                         T.C. Memo. 2000-59



                        UNITED STATES TAX COURT



          WILLIAM A. AND ANN M. JACOBS, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent

         JOHN W. AND PHYLLIS M. CONNELLY, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 626-98, 627-98.       Filed February 23, 2000.



     Carol B. Bonebrake, for petitioners.

     Robert J. Burbank, for respondent.



                MEMORANDUM FINDINGS OF FACT AND OPINION

     GERBER, Judge:     These consolidated cases involve income tax

deficiencies determined by respondent for petitioners’ 1994

taxable year.    Respondent determined a $14,672 deficiency for

petitioners William A. and Ann M. Jacobs, docket No. 626-98, and

a $13,200 deficiency for petitioners John W. and Phyllis M.
                                 - 2 -

Connelly, docket No. 627-98.     These cases were consolidated for

trial, briefing, and opinion pursuant to Rule 141(a).1

     The sole issue for our consideration is whether the portion

of petitioners’ judgment allocated as liquidated damages received

in an action under the Fair Labor Standards Act of 1938, 29

U.S.C. secs. 201, 216(b) (1994) (FLSA), is excludable from gross

income as damages received on account of personal injury or

sickness under section 104(a)(2).

                           FINDINGS OF FACT2

         At the time their respective petitions were filed,

petitioners William A. and Ann M. Jacobs, husband and wife,

resided in Silver Lake, Kansas, and petitioners John W. and

Phyllis M. Connelly, husband and wife, resided in Wichita,

Kansas.      Ann Jacobs and Phyllis Connelly are petitioners in

this case solely because they joined in filing Federal income

tax returns with their husbands.      Hereinafter, references to

“petitioners” refer only to William Jacobs and John Connelly.

         Petitioner Jacobs was employed by the Kansas State Highway

Patrol from 1973 to 1997.      He worked as a road trooper, an

aircraft pilot, and then held a position in the highway patrol


     1
       Unless otherwise indicated, Rule references are to this
Court’s Rules of Practice and Procedure, and section references
are to the Internal Revenue Code in effect for the taxable year
in question.
     2
       The stipulation of facts and the attached exhibits are
incorporated herein by this reference.
                               - 3 -

headquarters.    Petitioner Connelly was employed by the Kansas

State Highway Patrol from 1960 until 1993.    During his tenure,

he was a field trooper, field sergeant, field lieutenant, and

field captain.    He retired in February 1992 and was rehired the

following day by the highway patrol as a motor-carrier

inspection lieutenant until his termination in 1993.

       Jacobs and Connelly joined in a suit entitled Kinnett v.

State of Kansas, Case Nos. 90-4209-DES, 90-4214-DES, and 90-

4215-DES, filed in the U.S. District Court for the District of

Kansas in 1990 (Kinnett).    Kinnett involved claims under the

FLSA for unpaid overtime compensation for employee-plaintiffs

who had been classified as exempt from the requirements of the

act.

       The amended complaint alleged that the defendant had

employed the plaintiffs on an hourly basis but required them to

work in excess of the hourly levels specified in 29 U.S.C.

section 207 and did not compensate the plaintiffs for their

overtime hours.    Both Jacobs and Connelly had consistently

worked in excess of 40 hours a week during their tenure.      The

employee-plaintiffs’ action challenged the exempt

classification as improper because the employees did not meet

the exemption test set forth in 29 C.F.R. section 541.118

(1991) and sought “unpaid overtime compensation, * * *

liquidated damages, * * * attorney’s fee * * * and costs” under
                              - 4 -

29 U.S.C. section 216(b).   A subsequent pretrial order

contained further details of the parties’ factual contentions

and legal theories and bifurcated the action to arrange for

separate trials on the liability and damage issues.   Neither

the amended complaint nor the pretrial order made any reference

to physical injuries or sickness claimed by any plaintiff.    The

only claims made were based on the allegedly improper exemption

and resulting loss of overtime pay.

     No trial was ever held because the parties reached a

settlement agreement and filed a Joint Motion for Judicial

Approval of Settlement Terms and Dismissal of Action With

Prejudice (joint motion), setting out the terms of the

settlement.   With one exception, the plaintiffs settled their

claims for 50 percent of the amounts claimed for unpaid

overtime compensation and for an equal amount for liquidated

damages. The joint motion provided that the defendant would

provide the settlement amounts in exchange for liability

releases signed by the plaintiffs.    The joint motion described

the settlement agreement as entailing a “full and final

settlement, release and waiver of any and all claims Plaintiffs

have made or could have made arising out of any and all known

and unknown economic losses or damages compensable under the

FLSA”.   The actual release stated:

     I * * * hereby release, acquit and forever discharge
     the State of Kansas * * * of and from any and all
                               - 5 -

     actions, causes of action, claims, demands,
     declaratory judgment, damages, back wages, overtime
     compensation, expenses, compensation, attorneys fees,
     interest, liquidated damages, costs, and all
     consequential damage on account of or in any way
     arising out of any and all known and unknown economic
     losses or damages compensable under the Fair Labor
     Standards Act resulting from or which may result from
     my employment with the State of Kansas or any agency
     of the State of Kansas from January 1, 1987 through
     August 31, 1994.

     On August 31, 1994, the U.S. District Court for the

District of Kansas entered a Journal Entry of Dismissal With

Prejudice and approved the settlement agreement.   Plaintiffs

received the settlement payments in two checks, one

representing the unpaid overtime compensation and the other

representing the liquidated damages portion of the settlement.

The portion allocated to back wages had all applicable taxes

and employee contributions withheld, and the portion allocated

to liquidated damages was paid in full to the employees.   The

release provided that the liquidated damages portion of the

settlement payment would be reported to the Internal Revenue

Service on a Form 1099-MISC.

     The total amount due to Jacobs by the State of Kansas was

$96,134.   The State issued him a W-2 in the amount of $48,067,

withheld income and FICA taxes on that amount, and paid the

balance of the $48,067 to Jacobs, which he then reported on his

1994 Federal income tax return as income.   The State of Kansas

also issued him a Form 1099-MISC in the amount of $48,067 and
                               - 6 -

paid him that amount, withholding nothing.   He disclosed

receipt of those funds on his return but did not report that

amount as income.

     The total amount due to Connelly by the State of Kansas

was $80,898.   The State issued him a Form W-2 in the amount of

$40,449, withheld income and FICA taxes, and paid him the

balance of the $40,449, which he then reported as income on his

1994 Federal income tax return.   The State also issued him a

Form 1099-MISC in the amount of $40,449 and paid him that

amount, withholding nothing.   He disclosed receipt of those

funds on his return but did not report that amount as income.

     Due to petitioners’ exclusion of the liquidated damages

settlement payments from income, the Commissioner issued

deficiency notices to each.

     Jacobs and Connelly each claim that the liquidated damages

payments were excluded from income as compensation for personal

injuries and/or sicknesses and that they had each suffered

medical conditions while working for the Kansas Highway Patrol.

     Jacobs began to have various physical problems in 1980,

including failing eyesight, elevated blood pressure, and sexual

dysfunction.   He also experienced mental anguish and stress

because his job schedule and fatigue caused him to miss out on

many family activities.   His physician put him on medication to

reduce his blood pressure, which decreased somewhat while he
                                - 7 -

was working and more so after he quit his job with the highway

patrol.   He also noticed that his sexual dysfunction improved

after retirement as well.

     Connelly also experienced medical problems, such as loss

of hearing, lower back problems, high blood pressure, and

depression.   He attributes his hearing loss to the State’s

failure to provide ear protection during firearms training and

the back problems to the physical demands placed on an officer,

such as sitting in a car for extended periods and helping

people on the road by pushing cars out of the way or pulling

people from cars.   He believes that his depression resulted

from the stresses of the job.    Connelly never filed a workman’s

compensation claim for any of these injuries.

                             OPINION

     Petitioners contend that the liquidated damages portions

of their settlement payments were excludable from gross income

pursuant to section 104(a)(2) as compensation paid “on account

of personal injuries or sickness”.      Respondent counters that

petitioners’ liquidated damages payments do not qualify for the

section 104(a)(2) income exclusion because they were not paid

as compensation for personal injuries or sickness and/or

because liquidated damages under FLSA are punitive.      Section

104(a)(2) states that gross income shall not include “the

amount of any damages received (whether by suit or agreement
                               - 8 -

and whether as lump sums or as periodic payments) on account of

personal injuries or sickness”.    Section 104(a) further states

that section 104(a)(2) “shall not apply to any punitive damages

in connection with a case not involving physical injury or

physical sickness.”

       We first consider whether the payments petitioners

received as settlement for liquidated damages in the Kinnett

litigation settlement are excludable from their 1994 taxable

income pursuant to section 104(a)(2) as damages received on

account of personal injuries or sickness.

       Section 61 includes in gross income all income from

whatever source derived.    This section is broadly constructed,

and any statutory exclusions from income must be narrowly

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

(1995).    Section 104(a)(2) provides an exclusion for damages

paid as compensation for personal injuries or sickness.      If the

damages are paid in settlement, the amount is excludable only

if (1) it is received “on account of personal injuries or

sickness”, and (2) it is received for claims “based upon tort

or tort type rights”.    See Commissioner v. Schleier, supra at

333.

       Where damages are received pursuant to a settlement

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

for settlement controls whether such damages are excludable
                              - 9 -

under section 104(a)(2).   See United States v. Burke, 504 U.S.

229, 237 (1992); Thompson v. Commissioner, 89 T.C. 632 (1987),

affd. 866 F.2d 709 (4th Cir. 1989);     Threlkeld v. Commissioner,

87 T.C. 1294 (1986), affd. 848 F.2d 81 (6th Cir. 1988).    The

determination of the nature of a claim is factual.    See Fabry

v. Commissioner, 111 T.C. 305 (1998).    The crucial question is

“in lieu of what was the settlement amount paid”?     Bagley v.

Commissioner, 105 T.C. 396, 406 (1995), affd. 121 F.3d 393 (8th

Cir. 1997).   We first look to the written terms of settlement

agreements to determine the origin and allocation of settlement

proceeds.   See Metzger v. Commissioner, 88 T.C. 834 (1987),

affd. without published opinion 845 F.2d 1013 (3d Cir. 1988).

We may make that determination by reference to such agreement

when it is entered into in an adversarial context, at arm’s

length, and in good faith.   See Knuckles v. Commissioner, 349

F.2d 610, 613 (10th Cir. 1965), affg. T.C. Memo. 1964-33.

     To support their claim that the liquidated damages portion

of the settlement was paid on account of personal injuries

and/or sickness, petitioners direct our attention to the

wording of the release and to petitioners’ testimony about

their understanding of the settlement agreement.     Petitioners
                               - 10 -

interpret the wording of the release3 so that the words “on

account of or in any way arising out of any and all known and

unknown economic losses or damages compensable under the Fair

Labor Standards Act” modifies only “all consequential damage”

rather than modifying the list of all types of relief preceding

and including “all consequential damage”.     By reading the

release in this manner, petitioners claim that they gave up all

possible “actions”, “causes of action”, “claims”, “demands”,

not limited to economic losses or damages, against the State of

Kansas when they signed that release.     In doing so, petitioners

contend that they settled the claims for petitioners’ medical

conditions, thereby making the settlement proceeds paid on

account of personal injury and/or sickness.     We reject this

interpretation.

        Petitioners’ interpretation of the release language is

untenable when considered in conjunction with the explanations


    3
        The actual release stated:

    I * * * hereby release, acquit and forever discharge
    the State of Kansas * * * of and from any and all
    actions, causes of action, claims, demands, declaratory
    judgment, damages, back wages, overtime compensation,
    expenses, compensation, attorneys fees, interest,
    liquidated damages, costs, and all consequential damage
    on account of or in any way arising out of any and all
    known and unknown economic losses or damages
    compensable under the Fair Labor Standards Act
    resulting from or which may result from my employment
    with the State of Kansas or any agency of the State of
    Kansas from January 1, 1987 through August 31, 1994.
    [Emphasis added.]
                               - 11 -

of the release in the settlement and the description of the

cause of action in the pretrial order.      The language in the

release does not indicate that the clause at issue modifies

only the last type of relief in the list given.      If that had

been the intention, the authors could have written it as

petitioners rewrote it in their briefs, with numbers clearly

delineating the types of relief and applying the modifying

clause only to the last type of relief.      The pretrial order

description of the settlement agreement also belies

petitioners’ interpretation.    The release is described as a

release of “any and all claims Plaintiffs have made or could

have made arising out of any and all known or unknown economic

losses or damages compensable under the FLSA”.      This language

clearly excludes from the release any claims for noneconomic

injuries or for any claims for losses or damages arising out of

non-FLSA causes of action.

     Petitioners testified that they understood the release to

cover all claims against the State of Kansas, including any

claims for the medical conditions they contend resulted from

their employment with the State.    Although the belief of the

payee is relevant to the inquiry, the character of the

settlement payment hinges ultimately on the dominant reason of

the payor in making that payment.       See Agar v. Commissioner,

290 F.2d 283, 284 (2d Cir. 1961), affg. T.C. Memo. 1960-21;
                             - 12 -

Fono v. Commissioner, 79 T.C. 680, 694 (1982), affd. without

published opinion 749 F.2d 37 (9th Cir. 1984).   That intent is

clearly expressed in the language of the release and pretrial

order.   We do not need to look further.

     We also find persuasive the lack of any reference to

personal injuries in the amended complaint and/or pretrial

order.   Petitioners never made a claim for or reference to

personal injuries suffered on the job in either.    The complaint

contained only a challenge to the exempt status of certain

State employees and asserted those employees’ rights to receive

overtime compensation.   Though notice pleading is allowed by

the Kansas Code of Civil Procedure, Rules Civ. Proc., Kan.

Stat. Ann. sec. 60-208(e)(1) (1994), the short plain statement

of the claim is sufficient only if it gives the defendant “fair

notice of what the plaintiff’s claim is and the ground upon

which it rests.”   Rinsley v. Frydman, 559 P.2d 334, 338 (Kan.

1977) (citing Conley v. Gibson, 355 U.S. 41, 47 (1957)).

Though it is not necessary to spell out a legal theory of

relief in the pleadings, the opponent must be apprised of the

facts that entitle the plaintiff to relief.   See Oller v.

Kincheloe’s, Inc., 681 P.2d 630, 637 (Kan. 1984).    Petitioners

alleged no facts that provide even a hint of personal injury or

illness.   Petitioners attempt to justify the lack of facts

about injury or illness by claiming that the pretrial order had
                                - 13 -

bifurcated the damages and liability portions of the trial4

and, therefore, claim no discovery on personal injuries was

appropriate.      This reasoning is unsatisfactory because it

ignores the fact that the bifurcation happened more than 2

years after the amended complaint was filed without reference

to injury or illness.

         Moreover, the settlement terms make it unlikely that the

liquidated damages payments were made to compensate specific

personal injuries or sicknesses.      All plaintiffs in Kinnett

received a liquidated damages settlement amount equal to their

back wages payment.      The amounts paid were paid to each

plaintiff in the action without reference to the severity or

even existence of injury.

         Finally, petitioners filed their cause of action under a

Federal act that does not provide for personal injury

compensation.      The FLSA was enacted to establish minimum wages

and maximum hours for employees.      See Brooklyn Sav. Bank v.

O’Neil, 324 U.S. 697, 707 (1945).        According to 29 U.S.C.

section 216(b) (1994), the only relief available under the FLSA

for excessive hours worked is the payment of back wages and

payment of liquidated damages, which are intended to compensate

the employee for damages too obscure or difficult to estimate



     4
       The pretrial order does not explain why the damage and
liability portions of the trial were bifurcated.
                            - 14 -

caused by the delay of wage payment.   See Overnight Motor

Transp. Co. v. Missel, 316 U.S. 572, 583-584 (1942).     While we

do not question the existence or severity of petitioners’

medical conditions, they have failed to demonstrate that any

portion of the settlement was paid on account of those

conditions.

     With no mention of personal injuries in the amended

complaint or pretrial order and given the unavailability of the

type of relief claimed by petitioners under the cause of action

they pursued, there has been no showing that the defendant

settled the claim with an intention of compensating plaintiffs

for personal injury or illness.

     The income exclusion test, under section 104(a)(2), for

personal injury or sickness compensation is two-prong.    Both

prongs, settlement on account of personal injury or sickness

and settlement of a tort or tortlike claim, are required.

Because petitioners cannot show that any portion of the

settlement was paid as compensation for personal injury or

sickness, the income is not excludable under section 104(a)(2).

Though there is some authority that a claim under FLSA may not

sound in contract, thereby opening the possibility of a claim

sounding in tort, it is unnecessary to consider that argument

here because both prongs of the test must be met.
                              - 15 -

     Seeking a more global holding regarding the nature of the

liquidated damages under the FLSA, respondent makes an

alternative argument that the liquidated damages are punitive

and therefore not excludable under section 104(a)(2).    Because

we have already found that petitioners’ liquidated damages

payments were not compensation for personal injury or illness

and therefore not excludable under section 104(a)(2), we need

not decide whether liquidated damages under FLSA constitute

punitive damages.

     To the extent not herein discussed, we have considered all

other arguments made by the parties and find them to be moot or

without merit.

  To reflect the foregoing,


                                Decisions will be entered for

                         respondent.
