                                 T.C. Memo. 2017-111



                           UNITED STATES TAX COURT



    MICHAEL L. DEVINE, JR. AND THERESA M. DEVINE, Petitioners v.
        COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 16329-15.                            Filed June 13, 2017.



      Edward James Leyden, for petitioners.

      Scott A. Hovey, for respondent.



               MEMORANDUM FINDINGS OF FACT AND OPINION


      LAUBER, Judge: With respect to petitioners’ Federal income tax for 2012,

the Internal Revenue Service (IRS or respondent) determined a deficiency of

$65,401 and an accuracy-related penalty of $13,070 under section 6662(a).1 After


      1
          All statutory references are to the Internal Revenue Code (Code) in effect
                                                                        (continued...)
                                         -2-

[*2] concessions,2 the principal issue for decision is whether petitioners may

exclude from gross income under section 104(a)(2), as damages received “on

account of personal physical injuries or physical sickness,” proceeds that Ms.

Devine received under a settlement agreement with her employer.

      We conclude that the settlement proceeds compensated Ms. Devine for

damages she suffered on account of sexual harassment and gender discrimination

and that no portion of the settlement represented damages on account of personal

injury or physical sickness. We accordingly hold that petitioners may not exclude

any portion of the settlement payment from gross income. We also find that they

are liable for an accuracy-related penalty.




      1
        (...continued)
for the tax year in issue, and all Rule references are to the Tax Court Rules of
Practice and Procedure. We round all monetary amounts to the nearest dollar.
      2
         Petitioners conceded that they had received, but not reported on their 2012
return, taxable interest of $14, taxable wages of $207, and a taxable State income
tax refund of $790. Petitioners also stipulated that they had received, but not re-
ported on their 2012 return, retirement income of $5,192 from USAA Federal
Savings Bank, which was reported to the IRS as a taxable distribution on Form
1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing
Plans, IRAs, Insurance Contracts, etc. Petitioners did not allege--in their petition,
at trial, or in their post-trial brief--that this distribution was nontaxable, and they
are thus deemed to have conceded this issue. See Rules 34(b)(4), 151(e)(4) and
(5); Swain v. Commissioner, 118 T.C. 358, 358 (2002).
                                           -3-

[*3]                             FINDINGS OF FACT

         The parties filed a stipulation of facts with attached exhibits, which is incor-

porated by this reference. Petitioners resided in Florida when they petitioned this

Court.

         From 2008 through February 2010 Theresa M. Devine (petitioner) was

employed as a civilian aircraft technician by the District of Columbia Air National

Guard (National Guard) at Andrews Air Force Base. Beginning in 2008 she

became the target of sexual harassment and gender discrimination by senior

noncommissioned officers (NCOs). This harassment continued through February

2, 2010, when she resigned, and was thus constructively discharged, from her

civilian position with the National Guard. She continued to serve through 2011 in

a military position with her unit.

         In late 2008 petitioner informed her supervisors that she was pregnant. In

alleged contravention of National Guard rules, she was ordered to continue work-

ing in an area where she would be exposed to toxic chemicals. When she devel-

oped a rash allegedly attributable to this exposure, she was denied leave to receive

medical treatment and was ordered to “stock parts” on shelves.

         Several months later petitioner consulted informally with a National Guard

human relations officer. During this meeting she reported that she had experi-
                                         -4-

[*4] enced several incidents of sexual harassment, inappropriate behavior, and

retaliatory action by senior NCOs in her unit. When her supervisors learned that

she had done this they chastised her for “breaking the chain of command and

going outside to report the incident.”

      In March 2010 petitioner sought counseling from National Guard equal em-

ployment opportunity (EEO) officers. During a meeting on April 10, 2010, she

described the misconduct she had experienced, including inappropriate advances

by a senior NCO and retaliation by him when she rebuffed those advances. She

informed the EEO officers that the bases of her complaint were sexual harassment

and gender discrimination. She did not allege during this meeting that she had

suffered any physical injury for which the National Guard might be liable.

      On April 23, 2010, petitioner submitted through military channels two

Forms NGB 333, Discrimination Complaint in the Army and Air National Guard

(military side complaints). In the first petitioner alleged sexual discrimination by

NCO-1. She alleged that NCO-1 had denied her a promotion because she was

pregnant; made romantic advances toward her notwithstanding his knowledge that

she was married; and informed other unit members that he desired to have sexual

relations with her. Petitioner did not allege that she had suffered any physical

injury.
                                         -5-

[*5] In the second military side complaint petitioner alleged sexual harassment

by NCO-2. Petitioner alleged that NCO-2 had stated that he did not want women

working in his unit; referred to her in a derogatory fashion as a “good little mech-

anic”; and insisted that she could not receive a promotion because she was preg-

nant. Petitioner did not allege that she had suffered any physical injury.

      On May 28, 2010, the National Guard made determinations regarding peti-

tioner’s two military side complaints. It concluded that NCO-1 and NCO-2 had

engaged in sexual harassment and gender discrimination. By way of remedy it

reprimanded the two NCOs in question; ordered that supervisors in petitioner’s

unit receive EEO training; and directed that petitioner be considered for a promo-

tion in the normal course. The National Guard made no finding that petitioner had

suffered any physical injury.

      On October 19, 2010, petitioner filed an EEO complaint against the Nation-

al Guard.3 She alleged that she had suffered “sexual harassment and reprisal ac-

tions while * * * [she] was working as a civilian technician * * * as well as on-

going reprisals and sexual harassment in her current [military] position with the

National Guard.” In neither this complaint nor the accompanying statement, in


      3
       She alleged that she had filed this complaint after learning of the “far great-
er remedies” available through the civilian EEO procedure.
                                        -6-

[*6] which she detailed her allegations of sexual harassment, did petitioner allege

that she had suffered any physical injury.

      On October 20, 2010, petitioner filed (with the assistance of counsel) Form

NGB 713-5-R, National Guard Bureau Formal Complaint of Discrimination, al-

leging violations of the Civil Rights Act of 1964, 42 U.S.C. secs. 2000e-1 through

2000e-17 (2006) (civil side complaint). She alleged as the bases for this com-

plaint sexual harassment, nonsexual harassment, and reprisal. She did not allege

that she had suffered any physical injury.

      On April 6, 2011, petitioner amended her civil side complaint by alleging

further reprisal actions by NCO-1 and NCO-2. She also alleged inappropriate be-

havior by NCO-3, reporting that he “came up behind me and violently threw him-

self into me giving me a hug * * *. It was forceful enough that it actually hurt.

We currently do not have a friendly relationship and I find this behavior to be in-

appropriate and disturbing.” She did not allege that this conduct caused her phys-

ical injury. Rather, she cited it as an example of unwanted touching and indicative

of the hostile environment in which she worked.

      On April 18, 2011, petitioner requested a hearing before an administrative

law judge (ALJ) of the Equal Employment Opportunity Commission (EEOC) on

her civil side complaint. A significant volume of discovery requests and motions
                                         -7-

[*7] practice ensued. These litigation documents uniformly described petitioner’s

complaint as grounded on sexual harassment, gender discrimination, and reprisal.

At no point did either party refer to any physical injury petitioner had suffered.

      On January 11, 2012, the EEOC issued a memorandum and order determin-

ing that petitioner had “established a prima facie case of sexual, pregnancy-related

and reprisal-based harassment.” It concluded that petitioner had shown by a pre-

ponderance of the evidence that the National Guard had “discriminated against her

on the bases of sex and reprisal for prior EEO activity * * * from Summer 2008 to

the effective date of her resignation” in February 2010. This memorandum and

order mentions no claim by petitioner of, and makes no finding concerning, any

type of physical injury.

      Further litigation before the EEOC ensued. In March 2012 petitioner made

a submission listing 15 specific types of damage she had allegedly suffered be-

cause of the actions of the National Guard. This list included no assertion of any

physical injury. On June 5, 2012, the ALJ presiding over the EEOC case sched-

uled a hearing on damages for June 13, 2012.

      On June 12, 2012, petitioner’s litigation counsel, Joshua Bowers, made a

settlement offer to the National Guard. This offer stated that petitioner was “will-

ing to resolve her sexual harassment, pregnancy discrimination and reprisal case”
                                        -8-

[*8] in exchange for (among other things) “payment to complainant of a lump sum

of $225,000” plus attorney’s fees. This letter recited petitioner’s understanding

that “she is responsible for the Federal and Maryland taxes due based on receipt of

this amount.”

      The National Guard accepted petitioner’s offer that same day. The parties

executed a formal settlement agreement resolving all issues between them and

filed a motion to dismiss the EEOC complaint. The National Guard wired the

$225,000 settlement payment to attorney Bowers’ escrow account and separately

wired $155,860 in payment of his attorney’s fees. Neither petitioner’s offer nor

the settlement agreement made any reference to any form of physical injury.

      Petitioners timely filed Form 1040, U.S. Individual Income Tax Return, for

2012. Before preparing this return they received from attorney Bowers a Form

1099-MISC, Miscellaneous Income, reporting a payment of $220,252 from the

litigation settlement.4 Petitioners nevertheless did not report any income from the


      4
        The record does not conclusively establish why the Form 1099-MISC re-
ported $220,252 rather than $225,000 as the settlement proceeds petitioner re-
ceived. It appears that petitioner directed attorney Bowers to pay the difference
between these amounts, or $4,748, directly into a retirement account at USAA
Federal Savings Bank; that petitioner withdrew the balance of this retirement ac-
count (including earnings thereon) later in 2012; and that this withdrawal was re-
flected on the Form 1099-R issued to her by the bank, which reported a taxable
retirement plan distribution of $5,192. See supra note 2.
                                        -9-

[*9] settlement on their 2012 return. After a document-matching examination re-

vealed this discrepancy, the IRS issued petitioners a timely notice of deficiency for

2012, determining that the $220,252 payment should have been included in gross

income. The IRS also determined an accuracy-related penalty. Petitioners timely

petitioned this Court, contending that the $220,252 payment was excludable from

gross income under section 104(a)(2).

                                     OPINION

      The IRS’ determinations in a notice of deficiency are generally presumed

correct though the taxpayer can rebut this presumption. Rule 142(a); Welch v.

Helvering, 290 U.S. 111, 115 (1933). The taxpayer bears the burden of proving

her entitlement to deductions allowed by the Code and of substantiating the

amounts of claimed deductions. INDOPCO, Inc. v. Commissioner, 503 U.S. 79,

84 (1992); sec. 1.6001-1(a), Income Tax Regs. In certain circumstances the bur-

den of proof on factual issues may shift to respondent. See sec. 7491(a); Rule

142(a)(1). Petitioners do not contend that this provision applies here, and they

thus bear the burden of proof.

A.    Taxability of Settlement Proceeds

      Section 61(a) defines “gross income” as “all income from whatever source

derived.” This definition has broad scope, and exclusions from gross income must
                                       - 10 -

[*10] be narrowly construed. Commissioner v. Schleier, 515 U.S. 323, 328

(1995); Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 429 (1955);

Helvering v. Clifford, 309 U.S. 331, 334 (1940). Proceeds from litigation

settlements constitute gross income unless the taxpayer proves that the proceeds

fall within a specific statutory exclusion. Schleier, 515 U.S. at 328-337; Save v.

Commissioner, T.C. Memo. 2009-209, 98 T.C.M. (CCH) 218.

      The exclusion from gross income upon which petitioners rely appears in

section 104(a)(2). It provides that gross income does not include “the amount of

any damages (other than punitive damages) received (whether by suit or agree-

ment * * *) on account of personal physical injuries or physical sickness.” Con-

gress intended this exclusion to cover all damages that flow from a physical injury

or physical sickness. See H.R. Conf. Rept. No. 104-737, at 301 (1996), 1996-3

C.B. 741, 1041. For this purpose, “emotional distress shall not be treated as a

physical injury or physical sickness.” Sec. 104(a) (penultimate sentence).

      When damages are received under a settlement agreement, the nature of the

claim that was the actual basis for the settlement determines whether the damages

are excludable under section 104(a)(2). United States v. Burke, 504 U.S. 229, 237

(1992). “The nature of the claim” is typically determined by reference to the terms

of the agreement. See Knuckles v. Commissioner, 349 F.2d 610, 613 (10th Cir.
                                       - 11 -

[*11] 1965), aff’g T.C. Memo. 1964-33, 23 T.C.M. (CCH) 182; Robinson v.

Commissioner, 102 T.C. 116, 126 (1994), aff’d in part, rev’d in part, and

remanded on another issue, 70 F.3d 34 (5th Cir. 1995). If the settlement

agreement does not explicitly state which claims the payment was made to settle,

“the intent of the payor * * * is critical.” Longoria v. Commissioner, T.C. Memo.

2009-162, 98 T.C.M. (CCH) 11, 15; see George v. Commissioner, T.C. Memo.

2016-156, at *7.

      The intent of the payor may be determined by taking into consideration all

of the facts and circumstances, including the amount paid, the circumstances lead-

ing to the settlement, and the allegations in the injured party’s complaint. Green v.

Commissioner, 507 F.3d 857, 868 (5th Cir. 2007), aff’g T.C. Memo. 2005-250, 90

T.C.M. (CCH) 436; Bent v. Commissioner, 87 T.C. 236, 245 (1986), aff’d, 835

F.2d 67 (3d Cir. 1987). “[T]he nature of underlying claims cannot be determined

from a general release that is broad and inclusive.” Ahmed v. Commissioner, T.C.

Memo. 2011-295, 102 T.C.M. (CCH) 607, 608.

      Petitioner’s complaints against the National Guard were expressed in a vari-

ety of formats over 27 months from March 2010 through June 2012. These in-

cluded informal counseling with National Guard EEO officers, formal “military

side” and “civilian side” complaints, a formal proceeding before the EEOC that
                                        - 12 -

[*12] entailed extensive discovery and motions practice, and a settlement offer

that the National Guard accepted. At every stage of these proceedings petitioner

uniformly alleged as the bases for her complaints some combination of sexual

harassment (including hostile working environment), gender- and pregnancy-

based discrimination, and reprisals stimulated by her prior EEO activity and her

rejection of NCO-1’s amorous advances. At no point in these extended

proceedings did petitioner allege a physical injury of any kind or demand compen-

sation for any physical injury.

      The settlement agreement states that it is “in full and final settlement of the

discrimination complaint, EEOC Case No. 531-2011-00321X, and any amend-

ments thereto, as well as any other matters related to Complainant’s employment.”

The nonpecuniary relief petitioner secured was employment-related and responded

directly to her claims of discrimination. The National Guard promised to permit

her to reenlist “at her highest rank previously held”; pledged to re-employ her “as

a military technician (dual status) at her highest pay grade previously held”; and

pledged to ensure that NCO-2 would have no supervisory responsibility over (or

other interaction with) her. The settlement agreement mentions no physical injury

and provides petitioner no relief for any physical injury.
                                        - 13 -

[*13] In exchange for the National Guard’s promises as set forth above, petitioner

made several reciprocal promises. She agreed to withdraw with prejudice the

EEOC complaint that was the subject of the pending litigation as well as any other

“administrative complaints, claims, and investigations.” She promised not to in-

stitute any claim against the National Guard under the Civil Rights Act of 1964,

the Age Discrimination in Employment Act of 1967, the Civil Rights Act of 1866,

or any other Federal statutory or constitutional provision. And she agreed “to re-

lease the government, the Agency, and its employees * * * from any and all liabil-

ity * * * resulting from or relating to * * * the subject matter of this settlement and

* * * [her] employment with the Agency.” There is no suggestion in this release

clause that petitioner had made, or was releasing the defendants from, any claim

for damages on account of physical injury or physical sickness. See Molina v.

Commissioner, T.C. Memo. 2013-226, 106 T.C.M. (CCH) 371, 373-374.

      In urging that the settlement payment qualifies for exclusion from gross in-

come under section 104(a), petitioners note that several of the unfortunate inci-

dents described above had a physical component. These included NCO-3’s “vio-

lent hug” and NCO-1’s refusal to grant petitioner leave to seek medical treatment

for a rash allegedly caused by exposure to toxic chemicals. But in neither case did

petitioner allege any actual physical injury or demand compensation for any phys-
                                       - 14 -

[*14] ical injury. Rather, she cited these events as evidence of pregnancy-based

discrimination, retaliation, and a hostile working environment.

      The settlement agreement executed by the parties in June 2012 states quite

clearly what claims the payment was made to settle--namely, the discrimination

claims that were the subject of the pending EEOC litigation. Looking more broad-

ly at “the intent of the payor,” see Longoria, 98 T.C.M. (CCH) at 15, we find it

clear from petitioner’s complaints and the ensuing litigation documents that the

National Guard intended to settle, and did settle, claims based on sexual harass-

ment, gender discrimination, and retaliation. These documents nowhere refer to

physical injury of any kind. As respondent correctly points out, we have regularly

held that damages for sexual harassment and gender discrimination claims do not

qualify for the section 104(a)(2) exclusion. McGowen v. Commissioner, T.C.

Memo. 2011-186; Sanford v. Commissioner, T.C. Memo. 2008-158.

      We have considerable sympathy for petitioner’s position. She endured great

indignities in her workplace and undoubtedly suffered consequential emotional

distress for a very long period. But Congress has limited the section 104(a)(2)

exclusion from gross income to damages received “on account of personal phys-

ical injuries or physical sickness,” and Congress explicitly provided that “emotion-

al distress shall not be treated as a physical injury or physical sickness.” “Dam-
                                       - 15 -

[*15] ages received on account of emotional stress, even when resultant physical

symptoms occur, are not excludable from income under section 104(a)(2).”

Shelton v. Commissioner, T.C. Memo. 2009-116, 97 T.C.M. (CCH) 1592, 1594

(citing Hawkins v. Commissioner, T.C. Memo. 2005-149). Petitioner has not

carried her burden of proving that any portion of the settlement proceeds was paid

on account of “physical injury” as thus defined. We accordingly have no alterna-

tive but to conclude that the $220,252 payment that attorney Bowers reported on

the Form 1099-MISC was includible in full in petitioners’ gross income for 2012.

B.    Accuracy-Related Penalty

      The Code imposes a 20% penalty on the portion of any underpayment of tax

attributable to “[n]egligence or disregard of rules and regulations” or “[a]ny sub-

stantial understatement of income tax.” Sec. 6662(a) and (b)(1) and (2). Negli-

gence includes “any failure to make a reasonable attempt to comply” with the in-

ternal revenue laws, and the term “disregard” includes any “careless, reckless, or

intentional disregard.” Sec. 6662(c). An understatement of income tax is “sub-

stantial” if it exceeds the greater of $5,000 or 10% of the tax required to be shown

on the return. Sec. 6662(d)(1).

      Respondent determined a penalty of $13,070 attributable to two items of

omitted income: the $220,252 settlement payment reported to petitioners on the
                                       - 16 -

[*16] Form 1099-MISC and the $5,192 distribution reported to petitioners on the

Form 1099-R.5 Under section 7491(c) the Commissioner bears the burden of

production with respect to the liability of any individual for any penalty. See

Higbee v. Commissioner, 116 T.C. 438, 446 (2001). The tax deficiency we have

sustained, $65,401, yields an understatement of income tax that easily exceeds

both $5,000 and 10% of the tax required to be shown on petitioners’ 2012 return.

Respondent has thus carried his burden of showing a “substantial understatement”

of income tax.

      Respondent has also carried his burden of production with respect to negli-

gence. Petitioner’s settlement offer to the National Guard, presented by her attor-

ney, specifically stated that the settlement proceeds would be subject to Federal

and State income tax. Petitioner testified that attorney Bowers explicitly informed

her of this fact. The Form 1099-MISC that attorney Bowers supplied to petition-

ers clearly stated that the $220,252 payment was required to be reported on their

2012 return. In neglecting to report the payment, petitioners disregarded all of this

advice.


      5
       The bulk of the distribution reported on the Form 1099-R appears to repre-
sent the $4,748 balance of the $225,000 settlement to which the parties agreed,
which attorney Bowers paid directly into a retirement account on petitioner’s be-
half. See supra notes 2 and 4.
                                         - 17 -

[*17] A taxpayer may avoid the accuracy-related penalty by showing that she

acted with reasonable cause and in good faith. Sec. 6664(c)(1). Petitioner has the

burden of showing reasonable cause and good faith. See Higbee, 116 T.C. at 446-

447. This determination is made on a case-by-case basis, taking into account all

relevant facts. Sec. 1.6664-4(b)(1), Income Tax Regs. Circumstances that may

indicate reasonable cause and good faith include (among other things) an honest

misunderstanding of fact or law that is reasonable in light of all the circumstances,

including the taxpayer’s experience, knowledge, and education. The most impor-

tant factor is the taxpayer’s efforts to assess her correct tax liability. Ibid. A tax-

payer may demonstrate reasonable cause and good faith by showing reliance on

the advice of a competent tax professional. See Neonatology Assocs., P.A. v.

Commissioner, 115 T.C. 43, 99 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002).

      Petitioner acknowledges that attorney Bowers originally advised her that the

settlement proceeds would be taxable. But in their post-trial brief petitioners

assert that they “thereafter sought the advice of counsel” and were advised that

section 104(a) applied to shield those proceeds from taxation. Petitioner offered

no testimony to this effect at trial. And there is no documentary evidence that

petitioners sought or received, before filing their 2012 Federal income tax return,

advice from a competent tax professional that the settlement proceeds were ex-
                                        - 18 -

[*18] cludible from gross income under section 104(a)(2). We conclude that peti-

tioners were not operating under “an honest misunderstanding of fact or law” in

neglecting to report the settlement payment and did not make a good-faith effort to

assess their correct 2012 tax liability. We accordingly hold that they are liable for

an accuracy-related penalty.

      To reflect the foregoing,


                                                 Decision will be entered for

                                       respondent.
