS referred the matter,

including the improper telephone call, to the district attorney

for alleged criminal violations.

     Petitioner was subsequently indicted for falsifying

documents, a third-degree felony.   After petitioner surrendered

to the authorities, he was placed in a holding cell at Travis

County Jail.   Petitioner was handcuffed due to a disturbance that

had broken out in the cell.   Petitioner was released that same

day on a personal bond.

     On March 9, 1990, petitioner filed suit against the TDHS,

Cause No. 480,701, styled George Green v. Texas Department of

Human Services, under the Texas Whistleblower Act.    Tex. Rev.
                                 - 5 -

Civ. Stat. art. 6252-16a, recodified as Tex. Govt. Code sec.

554.001, effective Sept. 1, 1993 (Vernon 2004 & Supp. 2004-2005).

Petitioner alleged damages of:    (1) Loss of wages and benefits;

(2) past and future mental anguish; and (3) expenses incurred in

connection with prosecuting the case, including court costs and

attorney’s fees.   When the district attorney offered to dismiss

the criminal charges if petitioner would drop the whistleblower

suit, petitioner refused.   Shortly before trial of the criminal

case, the district attorney dismissed the charges under the

indictment, pending further investigation.

     Petitioner’s whistleblower suit was tried before a jury from

August 26, 1991, through September 17, 1991.   At that trial,

petitioner’s counsel, D. Douglas Brothers (Brothers), informed

the jury that they would be asked to award damages for:   (1) Out-

of-pocket expenses; (2) lost wages, past and future; (3) mental

suffering, past and future; and (4) punitive or exemplary

damages, awarded “as an example to others and as a penalty or by

way of punishment”.   Brothers informed the jury that exemplary

damages serve two purposes:   “to deter * * * [retaliatory]

conduct, to show how important it is that this never happen; and

two, to punish those that perpetuated * * * [the retaliatory]

conduct.”

     At the time of the whistleblower trial, petitioner suffered

from severe depression.   Richard E. Coons, M.D. (Coons), an
                                - 6 -

expert witness, testified at the whistleblower trial that

petitioner suffered from depression and posttraumatic stress

disorder; that the actions of TDHS were a cause of these

conditions; and that the injury would be permanent.      Coons

testified that some of the symptoms of petitioner’s depression

included compulsive eating, anxiety, crying, decreased

confidence, difficulty concentrating, and great sleep

disturbance.

     The jury found that petitioner was fired in retaliation for

reporting activities at TDHS.    The jury awarded the following

damages:

     Loss of earning capacity         $928,000
     Past mental anguish             1,000,000
     Future mental anguish           1,500,000
     Out-of-pocket expenses             31,832
     Punitive damages               10,000,000

     On October 10, 1991, the Travis County District Court, 53rd

Judicial District (the trial court), entered judgment in favor of

petitioner in the amount of $13,773,461.96.      The trial court

awarded prejudgment interest of $154,246.57 through September 24,

1991, with an additional $237.97 per day until the judgment was

signed.    The judgment bore postjudgment interest of 10 percent

per annum until paid.

     On March 17, 1993, the Court of Appeals for the Third

District of Texas affirmed the trial court’s judgment.      The Court

of Appeals held that petitioner must request a legislative
                                - 7 -

appropriation to collect the damages (including any interest)

because only the Legislature could pay the judgment.       Tex. Dept.

of Human Servs. v. Green, 855 S.W.2d 136, 145 (Tex. Ct. App.

1993).   The Court of Appeals judgment became final on April 26,

1994, after the Texas Supreme Court denied TDHS’s application for

writ of error.

     Between 1991 and 1993, petitioner developed a bleeding

peptic ulcer and required repeated hospitalization for

gastrointestinal bleeding and anemia of life-threatening

severity, requiring blood transfusions over a 45-day period.

During 1993, 1994, and 1995, petitioner suffered further

deterioration of his mental and physical health.

     From September 24, 1991, through November 8, 1995, the State

of Texas did not pay any part of the judgment or interest.

Petitioner discharged Brothers after the final judgment in the

whistleblower lawsuit when there was a disagreement as to how to

collect on such judgment.    Petitioner instituted legal

proceedings in an attempt to collect judgment.    Additionally,

petitioner, individually, attempted to secure a legislative

appropriation in 1993 to satisfy his judgment.    Petitioner’s

efforts were unsuccessful.

     A regular session of the Texas Legislature convenes only in

odd-numbered years.   There are two chambers in the Texas

Legislature:   the Senate and the House of Representatives.     All
                               - 8 -

bills that are introduced for consideration that affect revenues

or expenditures must be referred to the Legislative Budget Board

(LBB).   If a bill is passed by the introducing legislator’s

chamber, it must proceed to the other chamber for final passage.

If it passes the other chamber, it then proceeds to the Governor

for approval or veto.   The Legislature of the State of Texas may

choose (through the appropriation process) to pay some, all, or

none of any claims against the State.

     In or around February 1994, petitioner hired new counsel,

John C. Augustine (Augustine), to assist him in the collection of

the judgment.   In a memorandum to Augustine dated August 14,

1995, petitioner stated:

     Thus, when I engaged your firm on a contingency fee
     basis to assist me in my efforts in collecting the
     judgment I needed no help in collecting the
     $3.7 million. You were brought on board to help in
     collecting the punitive damages and the post-judgment
     interest.

Additionally, a team of representatives was hired to assist in

the collection by “raising consciousness and guiding * * *

[petitioner] in an effort to get the attention of the

authorities.”   On October 6, 1994, in order to fund his

collection attempts, petitioner sold an interest worth $1,000,000

of his ultimate recovery, if any, to James U. King, Jr. (King),

for $500,000.

     In an effort to collect the judgment, petitioner filed

abstracts of judgment in several counties against the State of
                                 - 9 -

Texas, all of which were unsuccessful in securing payment.

Petitioner and his representatives also attempted to influence

public opinion by newspaper and magazine articles and by

television broadcasts.   At or around this time, petitioner filed

a declaratory action, Cause No. 9509704, styled George Green vs.

The State of Texas and The Attorney General of Texas, Dan

Morales.

     Additionally, petitioner, Augustine, and petitioner’s

representatives tried once again to get a bill passed that would

appropriate funds towards petitioner’s judgment.    The 74th

regular session of the Texas Legislature commenced on January 10,

1995, and ended on May 29, 1995.    During this time, two bills

were introduced to provide for appropriation of amounts to

satisfy petitioner’s judgment.    The first bill that was

introduced died in the House Committee on Appropriations.      The

second bill that was introduced was passed by the House of

Representatives and amended and passed by the Senate.    However,

the House of Representatives refused to concur with the

amendments made by the Senate, and the 74th regular session of

the Texas Legislature adjourned without passing the bill.

     After the Legislature failed to appropriate funds for

payment of the judgment, petitioner approached the LBB.     Under

section 317.002 of the Texas Government Code, the Governor of

Texas or the LBB, after finding that an emergency exists, may
                              - 10 -

propose an expenditure or distribution of funds by a State

agency.   Tex. Govt. Code Ann. sec. 317.002(b) (Vernon 2004).

They may make this proposal at any time that the Legislature is

not in session.   Tex. Govt. Code Ann. sec. 317.003(a) (Vernon

2005).

     In order to convince the LBB that an emergency existed,

petitioner and Augustine worked with Lieutenant Governor Bob

Bullock (Bullock), chairman of the LBB, and his staff.

Petitioner met with Bullock on a few occasions to inform him of

petitioner’s unsuccessful efforts to collect on his judgment and

his continued stress and failing health.   In a letter dated

September 21, 1995, Augustine informed Bullock that petitioner

had authorized him to “propose a method of payment of the

judgment by the State of Texas in return for Mr. Green’s

execution of a Release of Judgment and withdrawal of liens”.

Augustine also informed Bullock that petitioner’s judgment had

reached $20,165,725.60 and would be accruing interest at a rate

of $5,524.86 per day.

     A quorum of the LBB met on November 15, 1995.   On that date,

at a public meeting, the LBB found that the existence of unpaid

monetary obligations of some State agencies created an emergency

requiring that those agencies be authorized to expend

appropriated funds to pay the obligations.   The LBB proposed a

budget execution order that authorized TDHS to pay to petitioner:
                               - 11 -

     a settlement, including attorney fees, in the case of
     George Green v. Department of Human Services in the
     amount of $13,775,000, contingent on the fact that
     acceptance of this amount by George Green constitutes a
     complete release by George Green of all claims and
     causes of action George Green may have against the
     state of Texas arising from the case of George Green v.
     Department of Human Services.

     Payments were also authorized to other litigants who had

judgments against the State of Texas “according to the terms of a

judgment”.   The LBB adopted the proposed budget execution order

on November 15, 1995.   On that date, Governor George W. Bush

ratified the order.

     Petitioner, the State of Texas, Brothers and Associates, and

King entered into a written Release and Settlement Agreement (the

agreement) dated November 8, 1995.      The agreement was contingent

upon action by the LBB to approve the agreement.     The agreement

was negotiated by parties with adverse interests and constituted

an arm’s-length transaction.   The agreement was drafted by

Augustine and Harry G. Potter III (Potter), a special assistant

attorney general for the State of Texas.

     The agreement provided:

          1. In Cause No. 480,701, styled George Green v.
     Texas Department of Human Services * * *. The State
     has agreed to enter into this Release and Settlement
     Agreement on the express condition that the State
     receive a substantial abatement of the amount of
     punitive damages it pays on account of the judgment.
     Plaintiff has agreed to compromise the portion of the
     judgment attributable to punitive damages in accordance
     with the State’s requirements in order to settle all
     matters in dispute.
                        - 12 -

     2. In Cause No. 9509704 styled; George Green vs.
The State of Texas, and The Attorney General of Texas,
Dan Morales * * * Plaintiff has asserted against
Defendants claims for declaratory and injunctive
relief, and attorney’s fees as specifically set forth
in Plaintiff’s Original Petition. Additionally,
Defendants have asserted counterclaims for declaratory
and injunctive relief. These claims and counterclaims
have been denied by the respective parties.

     3. * * * the parties have agreed to compromise
and settle each action referenced in paragraphs 1 and 2
above and all claims of any kind or character, whether
now known or unknown or whether asserted in these suits
that the parties have or may have for damages,
declaratory relief, injunctive relief, and/or
attorneys’ fees arising from the factual allegations or
theories of recovery contained in any of the pleadings
filed in either of the actions referenced above. * * *

     4. The State shall make a cash payment of
$3,427,999.87 to Plaintiff for the damages for loss of
earning capacity, mental anguish and suffering (past)
and mental anguish and suffering (future), in
accordance with the findings specified and incorporated
into the Final Judgment in Cause No. 480,701.

     5. The State shall fund annuities for additional
damages associated with the Final Judgment in Cause No.
480,701, which in turn shall pay to Plaintiff monthly
installments, commencing on January 4, 1996 and
continuing until December 4, 1998, each in the amount
of $13,499 with a final payment payable on January 4,
1999 in the amount of $3,000,000. * * *

      6. For all other damages, including punitive,
pre-judgment and post-judgment interest, the State
shall fund an annuity or annuities, which in turn shall
pay to Plaintiff monthly installments, commencing on
January 4, 1996 and continuing until December 4, 1998,
each in the amount of $7,924 with a final payment
payable on January 4, 1999 in the amount of $1,761,000.
* * *

     7a. The State shall make a cash payment of
$1,000,000.00 to James U. King, Jr., who has an
interest in the judgment * * *.
                         - 13 -

     7b. The State shall make a cash payment of
$4,586,000.00 to Brothers & Associates, Attorneys at
Law, which law firm owns an interest in the Final
Judgment * * *.

         *     *     *     *      *    *     *

     9. * * * The State shall be the owner of the
annuities referred to above, but shall have no
authority or ability to amend or decrease any
provisions during their respective terms. It is
further agreed and understood that the State’s
obligations with respect to the annuities described
herein are discharged upon funding of the annuities in
accordance with this Agreement.

         *     *     *     *      *    *     *

     11. The total cost to the State * * * shall not
exceed $13,775,000. * * *

     12. It is expressly understood and agreed that
the State’s obligations under this agreement are
contingent upon approval of a Budget Execution Proposal
by the Legislative Budget Board, the Governor, and
certification by the Comptroller of Public Accounts
that said funds are available. * * *

     13. For consideration given herein * * *, the
parties hereby agree that upon full funding of the
annuity contracts and payments of cash * * *, the
parties shall dismiss with prejudice their respective
claims against each other in Cause No. 9509704 * * *

     14. For the consideration given * * *, Plaintiff
* * * hereby releases and forever discharges the State
of Texas * * * from any and all liability, actions,
claims, demands or suits which Plaintiff has or may
have, which Plaintiff could have asserted in the suits
referenced in paragraphs 1 and 2, or in any other suit
* * *. It is expressly understood and agreed that
Plaintiff accepts the consideration herein as full
satisfaction of the Final Judgment signed on
October 10, 1991 in Cause No. 480,701 * * * and agrees
to fully, finally, and forever release, discharge,
acquit, and quitclaim said judgment. * * *
                              - 14 -

     Petitioner received $13,455 per month from January 1996

through December 1998, under the first annuity, and $7,924 per

month from January 1996 through December 1998, under the second

annuity.   Additionally, petitioner received the final payments of

$3,000,000 and $1,761,000 under the respective annuities in

January 1999.

Green Capital Corp. and TS Capital Asset, LLC

     Green Capital Corp. (Green Capital) and TS Capital Asset,

LLC (TS Capital), were formed by petitioner for the purpose of

employing consultants and advisers, including legal consultants,

publicists, and other professionals, to attempt to collect the

judgment or otherwise secure payment of damages from the State of

Texas.

     Petitioner was involved in a suit with Allied Interests,

Inc. (Allied), in which petitioner was being sued for expenses

owed by petitioner to Allied for services it rendered to

petitioner in its attempt to collect petitioner’s judgment

against the State of Texas.   In 1996, a judgment was entered

against petitioner and Green Capital.   In 1998, petitioner paid

Allied $753,629 in satisfaction of Allied’s judgment.   Included

in that amount was $365,000 of exemplary (punitive) damages.

     Some of the expenses incurred and paid by petitioner in

pursuit of his claims against the State of Texas and in defense
                              - 15 -

of his lawsuit with Allied consisted of payments to attorneys and

consultants and expenses associated with maintaining an office.

Petitioner’s Income Tax Returns for 1995 through 1999

     On October 15, 1996, petitioner filed his Form 1040, U.S.

Individual Income Tax Return, for 1995.   Attached to his income

tax return was Form 8275, Disclosure Statement, in which

petitioner stated:

     On November 17, 1995 I received a settlement amount by
     compromise of my Judgment owed to me by the State of
     Texas. In my settlement agreement I received
     $3,427,999 actual damages for personal/physical
     injury/sickness. * * * This settlement amount is
     nontaxable and not subject to tax.

Additionally, with respect to petitioner’s interest in Green

Capital, petitioner reported losses in the amount of $350,752.

Petitioner’s return for 1995 showed no tax due.

      On August 13, 1997, petitioner filed his income tax return

for 1996.   On his return, petitioner reported receipt of $257,076

of annuity income, of which $95,088 was reported as taxable.

Additionally, with respect to petitioner’s interest in Green

Capital, petitioner reported losses in the amount of $190,943.

Petitioner’s return for 1996 showed no tax due.

      On October 15, 1998, petitioner filed his income tax return

for 1997.   On his return, which was prepared by Hunter & Atkins,

Inc. (Hunter & Atkins), petitioner reported receipt of $257,076

of annuity income, of which $95,088 was reported as taxable.

Attached to his return was Form 8275, in which petitioner stated:
                               - 16 -

“This amount [$161,988] represents payments received for non-

punitive damages via Metropolitan Life.   No Form 1099 was issued,

further supporting Taxpayer’s position that such amount is not

taxable.    See attached statement for further clarification of

Taxpayer’s position.”    The attached statements were as follows:

     The Settlement Agreement included additional damages
     associated with the Final Judgment in Cause No.
     480,701, be provided to George Green (Plaintiff) from
     annuity contracts purchased by the State of Texas, the
     owner of the annuities as follows:

     (Non-punitive) 1. “The State shall fund annuities for
                    additional damages associated with the
                    Final Judgment in Cause No. 480,701
                    which in turn shall pay to Plaintiff
                    monthly installments . . . in the amount
                    of $13,499”. ($161,988 yr)
     (Punitive)     2. “For all other damages, including
                    punitive, pre-judgment and post-judgment
                    interest, the State shall fund an
                    annuity which in turn shall pay
                    Plaintiff monthly installments . . . in
                    the amount of $7,924”. ($95,088 yr)

          The annuity payments in the sum of $161,988
     received in 1997 represent additional damages other
     than punitive and interest, and are excluded from
     income under sec. 104(a)2 [sic].

Additionally, with respect to petitioner’s interest in Green

Capital, petitioner reported losses in the amount of $41,579.

With respect to petitioner’s interest in TS Capital, petitioner

reported losses in the amount of $45,017.    Petitioner’s return

for 1997 showed tax due in the amount of $8,066.

      On October 15, 1999, petitioner filed his income tax return

for 1998.   On his return, which was prepared by Hunter & Atkins,
                               - 17 -

petitioner reported receipt of $257,076 of annuity income, of

which $95,088 was reported as taxable.    Attached to his return

was Form 8275, in which petitioner made statements similar to

those on his 1997 Form 8275.    Additionally, with respect to

petitioner’s interest in TS Capital, petitioner reported losses

in the amount of $811,641.    Petitioner’s return for 1998 showed

no tax due.

     On October 16, 2000, petitioner filed his income tax return

for 1999.    On his return, petitioner reported receipt of

$4,761,000 of annuity income, of which none was reported as

taxable.    Attached to his return was Form 8275, in which

petitioner stated:

     (1) This amount [$3,000,000] represents payment
     received for additional damages from Met. Life annuity
     contract funded by the State of Texas. No Form 1099
     was issued. (See attached statement 1(a) for further
     explanation.)

     (2) This amount [$1,761,000] represents payment
     received for all other damages from Met. Life annuity
     contract funded by the State of Texas. A Form 1099 was
     issued. (See attached statement 2(a) for further
     explanation.)

The attached statements were as follows:

     1(a) The final annuity payment in the sum of $3,000,000
     received in 1999 represents additional damages
     excludable from income under IRC Section 104(a)(2).

     2(a) The final annuity payment in the sum of $1,761,000
     received in 1999 represents all other damages
     excludable from income under IRC Section 104(a)(2).
     Taxpayer cites what he believes is controlling case law
     as well as the Supreme Court’s historical principles of
     restoration of “Capital Lost-Not Income” to define
                              - 18 -

     other damages received via Jury Verdict and finally by
     the Release and Settlement Agreement of November 17,
     1995.

Additionally, with respect to petitioner’s interest in TS

Capital, petitioner reported losses in the amount of $30,587.

Petitioner’s return for 1999 showed no tax due.   Petitioner also

claimed a $100,000 deduction for legal fees.

     On July 13, 2001, petitioner filed Forms 1040X, Amended U.S.

Individual Income Tax Return, for 1996, 1997, and 1998, stating,

among other things, that “$95,088 of reported income was not

includable in taxpayer income.   Section 104(a)(2) establishes

taxpayer guidance for excludability, along with RR 65-29 and

RR 76-133 and PL 97-473.”   This resulted in petitioner’s

requesting a refund of $7,654 for 1997.

Internal Revenue Service (IRS) Determinations

     In connection with the damages awarded to petitioner under

the settlement agreement, the IRS determined that all amounts

received by petitioner in 1995, 1996, 1997, 1998, and 1999 were

taxable income.

     In connection with Green Capital and TS Capital, the IRS

disallowed all losses and subsequent carryforward losses claimed

by petitioner in 1995, 1996, 1997, 1998, and 1999.   The IRS also

disallowed the $100,000 itemized deduction petitioner claimed in

1999.
                                - 19 -

     Additionally, the IRS determined accuracy-related penalties

under section 6662(a) for all of the years in issue and an

addition to tax under section 6651(a) for failure to file timely

in 1999.

     On February 9, 2005, respondent requested leave of the Court

to file an amendment to the answer to include as gross income to

petitioner the $4,586,000 of attorney’s fees paid to Brothers

under the terms of the settlement agreement.

                                OPINION

Burden of Proof

     At trial, the parties agreed that petitioner bears the

burden of proof on all of the issues in these cases, except:

(i) The issue raised by the proposed amendment to the answer of

whether petitioner should have included the contingent attorney’s

fees in his gross income in 1995 and (ii) any new matter or new

issue not raised in respondent’s trial memorandum.   (Thus,

petitioner has agreed that respondent’s burden of production

under section 7491(c) with respect to penalties has been

satisfied.)

Payments Received Under the Settlement Agreement

     Section 61(a) includes in gross income “all income from

whatever source derived”, unless otherwise provided.   Section

104(a)(2) provides otherwise.    Before it was amended by the Small

Business Job Protection Act of 1996, Pub. L. 104-188, sec. 1605,
                               - 20 -

110 Stat. 1838, section 104(a)(2) excluded from gross income

amounts received on account of personal injuries or sickness.

While the reference to personal injuries or sickness did not

include damages received pursuant to the settlement of purely

economic rights, it did include “nonphysical injuries to the

individual, such as those affecting emotions, reputation, or

character”.   United States v. Burke, 504 U.S. 229, 235 n.6

(1992); see Robinson v. Commissioner, 102 T.C. 116, 126 (1994),

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

Cir. 1995); see also Fono v. Commissioner, 79 T.C. 680, 692

(1982), affd. without published opinion 749 F.2d 37 (9th Cir.

1984).   The parties have agreed that the version of section

104(a)(2) in effect prior to the 1996 amendment applies to all of

the payments received by petitioner pursuant to the settlement

agreement.

     In interpreting section 104(a)(2), the Supreme Court has

held that amounts are excludable from gross income only when

(1) the underlying cause of action giving rise to the recovery is

based on tort or tortlike rights and (2) the damages were

received on account of personal injuries or sickness.

Commissioner v. Schleier, 515 U.S. 323, 336-337 (1995); sec.

1.104-1(c), Income Tax Regs.

     If damages are received pursuant to a settlement agreement,

the nature of the claim that was the actual basis for settlement,
                               - 21 -

rather than the validity of the claim, determines whether the

damages were received on account of tortlike personal injuries.

See Robinson v. Commissioner, supra at 126.    The determination of

the nature of the claim is factual and is made by reference to

the settlement agreement in light of the surrounding

circumstances.   Id.   A key question to ask is:   “‘In lieu of what

were the damages awarded?’”    Id. (quoting Raytheon Prod. Corp. v.

Commissioner, 144 F.2d 110, 113 (1st Cir. 1944), affg. 1 T.C. 952

(1943)).   If the settlement agreement allocates clearly the

settlement proceeds between tortlike personal injury damages and

other damages, the allocation is generally binding for tax

purposes to the extent that the agreement was entered into by the

parties in an adversarial context at arm’s length and in good

faith.   If the settlement agreement does not expressly allocate

the settlement between tortlike personal injury damages and other

damages, the intent of the payor must be determined from all of

the pertinent facts and circumstances.    Id. at 127.   Although the

payee's belief is relevant to this inquiry, the ultimate

character of the payment hinges on the payor's dominant reason

for making the payment.    Fono v. Commissioner, supra at 696; see

Amos v. Commissioner, T.C. Memo. 2003-329.

     In these cases, the settlement agreement allocated damages

to petitioner under three separate paragraphs.     The provisions

are paragraphs 4 through 6 as set forth below:
                             - 22 -

          4. The State shall make a cash payment of
     $3,427,999.87 to Plaintiff for the damages for loss of
     earning capacity, mental anguish and suffering (past)
     and mental anguish and suffering (future), in
     accordance with the findings specified and incorporated
     into the Final Judgment in Cause No. 480,701.

          5. The State shall fund annuities for additional
     damages associated with the Final Judgment in Cause No.
     480,701, which in turn shall pay to Plaintiff monthly
     installments, commencing on January 4, 1996 and
     continuing until December 4, 1998, each in the amount
     of $13,499 with a final payment payable on
     January 4, 1999 in the amount of $3,000,000. * * *

           6. For all other damages, including punitive,
     pre-judgment and post-judgment interest, the State
     shall fund an annuity or annuities, which in turn shall
     pay to Plaintiff monthly installments, commencing on
     January 4, 1996 and continuing until December 4, 1998,
     each in the amount of $7,924 with a final payment
     payable on January 4, 1999 in the amount of $1,761,000.
     * * *

     The damages allocated in paragraph 4 are precisely traceable

to the jury award in petitioner’s whistleblower lawsuit, i.e.,

$2,500,000 of the damages awarded is for past and future mental

anguish and $927,999 is for loss of earning capacity.   Respondent

has conceded that all amounts received in 1995 pursuant to

paragraph 4 are excludable from petitioner’s gross income.

     As a result of respondent’s concession, only the effects of

the allocations in paragraphs 5 and 6 are disputed.   The nature

of the claim and the intent of the payor must be determined by

examining the facts and circumstances surrounding the settlement

agreement.
                              - 23 -

     Under paragraph 5, the State was to fund annuities for

“additional damages associated with the Final Judgment” in the

whistleblower lawsuit.   Because the underlying cause of action

giving rise to the recovery of damages was based on tort or

tortlike rights, petitioner has met the first prong of the

two-prong test set out in Commissioner v. Schleier, supra.

However, petitioner has failed to show that, as he contends, the

additional damages received under paragraph 5 of the settlement

agreement were received on account of personal injuries or

sickness.   Although there is substantial evidence that petitioner

suffered mental and physical deterioration between the time of

the judgment in 1991 and the settlement in 1995, there is no

allocation under paragraph 5 for any additional injuries.     There

is no allocation in paragraph 5 for any personal injuries or

sickness that arose out of the whistleblower lawsuit, and all

compensatory damages awarded in the final judgment of that

lawsuit were expressly allocated under paragraph 4 of the

settlement agreement.

     According to the testimony of Potter, who drafted the

agreement for the State of Texas, there was no independent

investigation in 1995 of either the jury findings in the original

lawsuit or petitioner’s injuries.   Potter had no knowledge of

petitioner’s massive bleeding ulcers at the time that he and

Augustine drafted the settlement agreement.   Though petitioner
                               - 24 -

made Bullock aware of his injuries, there is no evidence that any

of the payments received under paragraph 5 and the first annuity

contract were intended by the State to compensate petitioner for

personal injuries or sickness.

     Petitioner has failed to establish the second prong of

Schleier because he is unable to establish that any part of the

first annuity was allocable to personal injury or sickness, and

the record lacks any evidentiary basis for concluding that a

specific portion of the first annuity was allocable to any

personal injury or sickness.   See Lindsey v. Commissioner, 422

F.3d 684 (8th Cir. 2005), affg. T.C. Memo. 2004-113.   Therefore,

after examining the facts and circumstances surrounding the claim

and the settlement agreement, we conclude that the payments

received under paragraph 5 and the first annuity contract are not

excludable under section 104(a)(2) and are to be included in

petitioner’s gross income in the years received.

     Paragraph 6 of the settlement agreement allocates the second

annuity contract to “all other damages, including punitive

[damages] and pre-judgment and post-judgment interest”.

Petitioner contends that, notwithstanding this express

allocation, none of the payments received under the second

annuity were for punitive damages or interest.

     Punitive damages are included in gross income because they

are an element of damages not designed to compensate victims;
                               - 25 -

rather, they are punitive in nature.    O’Gilvie v. United States,

519 U.S. 79, 84 (1996) (citing Commissioner v. Schleier, 515 U.S.

323 (1995)).   In the whistleblower trial, petitioner asked for

punitive damages “to send a message to this agency, to all of

state government that they ought not treat their loyal employees

the way Mr. Green was treated”.

     Interest received is included in gross income because it

compensates for the delay in the receipt of a principal amount

(i.e., the final judgment).   See Kieselbach v. Commissioner, 317

U.S. 399, 404 (1943); see also Robinson v. Commissioner, 102 T.C.

at 126; Kovacs v. Commissioner, 100 T.C. 124, 129 (1993), affd.

per curiam 25 F.3d 1048 (6th Cir. 1994); Aames v. Commissioner,

94 T.C. 189, 193 (1990).    Though petitioner contends that “there

was no ‘indebtedness’” upon which the interest could accrue and

that respondent may not “convert a portion of the Settlement

Consideration to interest”, there is an express allocation for

prejudgment and postjudgment interest set out in paragraph 6 of

the settlement agreement.

     Additionally, according to Potter, the settlement agreement

was worded “to try to minimize the state’s exposure to punitive

damages * * * [and pay] as little as possible in punitive

damages”.   As set out in paragraph 1 quoted in our findings, the

State entered into the settlement agreement on the express

condition that it “receive a substantial abatement” of the
                                - 26 -

punitive damages that had been awarded under the final judgment

in the whistleblower lawsuit.    There is no indication that a

total abatement was intended or effected.    In any event,

petitioner has presented no persuasive reason for concluding that

any of the damages resolved by paragraph 6 fall within an exempt

category.

     Again, petitioner has failed to establish the second prong

of Schleier because he is unable to establish that any part of

the second annuity was allocable to personal injury or sickness,

and the record lacks any evidentiary basis for concluding that

any portion of the second annuity was allocable to personal

injury or sickness.   See Lindsey v. Commissioner, supra.

Therefore, after examining the facts and circumstances

surrounding the claim and the settlement agreement, we conclude

that the payments received under paragraph 6 and the second

annuity contract are not excludable under section 104(a)(2) and

are to be included in petitioner’s gross income when received.

Expenses for Green Capital and TS Capital

     The parties stipulated that for tax years 1995 through 1998

petitioner is entitled to additional deductions in agreed amounts

under either section 162 or section 212 as the Court may

determine.   Petitioner contends that the additional deductions

are allowable as ordinary and necessary business expenses under

section 162.   Respondent contends that the additional deductions
                               - 27 -

are allowable as amounts paid for the production or collection of

income under section 212(1).    Expenses deducted under section

162(a) generally are subtracted in full from gross income to

arrive at adjusted gross income.    However, expenses deducted

under section 212 ordinarily are subtracted from adjusted gross

income to arrive at taxable income and are subject to certain

floor limitations in section 67(a).     A deduction under section

212 may also be limited by application of the alternative minimum

tax.    See sec. 56(b); see also Guill v. Commissioner, 112 T.C.

325, 328-329 (1999); Benci-Woodward v. Commissioner, T.C. Memo.

1998-395, affd. 219 F.3d 941 (9th Cir. 2000).     Additionally, net

operating losses, such as the ones petitioner is claiming, may

carryover under section 172 from the year in which they were

incurred to another year only if the losses were the result of

operating a trade or business within the meaning of section

162(a).    See Eppler v. Commissioner, 58 T.C. 691, 696 (1972),

affd. 486 F.2d 1406 (7th Cir. 1973); see also Anderson v. United

States, 48 F.2d 201, 202 (5th Cir. 1931).

       Section 162(a) permits a deduction for all “ordinary and

necessary expenses paid or incurred during the taxable year in

carrying on any trade or business”.     Deductions are allowed under

section 212(1) for “the ordinary and necessary expenses paid or

incurred during the taxable year * * * for the production or

collection of income”.
                             - 28 -

     Sections 162(a) and 212 are considered in pari materia,
     except for the fact that the income-producing activity
     of the former section is a trade or business whereas
     the income-producing activity of the latter section is
     a pursuit of investing or other profitmaking that lacks
     the regularity and continuity of a business. [Guill v.
     Commissioner, supra at 328.]

     In order to be engaged in carrying on a trade or business,

the taxpayer must be involved in the activity with continuity and

regularity, and the taxpayer’s primary purpose for engaging in

the activity must be for income or profit.   A sporadic activity,

a hobby, or an amusement diversion does not qualify.   See

Commissioner v. Groetzinger, 480 U.S. 23, 35 (1987).   Determining

whether a taxpayer is engaged in carrying on a trade or business

requires an examination of the facts.   Id. at 36.

     Petitioner claims that he was in the trade or business of

attempting to collect compensation from the State of Texas and

conducted that business through Green Capital and TS Capital.

Petitioner argues in his brief:

     In pursuing compensation for Petitioner’s claims
     against the State from 1991 to 1995, Petitioner
     retained and consulted with several consultants and
     advisors, including * * * [lobbyists], engaged in an
     ongoing orchestrated media campaign and conferred with
     and lobbied Texas State legislators. From 1991 to
     1995, Petitioner engaged in such activities on [a]
     regular and continuous basis and such activities were
     done for the purpose of seeking profit, naming [sic]
     collecting compensation for Petitioner’s claims against
     the State. [Citations omitted.]

     Though petitioner continuously and regularly engaged in the

activity of attempting to recover his judgment between 1991 and
                              - 29 -

1995, we cannot conclude that petitioner was in a trade or

business in the customary use of those terms.    Petitioner did not

perform services for others, he had no customers, and he was not

in the business of trading securities or gambling on a regular

and continuous basis.   See id. at 33-34.   Petitioner’s asserted

purpose was to secure the compensation to which he was entitled.

Although a trade or business requires continuous and regular

activity, continuity and regularity, do not, standing alone,

constitute a trade or business.   Petitioner’s position ignores

the distinction between section 162 and section 212--a

distinction well-established in history.

     In Higgins v. Commissioner, 312 U.S. 212, 218 (1941), the

Supreme Court held that the salaries and expenses incident to

looking after a taxpayer’s own investments were not deductible

under section 23 (the predecessor of section 162(a)).    In so

holding, the Supreme Court stated that "No matter how large the

estate or how continuous or extended the work required may be”,

the fact that the taxpayer kept records and collected interest

and dividends from his securities through managerial attention

for his investments was not sufficient as a matter of law to

permit deduction of the expenses in dispute.    Id.

     The Revenue Act of 1942, ch. 619, sec. 121, 56 Stat. 819,

amended the Internal Revenue Code in response to Higgins and to

give relief to “Higgins-type” taxpayers.    See H. Rept. 2333, 77th
                               - 30 -

Cong., 2d Sess. (1942), 1942-2 C.B. 372.   In Whipple v.

Commissioner, 373 U.S. 193, 200 (1963), the Supreme Court

explained:

     section 23(a) [the predecessor of section 162(a)] was
     amended not by disturbing the Court's definition of
     “trade or business” but by following the pattern that
     had been established since 1916 of “[enlarging] the
     category of incomes with reference to which expenses
     were deductible,” to include expenses incurred in the
     production of income. [Citations omitted.]

     The 1942 amendment divided the old section 23(a) into two

parts.   One, section 23(a)(1), dealt with the previously

deductible “trade or business” expenses, now covered by section

162; the other, section 23(a)(2), dealt with a new category of

deductions relating to nontrade or nonbusiness expenses, now

covered by section 212.   The new category was intended to allow

deductions regarding certain income- or profit-oriented

activities, notwithstanding the absence of a “trade or business”.

See Carbine v. Commissioner, 83 T.C. 356, 360-361 (1984), affd.

779 F.3d 662 (11th Cir. 1985).   The reasoning behind the adoption

of section 212 supports respondent’s contention that petitioner

is allowed deductions related to his income-producing activities

to collect his judgment against the State only to the extent

provided under that statute.   Petitioner’s situation is analogous

to that of the taxpayers in Usry v. Price, 325 F.2d 657 (5th Cir.

1963), and Feagans v. Commissioner, 23 T.C. 208 (1954).
                               - 31 -

Therefore, his deductible expenses are allowed only under section

212.

       Additionally, petitioner contends that the $365,000 portion

of his payment in satisfaction of Allied’s judgment, which

constitutes exemplary damages, is deductible under section 162

or, in the alternative, under section 212.   Respondent contends

that, because petitioner is not carrying on a trade or business,

he is not entitled to deduct the $365,000 payment for exemplary

damages.

       Payment of punitive damages may be deductible under section

162.    See Kornhauser v. United States, 276 U.S. 145 (1928) (legal

expenses of taxpayer in defending against claim of former

business partner held deductible); see also Stark v.

Commissioner, T.C. Memo. 1999-1.    Petitioner, however, has

presented inadequate evidence to support his claim that the

payment of punitive damages is deductible in these cases.      There

is insufficient evidence explaining the basis of the award

against petitioner or to show that the expense was ordinary and

necessary.    Thus, the $365,000 payment to Allied is not

deductible.

Respondent’s Motion To Amend Answer

       Rule 41(a) allows for an amendment to the pleadings after a

case has been placed on the trial calendar only “by leave of the

Court or by written consent of the adverse party, and leave shall
                                - 32 -

be given freely when justice so requires.”    Whether a motion

seeking amendment should be allowed lies within the sound

discretion of the Court.    Estate of Quick v. Commissioner, 110

T.C. 172, 178 (1998); Law v. Commissioner, 84 T.C. 985, 990

(1985).

     In determining whether permitting a proposed amendment

serves justice, we must examine the particular circumstances in

the case before us.     Estate of Quick v. Commissioner, supra; Law

v. Commissioner, supra.    We consider, among other factors,

whether an excuse for the delay exists and whether the opposing

party would suffer unfair surprise, disadvantage, or prejudice if

the motion to amend were granted.    Estate of Quick v.

Commissioner, supra at 178; see Spain v. Commissioner, T.C. Memo.

1978-270.

     After two continuances and extensive pretrial proceedings,

on October 5, 2004, the Court sent notice to the parties that

these cases would be tried on March 7, 2005.    Respondent’s motion

for leave to file an amended answer was filed on February 9,

2005, and seeks to include as gross income to petitioner the

$4,586,000 of attorney’s fees paid under the terms of the

settlement agreement.    Respondent asserts that the issue of

contingent attorney’s fees was not originally included in the

pleadings because the Court of Appeals for the Fifth Circuit, the

Circuit to which an appeal in these cases lies, allowed a
                              - 33 -

taxpayer to exclude from gross income the portion of his or her

recovery attributable to contingent attorney’s fees.    See

Srivastava v. Commissioner, 220 F.3d 353, 355 (5th Cir. 2000),

revg. and remanding in part and affg. on another issue T.C. Memo.

1998-362.   On January 24, 2005, the Supreme Court resolved a

split in the circuits over the contingent fee issue, holding

that, as a general rule, when a taxpayer’s litigation recovery

constitutes income, the taxpayer is taxable on the contingent fee

portion of the litigation recovery.     Commissioner v. Banks, 543

U.S. ___, 125 S. Ct. 826, 829 (2005).

     Petitioner contends that the amendment would be prejudicial

to him.   Citing Estate of Horvath v. Commissioner, 59 T.C. 551,

555-556 (1973), petitioner argues that the attorney’s fees issue

“necessarily will require dramatically different evidence,

analysis, and case development from the issues previously pled.”

Although petitioner has not identified how the evidence or

analysis would be “dramatically different”, we agree that the

applicability of the Supreme Court’s Banks opinion is not

clearcut or absolute.   Certain arguments of the parties in Banks

were not addressed because they were not made in the lower

courts.   Commissioner v. Banks, 125 S. Ct. at 833.    We would have

to reopen the record so that these arguments could be properly

addressed in these cases.   We are not persuaded that justice
                              - 34 -

would be served by permitting the late amendment.     Respondent’s

motion for leave to file an amended answer will be denied.

Section 6662(a) Accuracy-Related Penalties

     Respondent determined accuracy-related penalties under

section 6662 for negligence or intentional disregard of rules and

regulations and for a substantial understatement of income tax on

petitioner’s income tax returns for 1995 through 1999.    Under

section 6662(a), a taxpayer may be liable for a penalty of

20 percent on the portion of an underpayment of tax due to

(1) negligence or intentional disregard of rules and regulations

or (2) any substantial understatement of income tax.    Sec.

6662(b)(1) and (2).   Section 6662(c) defines “negligence” as

including any failure to make a reasonable attempt to comply with

the provisions of the Internal Revenue Code and defines

“disregard” as any careless, reckless, or intentional disregard.

     An understatement of income tax is “substantial” if it

exceeds the greater of 10 percent of the tax required to be shown

on the return or $5,000.   Sec. 6662(d)(1)(A).   An

“understatement” is defined as the excess of the tax required to

be shown on the return over the tax actually shown on the return,

less any rebate.   Sec. 6662(d)(2)(A).   However, the amount of the

understatement may be “reduced by that portion of the

understatement which is attributable to * * * the tax treatment

of any item by the taxpayer if there is or was substantial
                               - 35 -

authority for such treatment”.   Sec. 6662(d)(2)(B)(i).   In the

alternative, the amount of the understatement may be reduced by

that portion of the understatement which is attributable to any

item if (1) “the relevant facts affecting the item’s tax

treatment are adequately disclosed in the return or in a

statement attached to the return”, and (2) “there is a reasonable

basis for the tax treatment of such item by the taxpayer.”       Sec.

6662(d)(2)(B)(ii).

     The section 6662(a) penalty will not be imposed with respect

to any portion of the underpayment as to which the taxpayer acted

with reasonable cause and in good faith.   Sec. 6664(c)(1); see

also Higbee v. Commissioner, 116 T.C. 438, 488 (2001).     The

decision as to whether a taxpayer acted with reasonable cause and

in good faith is made by taking into account all of the pertinent

facts and circumstances.   Sec. 1.6664-4(b)(1), Income Tax Regs.

Relevant factors include the taxpayer’s efforts to assess his or

her proper tax liability, including the taxpayer’s reasonable and

good faith reliance on the advice of a tax professional.    See id.

     Petitioner argues that it was reasonable for him to believe

that he received no substantial payments for punitive damages and

interest.   Petitioner has not cited any substantial authority to

support his argument that the entire amount received under the

settlement agreement was excludable under section 104.    Sec.

6662(d)(2)(B)(i).    Though petitioner disclosed his receipt of the
                                 - 36 -

payments and provided an explanation for the tax treatment of

those payments on his returns for 1997, 1998, and 1999 (there was

no statement or disclosure for 1996), there was no reasonable

basis for excluding the full amounts.     Petitioner knew that there

was an express allocation in the settlement agreement among

compensatory damages, “additional damages”, and “other damages”,

including punitive damages and interest.    Additionally,

petitioner included the amounts received from the second annuity

in his gross income on his original returns for 1996, 1997, and

1998.   On his original returns for 1997 and 1998, he specifically

designated those amounts as “punitive”, further indicating his

knowledge that punitive damages and interest were not excluded

under section 104.   Therefore, in the absence of reasonable cause

or substantial authority for excluding from his income any of the

payments received in 1996, 1997, 1998, or 1999, the disclosures

were inadequate to reduce the understatement of his tax that is

subject to penalty under section 6662(d).

     Finally, petitioner did not act with reasonable cause and in

good faith.   Sec. 6664(c)(1).    From 1996 through 1998, petitioner

reported on his original returns the receipt of punitive damages,

yet the damages received in 1999 under the same paragraphs of the

settlement agreement were not included by petitioner.

Furthermore, though it appears that petitioner had assistance in

preparing his returns for 1997 and 1998, there is no evidence as
                              - 37 -

to what petitioner told the preparer, what the preparer told

petitioner, and whether or not petitioner’s reliance on any

advice from the preparer was reasonable.   See sec. 1.6664-4(c),

Income Tax Regs.   Penalties are sustained for 1996 through 1999

for substantial understatement of tax.

     Petitioner has made no argument that penalties should not be

sustained to the extent of the disallowed deductions.     Petitioner

has not cited any substantial authority as to why penalties

should not be sustained.   Petitioner has not cited any

substantial authority to support his argument that he was in a

trade or business and allowed to deduct his expenses under

section 162.   It was unreasonable and thus negligent for

petitioner simultaneously to exclude income and claim deductions

for the expenses incurred in the collection of that income.

Penalties are sustained to the extent of the disallowed

deductions for 1995 through 1999.

Section 6651(a) Addition to Tax

     Respondent determined the addition to tax for late filing

because petitioner did not file his 1999 return until October 16,

2000.   There is no evidence that petitioner applied for an

extension of time to file his return.

     To avoid the addition to tax for filing a late return,

petitioner has the burden of proving that the failure to file

timely did not result from willful neglect and was due to
                              - 38 -

reasonable cause.   See United States v. Boyle, 469 U.S. 241, 245

(1985).   To prove reasonable cause, a taxpayer must show that he

or she exercised ordinary business care and prudence but

nevertheless could not file the return when it was due.    See

Crocker v. Commissioner, 92 T.C. 899, 913 (1989); sec. 301.6651-

1(c)(1), Proced. & Admin. Regs.

     Because petitioner failed to present any explanation as to

his late filing, respondent's determination with respect to the

addition to tax under section 6651(a)(1) is sustained.

     We have considered the arguments of the parties that were

not specifically addressed in this opinion.   Those arguments are

either without merit or irrelevant to our decision.

     To reflect the foregoing,


                                         Decisions will be entered

                                    under Rule 155.
