                         T.C. Memo. 2004-113



                       UNITED STATES TAX COURT



   PAUL S. LINDSEY, JR. AND KRISTEN L. LINDSEY, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 16843-02.            Filed May 11, 2004.



     Jim J. Shoemake, Dwight E. Cole, and Matthew S. McBride, for

petitioners.

     Michael W. Bitner, for respondent.



               MEMORANDUM FINDINGS OF FACT AND OPINION


     COHEN, Judge:    Respondent determined deficiencies in

petitioners’ Federal income taxes, an addition to tax, and a

penalty as follows:
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                            Addition to Tax       Penalty
       Year   Deficiency    Sec. 6651(a)(1)     Sec. 6662(a)

       1996    $725,255        $171,058          $145,051
       1997       4,494           --                –-

       After a concession by petitioners, the issues for decision

are:    (1) Whether any amount of the $2,000,000 that petitioner

received from a settlement in 1996 is excludable from gross

income under section 104(a)(2); (2) whether petitioners are

liable for an addition to tax under section 6651(a)(1); and

(3) whether petitioners are liable for an accuracy-related

penalty under section 6662(a).    The parties agree that the

deficiency for 1997 depends on our resolution of the section

104(a)(2) issue for 1996.

       Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the years in issue.

                           FINDINGS OF FACT

       Some of the facts have been stipulated, and the stipulated

facts are incorporated in our findings by this reference.

       Petitioners resided in Texas during the years in issue;

petitioners resided in Missouri at the time they filed their

petition in this case.

Empire Gas Corp.

       Paul S. Lindsey, Jr. (petitioner), has been involved in the

propane industry since February 1964.     In August 1967, petitioner
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began working for Empire Gas Corp. (EGC), a corporation engaged

in the liquefied petroleum business.

       In June 1994, petitioner and his wife, Kristen L. Lindsey

(Lindsey), acquired a controlling interest in EGC.    On or about

June 30, 1994, petitioner became chief executive officer and

chairman of the board of EGC.

EGC’s Agreement With Northwestern Growth Co.

       In late summer of 1994, petitioner was introduced by Morgan

Stanley, the investment banking house used by EGC, to

representatives from Northwest Public Service Co. (NPSC), a

utility company.    In 1995, EGC entered into an agreement with

Northwestern Growth Co. (NGC), a subsidiary of NPSC, to acquire

Synergy, a propane company.    In furtherance of their agreement,

EGC and NGC formed SYN, Inc. (SYN), which was to acquire Synergy.

Once Synergy was acquired, EGC was to supply the management team

to operate it, and NGC was to supply the necessary financial

resources.    EGC also was to manage any other propane companies

acquired by NGC through SYN.    In exchange for its management

services, EGC was to receive a 30-percent ownership interest in

SYN.    SYN acquired Synergy in August 1995.

       NGC wanted SYN to grow, with the ultimate goal of entering

the public financial market through the sale of interests in a

master limited partnership (MLP).    To that end, petitioner used

his contacts in the propane industry to pursue the acquisition of
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other propane companies for the benefit of SYN.    EGC dealt

primarily with smaller companies and introduced larger multi

state companies to representatives of NGC.    In late 1995 or early

1996, petitioner introduced NGC to representatives of Coast Gas,

a propane retailer.

Dispute Between EGC and NGC

     In late spring or early summer of 1996, representatives of

NGC met with petitioner to discuss the possibility of terminating

NGC and SYN’s relationship with EGC.    Shortly thereafter,

petitioner learned that NGC was going to acquire not only Coast

Gas, but also Empire Energy, a company that was originally part

of EGC.   Petitioner also learned that NGC did not intend for EGC

to manage SYN in the future.    Petitioner believed NGC’s actions

violated the agreement between EGC and NGC with respect to the

management of SYN.

     On September 20, 1996, EGC sought and obtained a temporary

restraining order to halt NGC’s acquisition of Empire Energy.      On

September 22, 1996, petitioner and Valerie Schall (Schall), an

executive vice president of EGC, met with Dick Hylland (Hylland)

and Dan Newell (Newell), representatives of NGC, in an attempt to

resolve all issues and potential claims that arose or might have

arisen from the dispute between EGC and NGC over the operation of

SYN (the dispute).    During that meeting, Schall raised a claim

for compensation due petitioner as a result of the dispute.
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Neither Schall nor petitioner informed Hylland or Newell that

petitioner was suffering from a physical injury or physical

sickness as a result of the dispute.    By the end of the meeting,

those present had negotiated a document titled “Issues to be

Resolved in Final Agreement”, which stated, in part:

     Upon effective closing of the contemplated Coast,
     Empire Energy, and SYN MLP transactions, NGC in
     resolution of all arrangements among NGC, SYN, and
     Empire Gas Corporation [EGC] would provide a cash
     payment of $20.0 million to Empire Gas and/or Paul S.
     Lindsey [petitioner]. In the event that Coast and
     Empire Energy acquisitions close and the MLP has not
     been effected by June 30, 1997 the cash payment in
     resolution of all arrangements shall be $15.0 million.

The Termination Agreement

     On September 28, 1996, the dispute was resolved by the

execution of a termination agreement.   The termination agreement

provided, in part:

          (e) NGC and Paul S. Lindsey, Jr. [petitioner]
     hereby agree that, in exchange for the written general
     release from Mr. Lindsey * * *, $2,000,000 of the
     Payment Amount shall be allocated to Mr. Lindsey, as
     the controlling shareholder of EGC, in settlement of
     his claims for tortious interference with contracts,
     for personal injury including injury to Mr. Lindsey’s
     personal and professional reputation and emotional
     distress, humiliation and embarrassment resulting from
     termination of the Synergy Acquisition documents, and
     Mr. Lindsey shall provide consulting services to NGC as
     the parties may agree * * *

Petitioner or EGC proposed the split between petitioner and EGC

of the $20 million settlement that was initially agreed upon on
                               - 6 -

September 22, 1996.   The termination agreement was signed by

petitioner on behalf of himself and EGC.

     From September 22, 1996, through the time of the execution

of the termination agreement, neither petitioner nor any

representative of petitioner or EGC provided a representative of

NGC or SYN with (1) substantiation of any medical expenses

incurred by petitioner, (2) information as to any treatments or

medications prescribed for petitioner, or (3) an exact dollar

figure that would compensate petitioner for any personal injuries

petitioner claims to have suffered as a direct result of the

dispute.

Receipt of Settlement Proceeds; Federal Tax Return

     On or about December 17, 1996, petitioner received a check

from NGC in the amount of $2 million pursuant to the termination

agreement.   NGC did not issue a Form 1099 to petitioner with

respect to that payment.

     Petitioners requested an automatic 4-month extension to file

their 1996 tax return.   On January 15, 1998, petitioners filed

their 1996 tax return, on which they reported a tax liability of

zero.   Petitioners did not report the $2 million settlement

proceeds.
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                                OPINION

Applicable Statute

     Section 61(a) includes in gross income “all income from

whatever source derived” unless otherwise provided.   Section

104(a)(2) provides otherwise.    Before it was amended by the Small

Business Job Protection Act of 1996 (SBJPA), Pub. L. 104-188,

sec. 1605, 110 Stat. 1838, section 104(a)(2) excluded from gross

income amounts received on account of personal injuries or

sickness.   While the reference to personal injuries or sickness

did not include damages received pursuant to the settlement of

purely economic rights, it did include “nonphysical injuries to

the individual, such as those affecting emotions, reputation, or

character”.   United States v. Burke, 504 U.S. 229, 236 n.6

(1992); see Robinson v. Commissioner, 102 T.C. 116, 126 (1994),

affd. in part and revd. in part on another issue 70 F.3d 34 (5th

Cir. 1995); see also Fono v. Commissioner, 79 T.C. 680, 692

(1982), affd. without published opinion 749 F.2d 37 (9th Cir.

1984).

     On August 20, 1996, the SBJPA amended section 104(a)(2) to

exclude from gross income “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”.   SBJPA sec.

1605(a), 110 Stat. 1838.   The flush language of 104(a) explains
                                - 8 -

that “emotional distress shall not be treated as a physical

injury or physical sickness.”    Only reimbursements for actual

medical care for such injuries are now excludable.    The

legislative history of this amendment 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 n.56.    Section 1605(d) of the SBJPA, 110 Stat.

1839, provides that (with an inapplicable exception) “the

amendments made by this section shall apply to amounts received

after the date of the enactment of this Act, in taxable years

ending after such date.”    The SBJPA was enacted on August 20,

1996.   Id. at 1755.

     Petitioners contend that the “clear language” of section

1605(d) of the SBJPA dictates that the SBJPA amendments to

section 104(a)(2) are not effective until 1997 because 1997 is

“the tax year ending after the effective date of the enactment of

the SBJPA”.    Petitioners argue that, if Congress had intended for

the amendments to become effective in the middle of a year, then

it could have unambiguously stated so.    Petitioners misinterpret

this statutory language.

     Petitioners’ 1996 taxable year ended December 31, 1996,

which is after the date of the enactment of the SBJPA.

Petitioner received the settlement proceeds on December 17, 1996,
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which is also after the date of enactment of the SBJPA but before

the end of the 1996 taxable year.   Thus, applying the plain

language of the statute, petitioner’s receipt of the settlement

proceeds was in a taxable year ending after the effective date of

the amendment.   See, e.g., Filson, The Legislative Drafter’s Desk

Reference (1992), illustration in sec. 26.4, Event-related

effective dates.   Accordingly, we apply section 104(a)(2), as

amended by the SBJPA.

Application

     In interpreting section 104(a)(2), the Supreme Court has

held that amounts are excludable from gross income only when

(1) the underlying cause of action giving rise to the recovery is

based on tort or tort-type rights and (2) the damages were

received on account of personal injuries or sickness.

Commissioner v. Schleier, 515 U.S. 323, 336-337 (1995); sec.

1.104-1(c), Income Tax Regs.   This test has been extended to

apply to the SBJPA amendments to section 104(a)(2).   See Shaltz

v. Commissioner, T.C. Memo. 2003-173; Henderson v. Commissioner,

T.C. Memo. 2003-168.    Accordingly, the second prong of the test

requires proof that the damages were received on account of

personal physical injuries or physical sickness.

     If damages are received pursuant to a settlement agreement,

the nature of the claim that was the actual basis for settlement,

rather than the validity of the claim, determines whether the
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damages were received on account of tortlike personal injuries.

See Robinson v. Commissioner, supra at 126.    The determination of

the nature of the claim is factual and is made by reference to

the settlement agreement in light of the surrounding

circumstances.   Id.   A key question to ask is:   “‘In lieu of what

were the damages awarded?’”    Id. (quoting Raytheon Prod. Corp. v.

Commissioner, 144 F.2d 110, 113 (1st Cir. 1944), affg. 1 T.C. 952

(1943)).   An important factor in determining the validity of the

agreement is the intent of the payor.    Id. at 127.

     Petitioners contend that section 7491, which was added to

the Code by the Internal Revenue Service Restructuring and Reform

Act of 1998, Pub. L. 105-206, sec. 3001, 112 Stat. 726, shifts to

respondent the burden of proof of the nature of the claim.

Respondent, however, argues that petitioners have not satisfied

the statutory requirements under section 7491 because petitioners

neither cooperated with reasonable requests for information nor

presented credible evidence.   See sec. 7491(a)(1) and (2)(B).   In

this case, we need not decide whether petitioners have complied

with the requirements of section 7491 because the resolution of

this issue does not depend on which party has the burden of

proof.   We resolve this issue on the preponderance of the

evidence in the record.

     Under the terms of the termination agreement, petitioner was

awarded $2 million “in settlement of his claims for tortious
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interference with contracts, for personal injury including injury

to [petitioner’s] personal and professional reputation and

emotional distress, [and] humiliation and embarrassment”.

Petitioners argue that, because the termination agreement

specifically sets forth the claims that formed the basis for

settlement, we need not look to the intent of the payor.

     Assuming, arguendo, that the claims stated in the

termination agreement accurately reflect the basis for

settlement, any amount received on such basis is nevertheless

includable in gross income because it was not received on account

of personal physical injury or physical sickness within the

meaning of section 104(a)(2).    As explained above, Congress

explicitly excluded from the definition of physical injuries or

physical sickness emotional distress and related injuries.      Sec.

104(a); see H. Conf. Rept. 104-737, at 301 n.56, supra, 1996-3

C.B. at 1041 n.56.   Injury to reputation, humiliation, and

embarrassment are akin to emotional distress.      See Shaltz v.

Commissioner, T.C. Memo. 2003-173.       Moreover, tortious

interference with contracts is an economic injury, not a physical

injury, and so damages received on account thereof are not

excludable under section 104(a)(2).      See Robinson v.

Commissioner, 102 T.C. 126.

     Petitioners nevertheless argue that petitioner suffered a

physical injury.   In support thereof, petitioners presented the
                                 - 12 -

testimony of William Taylor (Taylor), petitioner’s treating

physician.     Even he, however, acknowledged that petitioner’s

symptoms were the result of the “usual stress related to the

buyout of a large gas company”.     Taylor testified as follows:

          Q: And tell us generally please, if you would,
     based on your notes, your findings of that physical
     [examination] in June of 1995.

          A: * * * And my overall assessment at that time
     was that he had an unremarkable exam.

                 *     *     *     *      *    *     *

           Q: And would you tell us, please, what were your
     findings and conclusions based on that exam in June of
     1996?

          A: Okay. At that time, his only complaint was
     having usual stress related to the buyout of a large
     gas company. He noted low energy.

          He was complaining of loud snoring, easy
     fatigability during the day. Occasional indigestion.
     * * * Again, difficulty sleeping, some stress.

          Q: Did your assessment show that he had
     hypertension?

          A:    Yes.

     Although petitioners had introduced into evidence the nature

of petitioner’s alleged physical injury at this point in the

testimony, petitioners’ counsel continued by asking Taylor what

consequences might occur if hypertension goes untreated.     Taylor

testified that hypertension can lead to strokes, heart attacks,

and kidney disease.    What petitioner might have suffered had his

hypertension gone untreated, however, is not any injury for which
                              - 13 -

he made claim or for which he was compensated by NGC.    What

petitioner did suffer–-fatigability, occasional indigestion, and

difficulty sleeping–-are the types of injuries or sicknesses that

Congress intended to be encompassed within the definition of

emotional distress.   See H. Conf. Rept. 104-737, at 301 n.56,

supra, 1996-3 C.B. at 1041 n.56.    Consequently, amounts received

on the basis of such injuries are not excludable from gross

income under section 104(a)(2) even if the underlying cause of

action sounds in tort.

     Even if petitioner had suffered a personal physical injury

within the meaning of section 104(a)(2), such injury could not

have been the basis for settlement because, as the parties

stipulated, petitioner did not communicate any physical injury to

representatives of NGC during the settlement negotiations.

Clearly he did not make a claim for medical expenses that had

been incurred as a result of his injury.   Petitioners

nevertheless argue that, even though petitioner’s injury

(presumably the hypertension) was not disclosed to NGC during the

settlement negotiations, “this in no way lessens its existence or

the extent of such injury.”   Respondent does not dispute the

symptoms described by petitioner.   The key, however, is not

simply whether petitioner suffered an injury, but whether that

injury was the basis for any portion of the settlement.    In this

case, NGC was unaware that petitioner was suffering from any
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physical injury, and so neither petitioner’s physical injury nor

medical expense could have been the basis for settlement.

     On this record, we conclude that petitioner did not receive

the settlement proceeds on account of personal physical injuries

or physical sickness within the meaning of section 104(a)(2), as

amended by the SBJPA.   We therefore hold that the entire

settlement amount is includable in petitioners’ gross income.

Addition to Tax and Penalty

     Respondent determined an addition to tax for failure to file

timely under section 6651(a)(1) and an accuracy-related penalty

for substantial understatement or negligence or disregard of the

rules or regulations under section 6662(a).   Respondent has the

burden of production under section 7491(c) for the addition to

tax and the penalty and must come forward with sufficient

evidence showing that they are appropriate.   See Higbee v.

Commissioner, 116 T.C. 438, 446-447 (2001).

     Respondent determined the addition to tax for late filing

because, although petitioners received a 4-month extension to

file their 1996 tax return, petitioners did not file until

January 15, 1998.   The due date with the extension was August 15,

1997.   Respondent has met his burden under section 7491(c) by

establishing petitioners’ late filing.

     To avoid the addition to tax for filing a late return,

petitioners have the burden of proving that the failure to file
                              - 15 -

did not result from willful neglect and that the failure was due

to reasonable cause.   See United Stated v. Boyle, 469 U.S. 241,

245 (1985).   To prove reasonable cause, a taxpayer must show that

he or she exercised ordinary business care and prudence but

nevertheless could not file the return when it was due.    See

Crocker v. Commissioner, 92 T.C. 899, 913 (1989); sec. 301.6651-

1(c)(1), Proced. & Admin. Regs.

     Petitioners have presented neither evidence nor argument as

to why they did not file their 1996 tax return timely.    Instead,

petitioners argue that, because the settlement proceeds are

excludable from gross income, the related addition to tax under

section 6651(a) must not be allowed.

     As we concluded, supra, petitioners must include the entire

settlement amount in gross income.     Because petitioners have not

shown that their failure to file timely was due to reasonable

cause, respondent’s determination with respect to the addition to

tax under section 6651(a)(1) is sustained.

     Under section 6662(a), a taxpayer may be liable for a

penalty of 20 percent on the portion of an underpayment of tax

attributable to a substantial understatement of tax or due to

negligence or disregard of the rules or regulations.    Sec.

6662(b).   Whether the penalty is applied because of a substantial

understatement of tax or negligence or disregard of the rules or

regulations, the accuracy-related penalty is not imposed with
                                - 16 -

respect to any portion of the understatement as to which the

taxpayer acted with reasonable cause and in good faith.    Sec.

6664(c)(1); Higbee v. Commissioner, supra at 448-449.     The

decision as to whether the taxpayer acted with reasonable cause

and good faith depends upon all the pertinent facts and

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

     The term “understatement” is defined as the excess of the

amount of tax required to be shown on the return for the taxable

year over the amount of tax shown on the return for the taxable

year.   Sec. 6662(d)(2)(A).   A substantial understatement exists

if the understatement exceeds the greater of (1) 10 percent of

the tax required to be shown on the return or (2) $5,000.       The

$2 million that petitioners failed to report accounts for all

(using a stacking basis) or almost all (using a proportional

basis) of the deficiency, which exceeds the greater of 10 percent

of the tax required to be shown on petitioners’ tax return or

$5,000.   Accordingly, respondent’s burden of production under

section 7491(c) is satisfied.

     Petitioners contend that they are not liable for the penalty

under section 6662(a) because “the effective date of the SBJPA

was unclear, at best”.   Petitioners argue that “it is

inconceivable that an individual self-preparing an income tax

return would have knowledge of a purported change to the tax code

which occurred in the middle of the tax year.”    Petitioners,
                              - 17 -

however, have not shown what, if anything, they did to discern

the authority on which they relied to justify the exclusion of

the settlement proceeds from gross income or to determine the

correct effective date of the amendments to section 104(a)(2).

They have not identified any tax professionals that they

consulted or on whom they relied.   Because petitioners have not

shown reasonable cause or good faith for their failure to include

the settlement proceeds in gross income, the penalty determined

by respondent is sustained.

     To reflect the foregoing and the concession of petitioners,

                                         Decision will be entered

                                    for respondent.
