                        T.C. Memo. 2010-53



                      UNITED STATES TAX COURT



            ISIDRA ELIZABETH ESPINOZA, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 28320-08.                 Filed March 22, 2010.



     Isidra Elizabeth Espinoza, pro se.

     Brooke S. Laurie, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     COHEN, Judge:   Respondent determined a deficiency of $9,078

in petitioner’s 2006 Federal income tax and an accuracy-related

penalty of $1,816 under section 6662(a).     The issues for decision

are whether petitioner may, pursuant to section 104, exclude

settlement proceeds from her gross income, and whether petitioner

is liable for an accuracy-related penalty under section 6662.
                                - 2 -

All section references are to the Internal Revenue Code for the

year in issue, and all Rule references are to the Tax Court Rules

of Practice and Procedure.

                          FINDINGS OF FACT

     Some of the facts have been stipulated, and the stipulated

facts are incorporated in our findings by this reference.

Petitioner resided in Texas at the time she filed her petition.

     Petitioner worked for the Texas Department of Human Services

from 1990 to 2002.   During the course of her employment,

petitioner suffered from emotional distress and incurred various

medical expenses.    Petitioner commenced a suit against the Texas

Department of Human Services in the District Court of Hidalgo

County, Texas, alleging that she was subject to illegal

discrimination based on her gender, religion, and national

origin, as well as retaliation.

     As the suit dragged on, petitioner’s husband, Manuel

Espinoza, discussed with petitioner’s counsel, Jesus Villalobos,

a personal injury attorney, the possibility of settling with the

Texas Health and Human Services Commission, the successor agency

to the Texas Department of Human Services.   Mr. Espinoza

calculated the total cost of petitioner’s medical bills to be

$50,000 and offered to settle with the Texas Health and Human

Services Commission for that amount.    Villalobos represented to

Mr. Espinoza that the settlement amount would not be taxable, so
                               - 3 -

there was no need to increase the settlement amount to account

for Federal income tax.

     Between December 13, 2005, and January 27, 2006, petitioner

and the Texas Health and Human Services Commission executed a

release and settlement agreement.   The agreement stated:

     1.   This agreement, or any action taken pursuant to
     this agreement, shall not constitute an admission of
     liability by any party, and all liability is expressly
     denied. This agreement is entered into to resolve and
     settle all differences, disputes, and controversies
     between the parties, to compromise and settle doubtful
     and disputed claims, to avoid further litigation, and
     to facilitate peace. This agreement specifically does
     not represent an admission by any party of the merit or
     lack of merit of the claims made by the Plaintiff
     against the Defendant, nor shall this agreement or any
     actions taken pursuant to this agreement be admissible
     in any proceeding for the purpose of showing the merit
     or lack of merit of those claims.

     2.   In full and final settlement and compromise of all
     claims, but without admitting liability therefore
     [sic], Defendant agrees to pay Espinoza * * * a total
     amount of Fifty Thousand Dollars ($50,000). The
     parties will pay their own costs.

The settlement agreement does not identify any reasons for the

settlement payment other than those listed in the first

paragraph.   Nor does the settlement agreement dictate how the

money is to be spent.   Notwithstanding, petitioner believed that

the settlement proceeds were reimbursement for all of her medical

costs incurred as a result of the discrimination.

      Petitioner received the $50,000 settlement in 2006 along

with a Form 1099-MISC, Miscellaneous Income, from the Health and

Human Services Commission.   On May 10, 2007, the Internal Revenue
                                 - 4 -

Service received petitioner’s Form 1040, U.S. Individual Income

Tax Return, for 2006, which petitioner submitted using the status

of married filing separately.    Petitioner’s Form 1040 was

prepared by a paid return preparer.       Petitioner and her husband

told the return preparer that the settlement proceeds were paid

to compensate petitioner for medical costs as a result of her

medical condition.   The return preparer did not include the

settlement proceeds in petitioner’s gross income.

                                OPINION

The Settlement Proceeds

     The definition of gross income under section 61(a) broadly

encompasses any accession to a taxpayer’s wealth.       Commissioner

v. Schleier, 515 U.S. 323, 327-328 (1995); United States v.

Burke, 504 U.S. 229, 233 (1992).    Absent an exception by another

statutory provision, settlement proceeds must be included in

gross income.   Commissioner v. Schleier, supra; United States v.

Burke, supra.

     Section 104(a)(2) excepts 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”.   Although emotional distress is not treated as a

physical injury or physical sickness, the cost of medical care

attributable to emotional distress is.      Sec. 104(a) (flush
                                  - 5 -

language); see Stadnyk v. Commissioner, T.C. Memo. 2008-289,

affd. without published opinion No. 09-1485 (6th Cir., Feb. 26,

2010).

     To justify exclusion from income under section 104,

petitioner must show that her settlement proceeds were in lieu of

damages for physical injuries or physical sickness.     See Green v.

Commissioner, 507 F.3d 857, 867 (5th Cir. 2007), affg. T.C. Memo.

2005-250; Bagley v. Commissioner, 105 T.C. 396, 406 (1995), affd.

121 F.3d 393 (8th Cir. 1997); sec. 1.104-1(c), Income Tax Regs.

The nature of the settlement is a question of fact.      Green v.

Commissioner, supra at 866-867.     “Ultimately, the character of

the payment hinges on the payor’s dominant reason for making the

payment.”   Id. at 868.   “We first look to the language of the

agreement itself for indicia of purpose.”      Id. at 867.   Where the

agreement does not mention purpose, the Court may look at other

facts that reveal the payor’s intent, such as the amount paid,

the evidence adduced at trial, and the factual circumstances that

led to the agreement.     Id.   We recognize that Green and Bagley

were decided under section 104 before it was amended in 1996.

However, their holding regarding the characterization of

settlement proceeds in lieu of damages remains good law.      See

Save v. Commissioner, T.C. Memo. 2009-209.

     The settlement agreement between petitioner and the Texas

Health and Human Services Commission does not allocate
                                - 6 -

petitioner’s proceeds to a claim of personal physical injury or

physical sickness.   The agreement does not specify any particular

claim motivating the settlement.   It therefore fails to allocate

between claims that qualify and claims that do not qualify under

section 104.

     Petitioner argues that the Texas Department of Human

Services, the Texas Health and Human Services Commission, and the

Texas Attorney General’s Office were well aware of her physical

injuries.   However, petitioner has failed to present objective

and credible evidence that the Texas Health and Human Services

Commission intended that any part of petitioner’s settlement

proceeds be allocated to her medical expenses and therefore has

not shifted the burden of proof to respondent under section

7491(a).    In any event, the preponderance of the evidence is that

the settlement was unallocated among multiple claims, many of

which were not for physical injuries or physical sickness.    We

must conclude on the evidence that the settlement proceeds are

includable in petitioner’s income for 2006.

The Accuracy-Related Penalty

     Section 6662(a) and (b)(1) and (2) imposes a 20-percent

accuracy-related penalty on any underpayment of Federal income

tax attributable to a taxpayer’s negligence or disregard of rules

or regulations, or substantial understatement of income tax.

Section 6662(d)(1)(A) defines “substantial understatement of
                              - 7 -

income tax” as an amount exceeding the greater of 10 percent of

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

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

with regard to penalties and must come forward with sufficient

evidence indicating that it is appropriate to impose penalties.

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

once the Commissioner has met the burden of production, the

burden of proof remains with the taxpayer, including the burden

of proving that the penalties are inappropriate because of

reasonable cause or substantial authority.   See Rule 142(a);

Higbee v. Commissioner, supra at 446-447.

     Respondent has satisfied the burden of production by showing

that there is a substantial understatement, because the amount of

the understatement, $9,078, exceeds 10 percent of the tax

required to be shown on the return and is greater than $5,000.

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

imposed with respect to any portion of the underpayment as to

which the taxpayer acted with reasonable cause and in good faith.

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

decision as to whether a taxpayer acted with reasonable cause and

in good faith is made on a case-by-case basis, taking into

account all of the pertinent facts and circumstances.    See sec.

1.6664-4(b)(1), Income Tax Regs.   “Circumstances that may

indicate reasonable cause and good faith include an honest
                               - 8 -

misunderstanding of fact or law that is reasonable in light of

all of the facts and circumstances, including the experience,

knowledge, and education of the taxpayer.”     Id.   Reliance on

professional advice may constitute reasonable cause and good

faith if, under all the circumstances, such reliance was

reasonable and the taxpayer acted in good faith.      Freytag v.

Commissioner, 89 T.C. 849, 888 (1987), affd. 904 F.2d 1011 (5th

Cir. 1990), affd. 501 U.S. 868 (1991); sec. 1.6664-4(b)(1),

Income Tax Regs.

     Petitioner has convinced us that she acted with reasonable

cause and in good faith.   Petitioner has no experience or

education in tax law.   She relied upon the advice of Villalobos,

who told her that the settlement would not be taxable.     Although

Villalobos does not have tax experience, he is a personal injury

attorney, and it is reasonable for petitioner to assume that he

would be familiar with the Federal income tax consequences of

personal injury settlements.   See Stadnyk v. Commissioner, supra.

Furthermore, petitioner believed that the settlement was to

compensate her for her physical injuries.    This belief was

reinforced by the numerous medical expenses petitioner incurred.

We find that petitioner’s mistaken belief that the settlement

proceeds were compensation for physical injuries was reasonable

in the light of the circumstances.     Petitioner acted reasonably

and in good faith when she told her return preparer that the
                               - 9 -

settlement proceeds were paid on account of physical injury.       See

Shelton v. Commissioner, T.C. Memo. 2009-116; Pettit v.

Commissioner, T.C. Memo. 2008-87.   We therefore conclude that

petitioner has demonstrated reasonable cause for failing to

report the settlement proceeds as income and that she acted in

good faith.   She is therefore not liable for the accuracy-related

penalty.

     In reaching our decision, we have considered all arguments

made by the parties.   To the extent not mentioned or addressed,

they are irrelevant or without merit.

     For the reasons explained above,


                                        Decision will be entered

                                 under Rule 155.
