                          T.C. Memo. 1999-118



                      UNITED STATES TAX COURT



     PHILLIP LEE ALLEN AND CAROLYN F. ALLEN, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 243-97.                         Filed April 6, 1999.



     Jeri Gartside and Joseph Mudd, for petitioners.

     Andrew Lee, for respondent.



                          MEMORANDUM OPINION

     GERBER, Judge:   Petitioners, by motion under section 7430

and Rule 231,1 seek the award of litigation costs incurred in

this controversy where they have shown that respondent’s


     1
        Unless otherwise stated, all section references are to
the Internal Revenue Code in effect for the taxable years in
issue, and all Rule references are to the Tax Court Rules of
Practice and Procedure.
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determination was in error.   In Allen v. Commissioner, T.C. Memo.

1998-406, filed November 13, 1998, we found that a settlement

paid to petitioners by their homeowners’ insurance company was

for compensatory, and not punitive, damages.     Accordingly, the

settlement payment was not taxable, and no deficiency resulted.

Our findings of fact in Allen v. Commissioner, supra, are

incorporated by this reference.

     A tax litigant may recover the reasonable litigation fees

and costs incurred in connection with the litigation only if the

four elements of section 7430 are present.   See sec. 7430.    Those

elements are:   (1) The fees or costs requested were incurred in

an administrative or court proceeding in connection with the

determination, collection, or refund of a tax; (2) administrative

remedies have been exhausted; (3) the proceedings have not been

unreasonably protracted by the taxpayer; and (4) the taxpayer was

the prevailing party in the action.    See id.   The taxpayer will

not be treated as the prevailing party if respondent establishes

that respondent’s position was substantially justified.2    To be

     2
        Taxpayer Bill of Rights 2, Pub. L. 104-168, 110 Stat.
1463, 1464, modified sec. 7430(c)(4) by striking the requirement
that the party seeking an award must prove that the United
States’ position was “not substantially justified” in order to
recover. The 1996 amendment, for purposes of this case, provides
that “A party shall not be treated as the prevailing party in a
proceeding to which subsection (a) applies if the United States
establishes that the position of the United States in the
proceeding was substantially justified.” Thus, the 1996
amendment effectively shifted the burden of proof on the issue of
                                                   (continued...)
                                - 3 -


treated as the prevailing party, the taxpayer must show that the

taxpayer substantially prevailed with respect to the amount in

controversy or the main issues and has met the net worth limits.

See sec. 7430(c)(4)(B)(i).   If respondent’s position was

substantially justified, the taxpayer cannot be considered a

prevailing party and therefore cannot meet the requirements of

section 7430.

     The Supreme Court has interpreted “substantially justified”

to mean “justified to a degree that could satisfy a reasonable

person.”   Pierce v. Underwood, 487 U.S. 552, 565 (1988).   The

United States’ position need not be correct to be “substantially

justified”; it need only have “a reasonable basis in law and

fact.”   Id. at 566 n.2.   The determination of reasonableness is

made on the basis of all the facts and circumstances, and the

fact that the Government eventually loses the case is not

determinative.   See Baker v. Commissioner, 83 T.C. 822, 828

(1984), vacated and remanded on another issue 787 F.2d 637 (D.C.

Cir. 1986).

     In their motion for fees, petitioners contend that they have

met all elements for an award under section 7430.   Conversely,


     2
      (...continued)
the Government’s “substantial justification” from the party
seeking the award to the Government.
     The amendment applies to proceedings commenced after July
30, 1996. The petition was filed after July 30, 1996, making the
amended sec. 7430 applicable.
                               - 4 -


respondent argues that, although petitioners substantially

prevailed with respect to the issues and amounts in controversy,

petitioners are not the prevailing party because respondent was

substantially justified in maintaining his position.   Respondent

also argues that all administrative remedies were not exhausted,

that petitioners unreasonably protracted the proceedings, and

that the fees requested are unreasonable.   If we determine that

respondent was substantially justified, we need not address the

other aspects raised by respondent.

     Respondent contends that the evidence that was available

prior to trial substantially justified the position that

petitioners’ settlement included payment for punitive damages.

Petitioners counter that the evidence they provided to respondent

regarding the expenses of rehabilitating their home rendered

respondent’s position on the taxability of the settlement

unreasonable and without justification.

     In seeking to recover from their insurance company,

petitioners made a series of demands for reimbursement as the

repairs progressed and the amount of damage grew due to

subsequent discoveries of damage.   After a few payments to

petitioners, the insurance company disputed petitioners’

estimates and refused to honor petitioners’ demands.   Petitioners

brought suit over this refusal and alleged delay by the insurance

company.   In their complaint, petitioners set forth several
                               - 5 -


grounds for relief and/or damages, including bad faith and

punitive damages.

     In the settlement of the suit, petitioners released any

rights they may have had for all claims stated and for possible

future claims arising from their relationship with the insurance

company on this matter.   The terms of the settlement did not

specify any particular grounds for which the payment was made.

     In pursuing the question of whether the settlement was

taxable, petitioners seemed to focus on the fact that the cost of

repair approximated the total recovery from all sources.    When

respondent questioned whether the amount received was for

punitive damages, petitioners presented the Appeals officer with

repair receipts in an effort to demonstrate that they had spent

the funds received for repairs to the home.   Petitioners have

continued this approach in disputing the deficiency and emphasize

this aspect in their present motion.   Conversely, respondent has

focused on the fact that petitioners’ claims and settlement with

their insurance company may have been for punitive damages.3     The

parties’ arguments have gone off on different tangents.


     3
        Respondent did argue about the expenditures as a
secondary matter. Respondent questioned whether some of the
expenditures by petitioners were improvements, rather than
replacement and repairs. In the Court’s analysis, we found that
there were some improvements, as respondent contended, but we
found them to be de minimis. For example, petitioners added air
conditioning to their replacement heating unit. This aspect adds
some justification for respondent’s position.
                                 - 6 -


     Petitioners attribute their success to their evidence that

the settlement funds were spent on repairs.        This evidence,

however, does not address the threshold element of the two

section 1033 prerequisites to nonrecognition treatment.        To

qualify under section 1033, the payment must have been received

as compensation for an involuntary conversion of the taxpayer’s

property.    See sec. 1033(a).   Having established that, then it

must be shown that the money was expended within a specified

period of time for the replacement of the converted property with

similar property.    See sec. 1033(a)(2)(A) and (B).      Only after

the threshold question, whether the amount received was

compensatory, has been answered is it necessary to consider the

issue of how the funds were spent.       Although an explanation of

both prongs of section 1033 was given in our opinion, petitioners

have persisted in their single-minded focus on the repair and

replacement aspect.

        If the character is not clear on the face of a settlement,

the characterization of settlement proceeds becomes a factual

inquiry, dependent on the payor’s intent when the proceeds were

paid.    See Hentzel v. Commissioner, T.C. Memo. 1991-277.      “[W]hen

respondent receives conflicting evidence of the payor’s intent,

* * * respondent does not act unreasonably by insisting upon an

explanation to clear up the conflict.”       Id.    Where unexplained

facts support respondent’s position and the Court must consider
                                 - 7 -


the credibility of witnesses and probative value of evidence,

respondent’s position may be “substantially justified”.    See

Creske v. Commissioner, T.C. Memo. 1990-318, affd. 946 F.2d 43

(7th Cir. 1991).    In the case before us, the taxability of

petitioners’ settlement was dependent on the weight of the

evidence presented and our subsequent interpretation of the

settlement agreement.

     Throughout the pretrial process and up to the March 24,

1998, trial, respondent possessed conflicting information about

the purpose of the settlement.    Even though Allstate Insurance

Co.’s (Allstate) counsel, Charles Siegal, advised respondent’s

counsel on March 10, 1998, that Allstate did not pay punitive

damages, respondent possessed evidence supporting the position

that the payment was made in settlement of multiple claims,

including bad faith and/or punitive damages.    That evidence

included the complaint against Allstate, the settlement

documents, and two letters from petitioners’ prior

representative.    All referenced recovery for personal injury

and/or punitive damages.

     Respondent also points out that the Allstate underwriter

involved in petitioners’ claim had advised that the settlement

was made for punitive or bad faith damages.    It was only 4 days

before trial when the underwriter called respondent’s counsel to

advise that she could not testify to her prior statement because
                               - 8 -


she had not attended the settlement conference and may not have

remembered the situation correctly.

     Petitioners’ amended return and attachment, the complaint

against the insurance company, and settlement agreement and

accompanying memorandum were sufficient to create substantial

doubt regarding whether petitioners’ settlement included punitive

damages.   Even though respondent had the opportunity to consider

the credibility of the witnesses, a witness’ testimony is not

necessarily conclusive as to the outcome of a factual issue.    See

Williams v. United States, 26 Cl. Ct. 1031, 1032 (1992).     That is

especially so where, as here, there is contradictory evidence.

Respondent could have reasonably decided to go to trial in the

hope that the Court would have found the documentary evidence

supporting respondent’s view more persuasive than the contrary

oral testimony supporting petitioners’ view.

     Additionally, there is no indication that the evidence

relied on by respondent was “unusually scanty or unworthy of

belief” or that “respondent had taken his position for any

purpose other than to prevail in the litigation.”    VanderPol v.

Commissioner, 91 T.C. 367, 370 (1988).   Nor did respondent “offer

a novel or unsupported interpretation of the law or unreasonably

rely upon a statutory interpretation that already had been

rejected by this or another court.”    Williams v. United States,

supra at 1031-1032.   Respondent’s position was substantially
                              - 9 -


justified in light of the facts and circumstances presented in

this case.


                                      An appropriate order and

                              decision will be entered.
