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UNITED STATES v. DAUM

April 30, 1997

UNITED STATES OF AMERICA, Plaintiff,
v.
GARY A. DAUM and LINDA M. DAUM, Defendants.



The opinion of the court was delivered by: STANDISH

MEMORANDUM

 I

 In this civil action, the plaintiff, United States of America, seeks to recover, pursuant to Section 7405(b) of the Internal Revenue Code, 26 U.S.C. ยง 7405(b), an alleged erroneous tax refund paid to the defendants, Gary A. Daum and Linda M. Daum, for the tax year 1988. Presently, before the court is the United States' motion for partial summary judgment pursuant to Fed.R.Civ.P. 56. After consideration, and for the reasons set forth below, the motion will be granted.

 II

 The following facts are undisputed:

 Mr. Daum was employed by General Nutrition, Inc. (GNC) from 1962 until May, 1985. He served as GNC's President and Chief Operating Officer from 1979 until February, 1984. At that time, Mr. Daum was promoted to Chief Executive Officer of GNC, and he served in that capacity until May 13, 1985. (Original Motion for Summary Judgment, Exh. 1a, PP 1-3, Exh. 1b, P 1). *fn1"

 David B. Shakarian was the founder and controlling shareholder of GNC from its inception until his death on September 11, 1984. *fn2" David H. Lucas was the son-in-law of Mr. Shakarian, and he served on the Board of Directors of GNC. After Mr. Shakarian's death, Mr. Lucas gained control of GNC by virtue of a delegation of authority from the estate of Mr. Shakarian. (Original Motion for Summary Judgment, Exh. 1a, PP 4-6, Exh. 1b, P 1).

 In March, 1985, Mr. Daum filed a lawsuit against Mr. Shakarian's estate in Florida, seeking to enforce a promise allegedly made by Mr. Shakarian prior to his death to bequeath five percent of GNC's stock to Mr. Daum. Shortly thereafter, on May 13, 1985, Mr. Daum was fired as the President and Chief Executive Officer of GNC. (Original Motion for Summary Judgment, Exh. 1a, PP 7-8, Exh. 1b, P 1). As a result of his firing, Mr. Daum filed suit in the Court of Common Pleas of Allegheny County, Pennsylvania against GNC and Mr. Lucas, alleging claims for wrongful discharge, defamation, breach of contract and tortious interference with contract.

 On September 12, 1988, Mr. Daum settled his lawsuit against GNC and Mr. Lucas. The settlement agreement provides in relevant part:

 
* * *
 
2. In consideration for the settlement and discontinuance with prejudice of the lawsuit, GNC will pay Daum, on or before September 26, 1988, the sum of Six Hundred Seventy-Five Thousand Dollars ($ 675,000), which sum will be allocated as follows:
 
. $ 150,000 payable to Eckert Seamans Cherin & Mellott for counsel fees
 
. $ 300,000 for alleged personal injury losses, including specifically pain and suffering
 
. $ 225,000 for alleged lost salary and benefits.
 
Daum shall be responsible for all federal, state or local taxes payable with respect to the foregoing amounts, and shall indemnify GNC from any liability for failure to withhold federal, state or local taxes in connection with such payments.
 
3. GNC agrees to purchase 475,730 shares of its common stock now owned by Gary Daum and/or Gary Daum and Linda Daum for the price of 5-3/8 dollars per share, which purchase will occur and the consideration paid on or before September 25, 1988, provided that certificates evidencing such shares are available for inspection by GNC on or before September 23, 1988.
 
* * *

 (Original Motion for Summary Judgment, Exh. 1 to Exh. 1a).

 Pursuant to paragraph 3 of the settlement agreement, the defendants realized $ 2,557,048.70 on account of their GNC stock in 1988. *fn3" (Original Motion for Summary Judgment, Exh. 1a, PP 9-12, Exh. 1b, PP 1-12). In their original federal income tax return for 1988, which was filed on or about October 16, 1989, the defendants claimed a basis of $ 327,994.00 in the 475,730 shares of GNC stock sold pursuant to paragraph 3 of the settlement agreement, resulting in a long term capital gain of $ 2,229,055.00. *fn4" (Original Motion for Summary Judgment, Exh. 1a, P 14, Exh. 1b, P 14). Initially, the defendants reported a total tax liability of $ 579,036.00 for 1988, which they paid in full. (Original Motion for Summary Judgment, Exh. 3, line 10). Subsequently, in an amended return for the 1988 tax year, the defendants reported a total tax liability of $ 544,044.00. *fn5" (Original Motion for Summary Judgment, Exh. 2, lines 53-65).

 On or about October 15, 1992, the defendants filed a second amended federal income tax return for 1988, claiming a refund in the amount of $ 278,561.00 for that year. (Complaint, P 9, Exh. 1). The defendants' claim for a refund in their second amended federal income tax return for 1988 was based on the reduction of the defendants' taxable income by $ 975,351.00 due to the reduction of long term capital gain from $ 2,229,055.00 to $ 1,253,704.00 from the sale of the GNC stock pursuant to paragraph 3 of the settlement agreement. The defendants explained the change in their taxable income for 1988 as follows: "Taxpayer erroneously included personal injury proceeds of settlement award on Schedule D as sales proceeds received in connection with the redemption of 475,730 shares of defendant GNC's common stock." *fn6" (Complaint, P 9, Exh. 1).

 On or about May 3, 1993, the Internal Revenue Service refunded to the defendants the sum of $ 379,636.61, representing tax ($ 278,561.00), penalty ($ 1,582.48) and interest ($ 1,270.64) abatements with respect to the 1988 tax year, plus statutory interest of $ 98,222.49. (Complaint, Exhs. 2 and 3, Original Motion for Summary Judgment, Exh. 3, p. 2, lines 2-7). Thereafter, on March 3, 1995, the Internal Revenue Service sent the following letter to the defendants:

 
Dear Mr. and Mrs. Daum:
 
The refund check which we mailed to you on or about May 3, 1993, for your alleged 1988 overpayment was incorrect. This erroneous refund of $ 379,636.61 was due to the Form 1040X, Amended U.S. Individual Income Tax Return, which you filed on or after October 15, 1992.
 
You reported $ 2,229,055 in gain on the redemption of 475,730 shares of GNC stock on your original 1988 federal income tax return. On the Form 1040X which you filed on or after October 15, 1992, you reported that $ 975,351 of that gain was actually nontaxable personal injury damages. You also claimed a refund for the amount of tax, interest, and penalties previously assessed with respect to the gain.
 
A review of your account shows that the total amount of tax, interest, and penalties were abated, and a refund check in the amount of $ 379,636.61 (which includes $ 98,222.49 in interest on the alleged overpayment) was erroneously issued to you on or about May 3, 1993.
 
The government's position is that the $ 975,351 which you claimed as nontaxable personal injury damages is actually taxable gain on the redemption of the shares of GNC stock. Therefore, the refund check in the amount of $ 379,636.61 was erroneously refunded to you.
 
In order to resolve this matter, we are requesting that you make voluntary repayment of the $ 379,636.61 plus interest (May 3, 1993 through March 13, 1995) of $ 57,797.11 for a total of $ 437,433.72. Internal Revenue Code Section 7405 provides that the United States may bring a civil action to recover ...

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