                         T.C. Memo. 2007-278



                       UNITED STATES TAX COURT



          ESTATE OF CHARLES WHITTAKER WRIGHT, DECEASED,
   VALERIE WRIGHT-BALLIN, ADMINISTRATRIX, AND BETTY J. WRIGHT,
                     DECEASED, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No.     173-97.           Filed September 13, 2007.



      Gary H. Kuwada and Steve Mather, for petitioners.

      Wesley J. Wong, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     GOEKE, Judge:    Respondent determined a deficiency in income

tax of $413,369 against petitioners for the tax year 1992, based

on respondent’s position that Charles Whitaker Wright and Betty

J. Wright (hereinafter petitioners) erroneously excluded from

gross income settlement proceeds of $1,269,950 pursuant to
                                - 2 -

section 104(a)(2).1    We find that respondent’s determination was

in error regarding $1,257,500 of the amount in dispute.

                          FINDINGS OF FACT

     Petitioners were married and filed a joint Federal income

tax return for 1992.    Respondent issued a notice of deficiency to

petitioners on October 10, 1996.    Petitioners timely petitioned

this Court.   At the time they filed the petition, petitioners

resided in Los Angeles, California.

     Mr. Wright died on January 1, 1999, at the age of 78.    Mrs.

Wright had died on January 1, 1998.     Their daughter was appointed

as the administratrix of her parents’ estates by the Superior

Court of California for the County of Los Angeles.

     In the mid-1960s, Mr. Wright organized Marvin Engineering

Co., Inc. (MEC), a California corporation, with Marvin Gussman

and Gerald Friedman.    MEC’s primary business was making parts for

the aerospace and defense industries.    Mr. Gussman served as the

president and chief executive officer, and Mr. Friedman served as

the chief financial officer.    Mr. Wright was an engineer for MEC

and worked in production and the development of new products.

Mr. Wright was also a director of MEC.




     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.
                                - 3 -

     In 1988, Mr. Wright decided he wanted to leave MEC.    A

dispute arose because Mr. Wright believed that he owned 40

percent of the outstanding shares of MEC, while Mr. Gussman and

Mr. Friedman believed he owned only 10 percent.   Mr. Wright also

believed that MEC had paid Mr. Gussman and Mr. Friedman

disproportionately larger bonuses than it had paid him.    The

corporate records of MEC reflect that Mr. Wright was a 10-percent

shareholder, because he owned 40 shares of MEC’s 400 outstanding

shares of common stock.   Mr. Wright was emotionally distraught by

the discrepency between his understanding and the corporate

records.

     Mr. Wright engaged the law firm of Paul, Hastings, Janofsky

& Walker (Paul, Hastings) and began a lengthy effort to extract a

resolution from MEC and the other shareholders that would provide

a significant payment to him.   Tolliver Besson and John Burns of

Paul, Hastings represented Mr. Wright in negotiating with MEC and

the other shareholders.

     By October 1990, Mr. Burns was engaged in settlement

negotiations on behalf of Mr. Wright.   Mr. Burns prepared two

draft agreements as part of the negotiations.   The first was

dated October 26, 1990.   It outlined a settlement including a $7

million stock buyout and a payment of $1 million for emotional

distress.   It did not contain any reference to the underpayment

of compensation.   The second draft agreement was dated January
                                - 4 -

22, 1991.   It was similar to the first, but it provided different

terms regarding the timing of the payments.    When these proposals

proved unsuccessful, Mr. Besson took over control of the

negotiations in April 1991.   He directed that a memorandum be

prepared by other lawyers at Paul, Hastings.    This memorandum

discussed 10 potential causes of action that Mr. Wright might

have against Mr. Gussman and Mr. Friedman, including a claim for

intentional infliction of emotional distress.    Regarding the

intentional infliction of emotional distress, the memorandum

included the following:

          At a minimum, as a result of Messrs. Gussman’s and
     Friedman’s fraudulent, wrongful actions and self-
     dealing, and refusal to permit Mr. Wright to inspect
     the books and records of MEI [sic], Mr. Wright has
     suffered substantial emotional distress.

The memorandum further stated that a claim for intentional

infliction of emotional distress might be unlikely to result in

damages in litigation unless fraud by the other former

shareholders was established.

     A subsequent draft memorandum of agreement was dated July

1991.   This draft treated in greater detail certain intellectual

property that Mr. Wright sought to have assigned to him, Mr.

Wright’s employment with MEC, and other matters.    It provided for

$2 million in settlement of claims for personal injury.    Like the

prior draft agreements, it was never finalized.
                               - 5 -

     In negotiations, it appeared the other shareholders were

intentionally delaying to force Mr. Wright to capitulate because

of legal costs.   Mr. Besson observed that the stress of the

dispute was affecting Mr. Wright physically.   Mr. Wright’s

dilemma was that bringing suit would be even more expensive for

him although bringing suit appeared to be the only means likely

to force a settlement.   In a letter to Mr. Wright dated May 1,

1991, Mr. Besson discussed the likelihood of forcing a settlement

short of litigation.

     In June 1991, a draft complaint was prepared.   This

complaint included a cause of action for the intentional

infliction of emotional distress.   A complaint was never filed

because Mr. Besson and Mr. Friedman negotiated an agreement on

behalf of Mr. Wright, MEC, and the other shareholders.   This

agreement was documented in a Memorandum of Agreement dated May

15, 1992, but not finalized until July 29, 1992.   Each item of

payment in this agreement was negotiated separately.   In addition

to the Memorandum of Agreement, other documents were executed as

a part of the settlement.   These included a General Release

Agreement, an Option Agreement, a Consent of Spouse, a Bill of

Sale, Payment Instructions and Termination of Escrow, Mr.

Wright’s resignation of office in MEC, and a receipt in which Mr.

Wright acknowledged receipt of $952,883.37 in January 1992 and
                               - 6 -

$262,000 in 1991 in settlement of claims for personal injuries

suffered by Mr. Wright and his spouse.

     The Memorandum of Agreement provided that:   (1) MEC would

receive an option to purchase all of Mr. Wright’s shares for $2.5

million if exercised before August 1, 1996, or $2.6 million if

exercised before August 1, 1997; (2) Mr. Wright would receive $1

million in revenue bonds for settlement of compensation claims;

(3) Mr. Wright would receive $1,038,000 in cash for personal

injuries he and his spouse suffered in addition to $262,000 which

he had received in 1991; and (4) the titles to three automobiles

would be transferred to Mr. Wright.

     For 1992, MEC issued a Form 1099-MISC, Miscellaneous Income,

to Mr. Wright showing nonemployee compensation of $1,257,500 and

a Form W-2, Wage and Tax Statement, showing wages of $1,042,400.

There are discrepancies among the agreement, the cash receipt,

and the Form 1099-MISC regarding the amount for personal

injuries.

     In the notice of deficiency for 1992, respondent determined

increased taxable income of $1,269,950 and adjusted itemized

deductions.   The adjustments to itemized deductions are purely

computational and depend on the primary adjustment.   The

$1,269,950 amount is consistent with the Form 1099-MISC, plus the

total value of $12,450 stated on the Bill of Sale transferring

the three automobiles from MEC to Mr. Wright.   Although
                               - 7 -

$1,257,500 does not coincide with any of the settlement documents

in the record as noted above, petitioners have not contested that

this is the amount paid for personal injuries.    The transfers of

the automobiles are not stated in the Memorandum of Agreement to

be part of the personal injury settlement; rather, they are

separately listed in that document.

                              OPINION

      The controversy concerns whether petitioners may exclude

from gross income under section 104(a)(2) a portion of the

settlement proceeds they received from MEC, a corporation of

which Mr. Wright was one of the founding shareholders and a long-

term employee.

I.   General Rules

      “Except as otherwise provided”, gross income for the purpose

of calculating Federal income tax includes “all income from

whatever source derived”.   Sec. 61(a).   This definition is

sweeping in scope, and exclusions from income are to be narrowly

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

(1995).   Further, “exemptions from taxation are not to be

implied; they must be unambiguously proved.”2    United States v.

Wells Fargo Bank, 485 U.S. 351, 354 (1988).     The statute and the

regulations provide that compensation for services, including



      2
      No question has been raised with respect to the burden of
proof or production under sec. 7491(a).
                                     - 8 -

severance or termination pay, is expressly encompassed within the

definition of gross income.         See sec. 61(a)(1); sec. 1.61-

2(a)(1), Income Tax Regs.

     Section 104 provides for an exclusion from gross income for

certain payments received as compensation for injuries or

sickness.   Specifically, section 104(a)3 provides in part:

     SEC. 104.       COMPENSATION FOR INJURIES OR SICKNESS.

          (a) In General.--Except in the case of amounts
     attributable to (and not in excess of) deductions
     allowed under section 213 (relating to medical, etc.,
     expenses) for any prior taxable year, gross income does
     not include--

                 *       *     *       *     *     *     *

                 (2) the amount of any damages received
            (whether by suit or agreement and whether as lump
            sums or as periodic payments) on account of
            personal injuries or sickness;

     The regulations under section 104 provide that the term

“damages received (whether by suit or agreement)” means “an

amount received (other than workmen’s compensation) 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.




     3
      The 1996 amendments to sec. 104 by the Small Business Job
Protection Act of 1996, Pub. L. 104-188, sec. 1605, 110 Stat.
1838, do not apply because the amendments are effective for
amounts received after Aug. 20, 1996.
                               - 9 -

      In Commissioner v. Schleier, supra, the U.S. Supreme Court

established a two-prong test for determining whether a taxpayer

is eligible to exclude income under section 104(a)(2).    The

taxpayer must demonstrate (1) that the underlying cause of action

giving rise to recovery is based upon tort or tort-type rights,

and (2) that the damages were received on account of personal

injuries or sickness.   Id. at 336-337.

      Where amounts are received pursuant to a settlement

agreement, the nature of the claim underlying the damage award,

rather than the validity of the claim, determines whether damages

are excluded under section 104(a)(2).     United States v. Burke,

504 U.S. 229, 237 (1992).   The nature of the claim is generally

ascertained by considering the facts and circumstances

surrounding the settlement agreement.     Knoll v. Commissioner,

T.C. Memo. 2003-277.

II.   Contentions of the Parties

      Petitioners contend that the settlement documents reflecting

arm’s-length negotiations and the separately negotiated payments

speak for themselves as to their purpose.    In other words, a

portion of the settlement was earmarked for personal injuries as

had been negotiated from the outset, and this payment was

intended for that purpose by the payors.    Petitioners also

maintain that intentional infliction of emotional distress is a

tort or tort-like claim, citing United States v. Burke, supra at
                                  - 10 -

234, and California law.      Finally, petitioners assert that the

portion of the settlement in dispute was paid for personal

injuries or sickness as reflected in the settlement agreement.

Respondent does not contest that under California law intentional

infliction of emotional distress is a tort for purposes of United

States v. Burke, supra.       Rather, respondent maintains that the

settlement agreement is not reflective of the true intent behind

the payment.       Respondent asserts that this was a business dispute

and that under California law a claim for intentional infliction

of emotional distress could never have been sustained in

litigation.    Therefore, respondent reasons that personal injury

was not the motivation for any portion of the payments to Mr.

Wright.

III.    Analysis

       It would have been difficult to sustain a cause of action

for the intentional infliction of emotional distress; however,

the same could be said for the assertion of 40-percent ownership

by Mr. Wright’s counsel in the negotiations which led to the

settlement in question.      There is also little direct evidence of

physical harm to Mr. Wright.      It is uncontested that he suffered

severe emotional distress as a result of the shock of learning

that his longstanding business partners rejected his deeply held

belief that he was the 40-percent owner of MEC, but he rejected

advice to see a physician.      Regardless, under the law controlling
                               - 11 -

in 1992, it is not necessary for petitioners to establish

physical harm.    Rather, it is the intent of MEC in making the

payment that controls in this situation.

     There are several facts which cause us to find that the

intent in this case is consistent with the terms of the

settlement agreement.   First, the record establishes that amounts

for three key causes of action were each separately negotiated.

Second, a significant portion of the settlement was paid for

undercompensation and most of it for the option to buy Mr.

Wright’s stock.   This is not a case where the entire settlement

amount was recharacterized at a late point in negotiations to

achieve a favorable tax result for the payee.    Cf. Knoll v.

Commissioner, supra.    A claim for emotional distress was a part

of the negotiation throughout.    Third, Mr. Wright was actually

emotionally distressed because of the position taken by his

fellow shareholders and his belief that he was being defrauded.

Had his counsel been able to establish fraud in litigation

against MEC’s other shareholders, it is plausible that Mr. Wright

would have had a recovery for the intentional infliction of

emotional distress. Given these circumstances, the record simply

does not support ignoring the negotiated agreement which is the

basis for the distinct types of payments to Mr. Wright.

     Thus, because the Memorandum of Agreement did not designate

the transfer of the automobiles as part of the consideration for
                             - 12 -

the emotional distress claim, we find that $12,450 of the amount

in dispute is not excludable under section 104(a)(2).   We do,

however, hold that $1,257,500 is so excludable.

     To reflect the foregoing,


                                        Decision will be entered

                                   under Rule 155.
