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received in the tortious interference with present employment claim and
$390,058.48 paid in connection with the settlement petitioner received from
IBP. Of the $378,426.39 in legal fees paid by petitioner in connection with
the tortious interference with present employment claim, $245,336.94
represented the 25-percent contingency fee, and $133,089.93 represented the
$50-per hour fixed fee. The fee agreement had been structured with a
contingency fee, as well as an hourly fee, because of the difficulty in
determining when the attorneys were defending against IBP's claims and when
they were prosecuting petitioner's claims, when they were working on the
litigation. On their 1987 Federal income tax return, petitioners reported
$333,000 of interest received from IBP on Schedule B and deducted $105,869 of
legal and accounting fees as miscellaneous itemized deductions on Schedule A.
Petitioners showed the receipt of the $150,000 of compensatory damages from
the tortious interference with present employment claim, and the receipt of
$500,000 of punitive damages from that claim, but excluded both the
compensatory damages and punitive damages from their taxable income. Also,
petitioners showed the receipt of $1.5 million paid in connection with the
settlement, but excluded the entire $1.5 million from their taxable income.
The amounts were shown on the tax returns on a Form 8275, Disclosure Statement
Under Section 6661.
Respondent, in her notice of deficiency, increased petitioner's income
as shown on petitioners' Federal income tax return for the year 1987 by the
amount of $500,000, explained as a court-ordered award, and by the amount of
$1,305,000, explained as an out-of-court settlement payment. Although the
notice of deficiency does not state an explanation for the increases in
income, other than stating "it is determined that petitioner received
additional income in these amounts which was not reported", respondent, at the
trial, stated that these amounts represented the amounts of the awards which
were punitive damages, which were not excludable from income under section
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