                        T.C. Memo. 2009-38



                      UNITED STATES TAX COURT



             RICHARD S. MOULTON, JR., Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 4552-06.                Filed February 18, 2009.


     Richard S. Moulton, Jr., pro se.

     Louise R. Forbes, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     GALE, Judge:   Respondent determined a deficiency of $13,248

and a section 6662(a) accuracy-related penalty of $2,650 with

respect to petitioner’s 2003 Federal income tax.
                                 - 2 -

     After a concession,1 the issues for decision are:

(1) Whether $65,000 petitioner received in 2003 in connection

with a mediation agreement with his former employer is includible

in gross income; and (2) whether petitioner is liable for a

penalty under section 6662(a).

     Unless otherwise noted, all section references are to the

Internal Revenue Code of 1986, as in effect for the year in

issue, and all Rule references are to the Tax Court Rules of

Practice and Procedure.    All dollar amounts have been rounded to

the nearest dollar.

                          FINDINGS OF FACT

     Some of the facts have been stipulated and are incorporated

by this reference.    At the time the petition was filed,

petitioner resided in New Hampshire.

Petitioner’s Employment at the Morrell Corp.

     Petitioner was an employee of the Morrell Corp., which

operated an amusement park called Story Land near North Conway,

New Hampshire, for approximately 30 years.    In that capacity he

provided financial, administrative, and supervisory services,

first under the direction of Story Land’s original owner and

founder and then under the direction of the founder’s son, R.




     1
      Petitioner has conceded that he failed to report $100 in
interest income for 2003.
                                 - 3 -

Stoning Morrell, Jr. (Mr. Morrell, also referred to herein as

Stoney Morrell).

     Sometime in 1998 or 1999 petitioner began having disputes

with certain employees of Story Land that eventually led to an

estrangement between petitioner and Mr. Morrell.       As a result of

his difficulties at work, petitioner became anxious and

depressed.   In 1999 petitioner sought treatment from a

psychologist, which extended to the fall of 2006.       The

psychologist also sought to mediate the employment dispute on

petitioner’s behalf during 2000, to no avail.

Petitioner’s Termination

     In the fall of 2000 the Morrell Corp. fired petitioner.

Petitioner strongly believed that his dismissal was unjustified.

     In August 2002, still aggrieved over the circumstances of

his termination, petitioner mailed a series of letters to Mr.

Morrell and two Story Land employees which the recipients

perceived as threatening violence.       Mr. Morrell and the two

employees obtained temporary restraining orders against

petitioner from a State court.    Local newspapers published

detailed accounts concerning the allegedly threatening letters

and the issuance of the restraining orders.       In petitioner’s view

the claims underlying the restraining orders were exaggerated and

unfounded.   Petitioner believed that the adverse publicity,
                              - 4 -

coupled with his earlier dismissal, had ruined his reputation and

his ability to find gainful employment in the area.

Mediation

     At a hearing on the status of the restraining orders the

presiding judge suggested that Mr. Morrell and petitioner engage

in professional mediation to resolve their differences.    A

day-long session with a mediator was conducted.   The mediation

session culminated in a mediation agreement; it has been

stipulated that the purpose of the mediation agreement was “to

resolve inter alia ‘a painful and questionable termination’ by

the Morrell Corporation.”

Mediation Agreement

     The agreement, executed on March 28, 2003, by petitioner and

by Mr. Morrell on behalf of the Morrell Corp., provided in

pertinent part:

     1.   Stoney Morrell’s restraining order against * * *
     [petitioner] shall be dismissed. Marian Owen and Nancy
     Porath have each indicated that they will also dismiss their
     restraining orders as a result of this agreement.

     2.   Peter Malia [Morrell Corp.’s counsel] shall fax the
     agreed upon joint press release to the Conway Daily Sun on
     April 8, 2003. Neither party shall have any further comment
     to the press. However, both parties reserve the right to
     respond--in writing or verbally--to factual inaccuracies
     printed in the press, but agree to provide any written
     comments to Peter Malia, and to discuss the same with Peter
     Malia, and to allow Peter Malia time to discuss the same
     with the other party, prior to disseminating such a
     correction to the press.

     3.   In order to provide * * * [petitioner] with resources
     to enhance his employment opportunities, maintain his health
                               - 5 -

     insurance, and/or enhance his ability to relocate, the
     Morrell Corporation will pay, by check, the sum of
     $65,000.00 (gross) subject to all applicable state and
     federal taxes.

     4.   In exchange for the consideration set forth in #3
     above, * * * [petitioner] agrees to release and forever
     discharge the Morrell Corporation, its owners, employees and
     agents, from any and all claims and causes of action that he
     had in the past or may now have in any way related to or
     arising out of his employment and its termination. The
     Morrell Corporation agrees to release and forever discharge
     * * * [petitioner] from any claims that could arise out of
     the restraining order docketed as 02-CV-127.

Settlement Payment

     The Morrell Corp. issued a check to petitioner for $60,028

on April 2, 2003, which petitioner endorsed and cashed shortly

thereafter.   The Morrell Corp. took the position that the $65,000

it agreed to pay petitioner pursuant to the mediation agreement

was taxable wages.   It subsequently issued petitioner a Form W-2,

Wage and Tax Statement, for 2003, which listed wages of $65,000

and withholdings in the amounts of $4,030 and $943 for Social

Security and Medicare, respectively.   The Form W-2 was addressed

to petitioner’s residence in North Conway, New Hampshire.

     Through the time of the execution of the mediation agreement

petitioner did not bring to the attention of Mr. Morrell or the

mediator any medical problems he was experiencing or seek

compensation for any medical expenses other than identifying his

need to maintain health insurance coverage.
                              - 6 -

Subsequent Medical Care

     In 2005 petitioner received medical treatment for sleeping

problems that he attributed to depression.   In 2006 petitioner

received medical treatment for elevated blood sugar levels, which

petitioner attributed to “increased stress and some emotional

issues over the past few years”.

Petitioner’s 2003 Return

     Petitioner did not consult an accountant, lawyer, or other

professional as to the proper treatment of the mediation proceeds

on his 2003 Federal income tax return.    Petitioner did not report

on the 2003 return any amount he received pursuant to the

mediation agreement.

Notice of Deficiency

     Respondent mailed petitioner a notice of deficiency in which

he determined that petitioner failed to report $65,000 in wage

income from the Morrell Corp. for 2003.   Respondent further

determined that petitioner was liable for a $2,650

accuracy-related penalty under section 6662(a) for 2003.

Petitioner timely filed a petition for redetermination.

                             OPINION

Unreported Income

     We first decide whether petitioner must include in his 2003

gross income the proceeds he received from the Morrell Corp.

pursuant to the mediation agreement.   Petitioner contends that
                                - 7 -

the proceeds are excludable from gross income under section

104(a)(2) because they were compensation for injuries he suffered

because of a wrongful termination and subsequent defamation by

the Morrell Corp., including injury to his health.   Respondent

counters that petitioner is not entitled to exclude the proceeds

under section 104(a)(2) because the Morrell Corp. did not make

the payment on account of physical injuries but intended the

payment to be treated as taxable wage income.

     Respondent’s determinations in the notice of deficiency are

presumed correct, and petitioner bears the burden of proving that

the determinations are in error.   See Rule 142(a); Welch v.

Helvering, 290 U.S. 111, 115 (1933).2

     Generally, gross income includes all income from whatever

source derived.   See sec. 61(a); sec. 1.61-1(a), Income Tax

Regs.    While section 61(a) broadly applies to any accession to

wealth, statutory exclusions from gross income are to be narrowly

construed.    See Commissioner v. Schleier, 515 U.S. 323, 328

(1995); United States v. Burke, 504 U.S. 229, 233 (1992);

Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955).

Petitioner must bring himself within the clear scope of any

statutory exclusion.   See Commissioner v. Schleier, supra at

336-337; United States v. Burke, supra at 233.



     2
      Petitioner has not claimed or shown entitlement to a shift
in the burden of proof under sec. 7491(a).
                                - 8 -

     The statutory exclusion at issue appears in section

104(a)(2).    Before it was amended by the Small Business Job

Protection Act of 1996 (SBJPA), Pub. L. 104-188, sec. 1605(a),

110 Stat. 1838, section 104(a)(2) excluded from gross income

amounts received on account of personal injuries or sickness.

The reference to personal injuries or sickness included

“nonphysical injuries to the individual, such as those affecting

emotions, reputation, or character”.    United States v. Burke,

supra at 235 n.6; see Robinson v. Commissioner, 102 T.C. 116,

125-126 (1994), affd. in part and revd. in part on another issue

70 F.3d 34 (5th Cir. 1995).

     The SBJPA amended section 104(a)(2) to exclude from gross

income “the amount of any damages (other than punitive damages)

received (whether by suit or agreement and whether as lump sums

or as periodic payments) on account of personal physical injuries

or physical sickness”.    SBJPA sec. 1605(a) (emphasis added).    The

SBJPA also amended section 104(a) by adding the following flush

language:    “For purposes of paragraph (2), emotional distress

shall not be treated as a physical injury or physical sickness.

The preceding sentence shall not apply to an amount of damages

not in excess of the amount paid for medical care * * *

attributable to emotional distress.”    Id. sec. 1605(b).   The

foregoing amendments are effective generally for amounts received

after August 20, 1996.    See id. sec. 1605(d), 110 Stat. 1839.
                              - 9 -

     Taken together, the SBJPA amendments eliminate the section

104(a)(2) exclusion for damages received on account of emotional

distress (1) unless the emotional distress is attributable to a

physical injury or physical sickness, or (2) except to the extent

the damages do not exceed amounts paid for medical care

attributable to emotional distress.   The legislative history

confirms this view.

          The House bill [followed in the conference bill]
     provides that the exclusion from gross income only applies
     to damages received on account of a personal physical injury
     or physical sickness. * * *

          The House bill also specifically provides that
     emotional distress is not considered a physical injury
     or physical sickness.56 Thus, the exclusion from gross
     income does not apply to any damages received (other
     than for medical expenses as discussed below) based on
     a claim of employment discrimination or injury to
     reputation accompanied by a claim of emotional
     distress. Because all damages received on account of
     physical injury or physical sickness are excludable
     from gross income, the exclusion from gross income
     applies to any damages received based on a claim of
     emotional distress that is attributable to a physical
     injury or physical sickness. In addition, the
     exclusion from gross income specifically applies to the
     amount of damages received that is not in excess of the
     amount paid for medical care attributable to emotional
     distress.

     __________
     56
        It is intended that the term emotional distress includes
     symptoms (e.g., insomnia, headaches, stomach disorders)
     which may result from such emotional distress. [H. Conf.
     Rept. 104-737, at 301 (1996), 1996-3 C.B. 741, 1041.]

     In interpreting section 104(a)(2) the Supreme Court has held

that damages are excludable from gross income where a taxpayer

proves (1) the underlying cause of action giving rise to the
                                - 10 -

recovery is based on tort or tort type rights and (2) the damages

were received on account of personal injuries or sickness.    See

Commissioner v. Schleier, supra at 336-337.   Lower courts have

applied the foregoing two-pronged test from Schleier in

interpreting section 104(a)(2) as amended in 1996.   See Lindsey

v. Commissioner, 422 F.3d 684, 688 (8th Cir. 2005), affg. T.C.

Memo. 2004-113; Goode v. Commissioner, T.C. Memo. 2006-48; Shaltz

v. Commissioner, T.C. Memo. 2003-173; Henderson v. Commissioner,

T.C. Memo. 2003-168, affd. 104 Fed. Appx. 47 (9th Cir. 2004).

Accordingly, the second prong of the Schleier test now requires a

taxpayer to prove that the damages were received on account of

personal physical injuries or physical sickness.   See Lindsey v.

Commissioner, supra; Goode v. Commissioner, supra; Shaltz v.

Commissioner, supra; Henderson v. Commissioner, supra.    Moreover,

satisfaction of the second prong requires the taxpayer to show “a

direct causal link” between the damages received and the physical

injury or sickness sustained.    Lindsey v. Commissioner, supra at

688; see also Banaitis v. Commissioner, 340 F.3d 1074, 1080 (9th

Cir. 2003), affg. in part and revg. in part on another issue T.C.

Memo. 2002-5, revd. sub nom. Commissioner v. Banks, 543 U.S. 426

(2005).

     When determining the tax consequences of a payment made

pursuant to a settlement agreement, it is the nature of the

underlying claim, not its validity, that determines whether the
                               - 11 -

payment was received on account of a tort type claim for personal

injuries.    See United States v. Burke, 504 U.S. at 237; Threlkeld

v. Commissioner, 87 T.C. 1294, 1297 (1986), affd. 848 F.2d 81

(6th Cir. 1988); Glynn v. Commissioner, 76 T.C. 116, 119 (1981),

affd. without published opinion 676 F.2d 682 (1st Cir. 1982).    In

seeking the nature of the underlying claim, the court should

consider “‘In lieu of what were the damages awarded?’”    Robinson

v. Commissioner, supra at 126 (quoting Raytheon Prod. Corp. v.

Commissioner, 144 F.2d 110, 113 (1st Cir. 1944)) (emphasis added

in Robinson), affg. 1 T.C. 952 (1943).

       The determination of the nature of the underlying claim is a

question of fact which is determined by considering the agreement

in light of all the facts and circumstances, including the

claim’s characterization under applicable State law, the evidence

marshaled, the arguments made by the parties, and the intent of

the payor of the settlement.   See Threlkeld v. Commissioner,

supra at 1306; Burditt v. Commissioner, T.C. Memo. 1999-117

(citing Robinson v. Commissioner, supra at 127); see also Gross

v. Commissioner, T.C. Memo. 2000-342.    Paramount to this inquiry

is the payor’s intent in making the settlement payment.   See

Knuckles v. Commissioner, 349 F.2d 610, 613 (10th Cir. 1965),

affg. T.C. Memo. 1964-33; Robinson v. Commissioner, 102 T.C. at

127.
                                - 12 -

     If the settlement agreement expressly allocates the

settlement between tort type personal injury damages and other

damages, it will be respected for tax purposes to the extent that

the parties entered into the agreement in an adversarial context

at arm’s length and in good faith.       See Robinson v. Commissioner,

supra at 127.   Absent an express allocation in the settlement

agreement, the most important consideration is the payor’s intent

in making the payment.     See Delaney v. Commissioner, 99 F.3d 20,

24 (1st Cir. 1996), affg. T.C. Memo. 1995-378; Knuckles v.

Commissioner, supra at 613; Metzger v. Commissioner, 88 T.C. 834,

847-848 (1987), affd. without published opinion 845 F.2d 1013 (3d

Cir. 1988); Gerard v. Commissioner, T.C. Memo. 2003-320; Gross v.

Commissioner, supra.

     A.   Were the Underlying Claims Giving Rise to the
          Proceeds Based on Tort or Tort Type Rights?

     We find petitioner meets the first prong of the Schleier

test, having had tort type claims against the Morrell Corp. for

wrongful termination and defamation at the time the mediation

agreement was executed.3




     3
      The State of New Hampshire recognizes tort claims based on
both wrongful termination, see Hutton v. Essex Group, Inc., 885
F. Supp. 331, 332 (D.N.H. 1994); Porter v. City of Manchester,
849 A.2d 103, 114 (N.H. 2004); Cloutier v. Great Atl. & Pac. Tea
Co., 436 A.2d 1140, 1143 (N.H. 1981), and defamation, see Moss v.
Camp Pemigewassett, Inc., 312 F.3d 503, 507 (1st Cir. 2002);
Indep. Mech. Contractors, Inc. v. Gordon T. Burke & Sons, Inc.,
635 A.2d 487, 492 (N.H. 1993).
                                - 13 -

     The stipulations establish that the mediation agreement was

entered into to resolve a “questionable termination” by the

Morrell Corp.    Petitioner testified credibly as to his view that

his abrupt termination after 30 years’ employment was unjustified

and that his termination and the unfavorable newspaper coverage

of the restraining orders destroyed his reputation in the

community.    Finally, the mediation agreement was conditioned upon

petitioner’s release of all claims against the Morrell Corp. (and

its owners, employees and agents) “in any way related to or

arising out of his employment and its termination.”

     On these facts, we are satisfied that petitioner had

underlying claims based on tort or tort type rights.     He

therefore satisfies the first prong of the Schleier test.

     B.      Were the Proceeds Received on Account of
             Personal Physical Injuries or Physical Sickness?

     The second prong of the Schleier test requires that the

amounts to be excluded from income be received on account of

personal physical injuries or physical sickness.     As noted, to

satisfy this prong petitioner must show a direct causal link

between the damages received and a personal physical injury or

sickness sustained.

     While the mediation agreement does not contain express

allocations to specific claimed injuries, we find that when read

in context the agreement is directed at wrongful termination and,

to a lesser extent, possible injury to petitioner’s reputation.
                              - 14 -

Although the agreement does not acknowledge that petitioner was

the victim of a wrongful termination, it has been stipulated for

purposes of this case that the termination was “questionable”.

The agreement states that the Morrell Corp. will pay petitioner

$65,000 “[i]n order to provide * * * [petitioner] with resources

to enhance his employment opportunities, maintain his health

insurance, and/or enhance his ability to relocate”.   These

purposes suggest a payment in the nature of severance.     The

agreement also expressly provides that in exchange for the

$65,000, petitioner “agrees to release and forever discharge the

Morrell Corporation, its owners, employees and agents, from any

and all claims and causes of action that he had in the past or

may now have in any way related to or arising out of his

employment and its termination.”   This language demonstrates a

clear nexus between petitioner’s possible claim of wrongful

termination and the amounts he received pursuant to the

agreement.   Finally, the agreement provides that the $65,000

gross payment is “subject to all applicable state and federal

taxes”, and within 1 week of the agreement’s execution petitioner

accepted a check for $60,028 in satisfaction of the Morrell

Corp.’s obligation.

     Taken together, we believe these provisions and the

surrounding circumstances demonstrate that petitioner and the

Morrell Corp. agreed to settle petitioner’s wrongful termination
                              - 15 -

claim by the Morrell Corp.’s providing $65,000 to petitioner in

the nature of a severance payment--that is, as taxable wages.

     We conclude that the mediation agreement also had a

secondary purpose of addressing potential injury to petitioner’s

reputation.   Petitioner believed that his abrupt termination as

well as the publicity surrounding the restraining orders had

damaged his reputation.   The mediation agreement addressed this

concern, albeit implicitly, by mandating carefully choreographed

communications with the media concerning the dispute between

petitioner and the Morrell Corp. and its resolution and by the

requirement that the restraining orders be dismissed.

     On the basis of the preponderance of the evidence, we

believe that petitioner received the $65,000 proceeds on account

of a wrongful termination.   Petitioner has not demonstrated any

direct causal link between the $65,000 proceeds and a personal

physical injury or physical sickness.   To the contrary, although

petitioner testified that he became depressed and suffered

various other maladies as a result of his termination and related

events, he conceded that he had not brought any medical problems

to the attention of Mr. Morrell or the mediator, or sought

compensation for any medical expenses in connection with the

mediation (other than identifying his need to maintain his health

insurance).   Thus, as payor the Morrell Corp. was unaware of any

medical claims and could not have intended to compensate for
                                - 16 -

them.     See Sodoma v. Commissioner, T.C. Memo. 1996-275, affd.

without published opinion 139 F.3d 899 (5th Cir. 1998); Foster v.

Commissioner, T.C. Memo. 1996-26, affd. without published opinion

122 F.3d 1071 (9th Cir. 1997); Galligan v. Commissioner, T.C.

Memo. 1993-605.     The claims of wrongful termination and

defamation that we believe prompted the consideration petitioner

received under the mediation agreement were not physical injuries

to petitioner or physical sickness.      To the extent petitioner may

have suffered depression, sleep disorders, or elevated blood

sugar levels that he attributed to heightened stress from his job

termination and its aftermath, those conditions fall within the

category of “emotional distress” that “shall not be treated as a

physical injury or physical sickness” for purposes of the

exclusion provided in section 104(a)(2).     Sec. 104(a) (flush

language); see also H. Conf. Rept. 104-737, supra at 301 n.56,

1996-3 C.B. at 1041 (“It is intended that the term emotional

distress includes symptoms (e.g., insomnia, headaches, stomach

disorders) which may result from such emotional distress.”).

        Finally, while there is evidence that petitioner was treated

by a psychologist before, during, and after the year in issue and

that he received other medical care in 2005 and 2006, there is no

substantiation in the record of any actual expenditures for

medical care.     Thus, petitioner has not shown eligibility for
                              - 17 -

exclusion of any amount under the last sentence of the flush

language of section 104(a).

     C.    Conclusion

     We conclude on the basis of the preponderance of the

evidence that no part of the $65,000 proceeds petitioner received

in exchange for a release of any claims he might have had against

the Morrell Corp. was received by him on account of personal

physical injuries or physical sickness.   We accordingly sustain

respondent’s determination that petitioner had unreported taxable

wage income of $65,000 in 2003.

Accuracy-Related Penalty

     We now consider whether petitioner is liable for the

accuracy-related penalty under section 6662(a).   Respondent bears

the burden of production with respect to petitioner’s liability

for the section 6662(a) penalty.   See sec. 7491(c).   In order to

meet that burden, respondent must offer sufficient evidence to

indicate that it is appropriate to impose the accuracy-related

penalty.   See Higbee v. Commissioner, 116 T.C. 438, 446 (2001).

Once respondent meets his burden of production, petitioner bears

the burden of proving error in the determination, including

establishing reasonable cause or other exculpatory factors.    Id.

at 446-447.

     Section 6662(a) and (b)(2) imposes a penalty of 20 percent

on the portion of an underpayment of tax attributable to a
                              - 18 -

substantial understatement of income tax.   Pursuant to section

6662(d)(2)(A), the term “understatement” is defined as the amount

of tax required to be shown on the return for the taxable year

over the amount of tax shown on the return for the taxable year.

A substantial understatement arises where the understatement

exceeds the greater of 10 percent of the tax required to be shown

on the return for the taxable year or $5,000.   Sec.

6662(d)(1)(A).

     The section 6662(a) penalty is not imposed on any portion of

an underpayment as to which the taxpayer acted with reasonable

cause and in good faith.   Sec. 6664(c)(1); Higbee v.

Commissioner, supra at 448-449.   Whether the taxpayer acted with

reasonable cause and in good faith depends upon all the pertinent

facts and circumstances, including the taxpayer’s reasonable

reliance on a professional tax adviser, the taxpayer’s efforts to

assess his or her proper tax liability, and the knowledge and

experience of the taxpayer.   Lindsey v. Commissioner, T.C. Memo.

2004-113; sec. 1.6664-4(b)(1), Income Tax Regs.

     Petitioner’s failure to include in his 2003 gross income the

$65,000 gross payment and the $100 in interest income resulted in

a $13,248 understatement of income tax for 2003.   Because the

understatement exceeds the greater of 10 percent of the tax

required to be reported on petitioner’s tax return or $5,000,
                               - 19 -

respondent has satisfied his burden of production under section

7491(c).

     Petitioner claims that he is not subject to the

accuracy-related penalty because he concluded reasonably and in

good faith that the proceeds were excludable from gross income

under section 104(a)(2) as payments for personal injuries.

However, petitioner has not shown that he undertook any

investigation of a basis for excluding the $65,000 proceeds when

he filed his return.    In petitioner’s apparent circumstances this

was a significant sum of money that warranted greater diligence.

     Other factors gave petitioner reasonable notice that his

treatment of the proceeds as nontaxable was subject to doubt.

First, the mediation agreement petitioner signed stated that the

payment would be “subject to all applicable state and federal

taxes.”    Second, the Morrell Corp. mailed a Form W-2

characterizing the $65,000 gross payment as wages to petitioner’s

residence, and petitioner has offered no evidence to support an

inference that he did not receive it.    Nonetheless, petitioner

failed to seek any guidance as to the correct treatment on his

2003 return of this very sizable amount until he received the

notice of deficiency.

     Considering all the facts and circumstances, we conclude

that petitioner has not shown reasonable cause with respect to

any portion of the underpayment.    We shall therefore sustain
                             - 20 -

respondent’s determination of the accuracy-related penalty under

section 6662(a).

     To reflect the foregoing,


                                      Decision will be entered

                                 for respondent.
