Polone v. C.I.R.

• Decision Date: 05 June 2006
• Docket Number: No. 04-72672.,04-72672.
• Citation: 449 F.3d 1041
• Parties: Gavin POLONE, Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: U.S. Court of Appeals — Ninth Circuit

449 F.3d 1041

Gavin POLONE, Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 04-72672.

United States Court of Appeals, Ninth Circuit.

Argued and Submitted April 6, 2006.

Filed June 5, 2006.

James M. Harris, Edwin L. Norris, Jonathan M. Brenner, Sidley Austin Brown & Wood LLP, for appellant Gavin Polone.

Bridget M. Rowan, Kenneth L. Greene, Eileen J. O'Connor, United States Department of Justice, for appellee Commissioner of the Internal Revenue Service.

Appeal from a Decision of the United States Tax Court. Tax Ct. No. 12665-00.

Before FARRIS and THOMAS, Circuit Judges, and GEORGE SCHIAVELLI,^* District Judge.

THOMAS, Circuit Judge.

This appeal presents the question of whether payments received after the effective date of amendments to 26 U.S.C. § 104(a)(2) based on a defamation settlement agreement executed prior to the effective date can be excluded from gross income. We conclude that the amendments apply to payments received after the effective date of the amendment, and we affirm the judgment of the Tax Court.

I

Gavin Polone worked as a talent agent at United Talent Agency ("UTA") from 1989 until April 21, 1996, when he was fired. After terminating Polone, UTA spoke with various entertainment industry trade publications, and made statements about Polone's termination. Specifically, UTA alleged that Polone was terminated for "inappropriate behavior."

Polone hired counsel, and sent UTA a demand letter on April 22, 1996. The letter alleged that UTA had made defamatory statements about Polone, and requested that UTA "cease and desist from making further defamatory statements." On April 24, 1996, Polone filed a complaint in the Los Angeles County Superior Court alleging, among other things, wrongful termination and defamation. Polone and UTA settled both claims on May 3, 1996.

Polone received $2 million as settlement of the wrongful termination claim, which is not at issue in this case. As part of the settlement of the defamation claim, UTA issued a press release retracting its previous statements about Polone's termination, and paid Polone $4 million. The $4 million was paid in four installments of $1 million, which Polone received on May 3, 1996; November 11, 1996; May 5, 1997; and November 11, 1998.

Polone, a cash basis taxpayer, did not include the May 1996 payment on his 1996 federal income tax return. He included the November 1996 payment, but later filed an amended 1996 return seeking a refund. He did not pay taxes on the May 1997 or November 1998 payments. Polone justified his failure to pay taxes on this income on our decision in Warren Jones Co. v. Comm'r, 524 F.2d 788 (9th Cir.1975), alleging that Warren Jones Co. required him "to treat his receipt of his former employer's promise to pay $4 million as an amount realized in the 1996 taxable year at the time of his receipt of the promise to pay."

In September 2000, the IRS sent Polone a deficiency notice for his failure to pay taxes on the settlement payments he received in May 1996, May 1997, and November 1998. Polone petitioned for review in the Tax Court in December 2000. He also filed an amended petition in August 2002, claiming that the IRS should have reduced his 1996 taxable income by $1 million because he had erroneously paid taxes on the November 1996 settlement payment. The Tax Court held that Polone owed taxes on the May 1997 and November 1998 settlement payments, and that the taxes he paid on the November 1996 settlement payment were proper. Polone v. Comm'r, T.C. Memo 2003-339 (2003). The Tax Court also held that Polone did not owe any taxes on the May 1996 settlement payment. Id. He appeals.

II

Section 61(a) of the Tax Code defines "gross income" as "all income from whatever source derived." 26 U.S.C. § 61(a). Thus, subject to certain exemptions, which are to be construed narrowly, § 61(a) applies to all income, including settlement payments. Comm'r v. Schleier, 515 U.S. 323, 328, 115 S.Ct. 2159, 132 L.Ed.2d 294 (1995) ("the default rule of statutory interpretation [is] that exclusions from income must be narrowly construed." (quotations omitted)); Comm'r v. Glenshaw Glass, 348 U.S. 426, 431, 75 S.Ct. 473, 99 L.Ed. 483 (1955) ("The mere fact that payments were extracted from the wrongdoers as punishment for unlawful conduct can not detract from their character as taxable income to the recipients.").

In May 1996, when Polone and UTA settled, 26 U.S.C. § 104 exempted "the amount of any damages received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal injuries or sickness" from a taxpayer's gross income. 26 U.S.C. § 104(a)(2) (1995). The term "personal injuries" in § 104 had been interpreted to include damages from settlements of defamation claims. Roemer v. Comm'r, 716 F.2d 693, 700(9th Cir.1983).

Congress amended § 104 in August 1996 so that it exempted "the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or periodic payments) on account of personal physical injuries or physical sickness." 26 U.S.C. § 104(a)(1) (1996) (emphasis added). The amendment legislatively overruled court decisions, like Roemer, that had exempted awards for nonphysical injuries from a taxpayer's gross income. See H.R. CONF. REP. 104-737 at 301 ("Thus, the exclusion from gross income does not apply to any damages received . . . based on a claim of .. . injury to reputation."). The effective date of the amendments was August 20, 1996, but there was an exception to the amendment for "amount[s] received under a written binding agreement, court decree, or mediation award in effect on (or issued before) September 13, 1995." 26 U.S.C. § 104, Application of August 20, 1996 Amendments.

Here, the Tax Court held that pre-amendment § 104 applied to Polone's May 1996 payment from UTA, but that postamendment § 104 applied to the November 1996, May 1997, and November 1998 payments because Polone received those payments after the amendment's effective date. Polone, T.C. Memo 2003-339 at 66. As a result, it held that the May 1996 payment was tax exempt, but that the other payments were not. Id. at 68. Polone argues that the pre-amendment § 104 applies to all four settlement payments he received, and thus that the $4 million in its entirety is tax exempt. Whether the May 1996 version of § 104 or the amended version of § 104 governs the settlement payments that Polone received after the amendment's effective date is a question of statutory interpretation that we review de novo. Leslie v. Comm'r, 146 F.3d 643, 648 (9th Cir.1998).

Applying the plain language of § 104, the Tax Court properly held that the November 1996, May 1997, and November 1998 payments were taxable. The amended statute applies to any damages received after its effective date of August 20, 1996, unless the parties had contracted prior to September 13, 1995. P.L. 104-188, Title I, Subtitle F, Part 1, § 1605(d).¹ Although Polone settled his claims with UTA in May 1996, he did not actually receive the three payments in question until well after the effective date of the amendments to § 104. Because the settlement was not in effect before September 13, 1995, it was not subject to the exception to amended § 104 for preexisting settlement agreements. Thus, the amended version of § 104 applies to the payments Polone received in November 1996, May 1997, and November 1998, and the Tax Court properly sustained the IRS's deficiency notice.

III

Polone, citing our decision in Warren Jones Co., argues that under 26 U.S.C. § 1001, which explains how to calculate taxable gain from the "sale or other disposition of property," his entire settlement of $4 million was realized on May 3, 1996, the date of settlement, even though UTA paid him in installments. Therefore, he argues, pre-amendment § 104 applies to the entire $4 million he received from UTA. The application of § 1001 to Polone's settlement with UTA is a question of statutory interpretation that we review de novo. Leslie, 146 F.3d at 648.

Section 1001 provides that the "gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the adjusted basis." 26 U.S.C. § 1001(a).² To fall within its boundaries, property must (1) have an "adjusted basis" and (2) be transferable. Id. Because a personal injury claim, such as Polone's defamation claim, does not have an adjusted basis and is not transferable, § 1001 does not apply to a settlement of such a claim.

To calculate the "adjusted basis," § 1001(a) looks to 26 U.S.C. § 1011, which, in turn, looks to 26 U.S.C. § 1012. Section 1012 states, "The basis of property shall be the cost of such property, except as otherwise provided in this subchapter." 26 U.S.C. § 1012. It then specifically references sections of the Internal Revenue Code dealing with corporate distributions, partnerships, and capital gains. Id.

Polone's defamation claim has no adjusted basis within the meaning of § 1001. It was not a corporate distribution, partnership revenue, or a capital gain. Therefore, its "adjusted basis" would have had to have been calculated pursuant to § 1012. A § 1012 calculation, however, is based on cost, which is antithetical to a defamation claim. As the California courts have noted, defamation does not "interfer[e] with a property right, economic relations, or the sale of goods." Truck Ins. Exch. v. Bennett, 53 Cal.App.4th 75, 61 Cal.Rptr.2d 497, 503 (1997). Rather, "defamation invades the interest in personal or professional reputation and good name. A defamation claim vindicates personal interests, and is a personal injury." Id. Such a personal injury cannot reasonably be said to have a cost in the traditional market sense that § 1012 requires, in that one cannot sell one's dignity as a commodity on the open market.

Moreover, "[t]he test for characterizing proceeds of litigation is stated most simply as `In lieu of what were...