                         T.C. Memo. 2004-135



                       UNITED STATES TAX COURT



            WILLIAM L. AND MARSHA G. KIDD, Petitioners v.
             COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 7980-03.                Filed June 10, 2004.



     William L. Kidd and Marsha G. Kidd, pro sese.

     Margaret S. Rigg, for respondent.



               MEMORANDUM FINDINGS OF FACT AND OPINION


     LARO, Judge:    Petitioners petitioned the Court to

redetermine a $43,012 deficiency in their 2000 Federal income tax

and an $8,602 accuracy-related penalty under section 6662(a) and

(d) for substantial understatement of income tax.1   Following


     1
         Unless otherwise noted, section references are to the
                                                     (continued...)
                                -2-

petitioners’ concession, we decide whether section 104(a)(2)

excludes from their 2000 gross income $132,000 that petitioner

William L. Kidd (Kidd) received in settlement of the unspecified

“equitable remedy” awarded to him in his reverse discrimination

lawsuit (lawsuit) against the State of California and two of its

agencies (collectively, defendants).   We hold it does not.

We also decide whether petitioners are liable for an

accuracy-related penalty under section 6662(a) and (d).   We hold

they are not.

                         FINDINGS OF FACT

     Some facts were stipulated.   The stipulated facts and the

exhibits submitted therewith are incorporated herein by this

reference.   We find the stipulated facts accordingly.

Petitioners, husband and wife, resided in California when their

petition was filed.   They filed a joint 2000 Federal income tax

return (2000 return) on August 19, 2001.

     In 1985, Kidd and Edward Swiden (Swiden) commenced the

lawsuit in the California Superior Court for Sacramento County

(superior court) by filing a petition for writ of mandamus and

complaint for declaratory and injunctive relief.    The defendants

were the State of California (California), the California

Personnel Board (board), and the California Department of Fish



     1
      (...continued)
applicable versions of the Internal Revenue Code.
                                 -3-

and Game (department).   The plaintiffs asserted in the lawsuit

that the department’s affirmative action policy known as

supplemental certification was in violation of their rights under

(1) the Equal Protection Clause of the 14th Amendment to the U.S.

Constitution, (2) the merit principle described in Cal. Const.

art. VII, sec. 1, subdiv. b, and (3) Cal. Govt. Code secs. 19704,

19705, and 19057 (West 1993).2   Supplemental certification

allowed certain minority and female applicants to be selected for

positions in California civil service to the exclusion of

individuals who performed better on a competitive examination.

The plaintiffs had each applied for employment positions with the

department, and the department had through supplemental

certification filled those positions with individuals who had

performed worse than plaintiffs on the competitive examinations.

The plaintiffs did not in the lawsuit request an award of

monetary damages.   The plaintiffs prayed that the defendants be

ordered to stop using supplemental certification and that the

individuals who were hired pursuant to supplemental certification

be discharged from employment.


     2
       Cal. Const. art. VII, sec. 1, subdiv. b provides: “In the
civil service permanent appointment and promotion shall be made
under a general system based on merit ascertained by competitive
examination.” Cal. Govt. Code sec. 19057.1 (West 1993) requires
that appointments to California civil service be made from the
top three ranks of eligible applicants as determined by
competitive examination. Cal. Govt. Code secs. 19704 and 19705
(West 1993) prohibit the appointing power from receiving any data
related to an applicant’s race or gender.
                                -4-

     While the lawsuit was pending in superior court, the U.S.

Supreme Court decided in Richmond v. J.A. Croson Co., 488 U.S.

469 (1989), that a State government must have strong evidence of

past discrimination before it can employ racial or gender

classifications.   On the basis of this decision, the board

reexamined the department’s supplemental certification program

and concluded that it was improper.   The board suspended the

department’s use of that program in December 1989.   Shortly

thereafter, the superior court dismissed the lawsuit as moot in

that the department was essentially then in compliance with the

plaintiffs’ request in the lawsuit that it abandon its

supplemental certification program.   The superior court declined

in connection with the dismissal to grant the plaintiffs’ request

to discharge the individuals employed through the supplemental

certification program.

     The plaintiffs appealed the dismissal of the lawsuit to the

California Court of Appeal for the Third District (court of

appeal).   The court of appeal reversed the dismissal and remanded

the case to the superior court with instructions to declare that

the plaintiffs’ rights under the California Constitution and

California Government Code were violated by the use of

supplemental certification, to enjoin the defendants from using

supplemental certification, and to “fashion an equitable remedy

to redress the violation of plaintiffs’ constitutional and
                                 -5-

statutory rights”.   See Kidd v. State, 72 Cal. Rptr. 2d 758, 773

(Cal. App. 1998).    The court of appeals rejected as part of any

equitable remedy that the defendants be ordered to discharge from

employment those individuals who were hired pursuant to the

supplemental certification.   The court of appeal rested its

decision on its interpretation of the California Constitution and

California Government Code and declined to decide the plaintiffs’

claim under the U.S. Constitution.

     Upon remand, counsel for the parties to the lawsuit met on a

few instances in the presiding Judge’s chambers to discuss

settlement of the lawsuit and, more particularly, the specific

equitable remedy to which the plaintiffs were entitled under the

directive of the court of appeal.      During their discussions, the

parties to the lawsuit disputed the form of that remedy in that

neither plaintiff still wanted the civil service position for

which he had applied, and, even if he did, the results of his

prior competitive examination were too old to qualify him for

that position.   The parties’ counsel discussed settling the

equitable remedy award through a monetary payment but this was

problematic in that Swiden had suffered an economic loss from the

defendants’ violation of his rights but Kidd had not; Kidd had

earned more money during the relevant period than he would have

earned had he been employed in the civil service position for

which he had applied.   The defendants made a settlement proposal
                                -6-

that was based simply on Swiden’s lost wages and employment

benefits.   This proposal was rejected by the plaintiffs.

Finally, on September 17, 1999, while in the presiding Judge’s

chambers, counsel for the parties to the lawsuit agreed that the

defendants would pay a total of $350,000 to the plaintiffs in

settlement of the lawsuit, inclusive of attorney’s fees and

litigation costs, and that the plaintiffs and their attorneys

would have to apportion this amount among them.   The record does

not explain the mechanics underlying the calculation of the

$350,000 payment.   Nor did the parties to the lawsuit

specifically allocate any portion of that amount to a particular

claim raised in the lawsuit.

     The law firm of Nageley, Meredith & Miller (Nageley) and the

Pacific Legal Foundation (Pacific) represented the plaintiffs in

the lawsuit.   In 2000, the defendants paid the $350,000 to

Nageley in its capacity as the trustee responsible for

distributing the proper portions of this payment to the

plaintiffs and their counsel.   Nageley paid itself and Pacific a

total of $75,000 of the $350,000 for attorney’s fees and, on the

basis of an agreement between the plaintiffs, paid $132,000 to

Kidd and the rest ($143,000) to Swiden.   Nageley did not withhold

any Federal income taxes on the $132,000 payment that it made to

Kidd.
                                -7-

     Petitioners’ 2000 return was prepared by their certified

public accountant Wendy Boise (Boise).   During the discussions in

chambers mentioned above, Boise had asked Kidd whether any

settlement payment that he received would be reported as income

to him, and plaintiffs’ counsel relayed this question to the

defendants’ counsel and to the presiding Judge.   The latter two

individuals declined to opine on the matter and referred the

plaintiffs to Nageley in its capacity as trustee.   By way of

conversations between the plaintiffs and Nageley, Nageley led

Kidd to believe that any settlement would not be taxed to him and

that he would not be issued a Form 1099-MISC, Miscellaneous

Income, as to any payment that he received pursuant to the

settlement.   Kidd also was advised by other attorneys that they

would not issue a Form 1099-MISC to their clients in a similar

situation.

     In early 2001, contrary to his understanding, Kidd received

a 2000 Form 1099-MISC from Nageley that reported that the

$132,000 was taxable to him as “other income”.    Kidd asked Boise

not to report the $132,000 on petitioners’ 2000 return, and she

did not.   Boise advised Kidd to attach to that return the 2000

Form 1099-MISC issued to him, but he asked her not to do so

because he believed that he would be admitting to its taxability.

Kidd also noted to Boise that the $132,000 would be reported to

respondent on respondent’s copy of the 2000 Form 1099-MISC.
                                  -8-

Neither Boise nor petitioners attached the 2000 Form 1099-MISC to

petitioners’ 2000 return.

                              OPINION

     We decide whether the $132,000 payment is includable in

petitioners’ 2000 gross income.    Petitioners argue it is not.

According to petitioners, Kidd received this payment in

settlement of the unspecified “equitable remedy” that was awarded

to him for injuries which were unrelated to traditional work-

related compensation such as back pay or a lost job opportunity.

Petitioners assert that the claims underlying the lawsuit were

tortlike in nature and that the $132,000 payment compensated Kidd

for a personal physical injury.    As to the latter, petitioners

contend, a personal physical injury under section 104(a)(2) need

not manifest itself like a broken bone would but may be of a

latent type such as an injury to an individual’s dignity or

self-respect.   Respondent determined and argues that the $132,000

payment was includable in petitioners’ 2000 gross income.

According to respondent, petitioners bear the burden of proof as

to this deficiency and have failed to establish that either

(1) the settlement amount was paid on account of personal

physical injuries or (2) a cause of action underlying the lawsuit

was based upon tort or tort type rights.    Respondent asserts,

without reference to any particular, that petitioners have

neither asserted nor established that section 7491(a) applies in
                                -9-

this case to place upon respondent the burden of proof as to the

deficiency.

     We agree with respondent that section 104(a)(2) does not

exclude the $132,000 payment from petitioners’ 2000 gross income.

We do so, however, for reasons different than the burden of proof

grounds upon which respondent relies.    We decide the legal issue

at hand on the basis of the record, without regard to which party

bears the burden of proof.

     Section 61(a) provides that gross income includes all income

from whatever source derived.   Section 61(a) is construed broadly

to reach any accession to wealth.     Exclusions from gross income

are construed narrowly.   Commissioner v. Schleier, 515 U.S. 323,

328 (1995); United States v. Burke, 504 U.S. 229, 233 (1992).

     The parties disagree over the applicability of section

104(a)(2) to this case.   That section as applicable here excludes

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”.    In this context, the

terms “physical injury” and “physical sickness” do not include

emotional distress, except to the extent of damages not in excess

of the amount paid for medical care described in section

213(d)(1)(A) and (B) attributable to emotional distress.    See

sec. 104(a) (flush language).
                               -10-

     The term “damages received”, as used in section 104(a)(2),

denotes 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.”

Sec. 1.104-1(c), Income Tax Regs.     In the absence of bona fide

language in a settlement agreement as to the reason for a

settlement payment, we discern that reason by determining the

intent of the payor in making the payment.     Robinson v.

Commissioner, 102 T.C. 116, 127 (1994), affd. in part and revd.

in part on another issue not relevant herein 70 F.3d 34 (5th Cir.

1995).   We do so on the basis of all the facts and circumstances

of the case, including an analysis of the complaint filed and the

details surrounding the litigation.     Id.

     The $132,000 payment must meet a two-prong test in order for

it to be excluded under section 104(a)(2).    First, the underlying

cause of action giving rise to Kidd’s recovery of the payment

must be based upon tort or tort type rights.    Second, the payment

must be received on account of personal physical injuries or

physical sickness.   Commissioner v. Schleier, supra at 328; see

also sec. 104(a)(2); sec. 1.104-1(c), Income Tax Regs.       Unless

both of these prongs are met, the payment is not excludable from

petitioners’ gross income under section 104(a)(2).    E.g., Prasil

v. Commissioner, T.C. Memo. 2003-100.
                               -11-

     We begin our analysis with the second prong.    The court of

appeals awarded Kidd an unspecified equitable remedy for the

violation of his rights under the California Constitution and

California Government Code, and the defendants paid $132,000 to

Kidd in settlement of this award.     Under the facts herein, we

conclude that the $132,000 was not paid to Kidd for personal

physical injuries or physical sickness within the meaning of

section 104(a)(2).   No exclusion is available under that

provision insofar as the settlement was paid to compensate him

for injuries most akin to emotional distress.     Sec. 104(a)(2) and

flush language; see H. Conf. Rept. 104-737, at 301 n.56 (1996),

1996-3 C.B. 741, 1041 n.56 (emotional distress, including

symptoms such as insomnia, headaches, and stomach disorders, is

not considered a physical injury or physical sickness, except

that an exclusion may be allowed to the amount paid for medical

care attributable to the emotional distress).     See generally

Black’s Law Dictionary 542 (7th ed. 1999) (“emotional distress”

denotes “A highly unpleasant mental reaction (such as anguish,

grief, fright, humiliation, or fury) that results from another

person’s conduct; emotional pain and suffering.”).     In fact, Kidd

asserted in this proceeding that he believes that the $132,000

compensated him for the “abuse and mental distress” that he

suffered as a result of the defendants’ treatment of him as a

second class citizen.   We conclude that none of the $132,000 is
                                 -12-

attributable to personal physical injuries or physical sickness

and hold that none of that payment may be excluded from

petitioners’ gross income under section 104(a)(2).     We note that

petitioners have not asserted that Kidd paid for any medical care

attributable to emotional distress, so as to come within the

exception described in the flush language of section 104(a), and

that the record does not establish that any such payments were in

fact made.

     Respondent also determined that petitioners are liable for

the accuracy-related penalty under section 6662(a) and (d).

Section 6662(a) and (d) imposes an accuracy-related penalty if

any portion of an underpayment is attributable to a substantial

understatement of income tax.    An understatement of income tax is

substantial if it exceeds 10 percent of the tax required to be

shown on the return or $5,000.    Sec. 6662(d)(1).   Respondent

bears the burden of production under section 7491(c) and must

come forward with sufficient evidence indicating that it is

appropriate to impose an accuracy-related penalty.     Higbee v.

Commissioner, 116 T.C. 438, 446-447 (2001).    Once respondent has

met this burden, the taxpayer must come forward with persuasive

evidence that the accuracy-related penalty does not apply.        Id.

The taxpayer may establish, for example, that part or all of the

accuracy-related penalty is inapplicable because it is

attributable to an understatement for which the taxpayer acted
                                -13-

with reasonable cause and in good faith.    Sec. 6664(c)(1).

Whether a taxpayer acted as such is a factual determination, sec.

1.6664-4(b)(1), Income Tax Regs., for which the taxpayer’s effort

to assess the proper tax liability is an important consideration.

     Here, respondent has met his burden of production in that

the understatement on petitioners’ return is “substantial” within

the meaning of section 6662(d)(1).     Petitioners argue that they

acted reasonably and in good faith towards the subject matter of

the deficiency.   We agree.   On the basis of the record before us,

we find that petitioners were cognizant as to the issue of the

taxability of the $132,000 and that they reasonably relied upon

the advice and representations of professionals to conclude that

the payment was not taxable.    United States v. Boyle, 469 U.S.

241, 250 (1985) (reasonable reliance on the advice of a competent

adviser may be a defense to the accuracy-related penalty).

Although respondent notes correctly that petitioners did not heed

Boise’s advice to attach the 2000 Form 1099-MISC to their 2000

return, we know of no requirement (nor has respondent identified

any such requirement) that petitioners have attached that form to

their 2000 return.3   We also decline to find as a fact

respondent’s assertion on brief that petitioners did not heed

Boise’s advice to include the $132,000 in their income.    The



     3
       We note our finding that Nageley did not withhold any
Federal income tax on the $132,000 payment that it made to Kidd.
                                -14-

record does not establish such a finding, and respondent does not

even include this assertion in his brief as a proposed finding of

fact.   On the basis of section 6664(c), we hold for petitioners

as to the accuracy-related penalty.

     All arguments made by the parties have been considered, and

those arguments not discussed herein have been found to be

without merit.   Accordingly,



                                            Decision will be entered

                                       for respondent as to the

                                       deficiency and for petitioners

                                       as to the accuracy-related

                                       penalty.
