                       T.C. Memo. 2007-98



                     UNITED STATES TAX COURT



                CHRISTINA CONNOLLY, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 8224-05.                Filed April 24, 2007.


     Christina Connolly, pro se.

     Michelle L. Maniscalco, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     DEAN, Special Trial Judge:     Respondent determined for 2002 a

deficiency in petitioner’s Federal income tax of $16,582, an

addition to tax under section 6651(a)(1) of $3,332, and an

accuracy-related penalty under section 6662(a) of $3,316.

     The issues for decision are:    (1) Whether petitioner

improperly excluded from gross income proceeds from the
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settlement of a charge of discrimination filed with the Equal

Employment Opportunity Commission (EEOC),1 (2) whether petitioner

is liable for the section 6651(a)(1) addition to tax for failure

to file timely a Federal income tax return, and (3) whether

petitioner is liable for the section 6662 accuracy-related

penalty.

     Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the year at issue, and

all Rule references are to the Tax Court Rules of Practice and

Procedure.

     The stipulated facts and exhibits received into evidence are

incorporated herein by reference.   At the time the petition in

this case was filed, petitioner resided in New York, New York.

                         FINDINGS OF FACT

     Petitioner is employed as a real estate sales agent, working

as an independent contractor.   Petitioner was employed by J.L.

Shapiro Associates, Inc. (Associates), for the period 1989-90 and

was rehired in 1998 as the director of client services.   In

December 2001, petitioner filed with the EEOC Newark area office

a “Charge of Discrimination” against Associates.   A “Notice Of

Charge Of Discrimination” dated January 4, 2002, was issued to

Associates.   The alleged bases of employment discrimination were


     1
      Computations based on the Court’s resolution of this issue
will determine whether petitioner is entitled to claim the child
tax credit and the additional child tax credit.
                                - 3 -

sex, age, and retaliation under “Title VII of the Civil Rights

Act of 1964” and under “The Age Discrimination in Employment Act

of 1967”.

     As a result of participating in the mediation program of the

EEOC, completed on February 5, 2002, petitioner and Associates

entered into a Settlement Agreement and General Release and a

Mediation Settlement Agreement (collectively, settlement

agreement).    Under the settlement agreement, petitioner was to

receive a payment of $75,000 in 18 biweekly installments.

According to the settlement agreement, the $75,000 “includes all

vacation pay and monies owed to you by * * * [Associates].”    The

agreement also provided that the settlement paid to petitioner

“represents the sum to compensate Christina Connelly [sic] for

the alleged emotional distress suffered by her” and that the

$75,000 would be reflected on an “IRS Form 1099” as “other

income”.    In return, petitioner agreed to give up all claims,

known and unknown, that were asserted or could have been asserted

against Associates under Federal or State law.

     On October 6, 2003, petitioner filed a Federal income tax

return for 2002 that failed to report as income any of the

payments received from Associates under the settlement agreement.

     On November 25, 2003, petitioner’s primary care physician

referred her to a psychiatrist with a diagnosis of anxiety
                                 - 4 -

disorder and “panic attack”.    Petitioner was still receiving

treatment for anxiety disorder at the time of trial.



                                OPINION

     The Commissioner’s deficiency determinations are presumed

correct, and taxpayers generally have the burden of proving these

determinations are incorrect.    Rule 142(a); Welch v. Helvering,

290 U.S. 111, 115 (1933).   Under certain circumstances, however,

section 7491(a) may shift the burden to the Commissioner with

respect to a factual issue affecting liability for tax.    This

shifting of the burden, however, applies only where the taxpayer

has introduced “credible evidence” regarding facts affecting the

liability that, if no contrary evidence were submitted, would

show by a preponderance of the evidence that the Commissioner’s

determination is erroneous.    Petitioner has not introduced such

evidence.   In any event, the Court decides this case on the

record before it and without regard to the burden of proof.

     Taxpayers are required, under section 61(a), to include in

gross income “all income from whatever source derived” unless any

income has been specifically excepted from inclusion.    See

Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 430 (1955)

(Congress’s intent under section 61(a) was to tax income unless

specifically excluded).   Exclusions from gross income must be
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narrowly construed.   Commissioner v. Schleier, 515 U.S. 323, 328

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

Exclusion of Certain “Damages”

     Section 104(a)(2) allows taxpayers to exclude from income

“the amount of any damages (other than punitive damages) received

(whether by suit or agreement * * *) on account of personal

physical injuries or physical sickness”.    The flush language of

section 104(a) specifies that “emotional distress shall not be

treated as a physical injury or physical sickness.”

     Regulations provide that the term “damages” means amounts

received (aside from workmen’s compensation) through litigation

or settlement of an action that is based on “tort or tort type

rights”.   Sec. 1.104-1(c), Income Tax Regs.

     The Court in Commissioner v. Schleier, supra, held that

damages are excludable from income under section 104(a)(2) if

they meet a two-pronged test.    First, the taxpayer must

demonstrate that the underlying cause of action giving rise to

the recovery is “based upon tort or tort type rights”, and

second, the taxpayer must show that the damages were received “on

account of personal injuries or sickness.”     Id. at 335-337.   Both

requirements must be satisfied for the damages to be excluded

from income.   Id. at 333.

     Section 104(a)(2) was amended in 1996 to include the

requirement that damages be received for personal physical
                                 - 6 -

injuries or physical sickness.    Small Business Job Protection Act

of 1996, Pub. L. 104-188, sec. 1605, 110 Stat. 1838.    However,

this does not otherwise alter the analysis of Schleier.    See

Tamberella v. Commissioner, T.C. Memo. 2004-47, affd. 139 Fed.

Appx. 319 (2d Cir. 2005).

Nature of the Claim

      To determine whether the settlement payment is excludable

under section 104(a)(2) and Schleier, the Court must determine

the nature of the claim that was the basis of the settlement.

United States v. Burke, supra at 237.    The “key question” to be

answered is “‘In lieu of what were the damages awarded?’”.

Robinson v. Commissioner, 102 T.C. 116, 126 (1994) (quoting

Raytheon Prod. Corp. v. Commissioner, 144 F.2d 110, 113 (1st Cir.

1944), affg. 1 T.C. 952 (1943)), affd. in part, revd. in part on

another ground and remanded 70 F.3d 34 (5th Cir. 1995).    This

“determination is factual and is generally made by reference to

the settlement agreement in light of surrounding circumstances.”

Id.   Both parts of the Schleier test are applied in the light of

the nature of the claim underlying the settlement.     United States

v. Burke, supra at 237.

      The Court will assume here, without deciding, that

petitioner’s claims were “based upon tort or tort type rights”.

The next step in the analysis is to examine the second part of

the Schleier test.
                               - 7 -

Personal Physical Injuries or Physical Sickness

     To be excludable under section 104(a)(2) and to satisfy the

second part of the Schleier test, the damages must have been

received “on account of personal physical injuries or physical

sickness.”   This analysis is also guided by the “nature of the

claim underlying” the settlement.      United States v. Burke, supra

at 237.   The Court must therefore decide whether the amounts

Associates paid petitioner were for personal physical injuries or

physical sickness.

     The flush language of section 104(a) makes it clear that

emotional distress shall not be treated as a physical injury or

physical sickness. “[M]ental anguish, humiliation, and

embarrassment are not personal physical injuries or physical

sickness * * * but are most akin to emotional distress.”        Shaltz

v. Commissioner, T.C. Memo. 2003-173.     Anxiety is also part of

emotional distress.   4 Restatement, Torts 2d, sec. 905 (1979).

Physical manifestations of emotional distress such as fatigue,

insomnia, and indigestion do not transform emotional distress

into physical injury or physical sickness.     See Goode v.

Commissioner, T.C. Memo. 2006-48.

     Neither the charging document nor the settlement agreement

references any personal physical injuries.     The settlement

agreement specifically states that the amount paid includes

vacation pay and money owed to petitioner by Associates and
                                 - 8 -

“represents the sum to compensate Christina Connelly [sic] for

the alleged emotional distress suffered by her”.    (Emphasis

supplied.)

     The settlement agreement also released Associates from all

claims known or unknown that were asserted or could have been

asserted against Associates under Federal or State law.    The

nature of underlying claims cannot be determined by a general

release that is broad and inclusive.     Taggi v. United States, 835

F. Supp. 744, 746 (S.D.N.Y. 1993), affd. 35 F.3d 93, 96 (2d Cir.

1994).

     Under the flush language of section 104(a), amounts paid for

medical care attributable to emotional distress, however, may be

treated as damages received on account of personal physical

injuries or physical sickness.    Petitioner has provided evidence

that 21 months after the signing of the settlement agreement, she

was referred to a psychiatrist with a diagnosis of anxiety

disorder and “panic attack”.   However, she has failed to prove

any connection between the discrimination charges and the

disorder.    See Goode v. Commissioner, supra.   Even if the Court

were to assume, which the Court does not, that there is a causal

relationship between the event and the disorder, petitioner has

not shown that any of the amounts paid to her by Associates was

for the cost of her medical care.    See id.
                               - 9 -

     Where a settlement agreement does not address “what portion,

if any, of a settlement payment should be allocated towards

damages excludable under * * * [section 104(a)(2)], the courts

will not make that allocation for the parties.”     Taggi v. United

States, supra at 746.   If the “settlement agreement lacks express

language” regarding what the payment was for, “then the most

important fact in determining how section 104(a)(2) is to be

applied is ‘the intent of the payor’ as to the purpose in making

the payment.”   Metzger v. Commissioner, 88 T.C. 834, 847-848

(1987) (quoting Knuckles v. Commissioner, 349 F.2d 610, 613 (10th

Cir. 1965), affg. T.C. Memo. 1964-33), affd. without published

opinion 845 F.2d 1013 (3d Cir. 1988); see also Whitehead v.

Commissioner, T.C. Memo. 1980-508 (general release found to

indicate that payor “regarded the settlement payment as

compensation for all of the claims which may have been brought by

petitioner rather than as compensation for one particular type of

claim”).

     The ultimate character of the proceeds depends on the

payor’s “dominant reason” for making the payment.    Commissioner

v. Duberstein, 363 U.S. 278, 286 (1960); accord Agar v.

Commissioner, 290 F.2d 283, 284 (2d Cir. 1961), affg. per curiam

T.C. Memo. 1960-21.   Here, the intent of the payor is evidenced

in the settlement agreement.   Associates, by referring to the

amounts as income to be reported on Form 1099, and by making the
                              - 10 -

statement that the agreement included the settlement of all

claims without specific allocation to any particular claim,

demonstrated that its dominant reason for the payment was not as

damages on account of physical injury or physical sickness.

      From the evidence in the record, the Court finds that the

settlement amounts were not paid “on account of personal injuries

or sickness”, see Commissioner v. Schleier, 515 U.S. at 337, and

are not excludable from gross income under section 104(a)(2).

     Respondent’s determination that the settlement payment is

includable in petitioner’s income for 2002 is sustained.

Penalties and Additions to Tax

     Section 7491(c) imposes on the Commissioner the burden of

production in any court proceeding with respect to the liability

of any individual for penalties and additions to tax.    Higbee v.

Commissioner, 116 T.C. 438, 446 (2001); Trowbridge v.

Commissioner, T.C. Memo. 2003-164, affd. 378 F.3d 432 (5th Cir.

2004).   In order to meet the burden of production under section

7491(c), the Commissioner need only make a prima facie case that

imposition of the penalty or the addition to tax is appropriate.

Higbee v. Commissioner, supra.

     Addition to Tax Under Section 6651(a)(1)

     Once the Commissioner meets his burden of production

regarding the addition to tax, the burden of proof remains on the

taxpayer, who must prove that the failure to file was:   (1) Due
                              - 11 -

to reasonable cause and (2) not due to willful neglect.    Sec.

6651(a); United States v. Boyle, 469 U.S. 241, 245 (1985); Higbee

v. Commissioner, supra at 446-447.

     A failure to file a timely Federal income tax return is due

to reasonable cause if the taxpayer exercised ordinary business

care and prudence and nevertheless was unable to file the return

within the prescribed time.   Barkley v. Commissioner, T.C. Memo.

2004-287; sec. 301.6651-1(c)(1), Proced. & Admin. Regs.    Willful

neglect means a conscious, intentional failure or reckless

indifference.   United States v. Boyle, supra at 245.

     The parties agree that petitioner’s 2002 return was due on

April 15, 2003, and was not filed until October 6, 2003.

Therefore, respondent has met his burden of production.

Petitioner introduced no evidence or any legally sufficient

reason for her failure to file a timely return.    The Court finds

that petitioner did not have reasonable cause for her failure to

file timely as required by section 6651(a)(1).    Accordingly,

respondent’s determination of an addition to tax under section

6651(a)(1) is sustained.

     Section 6662(a) Accuracy-Related Penalty

     Respondent determined that petitioner is liable for an

accuracy-related penalty under section 6662(a).    Section 6662(a)

imposes a 20-percent penalty on the portion of an underpayment

attributable to any one of various factors, including negligence
                                 - 12 -

or disregard of rules or regulations and a substantial

understatement of income tax.     See sec. 6662(b)(1) and (2).

“Negligence” includes any failure to make a reasonable attempt to

comply with the provisions of the Internal Revenue Code,

including any failure to keep adequate books and records or to

substantiate items properly.     See sec. 6662(c); sec.

1.6662-3(b)(1), Income Tax Regs.

     A “substantial understatement” includes an understatement of

tax that exceeds the greater of 10 percent of the tax required to

be shown on the return or $5,000.     See sec. 6662(d); sec.

1.6662-4(b), Income Tax Regs.     The Commissioner bears the burden

of production.   Sec. 7491(c).

     Section 6664(c)(1) provides that the penalty under section

6662(a) shall not apply to any portion of an underpayment if it

is shown that there was reasonable cause for the taxpayer’s

position and that the taxpayer acted in good faith with respect

to that portion.   The determination of whether a taxpayer acted

with reasonable cause and in good faith is made on a case-by-case

basis, taking into account all the pertinent facts and

circumstances.   Sec. 1.6664-4(b)(1), Income Tax Regs.    The most

important factor is the extent of the taxpayer’s effort to assess

his proper tax liability for the year.     Id.

     Petitioner had a substantial understatement of tax for 2002

since the understatement amount exceeded the greater of 10
                               - 13 -

percent of the tax required to be shown on the return or $5,000.

The Court concludes that respondent has produced sufficient

evidence to show that the accuracy-related penalty under section

6662 is appropriate.

     The settlement agreement advised petitioner that the

payments were going to be made as “other income” and reported on

a Form 1099.   Petitioner’s income tax return for 2002 was

prepared by a paid preparer, but there is no evidence that

petitioner revealed to him the facts concerning her settlement

payments.    Petitioner has not shown that her failure to report

the payments from Associates as income was an action taken with

reasonable cause and in good faith.     Respondent’s determination

of an accuracy-related penalty under section 6662(a) is

sustained.

     To reflect the foregoing,

                                           Decision will be entered

                                      for respondent.
