                       T.C. Memo. 1997-330



                     UNITED STATES TAX COURT



    GEORGE AND KATHLEEN KNEVELBAARD, ET AL.,1 Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 21366-94, 21981-94,           Filed July 21, 1997.
                 22527-94, 22528-94,
                 22529-94, 22530-94,
                 22531-94.



     George and Kathleen Knevelbaard, pro sese.

     Danny D. Brace, Jr., for petitioners in docket No. 21981-94.

     Ronald W. Hillberg, for petitioners in docket Nos. 22527-94,

22528-94, 22529-94, 22530-94, and 22531-94.


     1
          Cases of the following petitioners are consolidated
herewith: Wilbur E. Gomes and Irene R. Gomes, docket No. 21981-
94; Sam S. Kooistra and Cynthia L. Kooistra, docket No. 22527-94;
Walter H. Brown and Helen Joan Brown, docket No. 22528-94; Arnold
Leroy Souza and Rosemary Souza, docket No. 22529-94; Vernon C.
Christian and June C. Christian, docket No. 22530-94; and Phillip
A. Souza and Llyn Souza, docket No. 22531-94.
                               - 2 -


     Kelly Mulholland and Andrew Gottlieb, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION

     PARR, Judge:   Respondent determined the following

deficiencies in petitioners’ Federal income tax for the 1990 tax

year:

Docket No.              Petitioners                  Deficiency

21366-94       George and Kathleen Knevelbaard            $6,592
21981-94       Wilbur E. and Irene R. Gomes               23,294
22527-94       Sam S. and Cynthia L. Kooistra              1,404
22528-94       Walter H. and Helen Joan Brown              2,393
22529-94       Arnold Leroy and Rosemary Souza             2,646
22530-94       Vernon C. and June C. Christian             1,680
22531-94       Phillip A. and Llyn Souza                   5,349

     All section references are to the Internal Revenue Code in

effect for the years in issue, and all Rule references are to the

Tax Court Rules of Practice and Procedure, unless otherwise

indicated.

     The issue is whether payments received by petitioner dairy

farmers from various Bank Defendants in settlement of a lawsuit

are excludable from gross income as compensation for personal

injuries under section 104(a)(2).     We hold they are.

                         FINDINGS OF FACT

     Some facts have been stipulated and are so found.       The

stipulation of facts and attached exhibits are incorporated

herein by this reference.   When their petitions were filed, all

petitioners resided in California.
                                - 3 -


     Petitioners are dairy farmers (milk producers) who sold raw

milk to Knudsen Dairy (Knudsen), a large independent processor

and distributor of dairy products in California.   The

Knevelbaards are members of the South Valley Milk Producers

Cooperative, and the Christians are members of the Cal-Dari

Cooperative.   Petitioners Gomes, Kooistra, and Brown are

independent producers.   The Souzas are partners in P&L Souza

Dairy.

     In early 1985 Knudsen purchased Foremost Dairies (Foremost).

Citicorp Industrial Credit, Inc. (Citicorp), along with Security

Pacific Business Credit, Inc., Wells Fargo Business Credit, Inc.,

Goldome Bank, and National Bank of Canada, provided the financing

for Knudsen’s purchase of Foremost (collectively, Bank

Defendants).   As part of the financing agreement for Knudsen’s

purchase of Foremost, the Bank Defendants also refinanced

Knudsen's existing debt.

     Knudsen entered into long-term agreements with dairy farm

cooperatives and independent producers, including petitioners,

for the purchase of raw milk.   The contracts required Knudsen to

buy all milk produced by the milk producers.   Knudsen was
                               - 4 -


required to pay for the raw milk twice per month;2 the dairies

were required to ship milk to Knudsen on a daily basis.

     On July 14 and again on July 31, 1986, Knudsen failed to pay

the milk producers about $30 million for raw milk delivered to

Knudsen between June 16 and July 15, 1986.     On July 15, Knudsen

began to make daily payments for milk delivered the previous day.

However, no payments were made on the $30 million back debt.

     When Knudsen defaulted, petitioners could not simply stop

producing milk.   Cows had to be milked and fed.    Farmhands had to

be paid.   Grain had to be purchased.    The farmers were operating

on very slim profit margins.   They faced the possibility of

slaughtering their herds or pouring the milk onto the ground.

For years (in some cases for more than one generation) they had

relied on the regularity of the milk payments.     Unexpectedly,

they were faced with borrowing money, depleting their savings,

and possible bankruptcy.

     The uncertainty of their situation produced enormous stress,

which did not end on July 15, 1986.     The financial problems

caused by losing payment for 4 weeks' worth of milk persisted,

because the loss was not repaid.   Even when Knudsen began making

daily payments, there was no guarantee that the money would be

     2
          According to the stipulation, the contract required
payment on the 13th and 28th days of each month. However,
petitioners testified that they received payment on the 15th and
either the last day of the month or 1st day of the succeeding
month. The discrepancy is not material.
                                - 5 -


there from one day to the next.    Petitioners had to rearrange

their lives so they could be personally present when the milk was

picked up, in order to see the money before they released the

milk.    The situation did not stabilize for months.

     The personal experiences of three of petitioners illustrate

the effects of these events.

     Phillip A. Souza (Souza) was in partnership with his

brother, petitioner Arnold Leroy Souza.    Souza has been a dairy

farmer for 30 years.    At the time of the default, he owned about

450 cows which had to be milked every day.    Unlike many of the

milk producers, Souza was able to find another dairy to buy his

milk within 2 days of Knudsen's default.    Even so, he lost about

$76,000, which forced him to borrow money from his father and a

bank.3   He suffered a stress-related heart attack in 1988 (for

which he takes 11 pills daily).

     George Knevelbaard (Knevelbaard) was born into the dairy

industry and believed, based on past experience, that "There

would always be work, there would always be bills, and on the

first and the 15th there was always a check in the mailbox.      This

was as certain as the sun rising and setting."    His expenses were

about 90 percent of his revenue.    He was shocked to discover that

the system on which he and his family had always depended was in

jeopardy.    Suddenly, and continuing for months, he could not

     3
            As of Dec. 14, 1995, the money had not all been repaid.
                                - 6 -


predict from one day to the next whether a truck would come to

pick up the milk or, if it did, whether he would be paid.

       At the time of the default by Knudsen, Wilbur Gomes (Gomes)

had been in the dairy business 29 years.     He grew up on a dairy

farm and began his own operation in 1957 with 29 cows.     By 1986,

he had 800 cows and 800 calves.    Each cow had to be milked twice

a day.    The "morning milking" began at 10 p.m. the prior evening

and ended at 6 a.m.    The evening milking went from 10 a.m. to 6

p.m.    This had to be done 365 days a year.   Gomes' operation

required nine full-time farmhands working 7 days per week.

       Gomes began selling his milk to Borden Dairy in 1957 and

continued with Knudsen when it acquired Borden in 1978.     For 29

years the milk money always came, twice a month.      His costs for

feed and overhead were about 95 percent of his revenue.     Expense

payments were geared to the milk payments.     For instance, his

employees were paid twice a month, on the 1st and 15th.     Gomes

paid his grain dealer with the milk check that came the 15th of

each month.    His grain bill ran between $30,000 and $40,000 per

month.    When the first milk check did not arrive, Gomes used up

all of his life savings to pay the grain bill.     Gomes' major fear

was that, because of the $4,000 daily overhead which he could no

longer pay, he would have to start slaughtering his herd of

purebreds, built up over 30 years.      He received an appraisal that
                                - 7 -


the slaughter price as meat would be only 20 percent of the

herd's value as dairy cows.

     Gomes frantically looked for another place to sell his milk,

going to daily meetings of dairymen's associations and

cooperatives, but all to no avail, because everyone was in the

same boat.   In September 1986, after Knudsen sold its plant in

Hughson, California, Gomes began shipping his milk to the new

owners there.

     Despite their stress, petitioners did not seek professional

mental health assistance.   Their reasons were varied.   Some were

cultural.    Gomes was brought up in a small Portuguese community

of about 2,000 people.   He had been taught that an emotional

problem was a sign of personal inadequacy, and to seek

professional help was a thing to be shunned.    Knevelbaard's

reasons for not seeking professional help were religious.    In

times of stress he seeks consolation and encouragement through

prayer and Bible reading.

     Within 2 months after Knudsen defaulted on payments to the

milk producers it filed a chapter 11 petition in the U.S.

Bankruptcy Court for the Central District of California.    The

milk producers were unsecured creditors.   All filed proofs of

claim.

     On January 12, 1989, petitioners were among nearly 1,000

milk producers, individually or through their cooperatives, who
                              - 8 -


also filed a complaint against the Bank Defendants, in the action

entitled In re Milk Producers v. Citicorp Industrial Credit, Inc.

(milk producers action) in the Superior Court of the State of

California, Los Angeles County.   By stipulation re amendment of

exhibit A to the complaint, filed July 2, 1990, all petitioners

herein were named as plaintiffs in their individual capacities;

the entities with which they were affiliated were also named.

The complaint alleged 12 causes of action sounding in tort based

upon the Bank Defendants' direct liability:   (1)

Fraud/misrepresentation, (2) negligent misrepresentation, (3)

intentional interference with contractual relationship, (4)

negligent interference with contractual relationship, (5)

intentional interference with prospective economic advantage, (6)

negligent interference with prospective economic advantage, (7)

intentional infliction of emotional distress, (8) negligent

infliction of emotional distress, (9) breach of fiduciary duty,

(10) constructive fraud, (11) unjust enrichment, and (12) unjust

enrichment as a result of good faith belief induced by the Bank

Defendants' behavior.

     Plaintiffs alleged eight additional causes of action (the

indirect causes of action) based upon a theory of the Bank

Defendants' alleged derivative liability through Knudsen:    (13)

Breach of contract, (14) breach of implied covenant, (15)

fraud/misrepresentation, (16) negligent misrepresentation, (17)
                               - 9 -


intentional infliction of emotional distress, (18) negligent

infliction of emotional distress, (19) breach of fiduciary duty,

and (20) constructive fraud.

     Causes of action 1 through 10 and 14 through 20 allege that

as a proximate result of the Bank Defendants' wrongful conduct,

     individual MILK PRODUCERS have suffered anxiety,
     humiliation, worry, mental anguish and emotional and
     physical distress * * * and have been injured in mind
     and body all to their general damage * * *.

Other injuries alleged were that plaintiffs incurred medical

expenses, were prevented from pursuing normal employment,

suffered a loss of income and business advantage, and suffered

loss of consortium.

     In the prayer for relief, plaintiffs sought damages for

mental suffering, emotional distress, and loss of consortium in

every cause of action except Nos. 11, 12, and 13.   They also

sought damages for medical and related expenses and for lost

earnings in every cause of action.

     The alleged behavior giving rise to the complaint was that

the Bank Defendants made risky loans to Knudsen for the purchase

of Foremost, knowing that both Knudsen and Foremost were highly

leveraged and vulnerable.   As the direct lender, Citicorp took

security interests in all of Knudsen's assets,4 thereby putting


     4
          The other Bank Defendants were participants in the loan
(i.e., they bought parts of the loan after it was made) and did
not have direct security interests.
                                - 10 -


in jeopardy payment to plaintiffs and other creditors.    The

complaint also alleged that the banks continued to give false

assurances of Knudsen's solvency, inducing plaintiffs to continue

to supply milk for a longer period than they otherwise would

have, so that the banks' security interests would be enhanced to

the detriment of plaintiffs.5    The indirect causes of action stem

from the allegation that the financing arrangements were such

that they gave the banks virtual control over Knudsen and were

thus indirectly responsible for its actions.    The Bank Defendants

denied the allegations.

     The amounts claimed as general damages in Exhibit A attached

to the complaint are approximately equal to the milk losses.

     The milk producers were represented by Michael J. Bidart

(Bidart) of Shernoff, Bidart & Darras.    William J. F. Roll III

(Roll) of Shearman & Sterling represented the Bank Defendants.

     The milk producers action was part of a larger coordinated

proceeding entitled Coordination No. 2138, which involved the

Knudsen matter and included approximately 20 different lawsuits

against the Bank Defendants.    Generally, five groups or subsets

of plaintiffs were represented.    One set was the milk producers

litigation, which eventually was resolved in a settlement that

included plaintiffs from a separate suit filed by the Danish

     5
          The milk producers, in fact, lost payment for 4 weeks'
worth of raw milk worth about $30 million before Knudsen began
paying on a daily, C.O.D. basis.
                               - 11 -


Creamery Association (Danish Creamery), another cooperative also

represented by Bidart.   The Danish Creamery plaintiffs are not

petitioners in this case.

     The coordinated proceedings included four other lawsuits.

One was a single suit brought by Knudsen and certain affiliates

and subsidiaries, known at the time as K.F. Dairies, Inc.

Another was also a single action brought by parties (known as the

F.D. partners) who had sold their stock in Foremost to Knudsen

and had received security interests that were subordinated to

those of the banks.

     In addition, Citicorp filed separate cross-complaints

against K.F. Dairies, Inc., and the F.D. partners for

indemnification.   Citicorp's suit against K.F. Dairies was based

on claims stemming from the loan and security agreement between

Citicorp and Knudsen.    Its suit against the F.D. partners was not

based on contract but on a theory of equitable indemnity.6

     6
          The related suits were conditionally settled in an
agreement dated Aug. 23, 1990. The settlement was subject to
various conditions and events in the future. Unlike the
situation of the milk producers settlement of Aug. 13, 1990, this
settlement required the approval of the bankruptcy court.
     One contingency in the Aug. 23 agreement was the banks'
obtaining releases by the milk producer plaintiffs of their
claims as unsecured creditors of the bankruptcy estate, in return
for an assignment by Knudsen of its causes of action for breach
of fiduciary duty against its individual directors and officers.
     The agreement called for a plan of reorganization of Knudsen
and its affiliates to be jointly proposed by all the various
parties (not including the milk producers), reflecting an agreed
division of the remaining assets in the estate. When the
                                                   (continued...)
                                - 12 -


     All of the coordinated lawsuits were assigned to Judge Jack

Tenner.

The Milk Producers Settlement

     On July 30, 1990, Judge Tenner held a settlement hearing on

the milk producers action.   The parties orally stipulated that

all causes of action alleged in the milk producers complaint be

dismissed, except for negligent infliction of emotional distress.

The Bank Defendants would pay $20 million as payment in full for

that cause of action.   Judge Tenner specifically found, on the

record, that the claims pending in the Knudsen bankruptcy

proceeding were "for the production and delivery of milk which

was not paid for", and that the settlement in the milk producers

action did not affect the rights of plaintiffs to receive payment

elsewhere for the lost milk.

     The judge then added:

     The Court has been with this litigation for some time
     and has read all of the allegations, and finds that the
     negligent infliction of emotional distress is a much
     more serious claim as far as the individual farmers are
     concerned; and, therefore, that would be the basis of
     the allocation, plus my familiarity with file cabinets
     full of paper in this lawsuit.

Judge Tenner also stated his understanding that the settlement


     6
      (...continued)
reorganization was finally confirmed and effected, the lawsuits
would be finally dismissed with prejudice.
     The record does not reflect whether or when the cases were
actually dismissed with prejudice.
                              - 13 -


applied to all plaintiffs who were Attorney Bidart's clients.

     The judge stated he would approve the settlement, which was

to be reduced to writing, and that negotiations on the language

would begin the next night.

     Roll, the banks' lawyer, prepared the first draft of the

settlement agreement.   The Bank Defendants' concern was twofold:

That all claims be released and that none of the money being paid

could fairly be said to arise out of gross negligence or willful

misconduct.   That was because the banks wanted to preserve a

right to indemnification by Knudsen (now KF Dairies) set out in

the loan and security agreements that financed the Foremost

purchase.   Although Knudsen was bankrupt, the banks were secured

creditors and hoped to recoup as much as possible of their

payment to the milk producers.   This left nine possible causes of

action on which to structure a settlement; i.e., Nos. 2, 4, 6, 8,

12, 13, 14, 16, and 18.

     Roll was familiar with evidence, in the form of depositions

and answers to written interrogatories, of particularized

emotional distress suffered by several dozen milk Producer

plaintiffs.

     In focusing on the emotional distress issue, the Bank

Defendants were also heavily influenced by an earlier off-the-

record conversation with Judge Tenner, who was actively involved

in the settlement talks.   The banks' consistent position was that
                              - 14 -


they were not liable for claims arising out of the contract

between Knudsen and the milk producers for delivered and unpaid

raw milk.   Judge Tenner had seen the depositions and answers to

interrogatories filed by dozens of dairy farmers.   He expressed

strong views that a jury would not care about the "technical

details" but would be very sympathetic to the milk producers'

individual testimony about claimed distress.7

     The judge told the Bank Defendants' counsel that in front of

a jury, they could "get killed", because they were representing

five large financial institutions, and plaintiffs were a thousand

dairy farmers around the State of California.

     Although the parties had indicated to Judge Tenner at the

settlement hearing that the entire amount would be attributed to

negligent infliction of emotional distress, the final written

agreement attributed $19,328,966 to that claim and $671,034 to

negligent interference with contractual relationship (the fourth

cause of action in the Complaint, which also sought both general

damages and damages for mental suffering and emotional distress).

The parties wanted to be sure all plaintiffs, including entities,

were covered by the settlement.




     7
          Respondent objected to the admission of Judge Tenner's
comments as hearsay. Those comments are received not for the
truth of the matter asserted but for the effect of Judge Tenner's
views on the chief negotiator for the Bank Defendants.
                              - 15 -


     To accomplish these goals, the settlement document did not

require any specific allocation to specific plaintiffs but left

allocation and distribution up to plaintiffs' counsel.    Paragraph

2(c) of the settlement agreement provides as follows:

          (c) Without reference to and without affecting
     the allocation or distribution of the Settlement
     Payment among the various parties plaintiff, the
     Settlement Payment [$20 million] shall be attributed as
     follows:

               (i) Six Hundred Seventy-one Thousand
          Thirty-Four Dollars ($671,034.00) shall be
          attributed to the so-called "direct" cause of
          action in the Milk Producers Complaint for
          negligent interference with contractual
          relationship (the fourth cause of action);
          and

               (ii) Nineteen Million Three Hundred
          Twenty-eight Thousand Nine Hundred Sixty-six
          Dollars ($19,328,966.00) shall be attributed
          to the so-called "direct" cause of action in
          the Milk Producers complaint for negligent
          infliction of emotional distress (the eighth
          cause of action);

               (iii) Nothing shall be attributed to
          any of the other causes of action in the Milk
          Producers Complaint or to any cause of action
          in the Danish Creamery complaint.

     [Emphasis added.]

     Neither the Bank Defendants nor the milk producers wanted to

settle on any basis relating to the contracts between Knudsen and

the milk producers.   The banks consistently denied any liability

on the contracts, and plaintiffs wanted to retain their direct

claims for nonpayment of milk against the bankruptcy estate.

Moreover, such a settlement would have required the bankruptcy
                                - 16 -


court's approval, which was not necessary under the agreement

reached.

     On August 13 and 14, 1990, a settlement agreement was

signed, binding the Bank Defendants on one hand and the milk

producers and Danish Creamery on the other.           The Bank Defendants

agreed to pay a total of $20 million in exchange for release of

all of the milk producers and Danish Creamery claims.          Funds were

to be distributed among plaintiffs in both suits by plaintiffs'

counsel.

     The record is not clear exactly how the $20 million was

allocated among the plaintiffs.    While there seems to be some

relationship between the amount recovered and the lost milk

money, there was not a pro rata distribution based on an exact

percentage.   For instance, petitioners recovered the following

amounts:

Petitioners          Amount Owed     Recovered             Percent

Knevelbaard           $58,500            $31,391            53.7
                                          1
Gomes                 118,369              62,368           52.7

Kooistra               10,000                 4,993         49.9

Christian              12,719                 6,487         51.0

A.L. Souza             37,000             18,721            50.6

P.A. Souza             37,000             18,721            50.6

Brown                  16,105                 8,545         53.1
1
 Petitioners Gomes received $2,012 of this amount in 1991.
                             - 17 -


Because both sides wished to retain their contract-based claims

in other proceedings or against other parties, paragraph 6 of the

settlement provided:

     Nothing in this Settlement Agreement in any way
     affects, either directly or indirectly:

          (a) The rights, if any, of the Milk Producers or
     Danish Creamery to assert their claims in the pending
     KF Dairies bankruptcy proceedings or to receive
     distributions or other compensation in those
     proceedings. In the event that any such distribution
     is received by the Milk Producers or Danish Creamery,
     Bank Defendants shall not receive any credit for any
     distribution because the sums paid in connection with
     this settlement are not attributable to the contractual
     claims asserted by the Milk Producers and Danish
     Creamery in the bankruptcy proceedings;

          (b) The rights, if any, of the Milk Producers or
     Danish Creamery to compromise those bankruptcy claims
     or to dispose of them in any other way;

          (c) The rights, if any, of the Milk Producers or
     Danish Creamery to participate in those bankruptcy
     proceedings as parties-in-interest;

          (d) Bank Defendants' rights, if any, to assert
     claims for indemnity against any other entity or party;
     and

          (e) The rights or liabilities, if any, of any
     other entities or parties in the coordinated
     proceedings or in the insolvency proceedings.

     After the milk producers action settled, petitioners (and

all other milk producers) still had outstanding claims in the

Knudsen bankruptcy action for the value of the milk.   Most of the

milk producers released their bankruptcy claims in exchange for

an assignment by Knudsen of its causes of action for breach of

fiduciary duty against its individual directors and officers.
                              - 18 -


They recovered small additional amounts from the directors and

their insurance company.   For instance, Knevelbaard received

$5,048.32 on a $58,500 loss; Gomes received $6,368 of $118,369.

                              OPINION

Evidentiary Matters

     Petitioners reserved several objections in the stipulation

of facts.

     One group of objections centers around the admission of

documents or facts concerning lawsuits, other than the milk

producers action, related to the Knudsen default.   These concern,

for instance, (1) petitioners' release of claims in the

bankruptcy action in exchange for an assignment of Knudsen's

claims against its directors and their insurer; (2) the banks'

indemnification rights against Knudsen and Foremost; and (3) the

Danish Creamery complaint.   We believe the exhibits in groups 1

and 2 are relevant to the parties' motivations in structuring the

settlement.   The Danish Creamery complaint may have slight

relevance, since its plaintiffs were included in the milk

producers settlement; however, since the complaint was dismissed

in its entirety, we give it little weight.

     Another group of disputed stipulations shows that

petitioners did not receive treatment from mental or physical

health care workers as a result of actions by the Bank

Defendants.   Petitioners also object to stipulations as to some
                                - 19 -


of them concerning the absence of loss of consortium.    They

contend these facts are irrelevant in proving whether they

actually suffered emotional or physical distress.    We think this

objection goes to the weight of the evidence, not to its

relevance.    Certainly, if petitioners had incurred such expenses,

the evidence would be admissible.    Accordingly, petitioners'

objections are overruled.

     Paragraphs 87, 97, and 109 of the stipulation (in re the

Christians, Arnold Leroy and Rosemary Souza, and the Browns)

state that petitioners:

     admit that the actual division of settlement proceeds
     among all of the Milk Producer Plaintiffs was made on
     the basis of the quantities of milk delivered by each
     of the Milk Producer Plaintiffs and not on the amount
     of emotional distress suffered by them.

We believe the first half of the statement is relevant to show

how the distribution was administered; however, as shown above,

all petitioners did not receive the same percentage of their lost

revenue.     And even if the distribution was made using the lost

revenue as an administratively convenient rule of thumb, it does

not follow that the proceeds were awarded for something other

than emotional distress.    The statement is relevant if read to

mean only that no individualized assessment of emotional damage

as to each of the 1,000 plaintiffs was separately made.    With

that understanding, the objection is overruled.
                                - 20 -


     Other disputed paragraphs seek to establish that

petitioners' representatives in the milk producers action

utilized tax advice regarding the settlement.       Since this may be

relevant to the motivation of the parties in structuring the

settlement, we overrule the objection.

     Petitioners also object to paragraph 51 and Exhibit 21-U on

the basis of rule 408 of the Federal Rules of Evidence.       The

exhibit is a letter from    plaintiffs' attorneys to the Bank

Defendants' attorneys, regarding an offer of settlement.       The

letter is not admissible to show liability for or invalidity of

the claim.    It is admissible to show other circumstances

surrounding the negotiations; however, we note that the offer

bears little or no relation to the final settlement, either in

amount or structure, and we give it little weight.

     Finally, we overrule petitioners' objection to Exhibit 35-

AI, stipulation re amendment of Exhibit A to milk producer

plaintiffs' third amended complaint.       It is an intrinsic part of

Exhibit 16-P, the complaint, which has been stipulated and forms

an important part of the evidence.       Exhibit 35-AI is received.

The Settlement

     Respondent contends the settlement payment was really for

the lost milk under the contract between the milk producers and

Knudsen.     Petitioners contend it was for emotional distress, as
                             - 21 -


delineated in the settlement agreement.   We agree with

petitioners.

     Section 61(a) provides a broad definition of "gross income":

"Except as otherwise provided in this subtitle, gross income

means all income from whatever source derived".   Thus,

petitioners' settlement proceeds constitute gross income unless

expressly excepted by another provision in the Code.

Commissioner v. Schleier, 515 U.S. 323, 328 (1995).    Petitioners

claim the settlement award falls within section 104(a)(2), which

excludes from gross income "the amount of any damages received

* * * on account of personal injuries or sickness".

     Section 1.104-1(c), Income Tax Regs., provides:

     Section 104(a)(2) excludes from gross income the amount
     of any damages received (whether by suit or agreement)
     on account of personal injuries or sickness. The term
     "damages received * * *" 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.

Thus, petitioners must meet two independent requirements to

exclude the recovery under section 104(a)(2):   First, they must

demonstrate that the underlying cause of action giving rise to

the recovery is based upon tort or tort type rights; and second,

they must show that the damages were received on account of

personal injuries or sickness.   Commissioner v. Schleier, supra

at 337.
                                  - 22 -


     Respondent contends that petitioners have satisfied neither

test.     Respondent argues that "the Milk Producers' recovery arose

out of garden-variety breach of contract and economic-injury

torts stemming from the breach."      Further, says respondent, the

proximate cause of the damages petitioners recovered was economic

injury from Knudsen's breach of its contractual duty to pay for

delivered milk.

Origin of the Claims:     Tort or Tort Type Rights?

        Respondent contends that "The primary focus of the Milk

Producers Complaint and the counts alleged therein was Knudsen's

contractual relationship with petitioners and the breach of that

relationship."     We disagree.

        The tax consequences of a settlement depend on the nature of

the litigation and on the origin of the claim but not on the

validity of that claim.     Woodward v. Commissioner, 397 U.S. 572

(1970); United States v. Gilmore, 372 U.S. 39 (1963).      Thus the

classification of a claim is extremely important.

     In United States v. Burke, 504 U.S. 229 (1992), the Court

defined a tort as "'a civil wrong, other than a breach of

contract, for which the court will provide a remedy in the form

of an action for damages.'"       Id. at 234 (quoting Keeton et al.,

Prosser and Keeton on the Law of Torts 2 (1984)).      The primary

characteristic of "an action based upon tort type rights" is the

availability of compensatory remedies.       Commissioner v. Schleier,
                              - 23 -


supra at 333.   Such remedies are intended to redress intangible

elements of injury that are deemed important, even though not

pecuniary in their immediate consequences.    These injuries may

include emotional distress, pain and suffering, impairment of

reputation, personal humiliation, and mental anguish.     United

States v. Burke, supra at 235-236.

     Here, under 17 of the 20 causes of action alleged,

petitioners sought damages for mental suffering and emotional

distress.   They also sought general damages and interest and, in

some causes of action, exemplary and punitive damages.    Of the 12

causes of action based upon the Bank Defendants' direct

liability, Nos. 1 through 10 are clearly torts or tortlike.        In

fact, of the 20 causes of action, direct and indirect, at most 4

(Nos. 11, 12, 13, and arguably 14) do not sound in tort.

     The origin of the milk producers' complaint against the

banks was that they made risky loans to Knudsen, knowing that it

was financially shaky, under conditions which practically

guaranteed they (the banks) would be repaid at the expense of the

milk producers.   The complaint also alleged that the banks lied

to the milk producers to induce them to continue to provide milk

after the banks knew that Knudsen was about to default, thereby

putting the plaintiffs in more jeopardy, and causing foreseeable

harm, all to make themselves more secure.    This was a claim
                                - 24 -


separate and apart from plaintiffs' contract claims against Knudsen.

     The origin of the claim for milk losses (raised in the

bankruptcy court and in claims against Knudsen's directors) was

Knudsen's breach of contract.    However, the milk producers had no

contract with the banks.   The origin of the claims in the milk

producers action against the banks was the Bank Defendants'

behavior.   We think it significant that the settlement agreement

did not foreclose petitioners' rights to collect the full amount

of milk proceeds in other arenas.    In fact, they did eventually

collect small amounts from the directors' insurance.8

     We hold that the milk producers action was based upon tort

or tortlike rights.

Personal Injuries or Sickness

     Finally, we examine whether the proceeds were paid "on

account of" the emotional harm done.     Respondent argues they were

paid on account of Knudsen's default and not on account of

petitioners' emotional distress.    We disagree.   Petitioners'


     8
          See Banks v. United States, 81 F.3d 874 (9th Cir.
1996), where the Court of Appeals for the Ninth Circuit, the
court to which this case is appealable, held that a claim against
a union for breach of duty of fair representation is tortlike and
distinct from a claim against the employer for unjust discharge,
even though the settlement amount paid by the union was based on
an estimate of past and future wages. "Unions do not pay wages
to their members, and what the Union paid in settlement * * * did
not constitute wages", id. at 876, but damages to compensate the
taxpayer for its unfair and arbitrary treatment. Thus, the claim
against the union was tortlike. Here, we might say: "Banks
don't buy milk."
                               - 25 -


claims against the banks were (except for the derivative claims,

which were dismissed by agreement) separate and apart from their

claims against Knudsen.   While petitioners undoubtedly suffered

emotional harm from the default itself, they alleged additional

and separate harm caused by the banks' violation of duties owed

to them.   Moreover, the settlement did not affect or limit their

right to pursue any and all claims for lost milk money in

bankruptcy or another forum.

     Petitioners must prove their recovery was received on

account of personal injuries or sickness.    Respondent points to

the lack of bills for medical or psychiatric treatment and the

lack of personalized proof of individual damages, arguing that

the recovery was simply payment for the lost milk, not for

emotional distress.    Again, we disagree.

     "Personal injury" within the meaning of section 104(a)(2)

comprehends both tangible and intangible harms.    Commissioner v.

Schleier, 515 U.S. at 329 n.4 (citing Justice Scalia's concurring

opinion in United States v. Burke, supra at 244 n.3,

acknowledging that "personal injuries or sickness" includes

nonphysical injuries).    Traditional harms associated with

personal injury are pain and suffering, emotional distress, harm

to reputation, or other consequential damages.    United States v.

Burke, supra at 239.
                              - 26 -


     While the incurring of expenses for medical or psychiatric

treatment would be relevant to show harm, they are not required

in order to prove that stress was endured.   Petitioners'

testimony convinces us that their experiences produced serious

and prolonged stress.   Proof of emotional distress is not limited

to the presentation of medical bills.9

     Nor do we think the fact that the damages were distributed

in approximately proportionate shares of the defaulted milk

payments proves that they were not received for emotional

distress.   Awards for personal injuries may be measured by lost

income and still be excluded under section 104(a)(2).    "If a

taxpayer receives a damage award for a physical injury, which

almost by definition is personal, the entire award is excluded

from income even if all or a part of the recovery is determined

with reference to the income lost because of the injury."

Threlkeld v. Commissioner, 87 T.C. 1294, 1300 (1986), affd. 848

F.2d 81 (6th Cir. 1988); see also Banks v. United States, 81 F.3d

874 (9th Cir. 1996).

     Furthermore, there were nearly 1,000 dairy farmer

plaintiffs.   To have assessed the individualized emotional harm

suffered by each would have been exceedingly time consuming and

     9
          Although Souza suffered a stress-related heart attack
in 1988, and undoubtedly incurred medical expenses, as one of
1,000 plaintiffs he was not asked for, nor did he give, a
personal description of his medical situation to the lawyers for
either side.
                              - 27 -


expensive, if not administratively impossible, resulting in a

smaller recovery to each plaintiff.    The pro rata distribution

was a practical, commonsense solution under the circumstances.

     Petitioners rely on Seay v. Commissioner, 58 T.C. 32 (1972).

There the taxpayer received a settlement of $105,000 for breach

of contract and personal injuries arising from embarrassing

publicity.   The settlement allocated different amounts to the

various plaintiffs for salary but identical amounts for personal

injury.   A letter confirming the distribution of the settlement

funds was signed by the principal negotiators from both sides.

The letter stated that the settlement consisted of salary

($60,000 for Mr. Seay) and additional sums to compensate the

parties for "personal embarrassment, mental and physical strain

and injury to health and personal reputation in the community".

Id. at 35.   We held that the letter helped to establish that the

nature of the claim was for personal injuries, the additional

$45,000 should be excluded from gross income, and only $60,000

should be recognized as salary and ordinary income.

     Here, Roll, the banks' chief negotiator, testified that the

money was paid "not for the value of milk, but for the value, if

you will, of the emotional distress claims asserted by these

individual producer plaintiffs."

     Respondent points to the lack of an adversarial relationship

between the Bank Defendants and petitioners in structuring the
                               - 28 -


settlement.    Petitioners' concern was in receiving as much money

as possible.   The banks, however, were very concerned about which

of petitioners' claims was the basis for the settlement agree-

ment; they wanted to avoid claims based on gross negligence or

willful misconduct, in order to protect their right to indemnity.

     In Robinson v. Commissioner, 70 F.3d 34 (5th Cir. 1995),

affg. in part and revg. in part on another ground 102 T.C. 116

(1994), the taxpayers obtained a $60 million jury verdict against

a bank for wrongful failure to release a lien.    The award

included $6 million for lost profits, $1.5 million for mental

anguish, and $50 million in punitive damages.    While the trial

court was considering the bank's motion for a new trial, the

taxpayers settled their claims against the bank for $10 million.

In the final judgment reflecting the settlement, which was

drafted by the parties and signed by the trial judge, 95 percent

of the settlement proceeds were allocated to mental anguish and 5

percent were allocated to lost profits.   The taxpayers excluded

the 95 percent under section 104(a)(2).

     The Court of Appeals agreed with the Tax Court's finding

that the allocation was not entered into in a bona fide adversary

proceeding and that the judgment was simply "rubber stamped" by

the State court.   The testimony of the attorneys who represented

the taxpayers in their suit against the bank supported this

Court's finding that the bank allowed the Robinsons to allocate
                              - 29 -


the settlement proceeds in any way they wished.    The

circumstances surrounding the State court judge's entry of

judgment also supported those findings, in that the parties

presented the final judgment to the judge at his home in the

evening, the meeting lasted no longer than 1 hour, and neither

the final judgment nor the settlement agreement was discussed in

detail during that meeting.   Therefore, the Tax Court did not

give conclusive effect to the State court judgment's allocation

of settlement proceeds and instead allocated the proceeds on the

basis of the jury verdict, "the best indication of the worth of

the Robinsons' claims."   Robinson v. Commissioner, supra at 38.

     This case is distinguishable from Robinson.    There the

allocation had no relationship to the jury award and was not

entered into by the parties in an adversarial context at arm's

length.   Here, in contrast, although the parties' interests were

not directly adverse as to the structure of the settlement, there

was a bona fide basis for it aside from the tax consequences.

First, the emotional distress claim was not an afterthought; 85

percent (17 of 20) of the causes of action alleged in the

complaint sought damages for emotional distress.    Second, the

Bank Defendants' chief lawyer was familiar with dozens of

depositions and answers to interrogatories of the plaintiffs

alleging emotional harm, and he believed the Bank Defendants were

vulnerable on those claims.   Third, Judge Tenner was familiar
                               - 30 -


with the testimony of the farmers and was influenced by it.10

He did not "rubber stamp" the agreement, but made specific

findings on the record approving the settlement.    At the recorded

hearing the judge specifically found that the claim of negligent

infliction of emotional distress was the most serious claim and

that the settlement based upon it was appropriate.

     Respondent also relies on Every v. IRS, 74 AFTR 2d 94-5614,

94-2 USTC par. 50,478 (W.D. Wash. 1994), affd. without published

opinion 51 F.3d 279 (9th Cir. 1995).    The taxpayers, commercial

salmon fishermen, sought a refund for taxes paid as the result of

a settlement against Exxon for damages suffered as a result of

the Exxon Valdez oil spill in Cook Inlet, Alaska.     The court held

that, while their claim sounded in tort, it did not arise from an

injury to the person in the traditional tort sense.    Rather, it

was economic in nature, to redress the loss of plaintiffs'

livelihood from fishing.    The court drew an analogy to the loss a

farmer might suffer whose crop is destroyed by a crop duster

negligently using DDT.    The brief opinion of the District Court

discloses the facts only in broad outline, and the affirmance is

by unpublished opinion.    Here, in contrast, (1) the agreement is

unambiguous as to the reason for the payment, (2) petitioners

claimed emotional distress in nearly every cause of action in the


     10
          Knevelbaard was one of the dairymen whose depositions
were taken in the milk producers action.
                              - 31 -


complaint, and (3) the Bank Defendants were aware of the specific

emotional harm done to dozens of the plaintiffs, through their

depositions and answers to interrogatories.   Every is not

controlling.

     We therefore hold that the underlying claim giving rise to

the recovery was based upon tort or tortlike rights, and that the

settlement proceeds were received on account of personal

injuries.   The amounts recovered are excludable from income under

section 104(a)(2).

     To reflect the foregoing,

                                         Decisions will be entered

                                    for petitioners.
