                        T.C. Memo. 2003-82



                      UNITED STATES TAX COURT



     RALPH W. EMERSON AND SUZANNE O. EMERSON, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 5877-00.                Filed March 20, 2003.



     Thomas Casazza, for petitioners.

     Margaret A. Martin, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     COHEN, Judge:   Respondent determined a deficiency of $34,956

in petitioners’ Federal income tax for 1998 and a penalty of

$6,991.20 under section 6662(a).   The issues for decision are:

(1) Whether $90,684 petitioners received from settlement of a

lawsuit is excludable from income under section 104(a)(2);

(2) whether the settlement amount is subject to self-employment
                               - 2 -

tax; and (3) whether petitioners are liable for an accuracy-

related penalty under section 6662(a).

     Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the year in issue.

                         FINDINGS OF FACT

     Some of the facts have been stipulated, and the stipulated

facts are incorporated in our findings by this reference.

     Petitioners resided in Davis, California, at the time they

filed their petition in this case.

     Ralph W. Emerson (petitioner) received an undergraduate

degree from the University of California at Los Angeles, studying

neurobiology, mathematics, and chemistry.   He then attended

graduate school at Harvard University, studying informational

systems and chemistry.   Prior to 1998, petitioner was a research

biologist engaged in the business of developing pesticides,

fungicides, and other agricultural products.   Petitioner has

attained about 14 patents from the U.S. Patent Office dealing

with chemistries and biologies of biochemical pesticides and

about twice that amount in international patents.

Petitioner’s Relationship with ProGuard

     On June 26, 1994, petitioner entered into a contract for

services (the contract) with ProGuard, Inc. (ProGuard), to

perform scientific research as an independent contractor.

Petitioner and ProGuard shared an interest in developing “safer
                                - 3 -

chemistries” to be used on food supplies.   Petitioner’s duties

included developing pesticides for sale and developing

intellectual property patents to protect the pesticides

developed.   Under the contract, ProGuard paid to petitioner

$10,000 per month as compensation for these services.    The

contract provided that petitioner was entitled to 15 percent of

the net profits of products sold by ProGuard as a result of his

developments for the company.   The contract provided for the

treatment of proprietary rights of the parties as follows:

                         New Developments

          7.01   Emerson agrees that all designs, plans,
     reports, specifications, drawings, inventions,
     processes, and other information or items produced by
     Emerson while performing services under this agreement
     will be assigned to ProGuard as the sole and exclusive
     property of ProGuard and ProGuard’s assigns, nominees,
     and successors, as will any copyrights, patents, or
     trademarks obtained by Emerson while performing
     services under this agreement. On request and at
     ProGuard’s expense, Emerson agrees to help ProGuard
     obtain patents and copyrights for any new developments.
     This includes providing data, plans, specifications,
     descriptions, documentation, and other information, as
     well as assisting ProGuard in completing any required
     application or registration. ProGuard shall become the
     registrant of all products, shall acquire title to all
     patents and right to such products and shall produce,
     package and sell all products.

                    Successful “Start-Up” Phase

          7.01(a)   If and when the “start-up” phase is
     deemed by ProGuard to be successful and of sufficient
     size to warrant its own identity, a new identity may be
     formed which would handle the sales and marketing of
     the “start-up” products. The parties’ respective
     interests in the new entity shall be based on capital
     invested with Emerson owning 15% [capital interest] and
                                 - 4 -

     ProGuard owning 85%. If additional capital is
     required, equity interest shall be based on partners’
     capital balance. ProGuard will have a right of first
     refusal should Emerson decide to sell his respective
     interest.

     While at ProGuard, petitioner reported to Bradford G.

Crandall, Sr. (Crandall, Sr.).    Crandall, Sr. lent to petitioner

over time $128,424.60, and promissory notes were created to

document the loans (the loans).

     Petitioner was diagnosed with diabetes in about 1990.

During petitioner’s relationship with ProGuard, he took daily

medication for his diabetic condition.   Petitioner ceased working

for ProGuard on or about August 18, 1997.

Lawsuit Against ProGuard

     On September 11, 1997, petitioner filed a complaint against

ProGuard, Crandall, Sr., Bradford G. Crandall, Jr.

(Crandall, Jr.), and a group referred to as “Does 1 though 50”

(collectively, “defendants”) in the Superior Court for the State

of California for the County of Solano (the lawsuit).   The

complaint alleged that petitioner and Crandall, Jr. together

obtained patents for products developed by petitioner while

working with ProGuard.   The patents were held in ProGuard’s name,

which would then package and sell the products.   In consideration

for petitioner’s work, he was to receive 15 percent of the net

profits from the sale of the products and a 15-percent capital

interest in any entity formed by ProGuard and petitioner to sell
                                 - 5 -

and market the products.    The complaint also discussed the loans

made by ProGuard to petitioner.    Petitioner alleged that he

“reasonably believed” that the loans represented advances of

future compensation to be paid to him rather than a decrease in

his expected capital interest.

     The complaint referred to a document titled “Amendment to

Contract for Services dated June 26, 1994 and Secured Promissory

Note” signed in June 1997 (June 1997 agreement).    Petitioner

additionally alleged that, in the June 1997 agreement, ProGuard

loaned to him a final amount of $10,174.72 and, in consideration

of this loan, petitioner waived any interest in a future startup

entity formed by petitioner and the defendants.

     After raising the general allegations regarding the contract

and the June 1997 agreement, the complaint raised several causes

of action including:   (1) Rescission based on undue influence;

(2) rescission based on fraud and false promises; (3) breach of

contract; (4) breach of covenant of good faith and fair dealing;

(5) declaratory relief; (6) slander; (7) constructive trust;

(8) quantum meruit; (9) conspiracy; (10) intentional infliction

of emotional distress; and (11) injunctive relief.

     On October 2, 1997, petitioner filed a first amended

complaint in the lawsuit.   The amended complaint added

reformation based on unconscionability, fraud, and unilateral
                               - 6 -

mistake as additional causes of action.   In total, the amended

complaint raised 16 separate causes of action.

     The defendants filed their answer and a cross-complaint on

December 23, 1997.   The cross-complaint alleged breach of

contract, conversion, and breach of covenant of good faith and

fair dealing as causes of action against petitioner.   Petitioner

filed a status conference report on January 2, 1998, stating that

the nature of the case was in contract and tort.   Petitioner

filed a second status conference report on March 5, 1998, and

included a statement of the nature of the case as rescission or

reformation of written contracts, breach of covenant of good

faith and fair dealing, declaratory relief, quantum meruit,

slander per se, constructive trust, conspiracy, intentional

infliction of emotional stress, and injunctive relief.

Petitioner filed an answer to the defendants’ cross-complaint on

March 6, 1998.

Settlement of the Lawsuit

     In March 1998, retired California State Superior Court Judge

Richard Gilbert conducted a mediation with the parties.   In

attendance at the mediation were petitioner, petitioner’s counsel

Thomas Casazza, petitioner’s accountant Robert K. Stevenson

(Stevenson), the defendants, and their counsel Gregory Dyer

(Dyer).   Judge Gilbert suggested during the mediation that

petitioner add a personal injury claim to the suit as a vehicle
                               - 7 -

to reach settlement.   After the mediation, there were several

telephone conversations, facsimile exchanges, and correspondence

among Judge Gilbert and counsel for both parties regarding the

specifics of the settlement.

     On July 21, 1998, petitioner’s counsel sent to the

defendants’ counsel a package including the settlement agreement,

a stipulation to amend the complaint, a second amended complaint,

and a signed dismissal for both the complaint and the cross-

complaint.   Petitioner’s counsel included a cover letter to this

package stating:

          Per our discussion a couple of months ago, we are
     simply amending the complaint prior to dismissal to
     comply with accounting advice we have received. It has
     no operative effect whatever on the settlement.

          You can forward the dismissals to the Clerk with
     the instructions to enter the dismissals after the
     stipulation is signed and the amended complaint is
     filed * * *

     The settlement agreement was signed by petitioner on

July 20, 1998, and by the defendants on August 6, 1998.   The

other three documents in the settlement package were dated in

July 1998, but were not received by the court until October 13,

1998.

     The settlement agreement referred to the complaint and the

two amended complaints by stating that petitioner sought damages

for breach of contract and several causes of action including

infliction of emotional distress and personal injury.   The
                               - 8 -

settlement agreement stated that ProGuard would pay to petitioner

$65,000 with additional amounts to be paid beginning 1 year from

the settlement.   In addition, the settlement agreement provided

that ProGuard was to forgive, in equal amounts over 5 years, the

$128,424.60 that was owed by petitioner.   The $65,000 cash

payment and $25,684.92 of debt forgiveness that was received by

petitioner in 1998 are referred to as the settlement amount.    At

the time of settlement, the defendants did not report a personal

injury claim to their insurance company to cover the cost.

     On October 13, 1998, petitioner and the defendants filed a

stipulation, permitting petitioner to file a second amended

complaint.   Simultaneously, petitioner filed the second amended

complaint adding a cause of action for negligence.   The

negligence cause of action claimed that the defendants owed to

petitioner a duty of care as “not to exacerbate” petitioner’s

diabetic condition.   Petitioner claimed that the defendants

created “intolerably stressful working conditions” by harassing

petitioner while he was working, inducing him to work long days,

threatening to terminate his employment, and threatening to

reduce petitioner’s capital interest.   Petitioner alleged that

this stress exacerbated his diabetic condition resulting in a

“deterioration in his overall health and a reduction in his life

expectancy”.
                              - 9 -

     Four minutes after petitioner filed the second amended

complaint, the parties filed a request for dismissal, which the

court entered the same day.

Federal Tax Return

     Petitioners filed their Federal income tax return for 1998,

reporting taxable income of $108,004.08 and tax of $24,907.

Petitioners reported wages paid to petitioner of $141,000 from

Summus Group, Ltd., shown on a W-2, Wage and Tax Statement.

Petitioners received a Form 1099-MISC, Miscellaneous Income, from

ProGuard for $90,684.92 of nonemployee compensation.   When

preparing petitioners’ return, Stevenson was told that the

lawsuit settled after the parties agreed that a claim for

personal injury could be added by petitioner and that the payment

was made based on physical injury.    Stevenson did not review the

entire second amended complaint or the other two complaints prior

to preparing petitioners’ return.

     Petitioners included an attachment to their return, with a

copy of the Form 1099, stating that the $90,684.92 was

“excludable from taxpayer’s taxable income pursuant to section

104(a)(2)” and was therefore not reported on their return as

income.
                              - 10 -

                              OPINION

Settlement Proceeds

     Respondent determined that petitioners are not entitled to

exclude the settlement amount from income because it was not

received on account of any personal physical injury or physical

sickness.   Petitioners contend that the settlement payments are

excludable under section 104(a)(2) because they were received on

account of petitioner’s physical injury.   Specifically,

petitioners argue that the “lawsuit was settled only after there

was a specific agreement to allow an amendment to petitioner’s

complaint to include a claim for physical injury, and that the

reason the case was able to settle was because a payment was

going to be made and received on that basis.”

     In this case, petitioners have neither argued that section

7491 is applicable to shift the burden of proof to respondent nor

established that they complied with the requirements of section

7491(a)(2)(A) and (B).   The resolution of this issue does not

depend on which party has the burden of proof.   We resolve this

issue on the preponderance of the evidence in the record.

     Section 61(a) includes in gross income "all income from

whatever source derived" unless otherwise provided.   Section

104(a)(2), however, excludes 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
                              - 11 -

account of personal physical injuries or physical sickness”.

Amounts are excludable from gross income only when (1) the

underlying cause of action giving rise to the recovery is based

on tort or tort-type rights and (2) the damages were received on

account of personal injuries or sickness.     Commissioner v.

Schleier, 515 U.S. 323, 336-337 (1995); sec. 1.104-1(c), Income

Tax Regs.   Damages are not excludable from gross income under

section 104(a)(2) if the damages are received pursuant to the

settlement of economic rights arising out of a contract.       See

Robinson v. Commissioner, 102 T.C. 116, 126 (1994), affd. in

part, revd. in part on another ground 70 F.3d 34 (5th Cir. 1995);

see also Fono v. Commissioner, 79 T.C. 680, 692 (1982), affd.

without published opinion 749 F.2d 37 (9th Cir. 1984).

     If damages are received pursuant to a settlement agreement,

the nature of the claim that was the actual basis for settlement,

rather than the validity of the claim, determines whether the

damages were received on account of tortlike personal injuries.

See Robinson v. Commissioner, supra at 126.    The determination of

the nature of the claim is made by reference to the settlement

agreement in light of the surrounding circumstances.     Id.    A key

question to ask is:   “In lieu of what were the damages awarded?”

Id. (quoting Raytheon Prod. Corp. v. Commissioner, 144 F.2d 110,

113 (1st Cir. 1944), affg. 1 T.C. 952 (1943)).    If the settlement

agreement does not expressly allocate the settlement between
                                  - 12 -

tort-type personal injury damages and other damages, an important

factor in determining the validity of the agreement is the intent

of the payor.   Id. at 127.

     In this case, the settlement agreement does not allocate the

payment among the separate causes of action, so the nature of the

claim must be determined by looking at the facts and

circumstances surrounding the case and the intent of the payor.

Settlement Agreement and Underlying Complaints

     Petitioner first alleged a claim for personal injury in the

second amended complaint, which was filed with the court the same

day as the dismissal.   The second amended complaint alleged

harassment and threats by the defendants and long working hours.

Petitioner’s testimony at trial of this case was different.

Petitioner testified that he suffered physical injuries because

of poor laboratory conditions and exposure to toxins while

working for ProGuard and that these conditions harmed his

deteriorating health.   Petitioner testified in response to

questions from his counsel:

          Q      Did you suffer physical injury because of
     the conditions in the laboratory of ProGuard?

          A      I assume that I did, breathing in the
     solvents, and the active ingredients that, you know,
     that kill aphid, and spider mite, and various fungi.

                  *     *     *     *      *   *   *

          Q      Dean Emerson, do you know personally why
     you suffered physical injury while you were working at
     ProGuard?
                              - 13 -

          A       Yes.

          Q       And what was that?

          A      I think it was working under the conditions
     that were present in the work environment which were a
     physical situation with laboratories, preparations of
     materials without the best of good laboratory
     practices, and the mental attitude, the gestalt that
     went with that.

     Petitioner did not, however, raise the issue of the poor

laboratory conditions and exposure to toxins until the time of

trial of this case in May 2002, when petitioner’s counsel

attempted to introduce expert evidence to demonstrate the risk

associated with working with the chemicals to which petitioner

was exposed.   Petitioner’s sole tort claims prior to the second

amended complaint consisted of slander and intentional infliction

of emotional distress, neither of which qualifies for exclusion

under section 104(a)(2).

     At trial, when petitioner’s counsel questioned petitioner as

to why the defendants paid him the settlement money when the

products he developed had not yet made it to market, petitioner

responded that the money was paid for “positive results” and the

gamble taken in gaining the patents.   Petitioner then responded

to leading questions from his counsel that he received the money

for a medical settlement for the deterioration of his health.

The totality of petitioner’s testimony suggests that he settled

the case with the defendants based on the uncertainty of
                                - 14 -

litigation and questionable prospects for recovery on his

contract claims.

     In a similar situation, the taxpayers in Fono v.

Commissioner, supra at 698-699, initiated litigation because of

their disappointment with a contract under which they expected to

receive over $1 million.    The taxpayers requested the allocation

in the settlement agreement to include personal injury to avoid

taxation on the amount.     The defendants in Fono adamantly refused

to make such an allocation and did not recognize any liability in

tort.     In recognizing the economic realities of the litigation,

this Court held that the entire amount was taxable.

     Personal injury was 1 of 10 causes of action referred to in

the settlement agreement and 1 of 17 causes of action in the

second amended complaint.    The mere mention of a physical injury

in a complaint does not, by itself, serve to exclude the recovery

of gross income under section 104(a)(2).    Petitioners argue that

the settlement was finalized based on the stipulation between the

parties to allow the second amended complaint to be filed, adding

a claim for personal injury.    This agreement is insufficient to

meet the requirements under section 104(a)(2).    The settlement

agreement and the second amended complaint together do not show

that the actual basis of settlement was on account of personal

injury.    In fact, petitioner’s counsel admitted in his cover

letter to the defendants’ counsel that the second amended
                               - 15 -

complaint had “no operative effect whatever on the settlement.”

Even if we were to conclude that petitioner’s claim for personal

injury was valid, the settlement agreement did not specifically

allocate any of the payment towards settlement of that particular

claim.

Intent of the Payor

     Crandall, Jr. testified that the defendants had two reasons

for settling the case.    First, they wanted to have clear title on

the patents.   Second, they were afraid that, if they were tied up

in litigation for a period of time, they would lose their

“marketing opportunity”.    Crandall, Jr. further testified that

their “main objective in settling this case, our main reason to

settle this was not over a personal injury.    It was to make clear

the intellectual property that we wanted so that we could go to

market and make money.”    The defendants’ counsel, Dyer, also

testified similarly that the mediation and settlement were to

transfer clearly all rights in the patents to ProGuard.

Crandall, Jr. testified that the entire mediation discussion

revolved around the contractual dispute and there was no mention

of a claim for personal injury.    See Dickerson v. Commissioner,

T.C. Memo. 2001-53 (no evidence of personal injury discussed in

negotiations); Coblenz v. Commissioner, T.C. Memo. 2000-131 (no

discussion regarding tort claim during final settlement).
                              - 16 -

     In Robinson v. Commissioner, 102 T.C. at 123-124, the

parties entered into a settlement agreement that did not contain

an allocation, but they included an allocation in the final

judgment.   The judge approved the judgment which allocated 95

percent of the settlement amount to a personal injury claim

solely to minimize the tax liability.    This Court refused to

accept the allocation in the final judgment stating:

     Petitioners therefore desired, and were given, the
     unfettered discretion to allocate the settlement
     proceeds in any manner they desired in order to
     minimize their Federal income tax liability. We find
     that petitioners deliberately and unilaterally arrived
     at the allocations contained in the final judgment
     solely with a view to Federal income taxes, and not to
     reflect the realities of their settlement. [Id. at
     129.]

In Robinson, the Court concluded that the defendant did not

intend to settle one claim to the exclusion of another.

Similarly, in this case, the defendants solely intended to

dispose of the case and secure their proprietary interests, and

they did not object to petitioner’s attempt to structure the

settlement to satisfy his tax goals.    The defendants’ counsel

testified that how petitioner structured the pleadings was his

“problem” once the settlement amount was agreed to and the

proprietary interests were secure.

     As to petitioner’s belated claim for personal physical

injury, the “courts have not looked with favor upon retroactive

revisions of written instruments * * * as a ground for
                                - 17 -

determining tax liabilities.”    Fono v. Commissioner, supra at

695.    The allocation in this case is indistinguishable from

numerous cases denying such retroactive tax planning.    See

Robinson v. Commissioner, supra at 133-134; Banks v.

Commissioner, T.C. Memo. 2001-48; Burditt v. Commissioner, T.C.

Memo. 1999-117.    When the allocation language sought by a

taxpayer is entirely tax motivated and does not reflect the

economic realities of the settlement, the Court refuses to accept

the characterization made by only one of the parties to the suit.

       Based on the record, we cannot hold that the settlement

amount or any part of it was paid on account of personal injury.

The record compels the conclusion that the reference to personal

injuries in the settlement documents was an afterthought, solely

in anticipation of tax benefits, and did not reflect the nature

of the claim by petitioner against ProGuard.    We therefore hold

that the entire settlement amount is includable in petitioners’

gross income.

Self-Employment Tax

       Respondent contends that the entire settlement amount,

including the cancellation of indebtedness, is subject to self-

employment tax under section 1401 because the amount received was

compensation for services under petitioner’s employment contract.

Respondent claims that the defendants could have paid to

petitioner an increased cash amount, with which petitioner could
                               - 18 -

have repaid his debt, and that increased amount would be subject

to self-employment tax.    Petitioners argue that petitioner’s

activities in the litigation do not meet the criteria of section

1401 requiring an active trade or business.

       Section 1401(a) imposes a tax on self-employment income

consisting of the earnings of a trade or business carried on by

the individual.    See sec. 1402(a) and (b).   An individual is

engaged in a trade or business if such individual’s activities

are conducted with continuity and regularity and primarily for

income or profit.    Sec. 1402(c).

       Petitioner was an independent contractor engaged in the

trade or business of research.    The settlement amount he received

was to settle a contract dispute and represented compensation for

the research services he rendered to ProGuard as an independent

contractor.

       There is no reasonable dispute that the $65,000 cash payment

was for petitioner’s services and is subject to self-employment

tax.    Petitioner’s complaint against ProGuard alleged that he

“reasonably believed” that each of the loans from the defendants

represented advances against future compensation.     Thus the

forgiveness of this debt also represented compensation to

petitioner.    Petitioners did not distinguish between the cash

payment and the debt forgiveness on their return, during trial,

or in their briefs.    The total consideration received by
                               - 19 -

petitioner was compensation under the services contract and is

subject to self-employment tax.

Accuracy-Related Penalty

     Respondent contends that petitioners are liable for an

accuracy-related penalty under section 6662(a).   Respondent has

the burden of production under section 7491(c) and must come

forward with sufficient evidence that it is appropriate to impose

the penalty.    See Higbee v. Commissioner, 116 T.C. 438, 446-447

(2001).

     Under the narrow circumstances of this case, we hold that

petitioners are not liable for the accuracy-related penalty.

Petitioners relied on the suggestion of Judge Gilbert and on

their attorney’s advice to include a claim for personal injury.

Petitioner accepted less in settlement of his claims than he

hoped for, after a way to avoid tax on the proceeds was suggested

by Judge Gilbert.    Respondent does not contest the assertion that

Judge Gilbert suggested the form of the settlement agreement.

Petitioner was told that structuring the settlement to include a

claim for personal injury would relieve him of his tax liability.

Based on our review of the record, we conclude that petitioners

are not liable for the accuracy-related penalty imposed under

section 6662.
                        - 20 -

To reflect the foregoing,


                                  Decision will be entered

                             for respondent with respect

                             to the deficiency and for

                             petitioner with respect to the

                             penalty.
