Tax Court "Dances on Murphy's Grave": Reliance on D.C. Circuit's Initial Decision Not Reasonable Cause to Avoid Penalty

In Ballmer v. Commissioner, T.C. Memo. 2007-295 (9/27/07), the Tax Court on Thursday held that a taxpayer's reliance on the D.C. Circuit panel's original opinion in Murphy v. IRS (460 F.3d 79 (8/22/05)) before its withdrawal and replacement by the panel's revised opinion (493 F.3d 170 (D.C. Cir. 7/3/07)) does not constitute reasonable grounds to avoid a substantial understatement penalty.

Paul Ballmer received a $337,000 emotional damages jury award in 2001 from a lawsuit he filed against the California Franchise Tax Board.  Mr. Ballmer did not file any tax returns for 1986-2003.  The IRS caught up with Mr. Ballmer and assessed $109,000 in taxes and $32,000 in penalties for failing to report the damage award in income. At trial, Mr. Balmer asserted various tax protester arguments:

Petitioner testified that he had reviewed the Internal Revenue Code for many years and could find nothing that made him liable for Federal taxes or required him to file a return. Petitioner further testified that he did not believe that the amount he received from the FTB was income. Petitioner did not, however, seek advice from any tax professionals with respect to these conclusions.

The Tax Court relied on the revised Murphy decision in rejecting Mr. Ballmer's argument that the award did not constitute income:

Petitioner ... argues that the award of damages to compensate for emotional distress is not gross income within the meaning of § 61(a) regardless of the exclusions contained in § 104. Petitioner, citing certain rulings issued after the 16th Amendment was ratified ... , argues that his recovery from the FTB represents compensation for damage to human capital and thus is not income.

Petitioner’s argument is quite similar to that asserted before and ultimately rejected by the Court of Appeals for the District of Columbia Circuit. Murphy v. IRS, 493 F.3d 170 (D.C. Cir. 2007).Fn.3

Fn. 3:  At first, the Court of Appeals for the District of Columbia Circuit agreed with a position similar to petitioner’s and held that compensation for the loss of a personal attribute such as well-being was not income within the meaning of the Sixteenth Amendment. Murphy v. IRS, 460 F.3d 79 (D.C. Cir. 2006). However, the Court of Appeals then vacated its decision ... and heard additional arguments before issuing its decision rejecting that position, Murphy v. IRS, 493 F.3d 170 (D.C. Cir. 2007).

The Tax Court rejected Mr. Ballmer's argument that the original Murphy decision provided reasonable cause excusing him from penalties:

On cross-examination, petitioner admitted that he had not reviewed the flush language of § 104(a), which provides "emotional distress shall not be treated as a physical injury or physical sickness" for purposes of excluding damages received from gross income under § 104(a)(2). Petitioner further admitted that he had not sought the advice of a tax professional in regard to his conclusions that no provision of the Code required him to file a return or that the damages he received were not income.

Petitioner's attempt to cloak his argument of reasonable cause in the initial Murphy decision is also unpersuasive. First, as discussed above, the Court of Appeals for the D.C. Circuit vacated its initial decision and has since determined that damages for emotional distress are gross income. Further, there is no evidence before the Court that petitioner performed an analysis similar to that of the D.C. Circuit, nor that he received any advice from a competent tax professional, at the time he chose not to file a return for 2001.

We find that petitioner has failed to meet his burden of demonstrating that his failure to file a return was due to reasonable cause and not willful neglect.

As Joe Kristan puts it:  "the Tax Court danced on Murphy's grave."