Srivastava v. Commissioner

Decision Date06 October 1998
Docket NumberDocket No. 26605-95.
Citation76 T.C.M. 638
PartiesSudhir P. Srivastava and Elizabeth S. Pascual v. Commissioner.
CourtU.S. Tax Court

Michael D. Cropper, Midland, Tex., for the petitioners. W. Mark Scott, for the respondent.


PARR, Judge:

Respondent determined deficiencies in, and penalties on, the Federal income tax for 1991 and 19921 of Sudhir P. Srivastava (petitioner) and Elizabeth S. Pascual (Pascual) as follows:

                Year               Deficiency   Penalty Sec. 6662(a)
                1991 ...........   $1,188,920        $237,784
                1992 ...........       33,037           6,607

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, unless otherwise indicated. All dollar amounts are rounded to the nearest dollar, unless otherwise indicated.

The issues for decision are: (1) Whether petitioners may exclude from their gross income contingent fees of $3,455,500 paid to their attorneys from the settlement proceeds of petitioner's personal injury suit. We hold they may not. (2) Whether under section 104(a)(2) petitioners may exclude from their gross income the entire amount of the settlement petitioner received in 1991. We hold a portion of the amount petitioner received in settlement is attributable to punitive damages and interest and is taxable income to petitioners in the year it was received. (3) Whether petitioners may deduct the attorney's fees under section 162(a). We hold they may not deduct the attorney's fees under section 162(a), but they may deduct the fees under section 212(1), to the extent set out below. (4) Whether petitioners are liable for an accuracy-related penalty pursuant to section 6662 for 1991 and 1992. We hold they are to the extent set out below.


Some of the facts have been stipulated and are so found. The stipulated facts and the accompanying exhibits are incorporated into our findings by this reference. Petitioners were husband and wife during the taxable years at issue and filed 1991 and 1992 Forms 1040, U.S. Individual Income Tax Return, using the status of "Married filing joint return". At the time the petition in this case was filed, petitioners resided in Midland, Texas.

Petitioner and Pascual are medical doctors. In 1970, petitioner graduated from a medical school in India. He came to St. Louis in 1972 for a residency in general surgery and later went to Canada to complete a residency in general and cardiothoracic surgery. In 1981, petitioner returned to the United States to practice medicine in Texas. Petitioner is certified as having an adequate level of training and practice for the cardiac surgery specialty by the American Board of Specialties Surgery and by the American Board of Thoracic Surgery.

The Lawsuit

In 1984 and 1985, petitioner was practicing as a cardiovascular thoracic surgeon in San Antonio, Texas. On February 8, 1985, a San Antonio television station, KENS-TV, began broadcasting a series of investigative reports about petitioner and his practice entitled "A Second Opinion". KENS-TV is a wholly owned subsidiary of Harte-Hanks Television, Inc., which in turn is owned by Harte-Hanks Communications, Inc. (Harte-Hanks Television, Inc., and Harte-Hanks Communications, Inc., are referred to hereinafter as Harte-Hanks). The reports claimed that petitioner performed unnecessary surgery and delivered poor quality medical care; the reports alleged acts that would be criminal under the laws of Texas. As a result of the broadcast reports, petitioner's reputation and medical practice were destroyed, his hospital privileges were revoked, his medical malpractice insurance was canceled, and he was subjected to multiple malpractice suits.

After the series aired, petitioner brought suit in the 224th Judicial District Court of Bexar County, Texas, based upon defamation due to libelous and false statements, invasion of privacy, infliction of emotional distress, tortious interference with contracts, libel per se, and loss of medical practice, patients, and potential patients.2 Petitioner pled for actual damages in an amount in excess of $8,500,000 and punitive damages in an amount in excess of $2 million, with prejudgment interest on damages, and interest on the judgment at the legal rate from date of judgment.

The case was tried before a jury in San Antonio during March and April 1990 resulting in a verdict on April 10, 1990. The jury found that the broadcast series was defamatory and false, impeached the honesty, integrity, virtue, or professional reputation of petitioner, and exposed him to public hatred, ridicule, or financial injury; and that the television station acted with knowledge of the falsity or with reckless disregard for the truth or falsity of the subject matter of the broadcasts. The jury also found that the series constituted an intentional infliction of emotional distress and trauma on petitioner.

The jury awarded petitioner $11,500,000 in actual damages, composed of the following amounts: $1,750,000 for loss of past earnings from his medical practice, $5 million for loss of future earning capacity, $1 million for past mental anguish, including embarrassment and humiliation, $500,000 for future mental anguish, $1,500,000 for loss of past reputation, and $1,750,000 for future loss of reputation. In addition, the jury awarded punitive damages of $17,500,000, bringing the total award to $29 million, plus interest.

Petitioner moved for a posttrial amendment of his pleadings to allow for damages in excess of $10,500,000, the total amount he initially sought in his suit, and the court allowed petitioner to amend his pleadings to conform to the adduced proof and the jury's verdict. The district court then entered judgment (the judgment).

Of the $11,500,000 in actual damages, the court found that $4,250,000 represented actual damages that had occurred between the date of the broadcast and the date of the judgment. Prejudgment interest of $2,597,201 had accrued on this portion of the award, which brought the total actual damages and prejudgment interest to $14,097,201 and the total actual and punitive damages and prejudgment interest to $31,597,201. Postjudgment interest of 10 percent per annum as provided by Texas law was ordered to be paid on this total sum.

After the judgment was entered, Harte-Hanks moved for a new trial, but its motion was denied on June 15, 1990. On August 3, 1990, Harte-Hanks appealed the case to the Court of Appeals for the Fourth Court of Appeals District, San Antonio.3 However, while the appeal was pending, the parties agreed to settle.

The Insurance Coverage

Harte-Hanks' insurance coverage, which insured it against loss attributable to petitioner's claims against it, was "tiered". That is, no insurance company provided coverage for the full range of Harte-Hanks' potential liability; rather, insurance was provided by several companies, and each insurance company provided coverage for a defined level of liability. The television station's insurance coverage was provided as follows:

                Insurance Company                             Layer of Insurance Coverage
                                               Lower Tier
                Continental Casualty Co.      (Continental)   First $2 million
                American Casualty Company1                    Same as Continental
                Mission Insurance Company       (Mission)     $2 million to $7 million
                Western Employer's Casualty     (Western)     $7 million to $12 million
                Columbia Casualty Company       (Columbia)    $12 million to $22 million
                Hudson Insurance Company         (Hudson)     Co-insurer with Columbia
                                                Upper Tier
                Federal Insurance Company        (Federal)    Above $22 million
                1 Continental and American Casualty hereinafter are collectively referred to as

After the judgment had been communicated to the insurance companies, and while the appeal of the judgment was pending, petitioner learned that Mission had been declared insolvent, and Western was functionally insolvent. The insolvency of these two companies created an uninsured gap in Harte-Hanks' coverage between the $2 million and $12 million levels, which Harte-Hanks had to cover to activate coverage at the upper levels.

The Settlement Agreement

On January 17, 1991, after prevailing at the trial level but before he was aware that the two insurance companies were insolvent, petitioner attempted to settle the entire case with Harte-Hanks for $21 million; $9,500,000 to settle the actual damages and $11,500,000 to settle the punitive damages. Although this offer was rejected, the parties continued to negotiate.

On February 25, 1991, after he became aware of the insurance companies' insolvency, petitioner authorized his attorneys to settle with the lower tier insurance companies (the first $22 million of coverage) for $8,500,000, and to make a demand for settlement upon the upper tier insurance company (Federal) for $2 million. On March 14, 1991, upon authorization of petitioner, a partial settlement agreement (the agreement) was entered into by petitioner, petitioner's attorneys, and Harte-Hanks.

The agreement provided for a payment to petitioner of $8,500,000 from Harte-Hanks and its insurers. Of that amount, Continental agreed to pay $2,100,000, and Harte-Hanks agreed to pay $1 million to settle the first $7 million in principal liability of the judgment. Harte-Hanks agreed to pay $2,400,000 to settle the principal amount of the judgment between $7 million and $12 million, and to the extent necessary, to settle all postjudgment interest liability on the first $22 million of the judgment. Columbia and Hudson agreed to pay $3 million to settle the principal amount of the judgment between $12 million and $22 million.

In reaching agreement, none of the payors considered whether the amounts they were paying were for...

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