                          T.C. Memo. 2009-116



                        UNITED STATES TAX COURT



         HARTFORD AND JOSEPHINE SHELTON, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 16278-07.                Filed May 26, 2009.



     Hartford and Josephine Shelton, pro se.

     Rebecca Dance Harris, for respondent.



                MEMORANDUM FINDINGS OF FACT AND OPINION


     GOEKE, Judge:     Respondent determined a deficiency of $46,395

in petitioners’ Federal income tax and an accuracy-related

penalty of $9,279 under section 6662 for 2004.1    The issues for

decision are:    (1) Whether pursuant to section 104(a)(2)


     1
      Unless otherwise indicated, all section references are to
the Internal Revenue Code.
                               - 2 -

petitioners may exclude from their gross income the settlement

proceeds received by petitioner wife.     We hold that the

settlement award is gross income and not excludable; and (2)

whether petitioners are liable for an accuracy-related penalty

under section 6662 for their failure to report the settlement

proceeds.   We hold that they are not.

                         FINDINGS OF FACT

     Some of the facts have been stipulated and are so found.

The stipulation of facts and the attached exhibits are

incorporated herein by this reference.     At the time they filed

their petition, petitioners resided in Virginia.

     Petitioner wife was hired by the Dial Corp. (Dial) at some

time before 1999.   Petitioner husband is disabled and unable to

work.   While employed at Dial petitioner wife was subject to

sexual harassment by her supervisor.     Petitioner wife’s

supervisor repeatedly harassed her, made references to petitioner

husband’s disability, and refused to stop after petitioner wife

rebuffed his advances.   Petitioner wife complained about the

harassment to Dial’s management, but no corrective action was

taken, and petitioner wife’s employer retaliated against her.       As

a result of her complaints, petitioner wife was routinely

assigned to menial labor or given the least desirable

assignments.
                                 - 3 -

     Although petitioner wife was subject to harassment by her

immediate supervisor, she was also harassed by other members of

Dial’s management.   Petitioner wife developed severe emotional

problems and began to receive medical help.    Petitioner wife

began and continues to take antidepressants and other medication

to deal with the physical effects of her harassment.

     On May 20, 1999, the Equal Employment Opportunity Commission

(EEOC) filed a complaint against Dial in the U.S. District Court

for the Northern District of Illinois.    The complaint alleged

that Dial had engaged in a pattern and practice of discrimination

against a class of female employees based upon their sex by

subjecting them to a hostile and abusive work environment and

that Dial failed to remedy this situation after the company had

become aware of the alleged harassment.

     On April 29, 2003, the EEOC and Dial entered into a consent

decree.   The consent decree provided in pertinent part that Dial

would pay $10 million (the settlement proceeds) to be distributed

to all eligible class members.    The decree also provided for

corrective action on Dial’s part to prevent future instances of

sexual harassment.   Petitioner wife was a member of the class of

workers eligible for a portion of the settlement proceeds.

     In order to receive the settlement proceeds, an eligible

claimant had to sign a release form discharging Dial from

liability for all past instances of sexual harassment.    The
                                - 4 -

release provided in pertinent part that the settlement proceeds

were for emotional pain, suffering, inconvenience, mental

anguish, loss of enjoyment of life, and nonpecuniary losses.       The

release did not provide any information concerning the proper

treatment of the settlement funds for Federal tax purposes.

However, a claimant who signed the release acknowledged that the

settlement amount might be subject, in whole or in part, to

Federal and State income taxation.      Petitioner wife signed a

release and received $123,500 from Dial in 2004.      Dial issued a

Form 1099-MISC, Miscellaneous Income, to petitioner wife

reporting income of $123,500.

     Petitioner wife contacted the Internal Revenue Service (IRS)

at some point after receiving the settlement proceeds to

determine their proper treatment.    The IRS representative

informed petitioner wife that in some situations settlement

proceeds could be excluded from income if they were paid on

account of physical injury.   Petitioner wife, having suffered

physically as a result of her supervisor’s harassment, believed

that the settlement proceeds were paid to compensate her for

those injuries.

     On October 14, 2005, petitioners filed a joint Form 1040,

U.S. Individual Income Tax Return, for tax year 2004.

Petitioners’ Form 1040 was prepared by a paid return preparer.

Petitioner wife informed the return preparer that the settlement
                                 - 5 -

proceeds were paid to compensate her for physical injury.         In

accordance with petitioner wife’s representations, the return

preparer did not include the settlement proceeds on petitioners’

return.

     On April 23, 2007, respondent issued a notice of deficiency

(the notice) to petitioners for 2004.       Respondent determined in

the notice that petitioners were required to include the

settlement proceeds in gross income and that petitioners were

liable for a section 6662 accuracy-related penalty.       On July 18,

2007, petitioners timely petitioned this Court for a

redetermination of their tax liability.

                                OPINION

     Gross income generally includes all income from whatever

source derived.   Sec. 61(a).   The definition of gross income is

broad in scope, while exclusions from income are narrowly

construed.    Commissioner v. Schleier, 515 U.S. 323, 328 (1995).

Damages (other than punitive) received on account of personal

physical injuries or physical sickness may generally be excluded

from gross income.   Sec. 104(a)(2).      For the damages to be

excluded under this provision, the underlying cause of action

must be based in tort or tort-type rights, and the proceeds must

be damages received on account of personal physical injury or

sickness.    Commissioner v. Schleier, supra at 337.     Emotional

distress is not treated as a personal physical injury or physical
                                - 6 -

sickness except for damages not in excess of the amount paid for

medical care attributable to emotional distress.    Sec. 104(a)

(flush language).

     Petitioners focus on the severity of the harassment and the

physical ailments that it caused in arguing that they are not

required to include the settlement proceeds in gross income.

Petitioner wife contends that the settlement proceeds should not

be taxable because after being harassed she was not the same

person physically.    Petitioner wife points to the fact that she

sought medical help and continues to take medication to deal with

the physical effects of the harassment.    Respondent does not

argue that the underlying cause of action in this case is not a

tort or tort-type right; instead, respondent argues that the

damages petitioner wife received were not on account of personal

physical injuries or physical sickness.

     Although petitioners argue that petitioner wife suffered

physical injury as a result of her sexual harassment, that injury

does not meet the requirements of section 104.    Petitioner wife,

although she suffered physically, was not compensated for that

physical injury.    Petitioners do not claim that any portion of

the settlement proceeds were to reimburse them for amounts paid

for medical care attributable to emotional distress.    See sec.

104(a) (flush language); Sanford v. Commissioner, T.C. Memo.

2008-158.   The settlement proceeds were for emotional pain,
                                 - 7 -

suffering, inconvenience, mental anguish, loss of enjoyment of

life, and nonpecuniary losses, not physical injury.       Damages

received on account of emotional stress, even when resultant

physical symptoms occur, are not excludable from income under

section 104(a)(2).   Hawkins v. Commissioner, T.C. Memo. 2005-149.

Because petitioner wife did not receive the settlement proceeds

on account of personal physical injury or sickness, petitioners

must include those amounts in gross income.       See Sanford v.

Commissioner, supra; Shaltz v. Commissioner, T.C. Memo. 2003-173.

Accuracy-Related Penalty

     Respondent determined that petitioners are liable for an

accuracy-related penalty under section 6662 for negligence or

disregard of rules or regulations.       Section 6662(a) and (b)(1)

imposes a 20-percent penalty on an underpayment of tax that

results from negligence or disregard of rules or regulations.

Section 6662(c) defines the term “negligence” to include “any

failure to make a reasonable attempt to comply with the

provisions of this title”, and the term “disregard” to include

“any careless, reckless, or intentional disregard.”

     The section 6662 penalty is inapplicable to the extent the

taxpayer had reasonable cause for the underpayment and acted in

good faith.   Sec. 6664(c)(1).   The determination of whether the

taxpayer acted with reasonable cause and in good faith is made on

a case-by-case basis, taking into account the relevant facts and
                                 - 8 -

circumstances.     Sec. 1.6664-4(b)(1), Income Tax Regs.

“Circumstances that may indicate reasonable cause and good faith

include an honest misunderstanding of fact or law that is

reasonable in light of all of the facts and circumstances,

including the experience, knowledge, and education of the

taxpayer.”   Id.    Generally, the most important factor is the

extent of the taxpayer’s efforts to assess the proper tax

liability.   Id.    An honest misunderstanding of fact or law that

is reasonable in the light of the experience, knowledge, and

education of the taxpayer may indicate reasonable cause and good

faith.   Remy v. Commissioner, T.C. Memo. 1997-72.

     Petitioners have no experience or education in tax law and

sought advice from the IRS in order to determine the proper

treatment of the settlement proceeds.     The IRS employee informed

petitioner wife that in some circumstances settlement proceeds

could be excluded if they were paid to compensate for physical

injuries.    Petitioner wife believed that the proceeds were paid

to compensate her for physical injury.     This belief was

reasonable; as a result of the harassment petitioner wife did not

feel that she was the same physically.     Petitioner wife’s belief

is supported by the fact that petitioner wife required medical

help and began taking numerous medications soon after the

harassment began.     We find petitioners’ mistaken belief that the

settlement proceeds were for physical injury to be reasonable.
                                 - 9 -

Petitioners acted reasonably and in good faith when they informed

their return preparer that the settlement proceeds were paid on

account of physical injury.   See Stadnyk v. Commissioner, T.C.

Memo. 2008-289; Pettit v. Commissioner, T.C. Memo. 2008-87;

Gibson v. Commissioner, T.C. Memo. 2007-224.        Viewing all of the

circumstances, including the experience, knowledge, and education

of petitioners, we conclude that petitioners have demonstrated

reasonable cause for failing to report the settlement proceeds as

income and that they acted in good faith.       Accordingly,

petitioners are not liable for the accuracy-related penalty.

     To reflect the foregoing,


                                              Decision will be entered

                                      for respondent as to the

                                         deficiency and for petitioners

                                         as to the accuracy-related

                                         penalty.
