                  T.C. Summary Opinion 2003-148



                       UNITED STATES TAX COURT



                JACQUELINE MEDINA, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 13398-02S.                Filed October 7, 2003.


     Jacqueline Medina, pro se.

     William C. Bogardus, for respondent.



     KROUPA, Judge:    This case was heard pursuant to the

provisions of section 74631 in effect at the time the petition in

this case was filed.   The decision to be entered is not

reviewable by any other court, and this opinion should not be

cited as authority.



     1
      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. All dollar amounts are rounded to the nearest whole
dollar, unless otherwise indicated.
                                 - 2 -

     Respondent determined a deficiency of $20,511 in

petitioner’s Federal income tax for 2000 and an accuracy-related

penalty of $4,102 under section 6662(a).    After concessions,2 the

issues for decision to be entered are:

     (1) Whether $58,000 of the amount that petitioner received

from settlement of a lawsuit is excludable from her gross income

under section 104(a)(2).   We hold it is not excludable.

     (2) Whether petitioner is liable for an accuracy-related

penalty under section 6662(a).    We hold she is not liable.

     Some of the facts have been stipulated and are so found.

The stipulated facts and the accompanying exhibits are

incorporated into our findings by this reference. Petitioner

resided in Pomona, New York at the time she filed the petition in

this case.

                            Background

Work and Pregnancy

     Petitioner began work with Liberty Travel, Inc. (Liberty),

as a clerical worker on February 2, 1996, and was promoted to

operations supervisor within 2 months at an increased rate of




     2
      Respondent concedes petitioner is not liable for the self-
employment tax included in the notice of deficiency. Respondent
also concedes that, assuming we find that the $58,000 amount is
not excludable, petitioner is entitled to an itemized deduction
of $20,000 for legal expenses, subject under sec. 67(a) to the
2-percent floor.
                                - 3 -

pay.    Shortly thereafter, petitioner became pregnant with twins,

and her pregnancy was evaluated as high risk.

       Because of complications with her pregnancy, petitioner was

away from work from September 10 until October 8, 1996, during

which time she applied for and received disability benefits.      Two

months after petitioner returned to work, her doctor advised her

to decrease her work hours, and 2 days later petitioner’s doctor

advised complete bed rest.    Petitioner went on family leave on

December 13, 1996, and stayed on family leave until April 30,

1997.    That period included 1 month after petitioner delivered

twin boys prematurely by Cesarean section on March 30, 1997.

       Sometime late in May 1997, petitioner contacted Liberty

about returning to work and was informed that there was no

position available for her at that time.    Liberty terminated

petitioner’s employment on June 22, 1997.

Lawsuit and Settlement

       Petitioner filed a charge against Liberty with the Equal

Employment Opportunity Commission alleging unlawful

discrimination.    Petitioner also retained an attorney to

represent her after Liberty terminated her employment.    On March

25, 1999, petitioner filed a complaint against Liberty in the

U.S. District Court for the District of New Jersey (the lawsuit).

The complaint raised six causes of action:    (1) Unlawful

discrimination against petitioner because of her pregnancy; (2)

breach of contract; (3) breach of implied covenant of good faith
                               - 4 -

and fair dealing; (4) wrongful discharge; (5) intentional

infliction of emotional distress; and (6) retaliatory discharge.

Petitioner sought backpay along with related benefits and $2

million compensatory damages for pain and suffering and other

related torts, plus $6 million for punitive damages.

     Petitioner and Liberty were able to negotiate a settlement

of the lawsuit.   They each signed a settlement agreement

(settlement agreement) in which Liberty agreed to pay petitioner

$70,000.   Paragraph 1 of the settlement agreement specified that

Liberty would pay the $70,000 as follows:

     (a) the sum of $12,000.00 (less applicable withholdings
     and deductions) . . . [to] be reflected on an IRS Form
     W-2; and (b) the sum of $58,000.00 . . . [to] be
     reflected on IRS Form 1099.

     Paragraph 2(c) of the settlement agreement specified that

petitioner released Liberty from “all claims for wrongful

discharge, breach of contract, fraud, misrepresentation,

defamation, torts, or any other claims in any way related to

Plaintiff’s employment with and termination from Liberty Travel.”

In addition, paragraph 11 of the settlement agreement stated that

the agreement was the result of a compromise and was made solely

to avoid the expenses of litigation.   Liberty expressly denied

any liability to or wrongdoing against petitioner.
                               - 5 -

Settlement Payment and Petitioner’s Tax Return

     Liberty issued two checks made payable to petitioner

pursuant to the settlement agreement.   These two checks consisted

of a $12,000 employee compensation check, net of all applicable

withholding taxes,3 and a separate check in the amount of $58,000

(the $58,000 amount) as nonemployee compensation free of any

withholdings.   Petitioner’s attorney deposited both checks into

his trust account and then issued petitioner a check for $43,930,

the amount of the settlement less the attorney’s fees and the

withheld payroll taxes.

     Petitioner’s attorney advised her that the amount she

received from Liberty was to compensate her for her legal

expenses and for her personal injuries.   Petitioner’s attorney

also advised her that the $58,000 amount was excludable from her

gross income.

     Liberty issued petitioner a Form W-2, Wage and Tax

Statement, to report the $12,000 of back pay, and a Form 1099-

MISC, Miscellaneous Income, to report the $58,000 amount.

     Petitioner reported the $12,000 as wage income on her 2000

Federal income tax return, but she did not report the $58,000




     3
      The taxability of the $12,000 backpay is not in dispute.
Liberty withheld $6,070 for taxes from the backpay.
                               - 6 -

amount.   Respondent issued petitioner a notice of deficiency in

which respondent determined that petitioner failed to report the

$58,000 amount on her Federal income tax return.

                             Discussion

1.   Excludability of the $58,000 Amount4

      Section 61(a) provides that “gross income means all income

from whatever source derived” except as otherwise provided.

Section 104(a)(2) excludes 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”.

The term “damages received” means an amount received “through

prosecution of a legal suit or action based upon tort or tort

type rights, or through a settlement agreement entered into in

lieu of such prosecution.”   Sec. 1.104-1(c), Income Tax Regs.

The flush language of section 104(a) further provides that

“emotional distress shall not be treated as a physical injury or

physical sickness” for purposes of section 104(a)(2).   “[T]he

      4
      Sec. 7491(a) places upon the Commissioner the burden of
proof with respect to any factual issue relevant to a taxpayer's
liability for tax if the taxpayer proves that she maintained
adequate records, satisfied applicable substantiation
requirements, cooperated with the Commissioner, and introduced
during the Court proceeding credible evidence on the factual
issue. See Prince v. Commissioner, T.C. Memo. 2003-247.
Petitioner did not assert nor present evidence or argument that
she satisfied the requirements of sec. 7491(a). However, 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.
                                 - 7 -

term emotional distress includes symptoms (e.g., insomnia,

headaches, stomach disorders) which may result from such

emotional distress.”5   H. Conf. Rept. 104-737, at 301 n.56

(1996), 1996-3 C.B. 741, 1041.

     Respondent determined that petitioner must include the

$58,000 amount in income because none of it was received on

account of any physical injury or physical sickness.    Conversely,

petitioner asserts that the entire $58,000 amount is excludable

from income under section 104(a)(2) because she received it for

personal injuries she sustained during her pregnancy and the

premature birth of her twins.

     Petitioner must satisfy two requirements to exclude the

$58,000 amount from income under section 104(a)(2).    She must

prove first that the underlying cause of action giving rise to

her recovery of the payment is based upon tort or tort type

rights, and second that the payment was received on account of




     5
      Petitioner’s complaint raised intentional infliction of
emotional distress as a cause of action. However, the Small
Business Job Protection Act of 1996, Pub. L. 104-188, sec. 1605,
110 Stat. 1838 (the 1996 amendment), amended sec. 104(a)(2) to
narrow the exclusion for personal injury damages received
pursuant to a judgment or settlement, effective for amounts
received after Aug. 20, 1996. Under the 1996 amendment, personal
injury or sickness must be physical.
                                - 8 -

personal physical injuries or physical sickness.    See

Commissioner v. Schleier, 515 U.S. 323, 328 (1995); see also sec.

104(a)(2); sec. 1.104-1(c), Income Tax Regs.

     We find petitioner meets the first prong, having brought a

tort type action against Liberty.    We then turn to whether the

$58,000 amount pursuant to the settlement agreement with Liberty

was received on account of a personal physical injury or physical

sickness.

     When damages are received pursuant to a settlement

agreement, as here, the nature of the claim that was the actual

basis for settlement, not the validity of that claim, controls

whether the amounts are excludable under section 104(a)(2).    See

Bagley v. Commissioner, 105 T.C. 396, 406 (1995), affd. 121 F.3d

393 (8th Cir. 1997).    Determining the nature of the claim is a

factual inquiry that is generally made by reference to the

settlement agreement.    Robinson v. Commissioner, 102 T.C. 116,

126 (1994) (and cases cited thereat), affd. in part and revd. in

part on another ground 70 F.3d 34 (5th Cir. 1995).    If the

settlement agreement lacks express language stating what the

settlement amount was paid to settle, we determine the intent of

the payor by considering all the facts and circumstances of the

case, including the complaint filed and details surrounding the
                                 - 9 -

litigation.     Knuckles v. Commissioner, 349 F.2d 610, 613 (10th

Cir. 1965), affg. T.C. Memo. 1964-33; Robinson v. Commissioner,

supra at 127.

     We therefore look to the settlement agreement to examine the

nature of the claim.    The settlement agreement does not allocate

any part of the settlement payment to a personal physical injury

or physical sickness.    Indeed, there is no reference to a

physical injury or physical sickness resulting from Liberty’s

actions, nor does the settlement agreement specifically carve out

any portion of the settlement payment as a settlement on account

of personal physical injury or physical sickness.

     Reviewing the settlement agreement to ascertain Liberty’s

intent in making the settlement payment also does not support

petitioner’s argument.    Under the settlement agreement,

petitioner generally released Liberty from any “claims in any way

related to Plaintiff’s employment with and termination from

Liberty Travel” in exchange for the total $70,000 Liberty agreed

to pay petitioner to settle the lawsuit.    The settlement

agreement also states that Liberty and petitioner were entering

into the agreement as the result of a compromise and that the

agreement was being made solely to avoid the costs of litigation.

Liberty further expressly denied any wrongdoing against

petitioner.

     We conclude that no portion of the $58,000 amount was
                                - 10 -

received on account of any physical injury or physical sickness.

Accordingly, the $58,000 amount is not excludable under section

104(a)(2).

2.   Accuracy-Related Penalty

      We turn now to the determination in the notice that

petitioner is liable for the year at issue for the accuracy-

related penalty under section 6662(a).       Respondent has the burden

of production under section 7491(c) and must come forward with

sufficient evidence that it is appropriate to impose the penalty.

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

      Respondent determined that petitioner is liable for the

accuracy-related penalty for a substantial understatement of

income tax under section 6662(b)(2).       There is a substantial

understatement of income tax if the amount of the understatement

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

be shown on the return, or $5,000.       Sec. 6662(d)(1)(A).

      Respondent has met his burden of production with respect to

the accuracy-related penalty.    Petitioner reported taxable income

of $42,300 and Federal income tax of $6,794.       Respondent

determined petitioner’s taxable income was $98,231 and that

petitioner had an income tax deficiency of $20,511.       After

considering respondent’s concessions, we are satisfied that

petitioner substantially understated the income tax required to

be shown on her return for the year at issue.
                              - 11 -

     The accuracy-related penalty under section 6662(a) does not

apply to any portion of an underpayment, however, if it is shown

that there was reasonable cause for, and that the taxpayer acted

in good faith with respect to, that portion.    Sec. 6664(c)(1);

sec. 1.6664-4(b), Income Tax Regs.     The determination of whether

the taxpayer acted with reasonable cause and in good faith

depends on the pertinent facts and circumstances, including the

taxpayer’s efforts to assess his or her proper tax liability, the

knowledge and experience of the taxpayer, and the reliance on the

advice of a professional.   Sec. 1.6664-4(b)(1), Income Tax Regs.

     Petitioner argues that she is not liable for the accuracy-

related penalty because she relied upon the advice of her

attorney to exclude the $58,000 amount.    While the Commissioner

bears the burden of production under section 7491(c), the

taxpayer bears the burden of proof with regard to issues of

reasonable cause, substantial authority, or similar provisions.

Higbee v. Commissioner, supra at 446.     Therefore, petitioner must

show that she supplied her adviser with all the correct and

necessary information and that her error in not reporting the

$58,000 amount was the result of her adviser’s mistake.

     In the instant case, petitioner’s attorney represented her

during all stages of the lawsuit, including filing the complaint

and negotiating the settlement agreement.    Furthermore, the

attorney endorsed and deposited the two checks Liberty made
                                - 12 -

payable to petitioner into his trust account and paid petitioner

the net settlement proceeds with a check drawn on that account.

Thus, we find that petitioner’s attorney had complete knowledge

of all the necessary and relevant facts of petitioner’s lawsuit

and the settlement agreement.    Moreover, there is nothing in the

record to show that petitioner had any reason to suspect her

attorney’s advice was not competent.      Considering all the facts

and circumstances in this case, we find that petitioner acted

with reasonable cause and in good faith with respect to the

underpayment for the year at issue.      See sec. 6664(c)(1).

Accordingly, we conclude that petitioner is not liable for the

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

     To reflect the foregoing,


                                             Decision will be entered

                                         under Rule 155.
