                        T.C. Memo. 2011-18



                      UNITED STATES TAX COURT



      GARY L. GREENBERG AND IRENE GREENBERG, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 25420-07.            Filed January 24, 2011.



     James E. Brown, for petitioners.

     Anne W. Durning, for respondent.



                        MEMORANDUM OPINION


     COHEN, Judge:   Respondent determined a deficiency of

$1,161,134 in petitioners’ Federal income tax for 2004 and a

$232,227 penalty under section 6662(a).   After concessions by

petitioners, the issues for decision are:    (1) Whether

petitioners may exclude from income punitive damages received in

2004 from a successful lawsuit for improperly denied disability
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insurance claims under section 104(a)(3), and (2) whether

petitioners are liable for the penalty under section 6662.

Unless otherwise indicated, all section references are to the

Internal Revenue Code (Code) in effect for the year in issue, and

all Rule references are to the Tax Court Rules of Practice and

Procedure.

                             Background

     This case was submitted fully stipulated, and the stipulated

facts are incorporated as our findings by this reference.

Petitioners resided in Arizona at the time the petition was

filed.

     Gary Greenberg (petitioner) purchased a private disability

income insurance policy from the Paul Revere Life Insurance Co.

(Paul Revere) in 1988.    Petitioner purchased the policy entirely

with after-tax dollars and did not receive any contribution from

his employer.

     In 1990, petitioner became disabled and filed a claim with

Paul Revere.    Paul Revere accepted his claim and paid benefits

until approximately September 1998.     After Paul Revere ceased

paying benefits, petitioner filed suit against the company

alleging breach of contract and insurance bad faith.     In 2004,

the U.S. District Court for the District of Arizona ruled in

favor of petitioner and awarded damages as follows:
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                   Description                          Amount

     Past disability benefits and premiums         $151,552.42
     Future disability payments                     395,893.00
     Punitive damages                             2,400,000.00
     Costs and fees                                 340,919.77
     Interest                                        61,294.00
       Total                                      3,349,659.19

Paul Revere paid the judgment in full.

      Petitioners did not report any part of the award on their

Federal income tax return for 2004 or any other year.

Petitioners also received $199 in interest income in 2004 that

they did not report.

     The notice of deficiency adjusted petitioners’ income to

include the punitive damages, interest, and the proportional

amount of costs and fees awarded in the lawsuit as well as the

$199 in interest income.   The adjustments did not include the

compensatory damages of $547,445.42 or $63,411 of the awarded

legal fees and costs, the portion the parties have stipulated is

attributable to those payments.

                            Discussion

     Petitioners contest respondent’s determination that they are

not entitled to exclude the punitive damages from income.

Petitioners concede, however, that the $61,294 in interest

received from the lawsuit may not be excluded from income and

that the $199 additional interest item is taxable.
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Punitive Damages Under Section 104(a)(3)

     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).    Therefore, absent an

exception by another statutory provision, damage awards from a

lawsuit must be included in gross income.    See Kenseth v.

Commissioner, 114 T.C. 399, 413-417 (2000), affd. 259 F.3d 881

(7th Cir. 2001).

     Section 104(a)(3) permits taxpayers to exclude from gross

income:

     amounts received through accident or health insurance
     (or through an arrangement having the effect of
     accident or health insurance) for personal injuries or
     sickness (other than amounts received by an employee,
     to the extent such amounts (A) are attributable to
     contributions by the employer which were not includible
     in the gross income of the employee, or (B) are paid by
     the employer);

Proceeds from a lawsuit initiated to recover payments owed under

an insurance policy may also be excluded from income if they

otherwise meet the requirements of the statute.    See Watts v.

Commissioner, T.C. Memo. 2009-103 (“That petitioner had to

litigate to establish her rights to payment under the * * *

policy does not change the conclusion that the payment was

received ‘through’ accident insurance.”).

     In general, exclusions from income are narrowly construed.

Commissioner v. Schleier, supra at 328.     Petitioners argue that

the punitive damages may be excluded from income under section
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104(a)(3) primarily because punitive damages could not have been

awarded without the insurance policy.   This “but for” argument,

however, is discredited by the Supreme Court’s analysis of

section 104(a)(2) in O’Gilvie v. United States, 519 U.S. 79

(1996).   In that case the Supreme Court considered an earlier

version of section 104(a)(2) that excluded from income “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 Court reasoned that both the

statute and the intention of Congress to exclude only those

damages that compensate for personal injuries or sickness

indicate that the exclusion does not encompass punitive damages.

     Although the wording of section 104(a)(3) is slightly

different from that of section 104(a)(2), paragraph (3) similarly

does not permit taxpayers to exclude punitive damages.    There is

no legal or linguistic reason to distinguish between the

limitation of section 104(a)(2), that damages be received “on

account of” personal injuries or sickness, and the limitation of

section 104(a)(3), that the “amounts received through accident or

health insurance” must be received “for personal injuries or

sickness”.   See Commissioner v. Schleier, supra at 330

(suggesting that each of the provisions of section 104(a) imposes

identical requirements with respect to personal injuries).    Any

punitive damages award arguably is made because of some injury
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and thus would not be awarded “but for” the injury.     Punitive

damages are for the purposes of punishment, not compensation for

“personal injuries or sickness” and therefore do not meet the

requirements of the statute.   O’Gilvie v. United States, supra at

83-84; Commissioner v. Schleier, supra at 329-330.

     Congress has amended section 104(a) to address punitive

damages in the context of section 104(a)(2).   That section was

first amended to address punitive damages to eliminate from the

exclusion “punitive damages in * * * a case not involving

physical injury or physical sickness”, effective July 10, 1989.

Omnibus Budget Reconciliation Act of 1989, Pub. L. 101-239, sec.

7641, 103 Stat. 2379.   The Supreme Court held that this amendment

did not imply that all other punitive damages were excluded from

that section because the provision was intended as a legislative

compromise regarding nonphysical injuries, or simply a

clarification of the current law, rather than a change to the law

regarding punitive damages.    O’Gilvie v. United States, supra at

89-90.   Congress further amended the statute, effective August

20, 1996, specifically excepting punitive damages from the

exclusion.   Small Business Job Protection Act of 1996, Pub. L.

104-188, sec. 1605, 110 Stat. 1838.

     Petitioners contend that Congress must have intended section

104(a)(3) to encompass punitive damages because it failed to

amend that section when it amended section 104(a)(2).
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Petitioners, however, offer no evidence of Congress’ intent

regarding section 104(a)(3), only speculation.     Unlike section

104(a)(2), section 104(a)(3) has not been the subject of

significant litigation about the excludability of punitive

damages.     Thus, as described above we find no reason to read the

injury requirement differently under section 104(a)(3) than the

Supreme Court in O’Gilvie read section 104(a)(2) before the 1996

amendment.

     Petitioners claim that the punitive damages they received

were not punitive, but “bad faith damages”.    They contend,

without citation of relevant authority, that “damage awards that

serve both to compensate and punish are excludable”.    The

punitive damages they received are ineligible to be excluded

under section 104(a)(3), however, because they are not

compensating “for personal injuries or sickness” even if

attributable to bad faith accompanying contractual obligation or

tortious activity.

     For the reasons outlined above, petitioners are not entitled

to exclude from gross income the punitive damages they received.

The legal fees and costs received in a judgment that correspond

to taxable damages are also taxable.     See Goeden v. Commissioner,

T.C. Memo. 1998-18.    The parties have stipulated that $63,411 of

the costs and fees are related to the damages that petitioners

may exclude from income under section 104(a)(3).    The balance of
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the costs and fees that petitioners received in the lawsuit is

taxable.     Respondent has agreed that petitioners may deduct those

costs and fees as a miscellaneous itemized deduction, subject to

applicable rules.    See secs. 212, 67.

Section 6662 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(c) defines negligence as including any failure to

make a reasonable attempt to comply with the provisions of the

Code and defines disregard as any careless, reckless, or

intentional disregard.    Disregard of rules or regulations is

careless if the taxpayer does not exercise reasonable diligence

to determine the correctness of a return position that is

contrary to the rule or regulation.      Sec. 1.6662-3(b)(2), Income

Tax Regs.    A substantial understatement of income tax exists if

the understatement exceeds the greater of 10 percent of the tax

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

6662(d)(1)(A).

     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).
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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.    Considering the

erroneous nature of the deduction and the amount of the resulting

underpayment of tax, respondent has satisfied the burden of

producing evidence that the penalty is appropriate.

     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.

     Petitioners do not separately address the penalty issue.

Given the plain language of the statute and the applicable

caselaw, the arguments they provide in support of their position

on the deficiency itself do not amount to substantial authority

or reasonable cause.   Petitioners did not provide any evidence

that they relied on professional advice, and they did not

disclose their position on their return.    See sec. 6662(d)(2)(B).
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Petitioners have therefore not met their burden of proof and are

liable for the penalty.

     We have considered the other arguments of the parties, and

they either are without merit or need not be addressed in view of

our resolution of the issues.    For the reasons explained above,


                                         Decision will be entered

                                 under Rule 155.
