                          T.C. Memo. 2003-184



                        UNITED STATES TAX COURT



                  STEPHEN HAYDEN, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 10441-01.                 Filed June 24, 2003.


     Saul A. Bernick and Neal J. Shapiro, for petitioner.

     Helen H. Keuning, for respondent.



                          MEMORANDUM OPINION


     JACOBS,   Judge:     Respondent   determined   deficiencies   in

petitioner’s Federal income tax and additions to tax under section

6651(a)(1)1 for 1997 and 1998 as follows:




     1
          All section references are to the Internal Revenue Code
in effect for the years at issue, and all Rule references are to
the Tax Court Rules of Practice and Procedure.
                                   - 2 -

                                                    Addition to Tax
             Year             Deficiency            Sec. 6651(a)(1)

             1997             $102,731                 $25,683
             1998             $ 26,347                 $6,587

      After concessions by the parties,2 the issue remaining for

decision is whether disability benefits received by petitioner in

1997 and 1998 from UNUM Life Insurance Co. of America (UNUM) are

excludable from his gross income pursuant to section 105(c).          For

reasons set forth herein, we hold they are not.

                                Background

      The parties submitted this case fully stipulated, without

trial, pursuant to Rule 122.      The facts stipulated by the parties

are so found.       The stipulation of facts and the exhibits attached

thereto are incorporated herein by this reference.

      When the petition in this case was filed, petitioner resided

in Carson City, Nevada.      From 1991-94, petitioner was employed as

the   chief    executive    officer   of   Calera   Recognition   Systems

(Calera).3

      In August 1991, Calera contracted for a group long-term

disability insurance policy through UNUM (the UNUM policy) for the

benefit of its employees.       Under the UNUM policy, UNUM agreed to


      2
          Respondent concedes that petitioner is not liable for the
addition to tax under sec. 6651(a)(1). Petitioner concedes that he
failed to report properly a $14,677 State tax refund for 1995 as
income on his 1997 Federal tax return.
      3
             Calera ceased conducting business sometime in 2000.
                              - 3 -

pay a monthly benefit provided it received proof that the insured

employee was disabled.   As relevant in this case, under the UNUM

policy, the terms “disability” and “disabled” meant that, because

of injury or sickness: (1) The insured could not perform any of the

material duties of his regular occupation; or (2) while able to

perform at least one but not all of the material duties of his

regular occupation on a part-time or full-time basis, the insured

was earning not more than 80 percent of his indexed predisability

earnings.

     Under the UNUM policy, if an insured employee provided proof

of continued disability and regular attendance of a physician, UNUM

agreed to pay the monthly benefit for the period of disability

following a 90-day elimination period.   The monthly benefit could

neither exceed the insured employee’s amount of insurance nor be

paid for a period longer than the maximum benefit period.      The

amount of insurance was 66-2/3 percent of the insured employee’s

basic monthly earnings, not to exceed the maximum monthly benefit,

less other income benefits.     The maximum monthly benefit was

$10,000; the minimum monthly benefit was the greater of $100 or 10

percent of the monthly benefit before deductions for other income

benefits.   If an insured employee earned more than 20 percent of

his pre-disability monthly earnings in his regular occupation or

another occupation, then the monthly benefit was to be reduced (but

not below the minimum benefit) by the excess of the monthly benefit
                                     - 4 -

plus the insured employee’s earnings over his/her pre-disability

earnings.

      The maximum benefit period was determined by the insured

employee’s age at disability, as follows:

      Age at Disability              Maximum Benefit Period

          Less than 60               To   age 65
          60                         60   mos.
          61                         48   mos.
          62                         42   mos.
          63                         36   mos.
          64                         30   mos.
          65                         24   mos.
          66                         21   mos.
          67                         18   mos.
          68                         15   mos.
          69 and over                12   mos.

      If a disability was caused by mental illness, alcoholism, or

drug abuse, the benefit period generally could not exceed 24

months.4

      Calera paid the premium under the UNUM policy. Petitioner was

not   required   to   pay   any    portion    of    the   premium     or    to   make

contributions    in   order   to    be    covered    under     the   UNUM   policy.

Petitioner was not required to include (and did not include) any

portion of the premium payment in his gross income.

      In December 1994, petitioner suffered a severe neurological

impairment    that    prevented    him     from     engaging    in   any    gainful


      4
          If an insured employee continued to be disabled and
became confined in a hospital or institution after the 24-month
period and for at least 14 consecutive days, the monthly benefit
was payable during the confinement.
                                         - 5 -

employment.          On January 12, 1995, petitioner filed a claim with

UNUM for monthly disability benefits.

        Initially UNUM refused to pay petitioner’s disability claim

for lack of medical documentation establishing that petitioner

suffered a loss of function.                 Petitioner filed an administrative

appeal. UNUM eventually reversed its initial decision and approved

petitioner’s disability claim.

        On    June    19,   1997,     UNUM    paid   petitioner   a    lump   sum   of

$237,885.69 for benefits owed from March 21, 1995 to June 18, 1997.

In addition to the lump-sum payment, on July 20, 1997, petitioner

began        receiving      monthly    disability      payments       of   $9,333.33.

Petitioner received benefits totaling $286,931.22 in 1997 and

$115,597.08 in 1998.

     On his 1997 and 1998 Federal tax returns, petitioner reported

the $286,931 (rounded) received from UNUM in 1997 and the $115,597

(rounded) received in 1998 as non-taxable sick pay.                        Petitioner

filed both his 1997 and 1998 tax returns in December 1999.

        Although UNUM paid petitioner the disability payments in 1997

and 1998, petitioner disputed the amount of the monthly benefit he

was entitled to receive.            While UNUM paid petitioner $9,333.33 per

month in 1997 and 1998, petitioner demanded monthly benefits of

$10,000.        Petitioner filed suit against UNUM in State court on

September 17, 1998. Petitioner and UNUM settled their dispute, and

the suit was dismissed on November 15, 2000.                      The State court
                                      - 6 -

settlement had no effect on the amount petitioner had received from

UNUM in 1997 or 1998.

                                  Discussion

      Gross income includes all income from whatever source derived.

Sec. 61.    Generally, amounts received through accident or health

insurance for personal injuries or sickness are excluded from gross

income under section 104(a)(3), unless the amounts are either (1)

attributable    to    contributions     by    the   employer   that    were    not

includable in the gross income of the employee or (2) paid by the

employer.   If amounts received by an employee through accident or

health insurance for personal injuries or sickness are either (1)

attributable    to    contributions     by    the   employer   that    were    not

includable in the gross income of the employee or (2) paid by the

employer,   then      the   amounts   are    specifically   included    in    the

employee’s gross income under section 105(a).

      Four conditions must be met for section 105(a) to apply.                 See

Kees v. Commissioner, T.C. Memo. 1999-41.            First, the amounts must

be received through accident or health insurance; second, the

amounts must be for personal injuries or sickness; third, the

amounts must be attributable to contributions made by the employer;

and   fourth,   the    employer’s     contributions    must    not    have    been

includable in the employee’s gross income.

      In the instant case, petitioner received $286,931.22 in 1997

and $115,597.08 in 1998 from UNUM under the UNUM policy, an
                                       - 7 -

accident   or    health    insurance      plan.        Petitioner    received   the

benefits   for      a   disability     caused     by    a   severe   neurological

impairment,     a    personal    injury      or   illness,    that   he   suffered

beginning in December 1994.            The benefits were attributable to

contributions       made   by   Calera,   petitioner’s       employer,    and   the

contributions were not included in petitioner’s gross income.

Thus, in the situation involved herein, all four conditions of

section 105(a) have been met.

     Section 105(c), however, excludes from gross income amounts

described in 105(a) if (1) the amounts constitute payment for

permanent loss, or loss of use, of a member or function of the

body, or the permanent disfigurement, of the taxpayer employee, and

(2) the payments are computed with reference to the nature of the

injury and without regard to the period the taxpayer employee is

absent from work.

     The legislative history of section 105(c)(2) illustrates the

distinct   character       of   both   the     nature-of-the-injury       and   the

absence-from-work requirements of the statute.                S. Rept. 1622, 83d

Cong., 2d Sess. 183-184 (1954), provides the following example to

illustrate the kind of payments excludable from gross income under

section 105(c):

      Assume that under the plan of an employer payments equal
     to 25 percent of annual compensation are made to
     employees for loss of a leg. The $10,000 employee would
     therefore receive a payment of $2,500 and the $4,000
     employee would receive a payment of $1,000.         These
     amounts would be excludible from gross income if, under
                                     - 8 -

      the plan, they are payable regardless of the period that
      the employee is absent from work.

      In Beisler v. Commissioner, 814 F.2d 1304, 1308 (9th Cir.

1987), affg. T.C. Memo. 1985-25, the U.S. Court of Appeals for the

Ninth Circuit, to which an appeal of a decision in this case would

lie, described the exception provided in section 105(c) and its

purpose as follows:

      Section 105(c) * * * [excludes] from gross income certain
      payments under accident and health plans that do not
      resemble income, while including those that do. Section
      105(c)(2) is a mechanism for accomplishing this purpose.
      It excludes from gross income only those amounts of
      accident and health insurance payments that are computed
      with reference to the nature of the taxpayer's injury.
      Only these payments are compensation for "the permanent
      loss or loss of use of a member or function of the body,
      or permanent disfigurement," and as such do not resemble
      income. On the other hand, section 105(c)(2) includes in
      income amounts that vary according to the amount of time
      an employee is absent from work. These amounts resemble
      income in that they tend to compensate a person for lost
      wages.

           To accomplish the congressional purpose of excluding
      only those payments that compensate for permanent losses
      of bodily function, the nature-of-the-injury requirement
      is best read to require that benefits vary according to
      the type and severity of a person's injury. Only then
      are the payments and the injury sufficiently related to
      reflect the compensatory purpose required by section
      105(c). * * *

Thus, “amounts received as accident or health insurance benefits

may be excluded from gross income under section 105(c) only if paid

by a plan that varies the amount of payment according to the type

and   severity   of   the   injury   suffered   by   the   employee.”   Id.

Benefits are not excludable under section 105(c) if the plan does
                                - 9 -

not compute the amount of its payments with reference to the nature

of the injury.   Id.

     To exclude from income amounts described in section 105(a),

section 105(c) first requires that the taxpayer prove that the

amount received is payment for “the permanent loss or loss of use

of a member or function of the body, or permanent disfigurement, of

the taxpayer”.   Sec. 105(c)(1); see also Watts v. United States,

703 F.2d 346, 350-53 (9th Cir. 1983).   Next, the taxpayer must show

that the amount received is “computed with reference to the nature

of the injury without regard to the period the employee is absent

from work."   Sec. 105(c)(2).

     The parties agree that the payments petitioner received from

UNUM in 1997 and 1998 constitute payments for his permanent loss or

use of a member or function of his body within the meaning of

section 105(c)(1). The parties disagree as to whether the payments

were computed with reference to the nature of the injury without

regard to the period petitioner was absent from work as required by

section 105(c)(2).

     In the case before us, UNUM agreed to pay the monthly benefit

for the period of disability following a 90-day elimination period.

The UNUM policy provided that petitioner’s monthly disability

benefit would be based on 66-2/3 percent of petitioner’s salary at

the time of the disability up to the maximum $10,000, regardless of

the nature of the injury or illness.    Although the amount of the
                                      - 10 -

monthly benefit could not exceed the maximum benefit or be less

than the minimum benefit, the amount of the monthly benefit was not

affected by the severity or nature of the illness or injury that

caused the employee’s disability.

     Payments from a disability plan do not qualify for the section

105(c)(2) exclusion if the payments are the same regardless of the

nature   and   severity    of   the    particular    injuries      causing    the

disabilities.     Hines v. Commissioner, 72 T.C. 715 (1979).               Under

the UNUM policy, an employee who was disabled because he had lost

a leg was entitled to the same benefits as one who was disabled

because he had lost both legs, another limb, or his sight, suffered

kidney failure, or had a heart attack or a stroke.                Such payments

are not based upon the type and severity of the injury as required

by section 105(c)(2). Colton v. Commissioner, T.C. Memo. 1995-275.

     Petitioner    contends     that     the   benefits    were    computed    by

reference to the nature of the injury because the UNUM policy

distinguished    between    physical      injury    or   illness    and   mental

illness.   We disagree.

     The monthly benefit for a total disability caused by mental

illness did not differ from the monthly benefit for a total

disability caused by physical injury. The benefit period (and thus

the total benefit) for a disability caused by mental illness could

be shorter than the benefit period for a disability caused by a

physical illness or injury, only if the employee was under age 65
                              - 11 -

when he/she became disabled and did not return to work within 24

months.   We do not believe that such payments are based upon the

type and severity of the injury as required by section 105(c)(2).

     Furthermore, here, petitioner’s total disability benefit was

not calculated simply by virtue of his sustaining an injury.

Rather, it was contingent upon his absence from his job.   Payments

that are designed to replace the income an employee has lost due to

disability, rather than to compensate for the injury itself, cannot

be said to be computed without regard to the length of time the

employee was absent from work.   Beisler v. Commissioner, supra at

1308; Armstrong v. Commissioner, T.C. Memo. 1993-579.

     Section 105(c)(2) requires that the amount of the benefit be

calculated with reference to the nature of the particular injury

and that the amount not vary according to whether the injured

taxpayer retired immediately after the injury, returned to work

after some recuperation period, or returned to work immediately.

See S. Rept. 1622, 83d Cong., 2d Sess. 183-184 (1954) (accompanying

H.R. 8300, which was enacted as Internal Revenue Code of 1954, ch.

736, 68A Stat. 1); sec. 1.105-3, Income Tax Regs.    In the case at

hand, the monthly benefit to a totally disabled employee under the

UNUM policy spans a period beginning 90 days after he first becomes

unable to work and ending when he is able to work.   Had petitioner

been out of work for a period sufficient to collect a monthly

benefit and then returned to full duties, he still would have been
                              - 12 -

paid under the terms of the UNUM policy for the period of his

absence. It is difficult to conceive how the monthly benefit could

be more closely tailored to an employee’s period of absence from

work.   Armstrong v. Commissioner, T.C. Memo. 1993-579, supra.

     Payments under the UNUM policy are designed to replace the

income an employee lost due to disability and are computed with

regard to the employee’s absence from work.       The UNUM policy

plainly did not compute the amount of payments "with reference to

the nature of the injury," nor did it award benefits "without

regard to the period the employee [was] absent from work."       We

conclude, therefore, that the benefits are not excluded from income

under section 105(c).

     We have considered various arguments made by petitioner not

discussed above and have not found them persuasive

     To reflect the foregoing and the parties’ concessions,


                                          Decision will be entered

                                    for respondent with respect to

                                    the   deficiencies   and     for

                                    petitioner with respect to the

                                    additions to tax under section

                                    6651(a).
