                          T.C. Memo. 1997-25



                        UNITED STATES TAX COURT



                   E. PAULINE BARNES, Petitioner v.
             COMMISSIONER OF INTERNAL REVENUE, Respondent



        Docket No. 21856-95.                   Filed January 15, 1997.



        Kevin D. Watley, for petitioner.

        C. Glenn McLoughlin, for respondent.



                          MEMORANDUM OPINION


        DINAN, Special Trial Judge:   This case was heard pursuant

to the provisions of section 7443A(b)(3) and Rules 180, 181, and

182.1

        1
          Unless otherwise indicated, all section references are
to the Internal Revenue Code in effect for the taxable year in
issue. All Rule references are to the Tax Court Rules of
Practice and Procedure.
                                - 2 -

     Respondent determined a deficiency in petitioner's 1992

Federal income tax in the amount of $4,219.

            After concessions,2 the sole issue for decision is

whether section 104(a)(2) authorizes petitioner to exclude from

gross income the amount received in settlement of a claim for

wrongful termination of employment.

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

The stipulations of fact and attached exhibits are incorporated

herein by this reference.    Petitioner resided in Bethany,

Oklahoma, on the date the petition was filed in this case.

     Petitioner worked as a bookkeeper for National Livestock

Commission Association (NLCA) from May 22, 1982 until March 30,

1990.    On March 29, 1990, petitioner was served with a subpoena

to give a deposition in an action involving NLCA.    The next day

petitioner's employment was terminated.    Petitioner received a

final paycheck in the amount of $2,203.71 for her previous 2

weeks' work plus 1-month's severance pay.    NLCA withheld taxes

from this amount.

     As a result of the termination of her employment, petitioner

suffered the intangible harms of embarrassment, humiliation, and

other mental distress.    Petitioner contends that her mental



     2
          The parties agree that the issue of whether part of
petitioner's Social Security benefits are taxable is a statutory
computation controlled by our decision as to the exclusion of the
settlement proceeds.
                               - 3 -

distress manifested itself in the appearance of precancerous

tumors which are being monitored by her doctor.

     On November 26, 1990, petitioner filed a wrongful

termination action against NLCA alleging the following:

     5.   As a result of [the] fact that [petitioner] was
     about to testify against [NLCA] and as a result of
     [petitioner's] refusal to continue to engage in
     illegal, unethical and/or improper business practices
     [NLCA] terminated [petitioner] on March 30, 1990 in
     contravention of the public policy of the State of
     Oklahoma and the United States.

     6.   [Petitioner] further alleges that [NLCA]'s actions
     were intentional, wilful and malicious. [Petitioner]
     is entitled to punitive damages.

     7.   [Petitioner] alleges that as a direct result of
     her termination she has sustained damages for past and
     future lost wages as well as mental distress.

     The petition in the wrongful termination action did not

allocate any specific dollar amounts to the alleged damages but

rather generally prayed for a judgment "in excess of $10,000.00,

together with interest, costs and such other relief as the Court

deems just and proper."

     Petitioner's claim was settled on February 3, 1992, pursuant

to a General Release and Settlement Agreement signed by

petitioner and her attorney in that dispute.   Pursuant to this

agreement, NLCA paid petitioner $27,000 by check in exchange for

her release of all claims.   NLCA did not withhold any taxes from

this amount.   Petitioner received a Form 1099-MISC from NLCA

showing a prize or award in the amount of $27,000.   On her 1992

Federal income tax return, petitioner excluded this amount from
                                - 4 -

her gross income.    Respondent determined to the contrary that the

proceeds were taxable, and issued a deficiency notice stating so.

     Respondent's determinations are presumed correct and

petitioner bears the burden of proving the determinations

erroneous.   Welch v. Helvering, 290 U.S. 111, 115 (1933).

     Section 61(a) broadly defines gross income as including all

income from whatever source derived.      Any exceptions to the

inclusion of items of income as gross income must be narrowly

construed.   Commissioner v. Schleier, 515 U.S. ___, ___, 115 S.Ct

2159, 2163 (1995);     Commissioner v. Glenshaw Glass Co., 348 U.S.

426, 429-430 (1955).

     Section 104(a)(2) provides that gross income does not

include the amount of any damages received on account of personal

injuries or sickness.    The term "damages received" is further

defined as 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 Supreme Court has

interpreted the foregoing statute and regulation as establishing

a two-prong test:

     [There are] two independent requirements that a
     taxpayer must meet before a recovery may be excluded
     under section 104(a)(2). First, the taxpayer must
     demonstrate that the underlying cause of action giving
     rise to the recovery is "based upon tort or tort type
     rights"; and second, the taxpayer must show that the
     damages were received "on account of personal injuries
     or sickness." * * * [Commissioner v. Schleier, 515
     U.S. at ___, 115 S. Ct. at 2167.]
                                 - 5 -

     Therefore, we must decide: (1) Whether the wrongful

termination claim underlying petitioner's settlement agreement

was based upon tort or tort type rights; and (2) whether the

damages paid to petitioner in settlement of such claim were

received on account of personal injuries or sickness.

     We must first decide whether petitioner's settlement

agreement was based upon tort or tort type rights.    State law

controls the nature of the legal interests and rights created by

State law, even though the Federal tax consequences pertaining to

such interests and rights are solely a matter of Federal law.

Commissioner v. Tower, 327 U.S. 280, 288 (1946); Lucas v. Earl,

281 U.S. 111 (1930);     Brabson v. United States, 73 F.3d 1040,

1044 (10th Cir. 1996).    Accordingly, we look to the law of the

State of Oklahoma for guidance as to the nature of petitioner's

wrongful termination cause of action.

     The Oklahoma Supreme Court first adopted a public policy

tort exception to the Oklahoma terminable-at-will employment rule

in Burk v. K-Mart Corp., 770 P.2d 24 (Okla. 1989).    In discussing

the nature of the cause of action the Court was very specific:

     We recognize this new cause of action in tort. It is
     well settled in Oklahoma a tort may arise in the course
     of the performance of a contract and that tort may then
     be the basis for recovery even though it is the
     contract that creates the relationship between the
     parties. An employer's termination of an at-will
     employee in contravention of a clear mandate of public
     policy is a tortious breach of contractual obligations.
     Id. at 28. [Fn. refs. omitted].
                               - 6 -

     In addition, the Court of Appeals for the Tenth Circuit, to

which any appeal in this case lies, has consistently adhered to

the Oklahoma Supreme Court's recognition of this cause of action

as one proceeding in tort.   See Dupree v. United Parcel Serv.,

956 F.2d 219 (10th Cir. 1992); see also York v. American Tel. &

Tel. Co., 95 F.3d 948, 959 (10th Cir. 1996); McKenzie v.

Renberg's, Inc., 94 F.3d 1478, 1488 (10th Cir. 1996).

     Petitioner clearly satisfies the first requirement of the

Schleier test for excluding from gross income damages received

pursuant to a lawsuit.   The petition filed in the wrongful

discharge case alleged that petitioner was terminated in

contravention of the public policy of the State of Oklahoma.    The

settlement proceeds were received in lieu of the prosecution of

that action.   Since Oklahoma law definitively treats this cause

of action for wrongful termination as one proceeding in tort, we

hold that petitioner's settlement proceeds were received as

damages through a settlement agreement entered into in lieu of

prosecution of an action based upon tort or tort type rights.

     We must next decide whether the settlement proceeds satisfy

the second requirement of the Schleier test that they must be

damages received on account of personal injuries or sickness.     In

cases involving settlements, the critical question is in lieu of

what kind of damages was the settlement amount paid?    Bagley v.

Commissioner, 105 T.C. 396, 406 (1995).   As noted above,

petitioner bears the burden of proving that respondent's
                                - 7 -

determination that the settlement proceeds are not damages on

account of personal injuries or sickness is erroneous.       Welch v.

Helvering, 290 U.S. 111, 115 (1933).

     The first place we look to for a characterization of the

proceeds is the settlement agreement itself.    See Bagley v.

Commissioner, supra at 406.    However, the settlement agreement in

this case does not provide any indication as to what type of

damages the settlement proceeds were paid in lieu of.    Rather,

the agreement generally refers to a release of all claims which

petitioner may have had in connection with the termination of her

employment, including all claims asserted in her wrongful

termination action.

     Where the settlement agreement does not expressly specify an

allocation of the proceeds among the various claims, the most

important factor in deciding how to allocate the proceeds is what

motivated the payor to pay the settlement amount.    Knuckles v.

Commissioner, 349 F.2d 610, 613 (10th Cir. 1965), affg. T.C.

Memo. 1964-33.   In determining the intent of the payor, we may

look at the pleadings, jury awards, or any other Court orders or

judgments.   Miller v. Commissioner, T.C. Memo. 1993-49,

supplemented by T.C. Memo. 1993-588, affd. without published

opinion 60 F.3d 823 (4th Cir. 1995).    Again, these sources do not

provide much information.    We have no jury award or Court order

or judgment in our record.    The petition in the wrongful

termination case claims damages for mental distress and past and
                               - 8 -

future lost wages, as well as punitive damages.   However, as in

the settlement agreement, there is no allocation of monetary

damages among the claims.   The petition merely claims damages "in

excess of $10,000.00".

     We must therefore look to the record before us and examine

all of the facts and circumstances surrounding the settlement

agreement.   Stocks v. Commissioner, 98 T.C. 1 (1992).      The

allocation of the settlement proceeds is a question of fact.

Knuckles v. Commissioner, supra at 613.    Based upon our

examination of the record and upon due consideration, we allocate

$13,500 to the mental distress claim and $13,500 to the punitive

damages claim for the following reasons.

     Petitioner's attorney in the wrongful termination action and

settlement, Earl Remmel, testified that during the negotiations

with NLCA's defense counsel there was no discussion of past and

future lost wages, mental distress, or punitive damages.

However, Mr. Remmel further testified that under the

circumstances of her termination, petitioner had a strong case

for mental distress with the likelihood of punitive damages.        He

also stated that her opportunity for recovery for future wages

was not that good because of her age and health condition.        In

addition, petitioner had already been paid for the time she

worked at NLCA plus 1-month's severance.   Although not discussed

during settlement negotiations, these factors were no doubt the

same ones which motivated NLCA to settle the case.
                                 - 9 -

     Having found that the settlement proceeds were attributable

to both mental distress and punitive damages, we must now decide

whether these types of damages were received on account of

personal injuries or sickness.

     Respondent argues that our decision is controlled by the

Supreme Court's holding in Commissioner v. Schleier, 515 U.S.

___, 115 S. Ct. 2159 (1995).   We disagree with respondent's

assertion to the extent discussed herein.    The specific holding

of Schleier was that back pay and liquidated damages recovered

under the Age Discrimination in Employment Act (ADEA) are not

received on account of personal injuries.    Petitioner's case is

distinguishable in that it involves settlement proceeds received

in lieu of mental distress and punitive damages under Oklahoma's

wrongful termination tort cause of action.

     In Schleier, the Supreme Court recognized that damages

received on account of personal injuries or sickness may

encompass recoveries based on intangible as well as tangible

harms.   Commissioner v. Schleier, 515 U.S. at ___ n.4, 115 S. Ct.

at 2164 n.4.   Although the Court acknowledged that intangible

discrimination harms can constitute personal injuries, it held

that the ADEA does not provide for recovery for such harms.      Id.

at 2165 n.6.   We therefore interpret Schleier as allowing the

exclusion of damages received for intangible harms such as mental

distress where the law governing the underlying action provides

for such damages.   See Banks v. United States, 81 F.3d 874, 876
                               - 10 -

(9th Cir. 1996).   Oklahoma's wrongful termination tort cause of

action provides for such a remedy.      Burk v. K-Mart Corp., 770

P.2d 24 (Okla. 1989).

     Petitioner relies upon our decision in McKay v.

Commissioner, 102 T.C. 465 (1994), as precedent for

characterizing damages arising out of a wrongful discharge claim

as personal injuries.    However, the Court of Appeals for the

Fifth Circuit, in light of Schleier v. Commissioner, supra,

vacated our decision in McKay and remanded the case almost 2

months prior to our trial of petitioner's case.      McKay v.

Commissioner, 84 F.3d 433 (5th Cir. 1996), vacating without

published opinion 102 T.C. 465 (1994).     The outcome of that case

on remand is still pending, and we decline to rely upon it in any

fashion.

     The Supreme Court recently interpreted the meaning of "on

account of" personal injuries in the context of punitive damages

awarded in a wrongful death action.     In an opinion released after

this case was submitted for decision, the Court reasoned that the

phrase required a strong causal connection between the injury and

the damages received.    O'Gilvie v. United States, 519 U.S. ___,

117 S. Ct. 452 (1996).    In rejecting the taxpayers' argument that

the phrase requires no more than a "but-for" connection between

the damages and personal injury, the Court adopted the

Commissioner's argument that the phrase required the damages to
                                 - 11 -

be received "by reason of" or "because of" the personal injuries.

Id.   117 S. Ct. 452, 454-455.

      The Tenth Circuit has also had the opportunity to examine

the meaning of the phrase "on account of".   Brabson v. United

States, 73 F.3d 1040 (10th Cir. 1996); O'Gilvie v. United States,

66 F.3d 1550 (10th Cir. 1995), affd. 519 U.S. ___, 117 S. Ct. 452

(1996).   In Brabson, the Tenth Circuit held that an award of

prejudgment interest was not directly linked to the underlying

personal injury and thus not excludable under section 104(a)(2).

Brabson v. United States, 73 F.3d at 1047.   Rather, the Court

found that compensation received for the lost time value of money

is caused by the delay in obtaining judgment.   Id.   It reasoned

that time is the relevant factor in calculating the amount of

damages for prejudgment interest, not the injury itself.    Id.

      Thus the phrase "on account of" requires a strong causal

connection between the personal injury sustained and the

compensation received.   O'Gilvie v. United States, supra; Brabson

v. United States, supra at 1046-1047 (citing Schleier, 515 U.S.

___, 115 S. Ct. at 2164).   We find that petitioner's mental

distress claim satisfies this requirement.   Her wrongful

termination directly caused her mental distress for which

Oklahoma law allows a recovery in tort.   The relevant factor for

calculating damages for mental distress is the injury itself.

Since this type of intangible harm may constitute a personal

injury, Commissioner v. Schleier, 515 U.S. at ___ n.4, 115 S. Ct.
                                - 12 -

at 2164 n.4, we hold that the settlement proceeds allocable to

her mental distress claim were received on account of personal

injuries and are excludable from gross income by section

104(a)(2).

     It has been established, however, that noncompensatory

punitive damages are not excludable from gross income under

section 104(a)(2).     O'Gilvie v. United States, 519 U.S. ___, 117

S. Ct. 452 (1996); Commissioner v. Schleier, 515 U.S. at ___, 115

S. Ct. at 2165; Bagley v. Commissioner, 105 T.C. 396, 416 (1995).

At the time of petitioner's claim, Oklahoma law provided that a

jury could award punitive damages for the purposes of setting an

example and punishing the defendant.     Okla. Stat. Ann. tit. 23,

sec. 9 (West 1987) (repealed by 1995 Okla. Sess. Laws 287); see

Okla. Stat. Ann. tit. 23, sec. 9.1 (West Supp. 1996) for current

version.     Since Oklahoma law treats punitive damages as

noncompensatory, we conclude that the $13,500 of the settlement

proceeds that we allocated to punitive damages are not "on

account of" petitioner's personal injuries because they were not

"designed to compensate" petitioner for such personal injuries.

O'Gilvie v. United States, 519 U.S. ___, 117 S. Ct. at 455

(quoting Commissioner v. Schleier, 515 U.S. at ___ n.5, 115 S.

Ct. at 2165 n.5 (1995)).

     We therefore hold that the punitive damages portion of the

settlement proceeds is not excludable from gross income by

section 104(a)(2).
                        - 13 -

To reflect the foregoing,

                                 Decision will be entered

                                 under Rule 155.
