Alexander v. I.R.S.

• Decision Date: 08 September 1995
• Docket Number: No. 95-1451,95-1451
• Citation: 72 F.3d 938
• Parties: -301, 96-1 USTC P 50,011 J. Kenneth ALEXANDER and Joanne M. Alexander, Petitioners-Appellants, v. INTERNAL REVENUE SERVICE of the United States of America, Respondent-Appellee. . Heard
• Court: U.S. Court of Appeals — First Circuit

Page 938

72 F.3d 938

77 A.F.T.R.2d 96-301, 96-1 USTC P 50,011

J. Kenneth ALEXANDER and Joanne M. Alexander, Petitioners-Appellants, v. INTERNAL REVENUE SERVICE of the United States of America,

Respondent-Appellee.

No. 95-1451.

United States Court of Appeals, First Circuit.

Heard Sept. 8, 1995.

Decided Dec. 22, 1995.

Philip J. Ryan, with whom Ryan, Martin, Costello, Leiter, Steiger & Cass, P.C., Springfield, MA, was on brief for appellants.

William J. Patton, Tax Division, Department of Justice, Loretta C. Argrett, Assistant Attorney General, Gary R. Allen, and Richard Farber, Tax Division, Department of Justice, were on brief for appellee.

Before TORRUELLA, Chief Judge, ALDRICH and COFFIN, Senior Circuit Judges.

TORRUELLA, Chief Judge.

Respondent-Appellee, the Commissioner of Internal Revenue (the "Commissioner"), determined a deficiency of $57,441 in the 1989 Federal income tax filed by J. Kenneth Alexander (the "Taxpayer") and Joanne M. Alexander (together, the "Appellants" or the "Petitioners"). The Tax Court upheld the Commissioner's determination and the Petitioners now seek review of that decision. For the reasons stated below, we affirm.

I. BACKGROUND

The pertinent facts, some of which have been stipulated and incorporated in the district court's findings, are not in dispute, and are recapitulated here. Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for 1989. Internal Revenue Code, 26 U.S.C. Sec. 1 et seq. (1988 & Supp.1991).

In 1983, Taxpayer entered into an employment agreement with his employer, W.F. Young, Inc. ("Young"), according to which Taxpayer would remain in the capacities of Executive Vice President, Treasurer, and Chief Executive Officer until he reached the age of seventy (70), on December 13, 1993. On October 15, 1987, when Taxpayer was sixty-four (64) years old, Young terminated Taxpayer's employment. Subsequent to his termination, Taxpayer offered management consulting services for a fee, and in 1989 obtained a management consulting contract with the Hanson Group of Ludlow, Massachusetts.

On February 10, 1988, Taxpayer filed a civil lawsuit against Young (the "lawsuit"), in which Taxpayer was represented by the law firm of Ryan & White, P.C. ("Ryan & White"). ¹ In his complaint, Taxpayer alleged a breach of the express 1983 employment contract (or "Count I"), a breach of an implied pension benefits contract (or "Count II"), and age discrimination under Massachusetts General Law, Chapter 151B, Section 1 (1976) (or "Count III").

On May 1, 1989, Taxpayer and Young executed a written settlement agreement (the "Settlement Agreement"), according to which Young was to pay Taxpayer $350,000, of which $100,000 was allocated to Count III, and $250,000 to Counts I and II. ² On May 5, 1989, as per the Settlement Agreement, Young issued two checks payable to "J. Kenneth Alexander and Ryan & White, Attorneys for J. Kenneth Alexander," one in the amount of $100,000 (for Count III), and the other in the amount of $225,395.20 (for Counts I and II, less taxes withheld).

On the 1989 Federal income tax return, Taxpayer's tax preparer deducted $245,100 from the settlement proceeds attributable to Counts I and II. This deduction was explained in an attached statement, which stated that Taxpayer paid Ryan & White $258,000 in legal fees (the "Legal Fee"). ³ It also stated that according to Ryan & White's time allocations, 5% of the Legal Fee was attributable to settlement of Count III, and 95% to settlement of Counts I and II. Accordingly, $245,100 (95% of the $258,000 Legal Fee) was deducted from the settlement proceeds attributable to Counts I and II.

The Commissioner sent a notice of deficiency disallowing Taxpayer's direct deduction of the Legal Fee from the settlement proceeds. The Commissioner determined that the $250,000 received from Young in settlement of Counts I and II was gross income to Taxpayer, and that the Legal Fee associated with Counts I and II were miscellaneous itemized deductions. Accordingly, the Commissioner reduced the $245,100 deduction reported on the 1989 return to $240,198, due to the increase in Taxpayer's adjusted gross income and the two percent (2-percent) adjusted gross income limitation for miscellaneous deductions. In addition, the Commissioner determined that, due to these adjustments, Taxpayer was liable for the Alternative Minimum Tax ("AMT") under Section 55 of the Code, which resulted in a deficiency of $57,441.

Petitioners filed a petition in the United States Tax Court for redetermination of the deficiency. The Tax Court rejected Petitioners' arguments, entering a final judgment on January 31, 1995, upholding the Commissioner's determination of Petitioners' tax deficiency. This appeal followed. We have jurisdiction pursuant to 26 U.S.C. Sec. 7482(a)(1).

II. DISCUSSION

The only issue on appeal is the proper tax treatment of the Legal Fee. We must determine whether the Petitioners properly deducted the Legal Fee from the settlement proceeds under Section 1001. If we find that they did not, then we must determine whether to treat the Legal Fee as an "above the line" ⁴ trade or business deduction under Section 162 of the Code, or as a miscellaneous itemized deduction "below the line." ⁵

On appeal, Petitioners essentially contend that the Tax Court's decision to uphold the Commissioner's deficiency finding is caused by the erroneous determination that Taxpayer was in the trade or business of "the performance of services as an employee during 1989." Petitioners correctly assert that the defining issue is whether Taxpayer was Young's "employee" for purposes of classifying the settlement proceeds and for determining the deductibility of the Legal Fee under Section 62(a)(1). Although we agree with Petitioners' formulation of the defining issue, we reject their arguments and affirm the court below.

A. Standard of Review

We review the Tax Court's decision "in the same manner and to the same extent as decisions of the district courts in civil actions tried without a jury." 26 U.S.C. Sec. 7482(a). The treatment of the Legal Fee is purely a question of law and, therefore, subject to de novo review. Estate of Robertson v. Commissioner, 15 F.3d 779, 781 (8th Cir.1994); see also First National Bank in Albuquerque v. C.I.R., 921 F.2d 1081, 1086 (10th Cir.1990) (stating that de novo review is applied to tax court's findings of law and of ultimate fact derived from applying legal principles to subsidiary facts). The Tax Court's findings of fact will only be disturbed for clear error. Manzoli v. Commissioner, 904 F.2d 101, 103 (1st Cir.1990); Thomson v. Commissioner, 406 F.2d 1006, 1010 (9th Cir.1969); see also Connor v. Commissioner, 847 F.2d 985 (1st Cir.1988) (emphasizing appropriateness of giving weight to Commissioner's well-established views).

B. Characterization of the Legal Fee

Petitioners argue that the Legal Fee was properly subtracted from the amount realized in the settlement, as per Sections 1001 and 1016, ⁶ in order to determine the "gain" from the disposition of Taxpayer's "valuable intangible assets," the express and implied contracts and resulting lawsuit. In support of their position, Petitioners contend that the Legal Fee was the "cost of the disposition" of Taxpayer's assets because it was incurred after Taxpayer's employment was terminated for the "sole purpose" of enhancing their value and disposing of them by obtaining either a settlement or judgment. Petitioners further contend that, because Sections 1001 and 1016 make no distinction between the basis and gain rules for capital or ordinary assets, "there is a 'capital account' for all assets, whether those assets are considered capital or ordinary." Thus, Petitioners conclude, the Legal Fee is an "expenditure ... properly charged to [the assets'] capital account" within the meaning of Section 1016 to be offset against the settlement proceeds in order to determine the "gain" under Section 1001.

Upon de novo review, we reject Petitioners' arguments invoking treatment under Section 1001, and their contention that the Tax Court erred when it rejected them.

In determining the tax treatment of the Legal Fee, we take as our point of departure Section 61(a), which defines gross income as "all income from whatever source derived," subject to certain exclusions provided in the Code. It includes, and is not limited to, "[c]ompensation for services, including fees, commissions, fringe benefits, and similar items." See Helvering v. Clifford, 309 U.S. 331, 334, 60 S.Ct. 554, 556, 84 L.Ed. 788 (1940) (finding that Congress intended to exert the "full measure of its taxing power" through Section 61(a)). Next, we take into consideration the well-settled rule that the classification of amounts received in settlement of litigation is to be determined by the nature and basis of the action settled, and amounts received in compromise of a claim must be considered as having the same nature as the right compromised. Parker v. United States, 573 F.2d 42, 49, 215 Ct.Cl. 773 (1978) (quoting Carter's Estate v. Commissioner, 298 F.2d 192, 194 (8th Cir.1962)), cert. denied, 439 U.S. 1046, 99 S.Ct. 720, 58 L.Ed.2d 704 (1978); see Furrer v. Commissioner, 566 F.2d 1115, 1116 (9th Cir.1977), cert. denied, 437 U.S. 903, 98 S.Ct. 3088, 57 L.Ed.2d 1132 (1978); Clark v. Commissioner, 67 T.C.M. (CCH) 3105, 1994 WL 263688 (1994).

These two considerations lead us to our test: it "is not whether the action was one in tort or contract but rather the question to be asked is 'In lieu of what were the damages awarded?' " Raytheon Production Corp. v. Commissioner, 144 F.2d 110, 113 (1st Cir.) (citation omitted), cert. denied, 323 U.S. 779, 65 S.Ct. 192, 89 L.Ed. 622 (1944); see Getty v. Commissioner, 913 F.2d 1486, 1490 (9th Cir.1990) (applying Raytheon test in characterizing settlement payment for tax purposes). An amount received in lieu of compensation under an employment contract...