                          T.C. Memo. 2005-95



                      UNITED STATES TAX COURT



                 NANCY J. VINCENT, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 13470-03.               Filed May 3, 2005.


     John F. Sherwood, Sr., for petitioner.

     Jean Song, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     LARO, Judge:   Respondent determined a $161,940 deficiency in

petitioner’s 1998 income tax.    Following trial of this matter, we

must decide as to 1998:

     1.   Whether $240,000 received by petitioner in settlement

of an employment discrimination lawsuit (lawsuit) is excludable
                                - 2 -

from her income under section 104(a)(2).1    We hold that it is

not; and

     2.    whether respondent properly determined that $198,000

received by petitioner’s attorney was income to petitioner.       We

hold that he did.

                          FINDINGS OF FACT

     Some facts were stipulated.   We incorporate herein by this

reference the parties’ stipulation of facts and the exhibits

submitted therewith.   We find the stipulated facts accordingly.

Petitioner resided in Laughlin, Nevada, when this petition was

filed.

     Petitioner began working for Whittier Trust Co. (Whittier)

as vice president and director of client administration in

October 1991.   After developing symptoms in 1992, petitioner was

diagnosed with active peptic ulcer disease on October 29, 1993.

Petitioner was advised that high stress would exacerbate her

condition, and she therefore requested a 4-day workweek at or

around the end of 1993.   Michael Casey (Casey), the president of

Whittier, changed her work schedule to a 4-day workweek as a

reasonable accommodation of her disability (reasonable

accommodation).   Casey circulated a company-wide memorandum to

this effect on March 7, 1994.


     1
       Unless otherwise noted, section references are to the
applicable versions of the Internal Revenue Code. Rule
references are to the Tax Court Rules of Practice and Procedure.
                                - 3 -

     Subsequently, relations deteriorated between petitioner and

Whittier.    On May 12, 1994, Casey, acting on behalf of Whittier,

sent her a notice of disciplinary action which questioned her

honesty because, it alleged, she had inappropriately accepted

gifts from clients.    On December 20, 1994, she received an

unfavorable performance appraisal repeating in relevant part many

of the allegations set forth in the previous notice of

disciplinary action.    On March 20, 1995, she was placed on

probation for 6 months.    On the following day, March 21, 1995,

she was returned to her previous 5-day work schedule.

     On April 19, 1995, petitioner was instructed by her doctor,

Sylvia Preciado, M.D. (Preciado), to remain off work for 4 weeks

because of increased symptomatic complaints related to her

gastric ulcer.   A second doctor, Ronald P. Olah, M.D., instructed

petitioner on May 26, 1995, that she should not return to work at

that time.   By June 20, 1995, her condition was improving, and

Preciado advised Whittier that she could return to work on

September 10, 1995.    On August 1, 1995, Whittier terminated

petitioner, citing as cause her disability leave.

     Petitioner filed the lawsuit against Whittier, Casey, and

other defendants in the Los Angeles, California, Superior Court,

alleging causes of action under various State and Federal laws,

including one for intentional infliction of emotional distress.

Petitioner voluntarily dismissed with prejudice some of those
                                - 4 -

causes of action (including the one for intentional infliction of

emotional distress), and the court dismissed others pursuant to a

motion by Whittier for summary adjudication.   One cause of action

remained for trial; namely, petitioner’s claim against Whittier

under California’s Fair Employment and Housing Act (FEHA), Cal.

Govt. Code sec. 12900 et seq.   She alleged that, prior to and at

the time of her termination, she had a disability (i.e., ulcers)

within the meaning of FEHA, that Whittier knew of this condition,

and that Whittier wrongfully terminated her.   As a direct and

proximate result of Whittier’s actions, petitioner alleged, she

suffered lost wages and emotional distress.    She did not allege

in the FEHA cause of action that Whittier caused or exacerbated

her ulcer condition, and she voluntarily dismissed with prejudice

any such claims in her other causes of action.

     At trial of her lawsuit against Whittier, petitioner

presented facts to support the allegations in her complaint.     She

presented the testimony of economist Peter Formuzis, Ph.D., who

testified that as a result of Whittier’s actions, petitioner had

lost $161,817 in wages and benefits as of the time of trial, and

that she would lose a net present value of up to $235,912 in

future wages as a result of the discrimination, for a total

economic loss of up to $397,729.   At the conclusion of the trial,

the jury was given a special verdict form with the following nine

questions.
                                - 5 -

       (1) Did plaintiff’s ulcer condition substantially limit a

major life activity in March 1994?

       (2) Did defendant know as of March 1994, that plaintiff was

physically disabled due to an ulcer condition?

       (3) Did plaintiff, in March 1994, request a reasonable

accommodation for physical disability based on an ulcer

condition?

       (4) Did defendant reduce plaintiff’s workweek from 5 days a

week to 4 days a week in March 1994 because of a physical

disability due to an ulcer condition?

       (5) Did plaintiff’s ulcer condition substantially limit a

major life activity in March 1995?

       (6) Did defendant know or should it have known, as of March

1995, that plaintiff was physically disabled due to an ulcer

condition?

       (7) Did defendant remove plaintiff’s reasonable

accommodation, if any, for a physical disability based on an

ulcer condition when it reinstated her to a 5-day workweek in

March 1995?

       (8) What amount of damages, if any, is plaintiff entitled to

recover?

       (9) Did plaintiff prove, by clear and convincing evidence,

that defendant acted in a malicious or oppressive manner toward

her?
                                 - 6 -

     The jury answered the first seven questions in the

affirmative and awarded petitioner $400,000 in damages without

specifying the special and/or general damage(s) to which they

related.    The jury thus found as facts that Whittier was aware of

petitioner’s ulcer condition, knew that she was physically

disabled by this condition, and nonetheless removed her

reasonable accommodation when it reinstated her 5-day workweek in

March 1995.   The jury answered the ninth question in the

negative.   Upon motion by petitioner’s attorney, the court

awarded him $184,350.76 in attorney’s fees and costs pursuant to

Cal. Govt. Code sec. 12965(b).    Petitioner’s total recovery,

inclusive of attorney’s fees and costs, was $584,350.76.

     Both parties to the lawsuit ascribed error to the judgment

and appealed.   The case was settled in or around December 1997,

while the appeal was pending, for a lump sum of $510,000.

Pursuant to this settlement agreement, petitioner received

$30,000 in 1997 for back wages and fringe benefits, $30,000 in

1998 for back wages and fringe benefits, $12,000 in 1997 for

attorney’s fees, $198,000 in 1998 for attorney’s fees, and

$240,000 in 1998 for “personal injuries and emotional distress”

arising from the ulcer.   Petitioner reported the $30,000 she

received in 1998 on her income tax return and paid the taxes
                                   - 7 -

due.2       Petitioner did not report on her 1998 income tax return

the $198,000 received for her attorney’s fees and costs, nor did

she report the $240,000 received under the settlement agreement

“for personal injuries and emotional distress”.

        As part of this settlement, Whittier insisted that the

agreement contain a paragraph disclaiming any liability for its

actions and another paragraph requiring petitioner to indemnify

Whittier in the event her tax treatment of the settlement

proceeds was challenged by the Commissioner.       Petitioner had a

contingent fee agreement with her attorney whereby she agreed to

pay a percentage of any recovery to him as compensation for his

services.       In the event attorney’s fees were awarded by a court,

however, that award would constitute her attorney’s sole right to

recovery pursuant to the agreement.

        On May 20, 2003, respondent issued a notice of deficiency to

petitioner determining that petitioner should have included as

ordinary income for 1998 her $438,000 of damages as it was not

excluded from gross income by section 104(a)(2).

                                  OPINION

        Petitioner bears the burden of proving by the introduction

of probative evidence that the amount set forth in the notice of




        2
       Petitioner’s 1997 taxable year is not before us, and we do
not consider it.
                                - 8 -

deficiency is wrong.   See Rule 142(a); Welch v. Helvering, 290

U.S. 111 (1933).3

I.   Settlement Was Not Made “On Account Of” Physical Injuries

     We must decide whether the $240,000 petitioner received in

1998 was properly excluded from her gross income as damages

received “on account of personal physical injuries or physical

sickness”.   Sec. 104(a)(2).4

     Section 61, which mandates that gross income includes all

income from whatever source derived absent a specific statutory

exclusion, is to be broadly construed.   Commissioner v. Glenshaw


     3
       Sec. 7491(a) was added to the Internal Revenue Code by the
Internal Revenue Service Restructuring and Reform Act of 1998,
Pub. L. 105-206, sec. 3001, 112 Stat. 726, effective for court
proceedings arising from examinations commencing after July 22,
1998. Sec. 7491(a)(1) provides that the burden of proof shifts
to the Commissioner in specified circumstances. Petitioner makes
no argument that sec. 7491(a)(1) applies to this case, and we
conclude that it does not. See, e.g., sec. 7491(a)(2). As
relevant herein, sec. 7491(a)(2) provides that sec. 7491(a)(1)
shall apply with respect to an issue only if “the taxpayer has
complied with the requirements under this title to substantiate
any item” and “the taxpayer has maintained all records required
under this title and has cooperated with reasonable requests by
the Secretary for witnesses, information, documents, meetings,
and interviews”. Petitioner has not produced evidence to
establish that any of these requirements are met.

     4
       We apply sec. 104(a)(2) as amended in 1996 by the Small
Business Job Protection Act of 1996, Pub. L. 104-188, sec.
1605(a), 110 Stat. 1838, effective generally for amounts received
after Aug. 20, 1996. That amendment, in relevant part, added the
modifier “physical” after “personal” and before “injuries”, to
clarify that amounts received on account of personal injuries
must be received for physical injuries and not solely for
emotional distress.
                                - 9 -

Glass Co., 348 U.S. 426, 430 (1955).    Statutory exclusions from

gross income are construed narrowly.    See, e.g., O’Gilvie v.

United States, 519 U.S. 79 (1996); Commissioner v. Schleier, 515

U.S. 323, 328 (1995).

     Under section 104(a)(2), settlement proceeds are excludable

from gross income to the extent:   (1) The underlying cause of

action is based upon tort or tort-type rights, and (2) the

proceeds were received on account of “personal physical injuries”

or “physical sickness”.   See Commissioner v. Schleier, supra at

333-334 (analyzing section 104(a)(2) before its amendment in

1996, which added the restrictive modifier “physical” to limit

the scope of “personal injuries”); Robinson v. Commissioner, 102

T.C. 116 (1994), affd. in part and revd. in part on an issue not

relevant herein 70 F.3d 34 (5th Cir. 1995); Shaltz v.

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

T.C. Memo. 2003-168.    Respondent concedes petitioner has

satisfied the first part of the test and argues only that she has

not satisfied the second.   We therefore decide whether any part

of petitioner’s settlement was received on account of “personal

physical injuries” or “physical sickness”.   Petitioner argues the

$240,000 attributed in the settlement to “personal injuries and

emotional distress” was so received.

     We are not bound by a settlement agreement’s

characterization or division of settlement amounts, particularly
                             - 10 -

where it appears that one party may not have had a strong

motivation to negotiate at arm’s length as to the

characterization and/or division of the settlement amounts.

Hemelt v. United States, 122 F.3d 204, 208 (4th Cir. 1997);

Dotson v. United States, 87 F.3d 682, 687 (5th Cir. 1996);

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

Commissioner, 87 T.C. 1294, 1306-1307 (1986), affd. 848 F.2d 81

(6th Cir. 1988); Fono v. Commissioner, 79 T.C. 680, 694 (1982),

affd. without published opinion 749 F.2d 37 (9th Cir. 1984); see

also Mitchell v. Commissioner, T.C. Memo. 1990-617, affd. without

published opinion 992 F.2d 1219 (9th Cir. 1993).    Our ultimate

inquiry as to the character of a payment rests on the payor’s

intent or dominant reason for making the payment.    Knuckles v.

Commissioner, 349 F.2d 610, 613 (10th Cir. 1965), affg. T.C.

Memo. 1964-33; Agar v. Commissioner, 290 F.2d 283, 284 (2d Cir.

1961), affg. per curiam T.C. Memo. 1960-21; Metzger v.

Commissioner, 88 T.C. 834, 847 (1987), affd. without published

opinion 845 F.2d 1013 (3d Cir. 1988).   For a payment to be

excluded from gross income under section 104(a)(2), the payor

must have intended to recompense the payee for a claim arising

out of “personal physical injuries” or “physical sickness”; we

may rely on the jury’s verdict as the best evidence in

determining a payor’s intent for purposes of section 104(a)(2).

See United States v. Burke, 504 U.S. 229, 234 (1992); Miller v.
                              - 11 -

Commissioner, T.C. Memo. 1993-49.   We do so here, noting the

parties could have entered into a settlement only as to causes of

action which were before the trial court.5

     We find two facts determinative of the issue before us.

First, after review of the special verdict form returned by the

jury in the lawsuit, we do not find that the jury considered any

claim by petitioner for “personal physical injuries” as a basis

for the damage award.   Specifically, the jury was asked whether

Whittier knew in 1994 and 1995 of petitioner’s physical

disability due to her ulcer condition, whether that condition

substantially limited her activity in those years, whether she

requested and received a shortened workweek as a reasonable

accommodation for her injury before March 1995, and whether

Whittier removed that accommodation in March 1995.   Nowhere in

this special verdict was the jury asked whether Whittier’s

actions caused or exacerbated petitioner’s ulcer disease.

     While petitioner’s medical condition was discussed at length

in the lawsuit, including the introduction into evidence of

photographs of her ulcers, this evidence merely established that

she was “disabled” within the meaning of FEHA and therefore

entitled to recover under that statute.   The jury was never asked


     5
       We note that the settlement document itself failed to
state that the damages were being apportioned to “physical”
personal injuries, ab initio depriving the settlement of sec.
104(a)(2) treatment under the 1996 amendment.
                              - 12 -

to, and did not, conclude Whittier’s actions caused or

exacerbated her ulcers and thereby inflicted upon her a physical

injury.   We find that the jury did not conclude Whittier’s

actions caused her any physical injury, and it awarded damages

solely on the basis of Whittier’s discriminatory actions which

caused her lost wages and emotional distress, neither of which

provide a basis for exclusion from gross income.6   Thus, the jury

verdict underlying the settlement does not support any

apportionment of the settlement to “personal physical injury”

damages excludable from gross income under section 104(a)(2).

     Petitioner invites the Court to look solely at the

settlement agreement to determine the characterization of the

$240,000.   We decline to do so.   In Robinson v. Commissioner,

supra, the taxpayers sued a state bank for failing to release a

lien on their property.   After the jury returned a verdict in

their 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.   The final

judgment prepared by the parties allocated 95 percent of the

settlement to mental anguish and 5 percent to lost profits.     We


     6
       Any damages received on account of emotional distress are
excludable under sec. 104(a)(2) only to the extent that
petitioner paid for medical care as to the emotional distress.
See flush language of sec. 104(a). The record shows that
petitioner’s insurance paid her medical bills. Her emotional
distress claims therefore do not give rise to excludable income
under sec. 104(a)(2).
                             - 13 -

held that this allocation did not control the taxability of the

settlement proceeds, noting that the settlement was “uncontested,

nonadversarial, and entirely tax motivated.”     Robinson v.

Commissioner, 102 T.C. at 129.     We find this language equally

applicable to the present case.7

     While the underlying litigation was adversarial, once

Whittier agreed to a settlement amount and negotiated the

inclusion of the indemnification and release of liability

clauses, the negotiation as to the characterization of the

settlement proceeds ceased to be adversarial.    Petitioner wanted

a large portion of the recovery connected to a tortlike personal

injury so that she could avoid taxes under section 104(a)(2).8

Whittier, conversely, had no adversarial interest in the

classification of the settlement proceeds as it was indemnified

from any adverse tax consequences arising from the settlement.




     7
       We also find Robinson v. Commissioner, 102 T.C. 116
(1994), affd. in part and revd. in part on an issue not relevant
herein 70 F.3d 34 (5th Cir. 1995), inapt given the fact that it
was decided under sec. 104(a)(2) as it read before the 1996
amendment. Before amendment, that section arguably included
mental anguish as a personal injury. The section, as amended,
explicitly limits its application to “physical” injuries, thereby
excluding purely emotional distress.
     8
       We note that the total amount of the court judgment was
$584,350.76 (including court-awarded attorney’s fees and costs).
The matter was settled for $510,000. This $74,350.76 reduction
is almost exactly 30 percent of $240,000, approximating
petitioner’s expected tax benefit from the settlement as
structured.
                              - 14 -

Whittier’s only interest in the settlement was resolving the

matter and avoiding any future tax consequences from doing so.

Once these concerns were met, Whittier ceased to be an active

participant in the negotiations and, in effect, gave petitioner a

green light to classify the settlement proceeds in whatever

manner she desired.

     That petitioner did so is evident from the disparity between

her damages as argued at trial and the ultimate settlement.     She

documented actual lost wages of $161,817 and argued that she was

entitled to up to $397,729 for total past and future lost wages

and benefits, as well as emotional distress, on account of

Whittier’s removal of her accommodation.    The jury awarded her

$400,000.   In the settlement, she allocated only $60,000 for past

and future lost wages.   This large reduction in the amount

allocable to her lost wages (over $100,000 less than her

documented loss of past wages and $335,000 less than the total of

her lost past and future wages) was further tax advantaged to her

by splitting the receipt of it between 2 years.    Such tax

planning, from which Whittier was insulated by the

indemnification clause, is not the product of arm’s-length

negotiations between adversarial parties.    See, e.g., Robinson v.

Commissioner, supra at 127.

     We are not persuaded by such agreements and look beyond the

stated form of the settlement to its economic realities.      Id.
                                - 15 -

Here, the non-arm’s-length pretense reflected in the settlement

agreement does not reflect the reality of the underlying lawsuit,

which was submitted to the jury as a discrimination action rather

than as one arising from “personal physical injuries” to

petitioner.   We hold that none of the proceeds received under the

settlement agreement fall within the reach of section 104(a)(2).9

II.   Portion of Settlement Proceeds Paid to Petitioner’s Attorney

      We decide whether sums paid to petitioner’s attorney in lieu

of a contingent fee and pursuant to a court award authorized by

statute are includable within her gross income under section 61.

This case was submitted and briefed before the United States

Supreme Court’s decision in Commissioner v. Banks, 543 U.S. ___,

125 S. Ct. 826 (2005).   In Banks, the Court held that, as a

general rule, when a litigant’s recovery constitutes income, the

litigant’s income includes any portion of the recovery paid to an

attorney as a contingent fee.    In so doing, the Court explicitly

declined to reach the issue of whether sums awarded to an

attorney under a fee shifting statute are includable in the

client’s gross income.




      9
       Even were we persuaded, which we are not, by petitioner’s
argument that some of her $240,000 was attributable to emotional
distress, she would still not prevail. As we pointed out supra
note 6, petitioner’s situation does not fall within the flush
language of sec. 104(a)(2) that would allow her to exclude from
her gross income any damages received for emotional distress.
                              - 16 -

     Petitioner’s contingent fee agreement with her attorney

stated that the attorney would be entitled to a defined

percentage of any recovery, unless, as occurred, the attorney

received his fees and costs pursuant to a fee shifting statute.

We are thus presented with the issue which the Court in Banks did

not reach.10

     We are not without guidance, however.    The Court of Appeals

for the Ninth Circuit, the court to which an appeal of this

matter most likely lies, has held that a defendant’s payment of a

plaintiff/taxpayer’s attorney’s fees and costs pursuant to a fee

shifting statute constitutes income to the taxpayer.    Sinyard v.

Commissioner, 268 F.3d 756 (9th Cir. 2001), affg. T.C. Memo.

1998-364.   In Sinyard, the taxpayers signed with their attorney a

contingent fee agreement similar to the one here.   The settlement

agreement apportioned some of the settlement so as to pay in full

the attorney’s fees and costs pursuant to the fee shifting

provisions of 29 U.S.C. secs. 216(b) and 626(b).    The court held

that the apportioned funds were attributable to the taxpayers,

who, in the court’s words, “bound themselves to pay * * * [their

attorneys] one-third of what they received.   When * * * [the

defendant] satisfied this obligation, the Sinyards were so much



     10
       If the attorney’s fees were received under the contingent
fee agreement as opposed to the statute, Commissioner v. Banks,
543 U.S. ___, 125 S. Ct. 826 (2005), would control and the result
would be the same.
                                - 17 -

the richer.    That they never laid hands on the money paid to the

lawyers does not obliterate their constructive receipt.”         Id. at

759.    We agree and hold likewise.11

       We therefore sustain respondent’s determination that the

$198,000 paid to petitioner’s attorney in 1998 should have been

reported by her as income in 1998.12

               ______________________________________

       We have considered all of the parties’ arguments and

rejected those not discussed herein as meritless.         Accordingly,



                                             Decision will be entered

                                        under Rule 155.




       11
       Petitioner’s reliance on Flannery v. Prentice, 26 Cal.
4th 572 (2001), is misplaced. We are not bound by State law
classifications as to the ownership of income. Burnet v. Harmel,
287 U.S. 103 (1932). Any contingent attorney’s fees paid by
petitioner on account of her (taxable) civil settlement would
properly be income under Commissioner v. Banks, supra, and she
may not escape this outcome by arguing that, because her
attorney’s fees and costs were awarded by a civil court pursuant
to a statutory fee shifting provision, the income is properly
attributable to her attorney. See Sinyard v. Commissioner, 268
F.3d 756, 760 (9th Cir. 2001), affg. T.C. Memo. 1998-364. We are
not presented with, and do not decide, whether petitioner would
have been taxed on the attorney’s fees paid to her attorney, had
she been represented by a nonprofit legal foundation.
       12
       We note with approval respondent’s concession that any
sums payable to petitioner’s attorney in 1998 are deductible by
her in that year as a miscellaneous itemized deduction, subject
to any applicable limitations.
