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claim that the insurance company had acted in bad faith (punitive
damages).
After an arbitrator appraised the damage at $128,084, the
insurance company paid petitioners $102,000 during 1990.
Following negotiations, a global settlement was reached, and the
parties’ settlement agreement contained the statement that all of
petitioners’ claims, including the one for “bad faith”, were
being settled. As part of that 1991 settlement, the insurance
company paid petitioners an additional $130,000, which was
intended to be in full settlement of petitioners’ claims against
the insurance company. Following the final settlement,
petitioners amended their 1991 joint income tax return in order
to claim a $37,852 casualty loss and seek a $5,821 refund. In
support of their refund claim, petitioners’ relied on the
casualty loss provisions of section 165.
Petitioners’ 1991 tax return was examined by the Internal
Revenue Service. The sole focus of the examination was the
$130,000 payment received during 1991. Petitioners’
representative, an enrolled agent, argued that the cost to repair
the residence exceeded the total amount received from the
insurance company, so that no portion of petitioners’ settlement
recovery could have been a payment for punitive damages.
During the examination, the enrolled agent presented a March
28, 1995, letter, to the examining agent. The letter was from
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