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includable, it follows that the attorney's fees should be
allocated in the same proportion as the excludable and includable
portions of the settlement payments. Section 265(a)(1) precludes
a deduction for an amount paid for legal fees if it is allocable
to a class of income exempt from taxation. See also Stocks v.
Commissioner, 98 T.C. at 18; Metzger v. Commissioner, 88 T.C.
834, 860 (1987), affd. without published opinion 845 F.2d 1013
(3d Cir. 1988); sec. 1.265-1(c), Income Tax Regs. We so hold.
Issue 3. Section 6661 Addition to Tax
Respondent determined that petitioners are liable for an
addition to tax under section 6661 for substantial understatement
of tax for 1988. Petitioners contend that they are not liable
for the addition to tax because (1) there was substantial
authority for reporting as taxable only part of the settlement
payments received in that year, and (2) their Federal income tax
return adequately disclosed the settlement with the credit union.
We agree with petitioners.
Section 6661(a), for returns due on or before December 31,
1989, provided for an addition to tax if there was a substantial
understatement of income tax for the taxable year. In the case
of additions to tax assessed after October 21, 1986, the amount
of the addition to tax is equal to 25 percent of the amount of
any underpayment attributable to such understatement. Omnibus
Budget Reconciliation Act of 1986, Pub. L. 99-509, sec. 8002(c),
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