## Facts

- Dann Lee Duncan, a self-employed attorney, and Kathrine Gay Duncan filed a joint federal income tax return for 2008.
- Mr. Duncan represented a former police officer (Keith Walker) in litigation that lasted about 14 years and ended in a $360,000 lump-sum settlement for Walker.
- Walker wrote Mr. Duncan a $30,000 check after the settlement; there was no written contingent-fee agreement beyond an earlier $2,500 flat fee paid years earlier.
- The Duncans did not report the $30,000 on their 2008 return, treating it as a nontaxable gift based on friendship and gratitude.
- Walker treated the $30,000 payment on his own 2008 return as a deductible legal expense.
- On Schedule C for Mr. Duncan’s law practice, the Duncans reported $6,530 in gross receipts and $43,021 in expenses (including $3,423 for a home office), producing a loss.
- The IRS issued a notice of deficiency determining a $26,716 income tax deficiency and a $5,343 accuracy-related penalty under I.R.C. § 6662(a), primarily based on unreported income and disallowed expenses.
- After IRS concessions, the remaining disputes were timeliness of the notice, inclusion of the $30,000 as gross receipts, substantiation of deductions beyond amounts allowed, and the accuracy-related penalty.

## Issues

1. Whether the IRS timely mailed the notice of deficiency within the I.R.C. § 6501 limitations period.
2. Whether the $30,000 payment was excludable as a gift under I.R.C. § 102(a) or includable in gross income as compensation for services.
3. Whether the Duncans substantiated Schedule C deductions beyond the amounts allowed by the IRS under I.R.C. §§ 162 and 274.
4. Whether the Duncans were liable for the accuracy-related penalty under I.R.C. § 6662(a), or were protected by the reasonable-cause and good-faith exception under I.R.C. § 6664(c).

## Decision

- The notice of deficiency was timely mailed; assessment was not barred by the statute of limitations.
- The $30,000 payment was compensation for legal services and was includable in Mr. Duncan’s Schedule C gross receipts.
- The Duncans failed to substantiate additional Schedule C deductions beyond those allowed by the IRS.
- The court sustained the I.R.C. § 6662(a) accuracy-related penalty.

## Legal Principles

- The IRS generally must assess tax within three years of filing, and timeliness of a deficiency notice is determined under I.R.C. § 6501 based on the applicable limitations period and the mailing date.
- Gross income includes compensation for services; a payment is excluded as a gift only if made from detached and disinterested generosity, determined primarily by the transferor’s intent and objective circumstances.
- A taxpayer bears the burden to prove entitlement to deductions; business expenses must be ordinary, necessary, and connected to carrying on a trade or business under I.R.C. § 162.
- Certain expense categories require strict substantiation under I.R.C. § 274; inadequate records can result in disallowance, and approximation is not permitted where strict substantiation applies.
- The I.R.C. § 6662(a) penalty applies to negligence or substantial understatement; taxpayers may avoid the penalty only by showing reasonable cause and good faith under I.R.C. § 6664(c).

## Conclusion

The Tax Court held that the IRS’s notice was timely, treated the $30,000 client payment as taxable legal-fee income rather than a gift, denied unsubstantiated Schedule C deductions beyond amounts allowed, and upheld an accuracy-related penalty because the underreporting and deduction positions lacked reasonable cause and good faith.


Duncan v. Commissioner, T.C. Memo. 2018-190 (2018)