                         T.C. Memo. 2005-149



                       UNITED STATES TAX COURT



      THOMAS B. HAWKINS AND LEANNA L. HAWKINS, DECEASED,
    THOMAS B. HAWKINS, SUCCESSOR IN INTEREST, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 18450-02.             Filed June 23, 2005.


     Douglas A. MacDonald, for petitioners.

     Kathryn K. Vetter, for respondent.



                         MEMORANDUM OPINION


     VASQUEZ, Judge:    Respondent determined a deficiency of

$194,7431 in petitioners’ 1998 Federal income tax.   After the

stipulation to be bound,2 the issues for decision are whether

     1
         All amounts are rounded to the nearest dollar.
     2
         Petitioners argued on brief that they could exclude from
                                                    (continued...)
                                  -2-

petitioners may exclude from gross income pursuant to section

104(a)(2)3 a portion of the amount received by petitioner Leanna

Hawkins from Merchants National Bank (Merchants) and whether

respondent is precluded from determining the deficiency because

respondent previously issued a notice of deficiency and a closing

letter to petitioners for 1998.

Background

     The parties submitted this case fully stipulated pursuant to

Rule 122.    The stipulation of facts and the attached exhibits are

incorporated herein by this reference.   Petitioner Thomas Hawkins

resided in Sacramento, California, when petitioners filed their

petition in this case.

     Leanna Hawkins (petitioner) worked for Merchants for

approximately 13 years.   Petitioner resigned from Merchants and

filed suit against Merchants and others in the U.S. District

Court for the Eastern District of California.   Petitioner

     2
      (...continued)
gross income the portion of Leanna Hawkins’s jury award used to
pay her attorney’s contingent fee. Petitioners and respondent
entered into a stipulation to be bound on this issue by the U.S.
Supreme Court’s decision in Commissioner v. Banks, 543 U.S. ___,
125 S. Ct. 826 (2005). The Supreme Court held that generally, to
the extent a litigant’s recovery includes income, that income
includes the portion of recovery that constitutes an attorney’s
contingent fee. Id. Therefore, petitioners must include Leanna
Hawkins’s attorney’s contingent fee in gross income.
     3
        Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the year in issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
                                -3-

alleged, inter alia, that petitioner was discharged due to sex

discrimination under title VII of the Federal Civil Rights Act of

1964 and age discrimination under the California Fair Employment

and Housing Act (FEHA).   The jury returned a special verdict on

October 13, 1995, awarding $703,000 compensatory damages for

“intentional discrimination based upon gender or age, or

negligent infliction of emotional distress” and $703,000 punitive

damages.

     Merchants appealed the District Court judgment to the U.S.

Court of Appeals for the Ninth Circuit.   The Ninth Circuit

affirmed the portion of the judgment for compensatory damages for

constructive discharge under title VII and FEHA.   The court

reversed the punitive damages portion of the judgment.

     Merchants paid petitioner and her attorneys $996,130 for the

judgment, legal fees, and court costs by a check dated March 13,

1998 (Merchants award).   Merchants also paid petitioner and her

attorneys $29,385 of interest per court order (award interest).

The attorneys who represented petitioner in her case against

Merchants advised petitioners that half of the jury award was not

taxable.

     On their 1998 Federal income tax return, petitioners

reported the $1,025,515 received from Merchants.   Petitioner then

subtracted $417,092 for “Attorney Fees not deducted from above”

to arrive at “Net amount received by taxpayers” of $608,423.
                                 -4-

From the net amount, petitioners then subtracted $304,212 as the

“portion deemed non-taxable (50%)”.      The remaining $304,211 is

listed as the “Taxable portion of Merchant’s Bank Settlement”.

     In a notice dated August 2, 2000, respondent proposed a

$304,212 increase to income on petitioners’ 1998 Federal income

tax return.    Petitioners did not agree with the proposed addition

to income.    On April 18, 2001, respondent issued a notice of

deficiency and determined a $700 increase in petitioners’ income

and a $285 deficiency.

     On May 8, 2001, respondent sent a letter to petitioners

advising them that the “proposed notice” was incorrect and

stating “damages for emotional distress may not be treated as

damages on account of a personal physical injury.”      On August 29,

2001, respondent sent petitioners a “closing letter” that stated

respondent was able to “clear up the differences between your

records and your payors’ records.      * * *   You won’t need to file

a petition with the United States Tax Court to reconsider the tax

you owe.”

     Respondent sent petitioners a letter dated October 25, 2001,

that stated their 1998 Federal income tax return was open for

examination and that “The primary purpose of the examination is

to review the lawsuit settlement paid to Leanna Hawkins in 1998.”

Respondent sent petitioners a letter dated January 2, 2002, that

stated “The law requires us to notify taxpayers in writing if we
                                -5-

need to reexamine their books and records after examining them

previously.   Because information that may affect your tax

liability has been developed since we last examined your books

and records, please make them available to us for reexamination.”

The letter was signed by Bill Marx, the acting territory manager

for the Large and Mid-Size Business Division.

     On August 28, 2002, respondent issued a notice of deficiency

that determined a $194,743 deficiency in petitioners’ income tax

for 1998.

Discussion

     Exclusion Pursuant to Section 104(a)(2)

     Respondent determined that none of the Merchants award was

excludable pursuant to section 104(a)(2).   Petitioners challenge

respondent’s determination.

     As a general rule, the Internal Revenue Code imposes a

Federal tax on the taxable income of every individual.   Sec. 1.

Section 61(a) specifies that, “Except as otherwise provided”,

gross income for purposes of calculating such taxable income

means “all income from whatever source derived”.   The Supreme

Court has long reiterated the sweeping scope of section 61.

Commissioner v. Schleier, 515 U.S. 323, 327 (1995); Commissioner

v. Glenshaw Glass Co., 348 U.S. 426, 429-431 (1955).

     Section 104, in contrast, provides an exception with respect

to compensation for injuries or sickness.   Such exclusions from
                                 -6-

gross income are construed narrowly.        Commissioner v. Schleier,

supra at 328; United States v. Burke, 504 U.S. 229, 248 (1992)

(Souter, J., concurring in judgment).       Before its amendment on

August 20, 1996, by the Small Business Job Protection Act of 1996

(SBJPA), Pub. L. 104-188, sec. 1605, 110 Stat. 1838, section 104

read in pertinent part as follows (pre-SBJPA section 104):

       SEC. 104. COMPENSATION FOR INJURIES OR SICKNESS.

            (a) In General.--Except in the case of amounts
       attributable to (and not in excess of) deductions
       allowed under section 213 (relating to medical, etc.,
       expenses) for any prior taxable year, gross income does
       not include--

                   *    *    *    *     *      *    *

                 (2) 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;

       The reference to personal injuries in this former version of

the statute did not include purely economic injuries but did

embrace “nonphysical injuries to the individual, such as those

affecting emotions”.    United States v. Burke, supra at 235 n.6,

239.

       The SBJPA then amended section 104, as relevant here, to

provide (post-SBJPA section 104):

       SEC. 104. COMPENSATION FOR INJURIES OR SICKNESS.

            (a) In General.--Except in the case of amounts
       attributable to (and not in excess of) deductions
       allowed under section 213 (relating to medical, etc.,
       expenses) for any prior taxable year, gross income does
       not include--
                                 -7-

                  *    *    *    *     *    *    *

               (2) 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;

                  *    *    *    *     *    *    *

     * * * For purposes of paragraph (2), emotional distress
     shall not be treated as a physical injury or physical
     sickness. The preceding sentence shall not apply to an
     amount of damages not in excess of the amount paid for
     medical care * * * attributable to emotional distress.

     The legislative history accompanying passage of the SBJPA

clarifies that “the term emotional distress includes symptoms

(e.g., insomnia, headaches, stomach disorders) which may result

from such emotional distress.”   H. Conf. Rept. 104-737, at 301

n.56 (1996), 1996-3 C.B. 741, 1041.    Post-SBJPA section 104 is

generally effective for amounts received after August 20, 1996,

in tax years ending after such date.    SBJPA sec. 1605(d), 110

Stat. 1839.

     Petitioners assert that petitioner suffered physical

sickness and injury in the form of emotional distress and that a

portion of the damages award should be excluded from their gross

income.   The language of section 104(a)(2) and the accompanying

legislative history make clear that damages for emotional

distress and resultant symptoms are not excluded from gross

income by section 104(a)(2).
                                  -8-

       Petitioners request that the Court apply pre-SBJPA section

104.    SBJPA section 1605(d)(1) provides that the amendments made

by SBJPA section 1605 shall apply to amounts received after the

date of the enactment of the SBJPA, i.e., August 20, 1996, in

taxable years ending after such date.    SBJPA section 1605(d)(2)

provided an exception to this rule for amounts received under a

written binding agreement, court decree, or mediation award in

effect on (or issued on or before) September 13, 1995.

Accordingly, post-SBJPA section 104 applies to amounts received

after its effective date unless they come within that exception.

       Here, a court decree was not issued until on or after

October 13, 1995, the date of the jury verdict.    Petitioner’s

situation therefore fails to satisfy the requirements for relief

under SBJPA section 1605(d)(2).    In that event, SBJPA section

1605(d)(1) unambiguously makes the section 104 amendments

applicable to the situation at hand.    Therefore, petitioners may

not exclude any of the damages award from gross income as an

award for physical injury or physical sickness.

       Merchants also paid award interest to petitioners.   This

payment was for interest accrued on the Merchants award not on

account of physical injury or physical sickness.    Accordingly,

petitioners cannot exclude the interest portion of the award from

gross income under section 104(a)(2).    Aames v. Commissioner, 94

T.C. 189, 193 (1990).
                                -9-



     Second Notice of Deficiency

     Petitioners assert that their case was closed and cannot be

reopened because respondent has not satisfied the policy section

of Rev. Proc. 94-68, 1994-2 C.B. 803.   Respondent’s procedural

rules for reopening cases closed after examination are set forth

in Rev. Proc. 94-68, supra.   The Internal Revenue Service’s

policy is not to reopen a closed case to make an adjustment

unfavorable to the taxpayer unless:

     (1) there is evidence of fraud, malfeasance, collusion,
     concealment, or misrepresentation of a material fact;
     (2) the prior closing involved a clearly defined
     substantial error based on an established Service
     position existing at the time of the previous
     examination; or
     (3) other circumstances exist that indicate failure to
     reopen would be a serious administrative omission.

Id. sec. 5.01, 1994-2 C.B. at 804.

     Petitioner alleges that respondent’s decision to reopen the

case does not satisfy any of the above criteria.   Procedural

rules such as Rev. Proc. 94-68, supra, are merely directory, not

mandatory, “and compliance with them is not essential to the

validity of a notice of deficiency.”    Luhring v. Glotzbach, 304

F.2d 560, 563 (4th Cir. 1962); accord Cleveland Trust Co. v.

United States, 421 F.2d 475, 481-482 (6th Cir. 1970); Geurkink v.

United States, 354 F.2d 629, 632 (7th Cir. 1965); Cataldo v.

Commissioner, 60 T.C. 522, 523 (1973), affd. 499 F.2d 550 (2d

Cir. 1970); Flynn v. Commissioner, 40 T.C. 770, 773 (1963);

Miller v. Commissioner, T.C. Memo. 2001-55. Furthermore, the
                                 -10-

evidence does not persuade us that respondent’s action was beyond

the permissible limits of Rev. Proc. 94-68 regardless of whether

he based his decision to reopen petitioner’s 1998 case upon Rev.

Proc. 94-68, sec. 5.01(2) or (3).

     Petitioner asserts that respondent is precluded from

performing a second inspection of petitioner’s records under

section 7605(b).     Section 7605(b) provides:

     SEC. 7605(b).    Restrictions on Examination of Taxpayer.--

     No taxpayer shall be subjected to unnecessary
     examination or investigations, and only one inspection
     of a taxpayer’s books of account shall be made for each
     taxable year unless the taxpayer requests otherwise or
     unless the Secretary, after investigation, notifies the
     taxpayer in writing that an additional inspection is
     necessary.

     The purpose of section 7605(b) is not to limit the number of

examinations, but to shift the discretion for a reexamination of

the taxpayer’s books to higher management personnel from the

field agent; this serves “to emphasize the responsibility of

agents to exercise prudent judgment in wielding the extensive

powers granted to them by the Internal Revenue Code.”    United

States v. Powell, 379 U.S. 48, 56 (1964); Miller v. Commissioner,

supra.    Section 7605(b) was not meant to restrict the scope of

respondent’s legitimate power to protect the revenue.    Section

7605(b) is not to be read so broadly as to defeat the powers

granted to respondent to examine the correctness of a taxpayer’s

return.    See De Masters v. Arend, 313 F.2d 79, 87 (9th Cir.
                               -11-

1963).   Delegation Order No. 57 (Rev. 9) (Oct. 2, 2000) delegates

authority to sign written notification of a second inspection to

various Internal Revenue Service officials, including Large and

Mid-Size Business Division territory managers.

     Here, respondent sent petitioners a letter signed by Bill

Marx, the acting Large and Mid-Size Business Division territory

manager, dated January 2, 2002.   The letter notified petitioners

that respondent intended to reexamine their books and records

because “information that may affect your tax liability has been

developed since we last examined your books and records”.

Respondent has complied with the requirements of section 7605(b)

that the taxpayer be notified in writing that an additional

inspection is necessary.   Therefore, respondent was not precluded

from reexamining petitioners’ records for 1998 and issuing a

second notice of deficiency.

     Section 6212(c)(1) states that respondent “shall have no

right to determine any additional deficiency of income tax for

the same taxable year * * * except in the case of fraud” if

respondent has mailed a notice of deficiency under section

6212(a) “and the taxpayer files a petition with the Tax Court

within the time prescribed”.   Hemmings v. Commissioner, 104 T.C.

221, 226-228 (1995).

     We find that the second notice of deficiency, dated August

28, 2002, for petitioners’ 1998 tax year, is not precluded under
                                 -12-

section 6212(c)(1).   Respondent issued a notice of deficiency on

April 18, 2001, for petitioners’ 1998 tax year.      Petitioners,

however, had not filed a Tax Court petition with respect to the

first notice of deficiency prior to respondent’s issuing the

second statutory notice.   Under these circumstances, section

6212(c)(1) did not preclude respondent from issuing a second

notice of deficiency.

     Petitioners argue that the August 29, 2001, “closing letter”

specifically instructed petitioners not to petition the Court.

We note that the first notice of deficiency is dated April 18,

2001, and lists the final date to petition the Court as July 17,

2001.   The “closing letter” is dated August 29, 2001.     Therefore,

petitioners could not have relied upon the “closing letter” in

deciding not to petition the Court because the “closing letter”

is dated after the last day petitioners could have filed a

petition with the Court.

     In reaching our holding herein, we have considered all

arguments made, and, to the extent not mentioned above, we

conclude that they are irrelevant or without merit.

     To reflect the foregoing,


                                             Decision will be entered

                                        for respondent.
