Opinion
13269-21S
03-21-2023
MICHAEL HERRMANN & MARY JO ADAMS-HERRMANN, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
ORDER
Patrick J. Urda Judge
Pursuant to Rule 152(b), Tax Court Rules of Practice and Procedure, it is
ORDERED that the Clerk of the Court shall transmit herewith to petitioners and the Commissioner a copy of the pages of the transcript of the trial in the above case before Judge Patrick J. Urda at San Francisco, California, on January 27, 2023, containing Judge Patrick J. Urda's oral findings of fact and opinion rendered at the conclusion of the trial.
In accordance with the oral findings of fact and opinion, decision will be entered under Rule 155.
Bench Opinion by Judge Patrick J Urda
January 27, 2023
Michael Herrmann & Mary Jo Adams-Herrmann v. Commissioner Docket No. 13269-21S
THE COURT: The Court has decided to render oral findings of fact and opinion in this case. The oral findings of fact and opinion are made pursuant to the authority granted by section 7459(b) of the Internal Revenue Code and Tax Court Rule 152, and shall not be relied upon as precedent in any other case. Rule references in this opinion are to the Tax Court Rules of Practice and Procedure, and section references are to the Internal Revenue Code, in effect at all relevant times. All monetary amounts are rounded to the nearest dollar.
By notice of deficiency dated January 25, 2021, the Commissioner determined a deficiency of $6,448 in Federal income tax for Mr. and Mrs. Herrmann's 2018 tax year and asserted a tax understatement penalty under section 6662(a). After concessions, the sole remaining issue is whether the Commissioner correctly determined that the Herrmanns were required to include a settlement payment of $18,000 in their taxable income for 2018. At trial, Mr. Herrmann represented himself, and Melody Morales represented the Commissioner. Also at trial the Commissioner moved to dismiss Ms. Adams-Herrmann for lack of prosecution, a motion that the Court took under advisement.
On the evidence before us, and using the burden- of-proof principles explained below, the Court finds the following facts:
FINDINGS OF FACT
In 2014, the Herrmanns applied to Bank of America, N.A., for a modification of their home mortgage loan. Bank of America denied this application, as well as the Herrmanns' subsequent appeal.
The Herrmanns brought a lawsuit in California State Court, claiming that Bank of America "took on a duty to perform the review and/or evaluation of the application competently" as it "invited [the Herrmanns] to apply for a loan modification." The Herrmanns asserted that Bank of America breached its duty of care by miscalculating their gross monthly income, and that this breach caused both the improper denial of the loan modification (resulting in higher monthly payments and interest rates) and emotional distress. The Herrmanns amended their complaint several times, with the first amended complaint expanding their injuries to include damage to their credit, increased interest and arrears, foregone alternative remedies and solutions, legal fees and costs, extreme emotional stress, distress, anxiety, depression, insomnia, and the imminent loss of their home. Bank of America thereafter paid $18,000 to the Herrmanns to settle their case.
On their 2018 tax return, the Herrmanns did not include the settlement amount in their gross income. They instead included an attachment in which they noted that the $18,000 settlement was offset by a corresponding reduction in the basis of their home. After an examination, the IRS issued a Notice of Deficiency determining, inter alia, that the Herrmanns were required to include the settlement payment in their 2018 gross income.
OPINION
The Commissioner's determinations in a notice of deficiency are generally presumed correct, and the taxpayer bears the burden of proving those determinations; erroneous. See Rule 142(a)(1); Welch v. Helvering, 290 U.S. 111, 115 (1933); Merkel v. Commissioner, 192 F.3d 844, 852 (9th Cir. 1999), aff'g 109 T.C. 463 (1997). The U.S. Court of Appeals for the Ninth Circuit, to which an appeal in this case would ordinarily lie, see I.R.C. § 7482(b)(1)(A), has held that the Commissioner must establish "some evidentiary foundation" linking the taxpayer to an alleged income-producing activity before the presumption of correctness attaches to the deficiency) determination, Weimerskirch v. Commissioner, 596 F.2d 358, 361-62 (9th Cir. 1979), rev'g 67 T.C. 672 (1977). Once the Commissioner has established such a foundation, the burden of proof shifts to the taxpayer to prove by a preponderance of the evidence that the Commissioner's determinations are arbitrary or erroneous. See Hardy v. Commissioner, 181 F.3d 1002, 1004-05 (9th Cir. 1999), aff'g T.C. Memo. 1997-97.
In this case, the Herrmanns do not contest receipt of the Bank of America settlement, and the Commissioner has established an evidentiary foundation linking them to this amount. The Commissioner's determination is therefore presumed correct, and the Herrmanns have the burden of proving it erroneous. See Rule 142(a)(1); Welch v. Helvering, 290 U.S. at 115.
Gross income includes all income from whatever source derived. See I.R.C. § 61(a); see also Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 429 (1955); Helvering v. Clifford, 309 U.S. 331, 334 (1940). Exclusions from gross income "must be narrowly construed." Commissioner v. Schleier, 515 U.S. 323, 328 (1995) (quoting United States v. Burke, 504 U.S. 229, 248 (1992) (Souter, J., concurring in the judgment)). Settlement proceeds constitute gross income unless the taxpayer proves that such proceeds fall within a specific statutory exception. See id.; Save v. Commissioner, T.C. Memo. 2009-209, 2009 WL 2950838, at *1.
The Herrmanns assert that the Bank of America settlement payment is excludable from gross income because it was for a loss in the value of property, relying primarily on I.R.S. Publication 4345, Settlements- Taxability. In relevant part, that publication states that "[p]roperty settlements for loss in value of property that are less than the adjusted basis of your property are not taxable and generally do not need to be reported on your tax return. However, you must reduce your basis in the property by the amount of the settlement."
As a general matter, recovery of capital is not income, and proceeds that represent compensation for lost value or capital are generally not taxable. Holliday v. Commissioner, T.C. Memo. 2021-69, at *8; see also Milenbach v. Commissioner, 318 F.3d 924, 933 (9th Cir. 2003). Whether a payment received in settlement of a claim represents a recovery of capital depends on the nature of the claims that were the basis for the settlement. Blum v. Commissioner, T.C. Memo. 2021-18, at *11, aff'd, No. 21-71113, 2022 WL 1797334 (9th Cir. June 2, 2022); see also Sager Glove Corp. v. Commissioner, 36 T.C. 1173, 1180 (1961) ("The taxability of the proceeds of a lawsuit or of a sum received in settlement thereof, depends upon the nature of the claim and the actual basis of recovery."), aff'd, 311 F.2d 210 (7th Cir. 1962).
"To determine whether a settlement represents...lost value, we ask: '[I]n lieu of what was the...settlement awarded?'" Holliday, T.C. Memo. 2021-69, at *10 (quoting Green v. Commissioner, 507 F.3d 857, 867 (5th Cir. 2007)). The nature of the claim is typically determined by looking to the settlement agreement, focusing on the "the origin and characteristics of the claims settled...[in that agreement]." Green, 507 F.3d at 867 (quoting Pipitone v. United States, 180 F.3d 859, 862 (7th Cir. 1999)). Should the underlying agreement not answer the question, we inquire as to the intent of the payor, taking into consideration all the facts and circumstances of the case including the amount paid, the allegations in the injured party's complaint, and the factual circumstances that led to the agreement. See Holliday, T.C. Memo. 2021-69, at *10; accord Tillman-Kelly v. Commissioner, T.C. Memo. 2022-111, at *5.
In this case, the Herrmanns failed to introduce the settlement agreement or adduce any evidence as to its terms. Without such evidence, the Court has no basis to conclude that the settlement payment is nontaxable. See Lawson v. Commissioner, T.C. Memo. 2015-211, at *28- 29 ("Where the agreement is silent as to the basis of the settlement or where the agreement does not specify that the payment was for a reason that a court finds to be nontaxable, this Court has held the settlement payment to be taxable."); see also Knauss v. Commissioner, T.C. Memo. 2005-6, 2005 WL 90985, at *11 ("[W]here the evidence did not provide a basis for determining an allocation of a settlement payment between claimed damages for lost profit and for lost capital, the taxpayer has not met his burden of proving a recovery of capital."). Even if we were to look past this fatal defect in proof, the Herrmanns would fare no better. In their lawsuit, the Herrmanns alleged that Bank of America breached a purported duty of care by negligently analyzing the Herrmanns' loan modification application. The Herrmanns fail to show that Bank of America intended the settlement payment to compensate for a loss of property value rather than for the breach of care alleged in their complaints. See, e.g., Blum, T.C. Memo. 2021-18, at *12 ("In short, we do not view her recovery in the...case as restoring her capital but instead as compensating her for distinct failings...").
CONCLUSION
The Herrmanns have not met their burden to show that the settlement payment they received constituted a nontaxable return of capital. A decision therefore will be entered under Rule 155. This concludes the Court's oral findings of fact and opinion in this case.
(Whereupon, at 10:17 a.m., the above-entitled matter was concluded.)