                  T.C. Summary Opinion 2001-44



                     UNITED STATES TAX COURT



    BRIAN DAVID NELSON AND SHAUNA LEE NELSON, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



    Docket No. 10322-99S.                      Filed April 2, 2001.


    Brian David Nelson and Shauna Lee Nelson, pro sese.

    Robert V. Boeshaar, for respondent.



     DEAN, Special Trial Judge:     This case was heard pursuant to

the provisions of section 7463 of the Internal Revenue Code in

effect at the time the petition was filed.    Unless otherwise

indicated, subsequent section references are to the Internal

Revenue Code in effect for the year in issue.    The decision to be

entered is not reviewable by any other court, and this opinion

should not be cited as authority.

     Respondent determined a deficiency of $2,520 in petitioners’
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1995 Federal income tax.   The issues for decision are:

(1) Whether proceeds received in settlement of an action under

the Fair Labor Standards Act of 1938, 29 U.S.C. secs. 201, 216(b)

(1994) (FLSA), are excludable from gross income as damages

received on account of personal injury or sickness within the

meaning of section 104(a)(2); and (2) whether petitioners may

exclude from gross income the portion of the settlement proceeds

retained by the attorneys representing the plaintiffs in the FLSA

action.

                            Background

     The stipulation of facts and the accompanying exhibits are

incorporated herein by reference.    Petitioners resided in

Vancouver, Washington, at the time the petition in this case was

filed.

     In 1993, petitioner Brian David Nelson (petitioner), along

with 266 other employees of PayLess Drugstores, Inc. (PayLess),

filed a class action lawsuit under the FLSA in the United States

District Court for the District of Idaho.    The class alleged

that, despite managerial-sounding titles and job descriptions,

they were in fact hourly employees who were required to work

overtime without compensation.    As relief, the class requested to

be paid time-and-a-half for all hours worked in excess of the

statutory limit of 40 hours, liquidated damages in an amount
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equal to the unpaid overtime compensation, attorney’s fees, and

costs.

     In January 1995, the case settled for a payment of five

million dollars, and the plaintiffs submitted a Motion for

Judicial Approval of the Class Settlement.   In their memorandum

in support of the motion, the plaintiffs explained how the cash

settlement was to be distributed among the various plaintiffs.

The memorandum specifies that the distributions were to be

calculated as follows:

     (1) All plaintiffs receive a $1,000 allocation,
     appropriate individuals receive $3,000 deposition
     scheduling allocation and named plaintiffs receive a
     $15,000 representation allocation.

     (2) Each individual’s claim is valued based on the
     fluctuating average workweek calculation.

     (3) The hours claimed are taken from the interviews of
     plaintiffs by plaintiffs’s counsel.

     (4) The hourly rate is determined from PayLess payroll
     records.

     (5) All overtime hours an individual claims between two
     years prior to the consent date and November 1, 1992
     are given 95% of calculated value to discount for a
     potential finding of no liability.

     (6) All overtime hours an individual claims for the
     time period between two and three years of their
     consent date are given 50% of calculated value to
     discount for a finding of no liability.

     (7) All overtime hours claimed for the time period
     between March 8, 1990 and three years prior to an
     individual’s consent date are given 5% of calculated
     value to recognize the limited, although existing,
     possibility that plaintiffs could have recovered for
     this time period.
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     (8) The individual’s claim is then totaled.

     (9) The remaining portion of the settlement, that is,
     the total settlement minus the amount allocated for
     participation and back wages is apportioned in the same
     ratio as that of each individual’s calculated back
     wages to the total of the calculated back wages for the
     class.

     (10) The sum of the participation allocation, the back
     wages allocation and the liquidated damages allocation
     equals each individual’s “Total Recovery.”

     (11) From the individual’s total recovery the
     contractual attorney fee is then subtracted.

     (12) Each individual is then allocated a share of the
     costs of the litigation based on the same ratio as that
     person’s total recovery to the total settlement
     proceeds. That share of the costs is then subtracted.

     (13) This leaves each individual with a Net Cash
     Recovery.

     The settlement allocation was approved by the court on

January 20, 1995.   On January 21, 1995, the plaintiffs entered

into a Settlement Agreement and Release (settlement agreement)

executed by PayLess and the class representatives and approved by

the court.   The release states the following:

     3.   Release of PayLess by the petitioner.

          In exchange for the payment of the amount set
     forth in paragraph 7 below, . . . Plaintiffs . . .
     hereby release and discharge PayLess . . . from all
     actions, claims, or demands for damages, liabilities,
     costs, or expenses, which the Plaintiffs, individually
     or collectively, have against PayLess on account of, or
     in any way arising out of the claims that were asserted
     or that could have been asserted in the Lawsuit by the
     Plaintiffs, which Lawsuit is hereby acknowledged as not
     fully plead [sic], further including, but not limited
     to, claims for personal injuries, intentional
     infliction of emotional distress, negligent infliction
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     of emotional distress, and from all known claims,
     whether based in tort, statute or contract, which are
     based in whole or in part, or arise out of, or in any
     way relate to: (1) the Lawsuit; and (2) anything done
     or allegedly done by PayLess arising out of, or in
     conjunction with or relating to, the employment of any
     and/or all Plaintiffs prior to November 1, 1992 by
     PayLess.

The settlement agreement further provides that “All Settlement

Proceeds are paid to Plaintiffs on account of personal injuries.”

     On March 15, 1995, pursuant to the settlement agreement,

petitioner received a payment of $24,076 ($7,935 in back wages

and $16,141 in liquidated damages), from which attorney’s fees of

$8,314 were deducted leaving petitioner with a net payment of

$15,762.

     Petitioners did not report any amount from the settlement on

their 1995 Federal income tax return.     As reflected in the notice

of deficiency, respondent determined that petitioners must

include the full $24,076 in settlement proceeds in their 1995

gross income and allowed petitioners an $8,314 miscellaneous

itemized deduction for attorney’s fees to collect back wages.

Petitioners argue that all the settlement proceeds are excludable

because they were paid “to Plaintiffs on account of personal

injuries”.

                             Discussion

     Section 61 provides for the inclusion in gross income of all

income from whatever source derived, except as otherwise

provided.    This definition of gross income is broadly construed,
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and any statutory exclusions from income must be narrowly

construed.   See Commissioner v. Schleier, 515 U.S. 323, 327-328

(1995).   Section 104(a)(2) provides an exclusion for “any damages

received (whether by suit or agreement and whether as lump sums

or as periodic payments) on account of personal injuries or

sickness”.

     To be excludable under section 104(a)(2), payments received

in settlement must be (1) received “on account of personal

injuries or sickness” and (2) received for claims “based upon

tort or tort type rights”.   Commissioner v. Schleier, supra at

333; sec. 1.104-1(c), Income Tax Regs.    Both of these

requirements must be satisfied in order for the exclusion to

apply.    See Commissioner v. Schleier, supra.

     The term “personal injuries” has been interpreted as

including nonphysical injuries such as those affecting emotions,

reputation, or character.1   United States v. Burke, 504 U.S. 229,

235 n.6 (1992).   Personal injuries are distinguished from “legal

injuries of an economic character” such as those arising out of

the unlawful deprivation of full wages earned for services

performed or the unlawful deprivation of the opportunity to earn

wages through wrongful termination.     Id. at 239.


     1
        The Small Business Job Protection Act of 1996, Pub. L.
104-188, sec. 1605(a), 110 Stat. 1755, 1838, amended sec.
104(a)(2) to limit the exclusion to “personal physical injuries
or physical sickness”. The amendment does not apply to 1995 and
thus has no bearing on the case herein.
                                - 7 -

     We look to the nature of the claim that was the basis of the

settlement to determine whether the payments petitioner received

are excludable under section 104(a)(2).    See id. at 237; Thompson

v. Commissioner, 89 T.C. 632, 644 (1987), affd. 866 F.2d 709 (4th

Cir. 1989).   The critical question is “in lieu of what was the

settlement amount paid?”    Bagley v. Commissioner, 105 T.C. 396,

406 (1995), affd. 121 F.3d 393 (8th Cir. 1997).   This

determination is factual.   See Stocks v. Commissioner, 98 T.C. 1,

11 (1992).

     When the settlement agreement expressly allocates the

settlement proceeds between tortlike personal injury damages and

other damages, the allocation is generally binding for tax

purposes to the extent that the agreement is entered into by the

parties in an adversarial context at arm’s length and in good

faith.   See Bagley v. Commissioner, supra; Robinson v.

Commissioner, 102 T.C. 116, 127 (1994), affd. in part, revd. in

part, and remanded on other grounds 70 F.3d 34 (5th Cir. 1995);

Threlkeld v. Commissioner, 87 T.C. 1294, 1306-1307 (1986), affd.

848 F.2d 81 (6th Cir. 1988).   Even an express allocation,

however, may be disregarded if the facts and circumstances

surrounding a payment indicate the payment was intended by the

parties to be for a different purpose.    See Bagley v.

Commissioner, supra; Robinson v. Commissioner, supra;
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Threlkeld v. Commissioner, supra at 1307; Burditt v.

Commissioner, T.C. Memo. 1999-117.

     The settlement agreement in the instant case expressly

provides:    “All Settlement Proceeds are paid to Plaintiffs on

account of personal injuries.”    The terms of the settlement

agreement, however, do not reflect the substance of the

settlement.    See Burditt v. Commissioner, supra.

     The 1993 complaint filed in the action underlying this case

was brought under the FLSA to recover unpaid overtime

compensation, liquidated damages, and attorney’s fees.     No claims

of personal injury were made in the complaint.

     The FLSA does not provide for personal injury compensation.

See Jacobs v. Commissioner, T.C. Memo. 2000-59.      The FLSA was

enacted to establish minimum wages and maximum hours for

employees.    See Brooklyn Sav. Bank v. O’Neil, 324 U.S. 697, 707

(1945).   The only relief available under the FLSA for excessive

hours worked is the payment of back wages and liquidated damages.

See 29 U.S.C. sec. 216(b) (1994).    The liquidated damages are

intended to compensate employees for damages too obscure or

difficult to estimate caused by the delay of wage payment.      See

Overnight Motor Transp. Co. v. Missel, 316 U.S. 572, 583-584

(1942).

     Petitioner’s recovery of back wages is not attributable to

personal injury or sickness.     See Schleier v. Commissioner, supra
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at 330 (finding that back wages received in action under ADEA

were not on account of personal injury).   The back wages were

paid to compensate for overtime work, not to compensate

petitioner for personal injury.   Petitioner’s recovery of

liquidated damages likewise is not on account of personal injury

or sickness.   See Jacobs v. Commissioner, supra.

     In their memorandum supporting their request for judicial

approval of the class settlement, the plaintiffs in the

underlying case state that their method of distributing the

settlement award is not meant to classify the money received but

is “merely a mechanical method of apportioning the lump sum

settlement among the class for the personal injuries each has

claimed.”   The memorandum, however, clearly indicates that the

settlement is based on the claims brought under the FLSA and

provides no information regarding any personal injuries.

     Although PayLess undoubtedly negotiated its total liability

to the plaintiffs in the lawsuits, petitioners have failed to

present any evidence that the allocation of the entire proceeds

to personal injuries was the result of adversarial negotiations.

Moreover, the method for apportioning the settlement among the

class is based on each individual’s level of participation in the

lawsuit and on the overtime hours claimed.   This method of

allocation is consistent with an intent to compensate the

plaintiffs for the economic harm they suffered as a result of
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PayLess’ refusal to compensate them for overtime work.

     We are unpersuaded by the language in the settlement

agreement indicating that the lawsuit giving rise to the

settlement was “not fully plead [sic]”.    Petitioners presented no

evidence that petitioner suffered personal injury or sickness as

a result of his employment with PayLess.    Petitioner Shauna Lee

Nelson testified: “I think PayLess realized that they could have

been held liable for * * * many things, including discrimination

and, you know, alienation of affections”.   Petitioners also point

to the broad language in the settlement agreement releasing

PayLess from all claims that could have been pled in the lawsuit.

There must be a direct link, however, between the personal injury

or sickness and the recovery of damages for the section 104(a)(2)

exclusion to apply.   See Commissioner v. Schleier, 515 U.S. 323,

330 (1995).   The language contained in the settlement agreement

is insufficient to establish a link between the settlement

agreement and any personal injuries.

     We thus find that petitioner’s settlement proceeds of back

wages and liquidated damages were not received on account of

personal injury and therefore do not qualify for exclusion under

section 104(a)(2).

     Petitioners must also include in their gross income the

portion of petitioner’s settlement proceeds retained by the

attorneys representing the plaintiffs in the underlying action.
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Although petitioner did not physically receive the portion of the

settlement proceeds used to pay attorney’s fees, he did receive

the benefit of those funds in the form of payment for the

services required to obtain the settlement.

     In Kenseth v. Commissioner, 114 T.C. 399 (2000), we

reconsidered the view of the U.S. Court of Appeals for the Fifth

Circuit regarding contingent fee agreements as expressed in

Cotnam v. Commissioner, 263 F.2d 119 (5th Cir. 1959), affg. in

part and revg. in part 28 T.C. 947 (1957), in light of Estate of

Clarks v. United States, 202 F.3d 854 (6th Cir. 2000), and the

views of other Courts of Appeals.     We concluded that we would

continue to adhere to our holding in O’Brien v. Commissioner, 38

T.C. 707 (1962), affd. per curiam 319 F.2d 532 (3d Cir. 1963),

that contingent fee agreements “come within the ambit of the

assignment of income doctrine and do not serve * * * to exclude

the fee from the assignor’s gross income.”     Kenseth v.

Commissioner, supra at 412.   We also declined to examine the

effect of States’ attorney’s lien statutes to decide the case.

See id.

     Thus, petitioners cannot avoid income tax by an anticipatory

assignment of a portion of petitioner’s settlement proceeds to

his attorneys.   See Coady v. Commissioner, 213 F.3d 1187, 1190

(9th Cir. 2000), affg. T.C. Memo. 1998-291; Kenseth v.

Commissioner, supra.   Furthermore,    petitioners have presented no
                             - 12 -

evidence indicating that the fee arrangement with petitioner’s

attorneys was of a contingent nature.

     Accordingly, petitioners must include in their gross income

their share of the gross proceeds received pursuant to the

settlement agreement with PayLess.    The proceeds allocable to

attorney’s fees are deductible subject to certain statutory

limitations as determined by respondent.

     Reviewed and adopted as the report of the Small Tax Case

Division.

                                           Decision will be entered

                                     for respondent.
