STATE OF WISCONSIN
TAX APPEALS COMMISSION
RANDALL SCHWARTZ and GAYLE J. NELSON
17505 River Birch Drive, Apt. 101
Brookfield, WI 53045,
WISCONSIN DEPARTMENT OF REVENUE
P.O. Box 8907
Madison, WI 53708-8907,
|DOCKET NO. 98-I-170
DECISION AND ORDER
DON M. MILLIS, COMMISSIONER:
This matter came before the Commission for trial on June 15, 1999, in Waukesha. Both parties have submitted post-hearing briefs. Petitioners appear pro se. Respondent is represented by Attorney Donald J. Goldsworthy.
Based on the evidence received at trial, the submissions of the parties, and the record in this matter, the Commission hereby finds, concludes, and orders as follows:
FINDINGS OF FACT
1. From 1985 until 1990, petitioner Randall Schwartz was one of three shareholders of Global Fastener & Supply, Inc. ("Global"). During this period, Mr. Schwartz was the principal salesperson for Global.
2. In 1990, Mr. Schwartz came to believe that the other shareholders in Global--Mr. James Witt and Mr. Arthur Salani--were causing Global to act improperly. Mr. Schwartz decided it was necessary to sever his relationship with Global.
3. As a result of the conduct of Messrs. Witt and Salani, Mr. Schwartz suffered anxiety and panic attacks, and he continued to exhibit a panic disorder condition for several years thereafter.
4. During the period from August 1990 to January 1991, Mr. Schwartz's condition prevented him from working for Global.
5. In January of 1991, Messrs. Schwartz, Witt, and Salani, and Global entered into a settlement and purchase agreement ("Settlement") that was dated as of September 15, 1990.
6. Under the terms of the Settlement, Global paid $100,000 in cash to Mr. Schwartz at closing and executed a promissory note payable to Mr. Schwartz in the amount of $250,000.
7. Of the $350,000 paid to Mr. Schwartz, the Settlement provided that $175,000 ("the $175,000 payment") was to be allocated as follows:
The parties shall allocate, for tax purposes, $175,000 (including $100,000 paid in cash at Closing) in consideration of the release by [Mr. Schwartz] of the possible claim for personal injury (and, therefore, such allocated amount shall be excludable as income for tax purposes in accordance with Internal Revenue Code section 104(a)(2) and the other relevant Code sections and Treasury regulations) and for the covenant not to compete.
8. The covenant not to compete limited Mr. Schwartz's activity with regard to Global's past and current customers and within Global's sales territory until March 1, 1991.
9. The parties to the Settlement also executed a mutual release agreement ("Release"). The Release provided in part:
The $175,000 payment set forth above shall be paid in exchange for Mr. Schwartz's non-competition agreement as set forth in the Settlement and Purchase Agreement executed by the parties hereto and in lieu of all possible claims of Randy G. Schwartz for personal injury and, therefore, shall be excludable from his income for tax purposes, all in accordance with Internal Revenue Code section 104(a)(2) and the other relevant Code sections and Treasury regulations.
10. Messrs. Salani and Witt executed a directors' resolution that provided in part:
That the proper officers of the Company are hereby authorized and directed to enter into a mutual release agreement with Mr. Schwartz pursuant to [which] Mr. Schwartz shall be paid $175,000 for releasing [Global] from any liability pursuant to any allegations or threatened allegations by Mr. Schwartz and in exchange for a covenant not to compete.
11. None of these documents, however, specified how the $175,000 payment was to be allocated between the covenant not to compete and the Release.
12. On its books, Global did not specifically allocate any portion of the $175,000 payment to either the covenant not to compete or the Release. In either case, the payments would have been deductible by Global on its corporate income tax return in the year they were paid.
13. Global paid Mr. Schwartz the amounts he was owed under the $250,000 note in payments of $8,000 per month, consisting of $6,139 in principal and $1,861 in interest.
14. Prior to the time that the Settlement was executed, Messrs. Schwartz, Witt, and Salani each drew a salary of $3,000 bimonthly. In 1991, Global's gross income was approximately $3.4 million and its ordinary income after expenses was approximately $244,000.
15. Mr. Schwartz honored the release and did not institute a lawsuit against Global or Messrs. Witt and Salani with regard to his claimed injuries.
16. On their 1991 income tax return, petitioners (who are husband and wife) attributed $10,000 of the $175,000 payment to the covenant not to compete and reported it as taxable income. Petitioners did not report the remainder of the $175,000 payment, based on their assertion that this payment was not taxable because it was received in exchange for the release of Mr. Schwartz's claims.
17. Under the date of April 4, 1994, respondent issued an income tax assessment against petitioners for 1989 through 1992. The largest adjustment, and the only one at issue here, is respondent's determination that all of the $175,000 payment should be attributed to the covenant not to compete and none of it to the release of Mr. Schwartz's personal injury claims.(1)
18. Petitioners filed a petition for redetermination objecting to the assessment. Respondent denied the petition for redetermination. Petitioners filed a timely petition for review with the Commission.
19. $112,278 of the $175,000 payment--all of which was received by Mr. Schwartz in 1991--is attributable to the covenant not to compete; the remainder of the $175,000 payment is attributable to the Release.
INTERNAL REVENUE CODE
Sec. 104 [1986 Code]. (a) IN GENERAL.--Except in the case of amounts attributable to (and not in excess of) deductions allowed under section 213 (relating to medical, etc., expenses) for any prior taxable year, gross income does not include--
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(2) the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness;
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CONCLUSIONS OF LAW
1. Payments to Mr. Schwartz in exchange for the Release are exempt pursuant to section 104(a)(2) of the Internal Revenue Code.
2. Only that portion of the $175,000 payment received by received by Mr. Schwartz in the first three months of 1991 is attributable to the covenant not to compete and, therefore, subject to the income tax.
Respondent bases its position on two grounds: (1) that the claims subject to the Release are not those contemplated by IRC section 104(a)(2); and (2) that petitioner has failed to show that any portion of the $175,000 can be attributed to the Release.
Section 104(a)(2) Claims
Section 104(a)(2) provides that gross income does not include damages on account of personal injuries or sickness, whether by suit or agreement. The plain language of the Settlement and the related documents provides that at least some portion of the $175,000 was to be paid in exchange for Mr. Schwartz's agreement not to pursue claims against Global and Messrs. Witt and Salani. The primary issue is whether the damages were paid on account of "personal injuries or sickness" as that phrase is used in IRC section 104(a)(2).
Respondent argues that there is no evidence of a bona fide tort claim against Global. Respondent asserts that Mr. Schwartz began to experience problems well before 1990 and that Mr. Scwartz's problems were aggravated after Mr. Schwartz severed his relationship with Global. To prove these assertions, respondent relied upon letter from Mr. Schwartz's psychiatrist. However, the very same letter contains substantial evidence that Mr. Schwartz had a bona fide tort claim that was based on his falling out with his former business associates. In this letter, Mr. Schwartz's psychiatrist opines that with "a reasonable degree of medical certainty that Mr. Schwartz's present panic disorder condition was substantially triggered and aggravated by the conduct of [his] business associates." (2) Perhaps the best evidence of the validity of Mr. Schwartz's claims is the apparent validity afforded these claims by his former business associates. The language of the Settlement and related documents strongly suggest that Messrs. Witt and Salani treated Mr. Schwartz's claims seriously.
The facts of this case are very similar to the facts of Massot v. Commissioner, 79 TCM 1399 (2000). In Massot, the taxpayer's termination resulted in weight gain, an increase in his cholesterol level, a diagnosis of diabetes, obsession with his termination, lack of interest in marital relations, inability to sleep, and the inability to leave his home. Id. at 1401. The taxpayer and his employer entered into a settlement agreement which provided, among other things, that the taxpayer would receive $750,000 as damages for "alleged personal injuries." Id. at 1402. The taxpayer's employer did not admit liability to the taxpayer. Id. While the Tax Court ultimately found that some of this settlement constituted severance pay, the Tax Court concluded that the injuries alleged came within the meaning of "personal injuries or sickness" as this term is used in section 104(a)(2). Id. at 1404-05.
We conclude, therefore, that the Settlement and related documents contemplated damages for personal injuries or sickness within the meaning of section 104(a)(2).
Allocation of the $175,000
In the absence of guidance from the Settlement and related documents, we must determine if the record contains enough evidence for the Commission to ascertain the allocation, if any, of the $175,000 payment between the covenant not to compete and the Release. This is not the first time that a tribunal has had to ascertain the allocation of payments to a covenant not to compete when the governing documents do not provide sufficient guidance. Kreider v. Commissioner, 47 TCM 1071, 1076-77 (1984) (allocating $631,383.80 between a covenant not to compete and compensation for services), aff'd 85-1 USTC ¶9427 at 88,165 (7th Cir. 1985) (the Tax Court "made the closest approximation it could since complete accuracy was impossible"); Peterson Machine Tool, Inc. v. Commissioner, 79 TC (CCH) ¶39,178 at 3498 (1982) (allocating $280,000 between stock price and a covenant not to compete); Kinney v. Commissioner, 58 TC (CCH) ¶31,552 at 3118 (1972) (allocating $125,000 between a covenant not to compete and the sales price of an insurance agency); Levine v. Commissioner, 21 TCM 363, 368 (1962) (allocating $35,000 between the sale of goodwill and a covenant not to compete), aff'd 63-2 USTC ¶9785 (3rd Cir. 1963).
The clear and unambiguous language of the Settlement and the related documents provide that the $175,000 was payment for both the covenant not to compete and the Release. Not surprisingly, respondent chose to characterize the entire amount as resulting from the covenant not to compete, and thus entirely taxable. This was an easy decision, since characterization of the $175,000 was irrelevant to Global's tax liability.
However, this conclusion is inconsistent with the clear and unambiguous language of the Settlement and related documents. There is no doubt that the parties intended some portion of the $175,000 to be paid in exchange for the Release. Because respondent's assessment allocates no value to the Release it cannot be correct and, therefore, the assessment loses its presumption of correctness, even though the ultimate burden of persuasion remains with petitioners. See, Universal Foods Corp. v. Dep't of Revenue, 1997 Wisc. Tax LEXIS 22, at 7 (WTAC 1997).
Contrary to respondent's assertion, there is evidence in the record that allows the Commission to determine with reasonable certainty what portion of the $175,000 was attributable to the covenant not to compete and, by implication, what portion was attributable to the Release. The covenant not to compete expired on March 1, 1991. Therefore, it is reasonable to assume that amounts paid after March 1, 1991 were not attributable to the covenant not to compete. This conclusion would certainly be consistent with the practice of spreading payments for a covenant not to compete over the life of the covenant, so as to enhance the ability to enforce the covenant. See generally, C. Rohrlich, M. Lee & L. Gross, Organizing Corporate and Other Business Enterprises §9.09[d] (2000); D. Aspelund & C. Eriksen, Employee Noncompetition Law §10.04[b] (1995-97).
That portion of the $175,000 payment payable to Mr. Schwartz on or before March 1, 1991 was $112,278: the $100,000 payment of cash at closing plus two months principal payments of $6,139 each. Thus, at a minimum, the amount attributable to the Release is $62,722. Based on the record before us, this is the closest approximation possible and is economically reasonable. See, Kreider, 85-1 USTC at 88,165.
Petitioners argue that the most that should be allocated to the covenant not to compete is $10,000. Petitioners argue that, since Mr. Schwartz's salary was $ 3,000 bimonthly, he would have earned approximately $10,000 from the closing in January 1991 through March 1, 1991. This reasoning ignores the fact that in 1991, Global's gross income averaged more than $280,000 per month and its income after expenses averaged more than $20,000 per month. Thus, payment for a covenant not to compete from September 15, 1990 through March 1, 1991 could reasonably be pegged at $112,278.
Respondent's action on the petition for redetermination is modified to reflect that $62,722 of the $175,000 payment at issue is exempt under IRC section 104(a)(2) and, as modified, is affirmed.
Dated at Madison, Wisconsin, this 7th day of February, 2001.
WISCONSIN TAX APPEALS COMMISSION
Mark E. Musolf, Chairperson
Don M. Millis, Commissioner
Thomas M. Boykoff, Commissioner
ATTACHMENT: "NOTICE OF APPEAL INFORMATION"
March23, 2001 Petition for rehearing denied under § 227.49(3)
April 6, 2001 Appealed to Waukesha County Circuit Court(01CV833)
2 While the December 8, 1995 letter offered by respondent might not, on its own, be admissible under the Rules of Evidence, such rules do not apply to matters before the Commission. All that matters is that the evidence possesses reasonable probative value. Wis. Stat. § 227.45(1). Moreover, respondent cannot complain that the Commission based its decision, in part, on a letter which respondent itself offered into evidence and relied upon.