                               T.C. Memo. 2016-156



                         UNITED STATES TAX COURT



                  ABRAHAM J. GEORGE, Petitioner v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 2065-15.                           Filed August 22, 2016.



      Jeffrey B. Melcer, for petitioner.

      Marissa J. Savit, for respondent.



                           MEMORANDUM OPINION


      LAUBER, Judge: This case is before the Court on cross-motions for sum-

mary judgment under Rule 121.1 For the 2012 taxable year, the Internal Revenue



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

[*2] Service (IRS or respondent) determined a deficiency in petitioner’s Federal

income tax of $8,518 and an accuracy-related penalty of $1,704 under section

6662(a). Respondent has conceded the penalty. The principal issue remaining for

decision is whether petitioner may exclude from gross income under section

104(a)(2), as damages received “on account of personal physical injuries or phys-

ical sickness,” proceeds of $45,000 that he received under a settlement agreement

with his former employer. We must also decide the proper tax treatment of the

legal fees that petitioner paid to his lawyer. There are no disputes of material fact,

and we largely agree with respondent’s legal analysis. We will accordingly grant

his summary judgment motion and deny petitioner’s.

                                    Background

      The following facts are based on the parties’ pleadings and motion papers,

including the attached exhibits and affidavits. See Rule 121(b). Petitioner resided

in Texas when he petitioned this Court.

      During 2005 and 2006 petitioner was employed as a car salesman at Dana

Motors, Ltd. (Dana), a New York automobile dealership. Petitioner alleges that he

was repeatedly harassed by his coworkers because of his national origin. Alleged-

ly because of this harassment, he left Dana’s employ at the end of 2006. He subse-

quently secured employment with another automobile dealership.
                                        -3-

[*3]   In 2011 petitioner filed a complaint against Dana and two of his former co-

workers in the U. S. District Court for the Eastern District of New York. His com-

plaint sought money damages to “remedy Dana’s discrimination in employment

against * * * [petitioner] based upon national origin,” allegedly in violation of the

Civil Rights Act of 1964, 42 U.S.C. secs. 2000e-1 et seq., and comparable pro-

visions of the New York Human Rights Law. His complaint also sought relief un-

der New York labor laws to remedy Dana’s “failure to pay compensation owed.”

He alleged that he had suffered “psychological and physical harms” and been

“constructively discharged” from Dana by virtue of a hostile work environment

caused by the alleged discrimination. He requested compensatory damages, puni-

tive damages, and liquidated damages.

       In May 2012 the parties entered into a Confidential Settlement and General

Release Agreement (settlement agreement). Petitioner thereby agreed, in ex-

change for a payment of $45,000, to release all claims against the defendants, in-

cluding “claims for back pay, bonuses, commissions, separation allowance, bene-

fits, severance pay, pension, [and] health benefits,” as well as any other claims for

compensation “with respect to the employment relationship and termination there-

of.” The settlement agreement did not mention any physical or emotional injury
                                        -4-

[*4] suffered by petitioner, nor did it state that any portion of the $45,000 was

being paid in consideration of claims for physical or emotional harm.

      Zurich American Insurance Co. (Zurich) issued to petitioner’s attorney a

check for $45,000 pursuant to the settlement agreement. In June 2012 petitioner’s

attorney issued him a check for $30,000, retaining $15,000 as the agreed-upon

legal fees. Zurich issued petitioner for 2012 a Form 1099-MISC, Miscellaneous

Income, reporting the payment of $45,000 as settlement proceeds.

      Petitioner timely filed his tax return for 2012 but reported no income from

the settlement agreement. On October 27, 2014, the IRS timely issued to him a

notice of deficiency determining that the $45,000 payment should have been in-

cluded in gross income. The IRS also determined an accuracy-related penalty.

      Petitioner timely petitioned this Court, contending that the $45,000 payment

was excludable from gross income under section 104(a)(2). Respondent filed a

motion for summary judgment disputing that contention, and petitioner filed a

cross-motion for summary judgment. In his motion, respondent conceded the

accuracy-related penalty and conceded that petitioner is entitled to a deduction for

his legal fees. Assuming that this would be a miscellaneous deduction on

Schedule A, Itemized Deductions, respondent computed a revised deficiency of

$4,346 for 2012. Respondent also agrees that petitioner is entitled to a net operat-
                                         -5-

[*5] ing loss carryback from 2014 to 2012; this will reduce by $681 petitioner’s

2012 balance due in the event we rule for respondent.

                                     Discussion

A.    Summary Judgment Standard

      The purpose of summary judgment is to expedite litigation and avoid costly,

time-consuming, and unnecessary trials. Rule 121(a); Fla. Peach Corp. v. Com-

missioner, 90 T.C. 678, 681 (1988). A motion for summary judgment will be

granted only if it is shown that there is no genuine dispute as to any material fact

and that a decision may be rendered as a matter of law. See Rule 121(b); Elec.

Arts, Inc. v. Commissioner, 118 T.C. 226, 238 (2002). The parties agree on all

questions of basic fact and have expressed that consensus by filing cross-motions

for summary judgment. We conclude that the question presented is appropriate for

summary adjudication.

B.    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

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 consti-
                                        -6-

[*6] tute 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 petitioner relies 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.

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

sioner, 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 ex-
                                        -7-

[*7] plicitly 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.

      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 the underlying claims cannot be deter-

mined from a general release of claims that is broad and inclusive.” Ahmed v.

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

nolly v. Commissioner, T.C. Memo. 2007-98, 93 T.C.M. (CCH) 1138), aff’d, 498

F. App’x 919 (11th Cir. 2012).

      Although petitioner’s complaint included a general allegation of “psycho-

logical and physical harms,” he did not allege with any specificity that he had suf-

fered actual physical injury or physical sickness. His cause of action was based on

the Civil Rights Act of 1964, comparable provisions of the New York Human

Rights Law, and New York labor law. His complaint sought compensation for

“constructive discharge” precipitated by a hostile working environment and dis-
                                        -8-

[*8] crimination based on national origin. Although these conditions likely caused

petitioner emotional distress, “emotional distress shall not be treated as a physical

injury or physical sickness” for purposes of excluding damage awards from gross

income. See sec. 104(a) (penultimate sentence).

      The settlement agreement does not mention physical injury or physical sick-

ness, much less allocate any portion of the $45,000 to settlement of claims there-

for. The only reference in the settlement agreement to petitioner’s claims is the

general release. Petitioner thereby released all “claims for back pay, bonuses,

commissions, separation allowance, benefits, severance pay, pension, [and] health

benefits,” as well as any other claims for compensation “with respect to the em-

ployment relationship and termination thereof.” There is no suggestion in this

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

claims 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.

      Petitioner contends that his constructive discharge from Dana caused him

no economic harm because he earned more income from his new employer in 2007

than he had earned from Dana in 2005 or 2006. Petitioner accordingly concludes

that Dana’s settlement payment must have been made on account of physical in-

jury or sickness, but the conclusion does not follow from the premise. The alleged
                                        -9-

[*9] lack of economic harm has no bearing on “the intent of the payor.” Longoria,

98 T.C.M. (CCH) at 15. Petitioner’s complaint sought lost wages; his economic

circumstances in 2007 shed no light on whether Dana intended to compensate him

for lost wages. And even if petitioner suffered no economic harm, this fact creates

no inference that he was being compensated for physical injuries or physical sick-

ness, as opposed to being compensated for violation of his civil rights, as his com-

plaint alleged.

      Finally, petitioner contends that the Federal tax treatment of the settlement

proceeds should be governed by New York law. In advancing this contention, he

relies on section 6 of the settlement agreement, captioned “Governing Law, Juris-

diction, and Dispute Resolution.” It provides that “[t]he rights and obligations of

the Parties hereunder shall be construed and enforced in accordance with, and

shall be governed by, the laws of the State of New York, without regard to prin-

ciples of conflict of laws.” Section 6 goes on to provide that any dispute regarding

the agreement “shall be resolved by arbitration.” Petitioner asserts that this provi-

sion operates to make New York tort law applicable to characterize his claims. He

further contends that, under New York tort law, settlement proceeds are presumed

to exclude compensation for economic loss and awards for harassment are treated

as personal injuries resulting from physical harm.
                                        - 10 -

[*10] Respondent vigorously disputes petitioner’s characterization of New York

law on these points, but we need not resolve this State law question. The determi-

nation of whether an item of income is taxable for Federal income tax purposes is

governed by Federal law. See, e.g., Commissioner v. Tower, 327 U.S. 280, 288

(1946); Kenfield v. United States, 783 F.2d 966, 969 (10th Cir. 1986); Killoran v.

Commissioner, 709 F.2d 31, 31-32 (9th Cir. 1983), aff’g T.C. Memo. 1981-659,

42 T.C.M. (CCH) 1662, 1663. Although State law determines what rights a per-

son has vis-a-vis a particular item of property, the proper characterization of those

rights for Federal income tax purposes is governed by the Internal Revenue Code.

See United States v. Nat’l Bank of Commerce, 472 U.S. 713, 722-723 (1985).

      The proper characterization of settlement payments under section 104(a)(2)

is determined by the analysis set forth above. That analysis makes clear that the

$45,000 Dana paid petitioner under the Settlement Agreement was not paid “on

account of personal physical injuries or physical sickness.” This amount was thus

includible in petitioner’s gross income for 2012.

C.    Deduction for Attorney’s Fees

      Section 62(a)(20) allows an above-the-line deduction for attorney’s fees and

court costs paid by a taxpayer in connection with any action involving a claim of

unlawful discrimination. Section 62(e) defines “unlawful discrimination” to in-
                                       - 11 -

[*11] clude (among other things) acts that are unlawful under “Section 703, 704,

or 717 of the Civil Rights Act of 1964 (42 U.S.C. 2000e-2, 2000e-3, or 2000e-

16).” These sections refer to unlawful employment discrimination on account of

race, color, religion, sex, or national origin. The amount of the deduction cannot

exceed the amount includible in the taxpayer’s gross income for the taxable year

on account of a judgment or settlement resulting from such claim. Sec. 62(a)(20)

(last sentence).

      Respondent properly concedes that petitioner is entitled to a deduction for

his legal fees, but we think he erred in assuming that this would be a Schedule A

miscellaneous itemized deduction. Petitioner’s complaint alleged discrimination

on account of national origin and referenced the relevant provisions of the 1964

Civil Rights Act. The settlement agreement specifically stated that it applied to

claims for compensation “with respect to the employment relationship and termi-

nation thereof.” We conclude that petitioner paid legal fees to secure a settlement

of his claim for unlawful employment discrimination, and section 62(a)(20) thus

entitles him to an above-the-line deduction of $15,000 for his legal fees.
                                    - 12 -

[*12]   To reflect the foregoing,


                                                  Decision will be entered under

                                             Rule 155.
