                     T.C. Memo. 1997-312



                UNITED STATES TAX COURT



    LANCE R. AND ELAINE C. LEFLEUR, Petitioners v.
     COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket No. 720-96.                 Filed July 7, 1997.



     H filed a lawsuit against his former employer
alleging breach of contract, fraud, and the tort of
outrageous conduct. Among other things, H received a
lump sum of $1 million to settle the suit, and he
incurred $173,542 in legal fees and costs in connection
therewith. The agreement expressly allocated $800,000
of the $1 million sum to compensatory damages for H's
tort claims on account of personal injuries, including
mental pain and suffering. The agreement allocated
$200,000 of that sum to one of H's contract claims.
None of the proceeds were allocated to punitive
damages. Ps included the $200,000 of the settlement
proceeds allocated to the contract claim in their gross
income on Schedule C attached to their Federal income
tax return for 1991. Ps relied on sec. 104(a)(2),
I.R.C., to exclude the remaining $800,000 allocated to
the personal injury claims from their gross income. Ps
also allocated the entire amount of attorney's fees and
costs to the contract claim, and deducted those fees
and costs as a Schedule C expense pursuant to sec. 162,
                                - 2 -

     I.R.C. As R's primary position in the notice of
     deficiency, R determined that Ps' gross income includes
     the total amount of settlement proceeds. R determined
     that $380,000 was attributable to salary and wages, and
     an additional $420,000 was characterized as business
     gross receipts. Consistent with that allocation, R
     determined that $107,596 of the legal fees and costs
     could be deducted as a Schedule C expense, and the
     remaining $65,946 was a miscellaneous itemized
     deduction pursuant to sec. 67, I.R.C. R also set forth
     an adjustment position which allocated $1 million to
     salary and wages and nothing to business gross
     receipts. In accordance therewith, R determined that
     all legal fees and costs must be taken as miscellaneous
     itemized deductions pursuant to sec. 67, I.R.C.

          1. Held: None of the proceeds are excludable
     from Ps' gross income under sec. 104(a)(2), I.R.C.,
     because they were not received on account of a personal
     injury.

          2. Held, further, Ps attorney's fees and costs
     are deductible as a miscellaneous itemized deduction to
     which the provisions of secs. 67 and 68, I.R.C., are
     applicable.



     Alan E. Rothfeder, Jo Karen Parr, and Carla R. Cole, for

petitioners.

     John F. Driscoll and Shuford A. Tucker, Jr., for respondent.



               MEMORANDUM FINDINGS OF FACT AND OPINION

     KÖRNER, Judge:    Respondent determined a deficiency in

the Federal income tax of petitioners (Lance R. and Elaine C.

LeFleur) for the tax year ended December 31, 1991, in the amount

of $283,078.   (Petitioner Elaine C. LeFleur is a party to this

proceeding solely because she filed a joint return with her
                                - 3 -

husband, and the term "petitioner" will be used henceforth to

refer to Lance R. LeFleur).

     Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the year at issue.    All

Rule references are to the Tax Court Rules of Practice and

Procedure.

     After concessions, the issues remaining for decision are as

follows:

     (1)    Whether $800,000 of the $1 million lump sum paid to

petitioner in 1991 in settlement of a suit against his former

employer is excludable from petitioners' gross income under

section 104(a)(2) as damages received on account of personal

injuries.    We hold that it is not.

     (2)    Whether petitioners may deduct legal fees and costs

incurred in bringing the suit as Schedule C expenses to the

extent that such fees are allocable to taxable income.    We hold

that they may not.

     Some of the facts are stipulated and are found accordingly.

The stipulation of facts and the attached exhibits are

incorporated herein by this reference.    Petitioners resided in

Montgomery, Alabama, at the time they filed their petition in

this case.

                          FINDINGS OF FACT

     In 1984, petitioner was hired as vice president for Blount

Energy Resource Corp. (BERC), a wholly owned subsidiary of
                                - 4 -

Blount, Inc. (Blount).    In late 1988, Blount decided to develop

an information package for the purpose of exploring the potential

sale of BERC.

     In March 1989, the management of Blount and BERC decided to

reduce operating expenses at BERC in anticipation of the possible

sale of the subsidiary.   As part of the expense reduction plan,

BERC's Montgomery-based staff was cut by approximately 50

percent.   Approximately 20 employees of BERC's Montgomery office

were either discharged or reassigned to other business entities

owned by Blount.

     As an incentive to many of BERC's remaining employees,

including petitioner, and in order to induce them to continue

their employment with BERC pending the sale, Blount offered

certain bonuses and severance benefits.   In so doing, Blount

sought to preserve BERC's value as a functioning business while

looking for a buyer.   Blount's use of incentive packages in such

a manner is a common business practice.

     The benefits were outlined in a letter from R. William Van

Sant (Van Sant), then president and chief operating officer of

Blount, to petitioner dated April 6, 1989 (the April 6 letter).

The April 6 letter provided a lump-sum bonus equal to 12 months'

salary, among other things, in the event that BERC was sold.

     Due to petitioner's request, Blount, by letter dated April

27, 1989 (the April 27 letter), offered petitioner an additional

arrangement whereby, among other things, petitioner would receive
                                - 5 -

a cash payment that was tied to the sales price obtained for

BERC.   On May 2, 1989, petitioner accepted the offer.

     On October 23, 1989, a meeting was held between Van Sant and

petitioner in which they discussed the possible separation and

sale of BERC's domestic and foreign assets (the October 23

meeting).    After the October 23 meeting, petitioner grew doubtful

of Blount's intent to abide by the arrangement set forth in the

April 27 letter.    Petitioner's concern led him to contact an

attorney, John Bolton (Bolton).    On November 3, 1989, a meeting

was held to discuss the terms of the April 27 letter (the

November 3 meeting).    At the conclusion of the November 3

meeting, Van Sant fired petitioner.

     Blount ultimately sold all of the assets of BERC in three

separate sales, all of which had closed prior to the end of 1991.

Blount sold BERC for $38-39 million net of transaction costs.

Blount failed to make any payments to petitioner under either the

April 6 or April 27 letters.

     Petitioner's Action Against Blount, BERC, and Van Sant

     On January 22, 1991, petitioner instituted suit against

Blount, BERC, and Van Sant (referred to collectively herein as

the defendants) in the Circuit Court of Montgomery County,

Alabama.    The complaint set forth five causes of action.    The

first and second counts alleged that Blount and BERC had breached

their contract with petitioner arising out of the April 6 and

April 27 letters.    The third and fourth counts alleged that the
                                 - 6 -

defendants fraudulently induced petitioner to enter into the

agreement set forth in the April 27 letter (fraud in the

inducement) and fraudulently represented to petitioner that they

would pay him an incentive commission based upon the sales price

of BERC, among other benefits (promissory fraud).    The fifth

count alleged that the defendants intended to inflict emotional

distress upon petitioner (the tort of outrageous conduct).

Petitioner sought compensatory damages, interest, and costs for

the breach of contract counts.    Petitioner sought compensatory

and punitive damages for the fraud counts, as well as for the

tort claim of outrageous conduct.

     Bolton agreed to represent petitioner in the suit.    After

evaluation of petitioner's various claims against the defendants,

Bolton determined that petitioner's best cause of action was for

breach of contract arising out of the April 27 letter.

     On March 1, 1991, the defendants filed a Notice of Removal

to the United States District Court for the Middle District of

Alabama, Northern Division, based upon the premise that all of

the claims asserted by petitioner were preempted and controlled

by the Employee Retirement Income Security Act of 1974, Pub. L.

93-406, sec. 502(a), 88 Stat. 829, 891.

     On October 14, 1991, Blount publicly disclosed the

unexpected resignation of Van Sant as its president.    Upon Van

Sant's resignation, Oscar J. Reak (Reak), a former president of
                               - 7 -

Blount, returned from retirement to serve as interim president of

the company.




     The Settlement Negotiations and Agreement

     On November 25, 1991, Reak met with petitioner to discuss

the possibility of a settlement (the November 25 meeting).   Reak

had no interest in partially settling the litigation with

petitioner and was interested only in a settlement that resolved

all outstanding issues.   After the November 25 meeting, Reak

tendered a written settlement offer to petitioner dated November

27, 1991 (the November 27 offer).   Petitioner did not accept the

November 27 offer.

     Jim Alexander (Alexander), defendant's counsel, was first

advised of petitioner's response to the November 27 offer by a

telephone call from Bolton the next day, November 28, 1991

(Thanksgiving Day).   On Thanksgiving Day, extensive discussions

took place between Bolton and Alexander.   By the end of the day,

Alexander and Bolton reached an agreement in principle for a

basis of settlement of the lawsuit (the agreement in principle),

and Alexander reported to his clients that the matter had been

resolved.   On Saturday, November 30, 1991, Alexander faxed a

draft settlement agreement to Bolton.

     On December 2, 1991, Alexander met with L. Daniel Morris

(Morris), Blount's vice president of legal services, and
                                 - 8 -

communicated with Bolton in an effort to finalize a written

settlement agreement.   Morris and Alexander considered the

adversarial nature of the relationship between petitioner and the

defendants reduced prior to the execution of this document since

an agreement in principle had already been attained.

     At this time, petitioner expressed concerns about the tax

implications that any settlement of the case would have on him.

Alan Rothfeder, another of petitioner's attorneys, advised

petitioner with regard to the allocation of the settlement

proceeds, and petitioner and his attorneys discussed the

settlement allocation issues with defendants.   Blount's sole tax

concern regarding the settlement of the case was that nothing be

done to compromise Blount's ability to deduct any settlement

payment.   In that regard, Morris, Alexander, and Reak received

assurances from Blount's comptroller that the proposed settlement

would be deductible by Blount.    Alexander, Bolton, and Morris all

actively participated in negotiating the final wording of a

formal settlement agreement letter.

     Petitioner accepted Blount's settlement offer on December 2,

1991 (the settlement agreement).    The settlement agreement states

in pertinent part as follows:

     Dear Lance,

          This letter will document the agreement which we
     have reached, through our attorneys, on November 28,
     1991. [Emphasis added.] We agree as follows:
                                 - 9 -

               1. * * * In exchange for the dismissal of *
     * * [the] lawsuit, * * * Blount will pay to LeFleur the
     sum of One Million Dollars ($1,000,000) * * *. This
     $1,000,000 sum will be payable within five days after
     the dismissal of that lawsuit. Blount agrees to pay
     LeFleur such sum for the following claims asserted by
     the plaintiff:

               A. the sum of $0.00 for the amounts claimed
     by LeFleur under the April 6, 1989 letter;

               B. the sum of $200,000 for the commissions
     due LeFleur under the April 27, 1989, letter plus any
     future payments due LeFleur under said April 27, 1989,
     letter * * *;

               C. the sum of $800,000 for LeFleur's tort
     claims on account of personal injuries and compensatory
     damages, including mental pain and suffering;

                 D.   the sum of $0.00 for punitive damages.

     Petitioners filed their 1991 Form 1040, U.S. Individual

Income Tax Return, on October 14, 1992.    Petitioners excluded

from gross income $800,000 of the $1 million lump-sum settlement

and reported on Form 8275, Disclosure Statement, attached to

their return that this amount was exempt income under section

104(a)(2).    Petitioners included in gross income the $200,000

allocated to the contract claim on Schedule C attached to their

return.   Petitioner's occupation was listed as "Commission

salesman" on Schedule C.    On line 17 of Schedule C, petitioners

deducted $173,542, the entire amount of litigation fees and costs

incurred in bringing and settling the suit against the

defendants.

     On October 12, 1995, respondent issued a statutory notice of

deficiency setting forth alternative positions.    As relevant
                               - 10 -

here, respondent determined in the primary position that $380,000

of the $1 million lump-sum settlement was attributable to salary

and wages.   Respondent thereby increased petitioners' taxable

income by that amount.   Respondent also determined that

petitioners received $620,000 of the $1 million as business gross

receipts, rather than $200,000, as petitioners had reported on

their return.   Petitioners' taxable income was thereby increased

by an additional $420,000.   Consistent with that allocation,

respondent disallowed $65,946 of the $173,542 of legal fees and

costs claimed on Schedule C, and increased petitioners' adjusted

gross income (AGI) by that amount.      Respondent then augmented

petitioners' miscellaneous itemized deductions by $65,946,

subject to the 2-percent AGI limitation of section 67.      Pursuant

to section 68, respondent reduced the amount of itemized

deductions otherwise allowable to petitioners since their AGI was

more than $100,000 for 1991.

     As an alternative position, respondent stated:

     if [it] is ultimately determined that the $620,000.00
     shown as corrected business gross receipts * * * is not
     in fact business gross receipts, then it is determined
     that wages * * * should be increased in the amount of
     $1,000,000.00 in lieu of the $380,000 * * *.
     Accordingly * * * taxable income from salaries and
     wages is increased in the amount of $1,000,000.00 and
     business gross receipts are decreased in the amount of
     $200,000.00 * * *.

In connection with that alternative position, respondent further

stated:
                                - 11 -

      should the allocation between business gross receipts
      and wages [set forth in the primary position] change,
      and/or the allocation between taxable and nontaxable
      settlement proceeds change, then legal fee allocations
      [set forth in the primary position] shall also change.
      Legal fees allocable to nontaxable settlement proceeds
      shall not be allowed and any allocations between wages
      and business gross receipts shall result in
      proportionate allocations between business expenses and
      miscellaneous itemized deductions.

                                OPINION

      We must decide whether the express allocation of proceeds

contained in the settlement agreement controls the tax effect of

such proceeds to petitioners.    We must also decide whether legal

fees and costs incurred by petitioners in connection with the

suit are Schedule C deductible expenses or miscellaneous itemized

deductions to the extent that the fees are allocable to

settlement proceeds that are includable in income.   As a

preliminary matter, we must address petitioners' contention that

respondent failed to comply with section 7522, and that this

alleged failure justifies a shift of the burden of proof to

respondent in this case pursuant to Rule 142(a).

I.   Burden of Proof

      Petitioners contend that the notice of deficiency fails to

satisfy the minimum standards required under section 7522 and,

therefore, the Court should, under Rule 142(a), shift the burden

of proof in this action to respondent.    In support of their

argument, petitioners assert that respondent's reasons for the

proposed changes to petitioners' taxable income are not set forth
                              - 12 -

with sufficient specificity in the notice of deficiency, inasmuch

as "only a general explanation" is offered.   Respondent, on the

other hand, maintains that the notice of deficiency provides an

adequate explanation of adjustments, and thus a shift of the

burden of proof is not warranted.   We agree with respondent.

     The general rule of law is clear that, upon the issuance of

a timely notice of deficiency by respondent, the burden of

proving the determinations in such notice to be erroneous is on

the taxpayer.   Rule 142(a) states that the burden of proof shall

be on the petitioner except as otherwise provided by statute or

"determined by the Court".

     As relevant here, section 7522(a) provides that any "notice

* * * shall describe the basis for, and identify the amounts (if

any) of, the tax due".   Section 7522(b) specifies that these

provisions shall apply to, among others, any notice "described in

section * * * 6212".   See Ludwig v. Commissioner, T.C. Memo.

1994-518.   Section 6212 pertains to notices of deficiency, as

here.   Upon examination, the notice of deficiency issued to

petitioners specifically provides the primary position determined

by respondent, details an alternative position, and calculates a

deficiency of $283,078 for petitioners based upon the primary

position.

     Based on the foregoing discussion, we hold that respondent

has met the requirements of section 7522.   We therefore decline
                               - 13 -

petitioners' invitation to shift the burden of proof in this case

to respondent.

II.   Excludability of Settlement Proceeds Under Section 104(a)(2)

      Except as otherwise provided, gross income includes income

from all sources.   Sec. 61.   In this regard, statutory exclusions

from income must be narrowly construed.     Commissioner v.

Schleier, 515 U.S. 232, 115 S. Ct. 2159, 2163 (1995).

      Under section 104(a)(2), gross income does not include "the

amount of any damages received (whether by suit or agreement and

whether as lump sums or as periodic payments) on account of

personal injuries or sickness".   Section 1.104-1(c), Income Tax

Regs., provides that "The term 'damages received (whether by suit

or agreement)' means an amount received * * * through prosecution

of a legal suit or action based upon tort or tort type rights, or

through a settlement agreement entered into in lieu of such

prosecution."    Thus, an amount may be excluded from gross income

only when it was received both:   (1) Through prosecution or

settlement of an action based upon tort or tort type rights and

(2) on account of personal injuries or sickness.    Sec. 104(a)(2);

O'Gilvie v. United States, 519 U.S. ___, 117 S. Ct. 452, 454

(1996); Commissioner v. Schleier, 515 U.S. at __, 115 S. Ct. at

2164; P & X Mkts., Inc. v. Commissioner, 106 T.C. 441, 443-444

(1996); sec. 1.104-1(c), Income Tax Regs.

      Petitioners contend that $800,000 is excludable from gross

income under section 104(a)(2) because the settlement agreement
                              - 14 -

expressly allocated that amount to the tort claim for personal

injuries.   In support of their position, petitioners cite Glynn

v. Commissioner, 76 T.C. 116, 120 (1981), affd. without published

opinion 676 F.2d 682 (1st Cir. 1982), in which we stated that the

most important fact in determining the purpose of the payment is

"express language [in the agreement] stating that the payment was

made on account of personal injuries."     Petitioners further

maintain that the settlement agreement should be respected by

this Court because it was entered into in good faith between

adverse parties at arm's length.   On the other hand, respondent

contends that no part of the settlement proceeds qualifies for

exclusion as "damages received * * * on account of personal

injuries" under section 104(a)(2).     On that basis, respondent

maintains that the entire amount of the settlement proceeds, or

$1 million, is includable in petitioners' gross income.

Respondent posits that the express allocation of the proceeds in

the settlement agreement should be disregarded since the

agreement was not entered into by the parties in an adversarial

context at arm's length and in good faith.     For the reasons set

forth below, we agree with respondent.

     We have had numerous opportunities to address the issue of

the proper allocation of the proceeds of a settlement agreement

in the context of section 104(a)(2).     See, e.g., Robinson v.

Commissioner, 102 T.C. 116 (1994), affd. in part, revd. in part

and remanded 70 F.3d 34 (5th Cir. 1995); Horton v. Commissioner,
                               - 15 -

100 T.C. 93 (1993), affd. 33 F.3d 625 (6th Cir. 1994); Stocks v.

Commissioner, 98 T.C. 1 (1992); Metzger v. Commissioner, 88 T.C.

834 (1987), affd. without published opinion 845 F.2d 1013 (3d

Cir. 1988); Threlkeld v. Commissioner, 87 T.C. 1294 (1986), affd.

848 F.2d 81 (6th Cir. 1988); Bent v. Commissioner, 87 T.C. 236

(1986), affd. 835 F.2d 67 (3d Cir. 1987); Fono v. Commissioner,

79 T.C. 680 (1982), affd. without published opinion 749 F.2d 37

(9th Cir. 1984); Glynn v. Commissioner, supra; Seay v.

Commissioner, 58 T.C. 32 (1972).

     Where amounts are received pursuant to a settlement

agreement, the nature of the claim that was the actual basis for

settlement, rather than the validity of the claim, controls

whether such amounts are excludable under section 104(a)(2).

United States v. Burke, 504 U.S. 229, 237 (1992); Robinson v.

Commissioner, supra at 126.    Ascertaining the nature of the claim

is a factual determination that is generally made by reference to

the settlement agreement, in light of the facts and circumstances

surrounding it.    Knuckles v. Commissioner, 349 F.2d 610, 613

(10th Cir. 1965), affg. T.C. Memo. 1964-33; Seay v. Commissioner,

supra at 37.   In this regard, we ask "in lieu of what was the

settlement amount paid"?    Bagley v. Commissioner, 105 T.C. 396,

406 (1995).    A key factor in that determination is the intent of

the payor, or the payor's dominant reason, in making the payment.

Robinson v. Commissioner, supra at 127; Britell v. Commissioner,

T.C. Memo. 1995-264; see Agar v. Commissioner, 290 F.2d 283, 284
                               - 16 -

(2d Cir. 1961), affg. T.C. Memo. 1960-21; Metzger v.

Commissioner, supra at 847-848.

       Where the settlement agreement expressly allocates the

settlement proceeds between tortlike personal injury damages and

other damages, the allocation is generally binding for tax

purposes (and the tortlike personal injury damages are excludable

under section 104(a)(2)).    Bagley v. Commissioner, supra at 406;

Robinson v. Commissioner, supra at 127; Threlkeld v.

Commissioner, supra at 1306-1307; Fono v. Commissioner, supra at

694.    However, an express allocation set forth in the settlement

is not necessarily determinative of the nature of the claim if

the agreement is not entered into by the parties in an

adversarial context at arm's length and in good faith, or if

other factors indicate that the payment was intended by the

parties to be for a different purpose.    Bagley v. Commissioner,

supra at 406; Threlkeld v. Commissioner, supra at 1306-1307.

Where the express allocation is not to be respected, other

factors, which include the payor's intent and the background of

the litigation, rise to the fore in determining the nature of the

claim.    See Knuckles v. Commissioner, supra at 613; Eisler v.

Commissioner, 59 T.C. 634, 640 (1973).

     A. The Settlement Agreement Was Not Entered Into by the
Parties in an Adversarial Context at Arm's Length.

       This Court has considered previously the circumstances under

which we will and will not disregard specific allocations made in
                                - 17 -

a written settlement agreement.    See, e.g., Bagley v.

Commissioner, supra; McKay v. Commissioner, 102 T.C. 465 (1994),

vacated and remanded per curiam without published opinion 84 F.3d

433 (5th Cir. 1996); Robinson v. Commissioner, supra; Fono v.

Commissioner, supra; McShane v. Commissioner, T.C. Memo. 1987-

151.    Petitioners aver that the situation herein is almost

identical to that in McKay v. Commissioner, supra, and is

distinguishable from both Robinson v. Commissioner, supra, and

Bagley v. Commissioner, supra, upon which respondent relies.

       Robinson v. Commissioner, supra, involved an action

initiated by the taxpayers in State court against a Texas bank

for failure to release its lien on the taxpayers' property.

After the jury returned a verdict in the taxpayers' favor for

approximately $60 million, including $6 million for lost profits,

$1.5 million for mental anguish, and $50 million in punitive

damages, the parties settled.    In the final judgment reflecting

the settlement, which was drafted by the parties and signed by

the trial judge, 95 percent of the settlement proceeds were

allocated to mental anguish and 5 percent were allocated to lost

profits.    We held that the allocation in the final judgment did

not control the tax effects of the settlement proceeds to the

recipients because it was "uncontested, nonadversarial, and

entirely tax motivated" and did not accurately "reflect the

realities of * * * [the parties'] settlement."    Id. at 129.
                               - 18 -

     In Bagley v. Commissioner, supra at 410, we concluded that

the express allocation of $1.5 million as damages for personal

injuries provided for in the settlement agreement was not

controlling, and we determined that $500,000 of that sum was to

be allocated as punitive damages.   The payor's primary concern

was to pay as little as possible to dispose of all claims of the

taxpayer.   Moreover, we noted that it was clearly in the interest

of both parties not to allocate an amount to punitive damages,

despite the fact that the record showed that both parties had

considered the strong possibility of petitioner's recovering

punitive damages.   Both parties worked on the terms of the

settlement document, and the taxpayer had consulted a tax

attorney concerning the allocation of the settlement proceeds.

     In contrast with Robinson v. Commissioner, supra, and Bagley

v. Commissioner, supra, in McKay v. Commissioner, supra, we found

that the settlement was made by hostile parties who continued to

be adverse with respect to the allocations to be made therein.

We noted that the "allocation of the settlement proceeds between

the wrongful discharge tort claim and the breach of contract

claim was based on * * * counsels' estimates of probability of *

* * success on the merits, recognition of the jury verdict, and

mutual assessment of the total and relative values of the

claims."    McKay v. Commissioner, supra at 472.

     In McKay v. Commissioner, supra, while the taxpayer wanted

the settlement award to be as high an amount as possible to
                              - 19 -

compensate him for his losses, he also desired that the other

party be punished for its behavior.    However, the settlement

agreement stated affirmatively that no amount was paid to the

taxpayer to satisfy damages under RICO or to satisfy punitive

damages claims.   The taxpayer was never given free reign to

structure the settlement allocation.    See also Fono v.

Commissioner, 79 T.C. at 694 (express allocation made in an

earlier settlement agreement between Quaker Oats Co. (Quaker) and

taxpayers was upheld as one entered into at arm's length and in

good faith.   The taxpayers sought an allocation of a portion of

the agreed payment to personal injury--"damages for emotional

distress"--but Quaker emphatically rejected that request.);

McShane v. Commissioner, supra (express language in settlement

agreement was respected where evidence in the record established

that the inclusion of the language in the settlement agreements

was the result of bona fide arm's-length negotiations and the tax

consequences of the settlement were "never considered in the

negotiations, but instead the settlement amounts were arrived at

solely from a consideration by each party of the risks it would

be subjected to by continuing the appeal.").

     While not identical, we think that the facts of the instant

case are similar to those of Robinson v. Commissioner, 102 T.C.

116 (1994), and Bagley v. Commissioner, 105 T.C. 396 (1995), and

are distinguishable from those of McKay v. Commissioner, supra,

McShane v. Commissioner, supra, and Fono v. Commissioner, 79 T.C.
                               - 20 -

680 (1982).    While the underlying litigation was certainly

adversarial, by the time the settlement agreement was executed on

December 2, the parties were no longer adversaries.    See Robinson

v. Commissioner, supra at 133.    An agreement in principle had

already been reached on Thanksgiving Day, and was expressly

referred to in the settlement agreement.    The record reflects

that Blount was not concerned with the amount of the settlement

proceeds that was allocated to tortlike personal injury damages

vis-a-vis other damages.    As a result, petitioner in effect was

able to unilaterally allocate the proceeds.    The defendant's only

concerns were that all of petitioner's claims be settled and that

nothing be done to compromise the deductibility of the settlement

to Blount.    While not controlling, the deductibility of the

payor's payment is a factor to be considered in determining

whether the parties have adverse interests in regard to their

allocations.    See McKay v. Commissioner, 102 T.C. at 485.

Indeed, we agree with respondent that, to the extent that such an

allocation resulted in a larger net recovery to petitioner and

had no corresponding negative impact on Blount, such allocation

was equally favorable to Blount in that it aided its ability to

resolve the lawsuit for the smallest settlement payment amount

possible.

     Moreover, as in Robinson v. Commissioner, supra at 129, and

Bagley v. Commissioner, supra at 409, but unlike McKay v.

Commissioner, supra at 472, the allocation did not accurately
                             - 21 -

reflect the realities of petitioner's underlying claims.    As

discussed above, neither party had any interest in ensuring that

the allocation language accurately represented the risks of the

various claims.

     The attorneys for both sides felt that petitioner's contract

and fraud claims were the strongest, and his tort claim of

outrageous conduct among the weakest.   Blount especially feared a

runaway jury on punitive damages in the event that the case were

remanded to State court, since Alabama juries were "known" for

their large punitive damages awards.    Despite the foregoing, the

settlement agreement allocated 80 percent of the lump-sum

proceeds to personal injury claims, only 20 percent to the

contract claim arising out of the April 27 letter, and nothing

whatsoever to the fraud claims and punitive damages claims.

Thus, in contrast to McKay v. Commissioner, supra, the settlement

agreement was not based on counsels' estimates of the probability

of success on the merits had the case gone to trial.   See McShane

v. Commissioner, T.C. Memo. 1987-151.    Moreover, we note that,

unlike McShane v. Commissioner, supra, the tax effects of the

allocation were considered by petitioner during the negotiations

on December 2, 1991.

     Contrary to petitioners' request, we shall not blindly

accept the parties' allocation of settlement proceeds where, as

here, the allocation is patently inconsistent with the realities

of the underlying claims as determined by the attorneys for both
                               - 22 -

parties.    See Robinson v. Commissioner, supra at 129; cf. Fono v.

Commissioner, supra at 696 ("We are not convinced that a weighing

of the 'economic realities'--i.e., the merits of petitioners'

claims * * *--is the standard to be applied where a taxpayer

challenges the allocation in his own agreement.") (Emphasis

added.)    To do so would effectively eviscerate the requirements

of section 104(a)(2), and would allow taxpayers to exclude

settlement proceeds from income at will in those instances where

the payor is unconcerned with how the allocation is made.

     B. The Facts and Circumstances in the Instant Case Reveal
That the Settlement Was Not on Account of Personal Injury Claims.

     Having decided to look behind the express allocation made in

the settlement agreement, we turn now to examine other factors,

including the payor's intent and the details surrounding the

litigation, to characterize the nature of the claim.    Robinson v.

Commissioner, supra at 127; Threlkeld v. Commissioner, 87 T.C. at

1306.

     Petitioners' attempt to characterize $800,000 of the $1

million payment as having been made on account of personal

injuries is belied by the record.   See Glynn v. Commissioner, 76

T.C. at 120.   Other than petitioner's self-serving testimony and

the conclusory testimony of his psychotherapist, which we do not

find persuasive, there is no evidence before the Court that the

defendants' actions caused petitioner to suffer emotional

distress.    Petitioner was fired discreetly and suffered no undue
                              - 23 -

amount of attention.   Moreover, petitioner could not point to the

interference of the defendants as the source of his difficulty in

finding a new job.   Finally, petitioner testified that he had

been seeing a psychotherapist for several years prior to his

firing as a result of the deterioration of his marriage and

problems with his children.   Compare Noel v. Commissioner, T.C.

Memo. 1997-113 ("The evidence before the Court is that * * *

[payor's] actions caused petitioner to suffer emotional

distress") with Knuckles v. Commissioner, T.C. Memo. 1964-33

("The doctor did not make a determination that * * * [taxpayer's]

emotional condition was attributable to an act * * * on the part

of * * * [the payor]").

     In light of the facts and circumstances, we conclude that

petitioner suffered no injury to his health that could be

attributed to the actions of the defendants, and we are not

persuaded that such injury was the basis of any payment to him by

Blount.   See Knuckles v. Commissioner, 349 F.2d at 610.    Rather,

while the settlement agreement ostensibly sought to settle all of

petitioner's claims, Blount's dominant reasons for payment were

to avoid a large punitive damages award as well as to avoid

losing on the contract claim arising out of the April 27 letter

at trial.   Settlement proceeds recovered under either of these

claims are not excludable from income under section 104(a)(2).

Accordingly, we sustain respondent's determination in the notice
                               - 24 -

of deficiency with respect to the inclusion of an additional

$800,000 of the lump sum as gross income.

III.   Deductibility of Legal Fees and Costs

       As we have often stated, deductions are a matter of

legislative grace, and petitioners bear the burden of proving

that they are entitled to any deductions claimed.    Rule 142(a);

INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992).

       Both parties agree that petitioner's legal fees and costs

are deductible, if at all, under section 162 as expenses paid or

incurred in the course of petitioner's trade or business.

However, the deductibility of petitioner's legal expenses must

also be tested against section 265.

       Section 265 provides in pertinent part as follows:

       (a) GENERAL RULE.--No deduction shall be allowed for--

            (1) EXPENSES.--Any amount otherwise allowable as a
       deduction which is allocable to one or more classes of
       income * * * wholly exempt from * * * taxes imposed by
       this subtitle * * *

Since we held above that none of the settlement proceeds are

excludable from income under section 104(a)(2), section 265 does

not apply to disallow any portion of the otherwise deductible

expenses.    Our inquiry, however, does not end here.   We must next

consider whether petitioners' deduction must be itemized rather

than taken on Schedule C.

       Section 62, which defines AGI, lists the deductions from

gross income which are allowed for the purpose of computing AGI
                               - 25 -

(above-the-line deductions).    Section 62(a)(1) states the general

rule that trade or business deductions are allowed for such

purpose only "if such trade or business does not consist of the

performance of services by the taxpayer as an employee".

Consequently, for employed individuals, section 162 trade and

business deductions are ordinarily itemized deductions.      Secs.

161 and 162; see Alexander v. Commissioner, T.C. Memo. 1995-51,

affd. 72 F.3d 938 (1st Cir. 1995).      Work-related expenses

incurred by an independent contractor, on the other hand, are

deductible above the line under section 62(a)(1).

     Petitioners contend that the legal fees and costs were

incurred in petitioner's capacity as an independent contractor,

rather than as an employee.    Petitioners state that respondent

"has adduced no evidence to dispute * * * [petitioner's]

independent contractor status."    Therefore, petitioners assert

that the deductions are not itemized deductions but above-the-

line Schedule C deductions.    Respondent, on the other hand, avers

that petitioners have presented no evidence entitling them to

deduct the expenses on Schedule C.      We agree with respondent.

     The Code does not define the term "employee".      Whether the

employer-employee relationship exists is a factual question.

Weber v. Commissioner, 103 T.C. 378, 386 (1994), affd. 60 F.3d

1104 (4th Cir. 1995).   Among the relevant factors in determining

the nature of an employment relationship are the following:      (1)

The degree of control exercised by the principal over the details
                               - 26 -

of the work; (2) which party invests in the facilities used in

the work; (3) the taxpayer's opportunity for profit or loss; (4)

the permanency of the relationship between the parties; (5) the

principal's right of discharge; (6) whether the work performed is

an integral part of the principal's business; (7) what

relationship the parties believe they are creating; and (8) the

provision of benefits typical of those provided to employees.

NLRB v. United Ins. Co. of Am., 390 U.S. 254, 258-259 (1968);

Weber v. Commissioner, supra at 387; Professional & Executive

Leasing, Inc. v. Commissioner, 89 T.C. 225, 232 (1987), affd. 862

F.2d 751 (9th Cir. 1988).   No single factor is determinative;

rather, all the incidents of the relationship must be weighed and

assessed.   NLRB v. United Ins. Co. of Am., supra at 258; Weber v.

Commissioner, supra at 387.

     The documentary evidence and testimony in the record

indicate that, at all times, BERC treated petitioner as an

employee and that petitioner regarded himself as such.

Nevertheless, petitioners maintain that petitioner "did not incur

these expenses in the course of his trade or business as an

employee of BERC because he would not have been entitled to the

commissions associated with the sale * * * as part of his regular

salary".    While this may be true, petitioners do not explain how

this transposes petitioner's employee status into that of an

independent contractor.   The arrangement set forth in the April

27 letter was meant as an addition to petitioner's regular
                               - 27 -

salary, in order to entice petitioner to continue his employment

with BERC pending its sale.

     We find that petitioners have failed to meet their burden of

proving that petitioner was anything other than an employee of

BERC.   Rule 142(a).   Consequently, no amount of petitioner's

recovery is allocable to business gross receipts.      On that basis,

we hold that petitioners must itemize their related deduction for

legal fees and costs on Schedule A rather than deduct their

expenses on Schedule C.

     Section 67(a) imposes a 2-percent floor on the miscellaneous

itemized deductions of individuals for all taxable years

beginning after December 31, 1986.      Miscellaneous itemized

deductions are defined in section 67(b) as those itemized

deductions that are not specifically enumerated in section 67(b).

As section 162 itemized deductions are not included in section

67(b), they are limited by the 2-percent floor.      Sec. 1.67-

1T(a)(1)(i), Temporary Income Tax Regs., 53 Fed. Reg. 9875 (Mar.

28, 1988).    Accordingly, we further hold that petitioners'

deduction for legal fees and costs is circumscribed by the 2-

percent floor under section 67(a).      In addition, since

petitioners' AGI was over $100,000 for the taxable year ended

December 31, 1991, the amount of miscellaneous itemized

deductions that they may claim is subject to the provisions of

section 68.
                             - 28 -

     We have considered all other arguments made by the parties

and found them to be either irrelevant or without merit.

     To reflect the foregoing and issues previously resolved,

                                   Decision will be entered

                              for respondent.
