                        T.C. Memo. 2003-277



                      UNITED STATES TAX COURT




     EDWARD P. KNOLL AND MARY K. KING-KNOLL, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 10973-99, 5281-00.    Filed September 23, 2003.



     Robert J. Paley and Scott A. Carlson, for petitioners.

     Sean R. Gannon, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     GERBER, Judge:   Respondent determined deficiencies in

petitioners’ Federal income tax and penalties for the taxable

years 1993, 1994, and 1995, as follows:
                                  - 2 -

                                              Penalty
     Year            Deficiency              Sec. 6662

     1993             $18,873                  $3,775
     1994              47,756                   9,551
     1995              51,584                  10,317

     The issues presented for our consideration are:     (1) Whether

a $116,000 settlement payment is excludable from gross income

under section 104(a)(2);1 (2) whether $48,4202 in payments was

nontaxable loans or taxable advances; and (3) whether petitioners

are subject to section 6662(a) penalties for substantial

understatement of tax or negligent disregard of the rules and

regulations.   To the extent that we hold amounts are includable

in gross income, petitioners do not contest that such income is

subject to self-employment tax.

                         FINDINGS OF FACT3

     Petitioners Edward P. Knoll and Mary King-Knoll resided in

Barrington, Illinois, at the time their petition was filed.

During 1965, following his graduation from Northwestern




     1
       All section references are to the Internal Revenue Code in
effect for the years at issue, and all Rule references are to the
Tax Court Rules of Practice and Procedure, unless otherwise
indicated.
     2
       If the $116,000 and/or $48,420 amounts are includable in
income, we must also decide the proper year for inclusion.
     3
       The parties’ stipulation of facts is incorporated by this
reference.
                                - 3 -

University School of Law, Edward P. Knoll4 (petitioner) was

employed by the law firm of Smith, Clinch, and Powers.

Approximately 2 years later, that firm was merged into the law

firm of Winston and Strawn (Winston).   Following the

consolidation, petitioner became an associate of Winston.

     Petitioner became an income (nonequity) partner and

continued in that status into Winston’s taxable year ending

January 31, 1993.   During his 26 years with Winston, petitioner

was primarily involved in the area of general corporate work.

His clients included a State agency that issued tax-exempt bonds

and a leveraged lease broker.   Petitioner also prepared tax

returns and acted as a trustee for a client’s estate planning

trust.

     In response to a reduced market and the need to improve

profitability, Winston initiated a reduction in force.   On March

23, 1992, petitioner along with several other partners, received

letters from Gary L. Fairchild, Winston’s then managing partner,

requesting that they resign from the firm.   The weak legal market

and the firm’s profitability concerns were the only reasons

stated in the letter as the basis for asking petitioner to

resign.



     4
       Petitioner, Mary King-Knoll is a party to this case by
reason of the fact that she filed joint Federal income tax
returns with Edward P. Knoll for the years under consideration.
                               - 4 -

     The March 23, 1992, letter from Mr. Fairchild offered the

following terms in return for petitioner’s voluntary resignation

from the firm:   (1) A $55,000 lump-sum payment; (2) receipt of

retirement benefits upon qualification, pursuant to the Winston

Partnership Agreement as if petitioner had not been severed, but

had retired from the firm; and (3) additional payments for

approved “Urgent Family Needs” for a period of 3 years.

     On April 15, 1992, petitioner received a second letter from

Mr. Fairchild which offered, in addition to the terms of the

March 23, 1992, letter, payments of $40,000 a year for 3 years.

To receive the additional payments, petitioner had to withdraw

voluntarily from the firm by April 30, 1992.    The payments would

commence on the date of petitioner’s withdrawal from the firm,

and could be counted, if necessary, as additional qualified

service for his eligibility to retire and receive benefits from

Winston.   The Winston retirement benefit was offered pursuant to

the firm’s partnership agreement, which was subject to

modification by the partnership.

     Most Winston partners who were being asked to resign

received letters similar to the first one received by petitioner.

A smaller subset of partners also received letters similar to the

second one received by petitioner.     The terms of the two letters

offered severance packages to petitioner and other Winston
                               - 5 -

partners.   If petitioner had accepted the terms offered in the

letters, he would have received payments totaling $175,000.

     Petitioner did not voluntarily resign from Winston by the

April 30, 1992, deadline.   However, as of May 1, 1992, he no

longer:   (1) Received partnership payments, (2) performed work on

behalf of Winston clients, or (3) used Winston office space.

Initially petitioner, and eventually his attorneys, negotiated

with representatives from Winston in an attempt to reach

agreement as to the terms of petitioner’s severance.    In all, 12

separate drafts of a settlement agreement were negotiated before

the final agreement was signed on December 22, 1994.

     Negotiations between petitioner and Winston were contentious

and lasted approximately 32 months.    Initially, petitioner

represented himself in talks with Winston.    The principal dispute

concerned the amount of retirement benefits petitioner was to

receive upon his withdrawal from the firm.    Petitioner believed

that he was entitled to receive a larger annual retirement

payment than that offered and that his priority in receiving that

payment should be subordinate to only a small group of other

retired partners.   Petitioner’s initial negotiating objective was

to increase the amount of his retirement payments and gain

assurance that his priority in receiving the retirement payments

would not be diluted.
                               - 6 -

     As a result of initial negotiations, Winston completed a

first draft of a final settlement agreement on May 29, 1992.

This draft included clause 2(b), which provided for a $55,000

lump-sum payment to petitioner.   The $55,000 lump-sum payment

approximated 5 months of petitioner’s partnership income.    The

draft also included clause 2(c), which provided for $3,333.33

monthly “bridging payments” from May 31, 1992, until such time as

petitioner became active in Winston’s retirement plan.    These

monthly payments were essentially the same as the annual payments

of $40,000 offered in the original April 15, 1992, severance

letter.

     The negotiations continued without agreement and the next

three proposed drafts of an agreement included similar

provisions, but with additional language reducing the $55,000

lump sum by amounts which Winston had already advanced to

petitioner.   The first four drafts of the agreement provided for

total cash payments to petitioner of $165,000.   That amount is

commensurate with the $175,000 offered under the severance

letters.   The $10,000 difference appears to be attributable to a

3-month variation in petitioner’s retirement date under the

letters as opposed to the draft agreements ($3,333.33 x 3

months).

     During February 1993, approximately 9 months after

negotiations began, petitioner began receiving psychotherapy
                               - 7 -

treatment for depression.   Petitioner initiated the counseling

treatment at the request of his wife, Mary King-Knoll, whose

background includes a master’s degree in psychology.   Petitioner

had been withdrawn from his family’s activities, moody, and

despondent.   Petitioner received psychotherapy treatment from

February 26, 1993, through March 16, 1994.   Prior to this time

petitioner had never been treated for depression or other

emotional problems.

     On February 8, 1994, petitioner began treatment with a

psychiatrist who prescribed medication in an effort to treat the

depression.   A few weeks later petitioner was treated at a

hospital emergency room for a condition described as a “major

depressive disorder--single episode”.

     The total cost for all of petitioner’s psychological

treatment amounted to approximately $5,000, a portion of which

was paid under Winston’s health insurance plan.   During the

negotiations, petitioner did not inform the representatives who

were negotiating on behalf of Winston, that he was receiving

mental health treatment.

     Other members of the Knoll family also received therapy

treatment at the same time as petitioner.    Petitioner’s son had

suffered with a bipolar disorder for more than 15 years, and two

of petitioner’s daughters underwent therapy for problems relating
                               - 8 -

to a car accident.   In addition, Ms. King-Knoll received

treatment to help her cope with the problems of other family

members.

     When negotiations began, petitioner was not aware of the

tort of intentional infliction of emotional distress (IIED) or

the tax benefits associated with that type of settlement.

Several months after initiating counseling treatment, petitioner

learned of the tax benefits for personal injuries from George

Leonard, who, along with petitioner, was asked to resign on March

23, 1992.   Petitioner and Mr. Leonard coordinated their

negotiation efforts with Winston by hiring the same attorney to

represent them, and they regularly discussed the terms of their

respective agreements.

     Mr. Leonard supplied petitioner with language for a clause

2(b) specifying that payments received by petitioner were in

satisfaction of personal injury claims.   Mr. Leonard also

informed petitioner that Winston had readily agreed to allocate

amounts toward personal injury claims for another partner who was

being severed from Winston.   Approximately 1 month after being

informed by Mr. Leonard about the personal injury information,

petitioner proposed that a personal injury clause be inserted

into the draft agreement.

     It was not until summer 1993 and after petitioner learned of

the tax benefits relating to personal injury settlements
                                - 9 -

(approximately 6 months after petitioner began psychological

counseling) that he introduced a claim for personal injuries into

the negotiations.    On August 6, 1993, approximately 16 months

after receiving the March 23, 1992, severance letter, petitioner

proposed revision of clause 2(b) of Winston’s June 22, 1993,

draft agreement.    The proposed revision contained only general

references that the $55,000 lump-sum payment was for personal

injury, as follows:

     in consideration of Mr. Knoll’s release of defamation,
     intentional infliction of emotional distress, loss of
     personal reputation and other personal injury claims
     described in paragraph 1.n. of this Agreement.

     Deborah Haude was the Winston attorney who was primarily

responsible for negotiating settlement agreements with severed

partners.   Ms. Haude was experienced in employment torts, and

during the course of the negotiations she also consulted with

other Winston attorneys who specialized in taxation and

employment torts.    During a break in the August 6, 1993, meeting,

Ms. King-Knoll spoke with Ms. Haude in the restroom.    Ms. King-

Knoll indicated to Ms. Haude that the extended negotiations and

Winston’s manner of negotiating was “destroying” petitioner.

     Petitioner, however, did not make Ms. Haude and/or Winston

aware of a specific tort claim, such as the IIED claim.    Ms.

Haude and other Winston negotiators knew that the negotiations

caused petitioner stress; however, they did not know that he was

receiving counseling treatment or know of his emergency room
                              - 10 -

visit. Petitioner did not specifically assert an individual

personal injury claim during negotiations, and Winston did not

attempt to verify any of the personal injury claims included in

clause 2(b) of the final agreement.

     The personal injury language was accepted by Winston, and

substantially similar provisions were included in all successive

draft agreements, as well as in the final agreement.   This

revised draft provided for approximately $165,000 in payments to

petitioner.

     Several additional revisions of the August 9, 1993, draft

agreement occurred prior to the signing of the final agreement on

December 22, 1994.   Changes were made in each draft agreement as

to the allocation of funds to a lump-sum and/or monthly bridging

payments.   However, the total amount of payments in every draft

agreement (with one exception) and the final agreement was within

$3,000 of the $165,000 original severance offer contained in the

first draft agreement.   The one exception involved a June 27,

1994, draft agreement providing for $117,833 in total payments.

The $117,833 amount was an oversight which was corrected

(increased to approximately $166,700) less than a week later.

     In addition to reallocating the lump-sum and bridging

payments, the amount to be allocated to the personal injury

clause 2(b) was increased.   An August 9, 1993, draft agreement

contained a $55,000 allocation to settlement of personal injury
                               - 11 -

claims.   The personal injury allocation increased to $94,500 in a

June 27, 1994, draft agreement, $95,000 in a July 1, 1994, and

succeeding draft agreements, and to $116,000 in the December 22,

1994, final agreement.

     The final agreement provided for a lump-sum payment of

$116,000 to be paid by December 29, 1994, (less $25,000 advanced

to petitioner on December 19, 1994) and one payment of $3,333.33

to be paid on January 1, 1995.   Petitioner’s retirement date, per

the final agreement, was February 1, 1995.    In addition, the

agreement did not require the repayment of the $48,420 advanced

to petitioner prior to the final agreement.    Ultimately,

petitioner received $167,753.33 ($116,000.00, $48,420.00, and

$3,333.33).

     The final agreement, in pertinent part, contains the

following personal injury clause:

     in consideration of Mr. Knoll’s release of all claims
     for compensatory damages, defamation, intentional and
     negligent infliction of emotional distress, loss and
     diminishment of personal reputation and all other
     claims of personal injury, including, but not limited
     to those described in subparagraph n of paragraph 1 of
     this Agreement, the Firm will pay Mr. Knoll a lump sum
     payment in the amount of $116,000 * * * .

Subparagraph n of paragraph 1 of the final agreement was a

general release, the language of which was substantially

unchanged from the time of the first draft through the final

agreement.    In particular, the general release paragraph was not
                               - 12 -

changed even after petitioner had introduced the personal injury

element into the negotiations.

     During the audit examination, petitioner asserted, in a June

8, 1998, letter, that his settlement payment from Winston was for

a release of his claims for IIED, defamation, and diminishment of

personal reputation.   Petitioner contended that the defamation

and diminishment of personal reputation claim was based on

certain improprieties of Winston’s managing partner, at the time

petitioner left the firm.   The managing partner’s improprieties

were not discovered or made public until approximately 9 months

after petitioner proposed the personal injury clause be added to

the agreement.   Petitioner did not raise a specific defamation

and diminishment of personal reputation claim in negotiations

with Winston and did not assert that position at trial.

     Between June 12, 1992, and January 13, 1993, Winston made

five separate payments to petitioner, which totaled $48,420.21.

The payments were issued pursuant to petitioner’s request and he

used them to pay estimated State income tax bills and to make a

Keogh plan contribution.    Upon receiving each payment, petitioner

signed documents confirming that he received an “advance” from

Winston on each of the five respective dates.   The signed

documents also contained the condition that the advances would be

recaptured from any lump-sum payment the firm might agree to give

petitioner upon his transition from status as an active partner.
                               - 13 -

All of the payments were reflected in Forms K-1, Partner’s Share

of Income, Credits, Deductions, etc., as petitioner’s share of

the firm’s annual partnership income.

     Petitioner reported the receipt of the $48,420 on his 1993

Federal income tax return using Form 8082, Notice of Inconsistent

Treatment or Amended Return.   On the Form 8082, petitioner

reported a difference of $48,420 from the amount reflected on his

Form K-1 for Winston’s tax year ending January 31, 1993, and the

amount reported as income on his 1993 Federal tax return.

Petitioner included, as an attachment to the Form 8082, a

detailed explanation of the difference.   The explanation

reflected that petitioner was in the process of being severed as

a partner from Winston and that the amount and character of his

severance agreement were still in dispute.   The explanation

further reflected that the $48,420 in payments was not taxable

income until the severance agreement and character of the

payments were resolved.

     Petitioner, using a Form 8082, reported the $48,420 as

income on his 1995 Federal income tax return.   He reflected a

$48,2405 difference from the amount shown as income on his Form

K-1 from Winston, for its tax year ending January 31, 1995.

Petitioner provided the explanation that the difference was due


     5
       Petitioner reported a $48,240 difference on Form 8082,
Notice of Inconsistent Treatment or Amended Return; however, the
amount of advances received by petitioner totaled $48,420.
                                - 14 -

to the fact that the payments were loans until the character of

the payments was resolved on December 22, 1994.     Based on this

theory, petitioner contended that the income was properly

reported on petitioner’s 1995 Federal income tax return because

the resolution of its character occurred in Winston’s fiscal year

ended January 31, 1995.


                                OPINION

      This controversy concerns the proper reporting of settlement

payments received by petitioner in connection with his severance

and/or being relieved from his position as a partner in a law

firm.    Petitioner contends that the $116,000 was paid to him to

settle a personal injury claim and is excludable from income

under section 104(a)(2).    Respondent contends that the payment

was in consideration of petitioner’s severance from the law firm

and not in settlement of a tort claim.

      A second issue concerns whether payments totaling $48,420

received by petitioner prior to the final settlement were

nontaxable loans or taxable advances.     Finally, we must decide

whether petitioners are liable for an accuracy-related penalty

under section 6662(a).

I.   Is The $116,000 Settlement Payment Excludable From Gross
     Income Under Section 104(a)?

        A. General Rules

        “[E]xcept as otherwise provided”, gross income for the
                                - 15 -

purpose of calculating Federal income tax includes “all income

from whatever source derived”.       Sec. 61(a).   This definition is

sweeping in scope and exclusions from income are to be narrowly

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

(1995).     Further, “exemptions from taxation are not to be

implied; they must be unambiguously proved.”6          United States v.

Wells Fargo Bank, 485 U.S. 351, 354 (1988).        The statute and

regulations provide that compensation for services, including

severance or termination pay, is expressly encompassed within the

definition of gross income.     See sec. 61(a)(1); sec. 1.61-

2(a)(1), Income Tax Regs.

     Section 104 provides for an exclusion from gross income for

certain payments received as compensation for injuries or

sickness.    Specifically, section 1047 provides:

     SEC. 104. COMPENSATION FOR INJURIES OR SICKNESS.

          (a) In General.–-Except in the case of amounts
     attributable to (and not in excess of) deductions
     allowed under section 213 (relating to medical, etc.,
     expenses) for any prior taxable year, gross income does
     not include--

                  *    *    *    *      *    *     *

             (2) the amount of any damages received (whether by


     6
       No question has been raised with respect to the burden of
proof or production under sec. 7491(a).
     7
       The 1996 amendments added to sec. 104 by the Small
Business Job Protection Act of 1996, Pub. L. 104-188, sec.
1605(a), 110 Stat. 1838, do not apply because the amendments are
effective for amounts received after Aug. 20, 1996.
                               - 16 -

     suit or agreement and whether as lump sums or as
     periodic payments) on account of personal injuries or
     sickness;

     The regulations under section 104 provide that the term

“damages received (whether by suit or agreement)” 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.”    Sec. 1.104-1(c), Income Tax Regs.

     In Commissioner v. Schleier, supra, the U.S. Supreme Court

established a two-prong test for determining whether a taxpayer

is eligible to exclude income under section 104(a)(2).    The

taxpayer must demonstrate (1) that the underlying cause of action

giving rise to recovery is based upon tort or tort-type rights

and (2) that the damages were received on account of personal

injuries or sickness.    See Commissioner v. Schleier, supra at

336-337.

     B.    Contentions of the Parties

     Petitioner contends that the $116,000 payment he received

from Winston was a result of arm’s-length negotiations resulting

in a settlement solely for his release of an IIED claim.

Respondent contends that the $116,000 settlement payment was a

portion of a severance payment, and not consideration for a

release of a specific IIED claim.
                                  - 17 -

     C.    Discussion

     The first requirement for exclusion under section 104(a)(2)

is that the claim underlying the settlement agreement must be

based on tort or tort-type rights.         Commissioner v. Schleier,

supra.    A tort is defined as a “‘civil wrong, other than breach

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

form of an action for damages.’”       United States v. Burke, 504

U.S. 229, 234 (1992) (quoting Keeton et al., Prosser & Keeton on

the Law of Torts 2 (1984)).

     In the absence of a general Federal common law of torts or

controlling definitions in the Internal Revenue Code, we look to

State law to determine the nature of the claim litigated.          Erie

R.R. v. Tompkins, 304 U.S. 64, 78 (1938); United States v.

Mitchell, 403 U.S. 190, 197 (1971).        The claim must be bona fide,

but it need not be sustainable or valid.        See Stocks v.

Commissioner, 98 T.C. 1, 10 (1992).

     In Illinois, “Tort law * * * applies in situations where

society recognizes a duty to exist wholly apart from any

contractual undertaking.”       Collins v. Reynard, 607 N.E.2d 1185,

1186 (Ill. 1992).       IIED has been recognized as a tort under

Illinois law.    See Valentino v. Hilquist, 785 N.E.2d 891, 903

(Ill. 2003).    This Court has also recognized the infliction of

emotional distress as a tortlike claim qualifying for exclusion
                                - 18 -

under section 104(a)(2).    See Bland v. Commissioner, T.C. Memo.

2000-98.

     In this case, petitioner contends that he suffered IIED due

to the conduct of Winston during negotiations.    Specifically,

petitioner contends that Winston failed to return or delayed in

returning his telephone calls and refused to meet and negotiate

for substantial periods of time.    Petitioner contends he became

distressed over this conduct and required psychological

treatment.

     Petitioner’s contention that he suffered from depression is

supported in the record.8    The insertion of the personal injury

clause into the settlement agreement, however, was motivated

solely by tax considerations.    Over the 32 months of

negotiations, Winston held firm to the original severance offer

of approximately $165,000.    By attempting to characterize the

settlement as received for personal injury, petitioner aspired to

maximize his recovery by lessening or eliminating the tax burden.




     8
       The record is not so clear, however, as to whether
petitioner’s depression was causally linked to an IIED claim or
to the negotiation process with Winston. During the same period
as the negotiations with Winston, petitioner’s son suffered from
a bipolar disorder, his daughters were undergoing therapy for
problems relating to a car accident, and his wife was receiving
treatment to help her cope with the problems of other family
members. It is difficult to discern a particular cause for
petitioner’s depression, especially because it could have been,
in part or whole, attributable to natural depression that may
accompany a loss of employment after 26 years with the same firm.
                              - 19 -

On the other hand, Winston would be paying approximately the same

amount that was originally offered to petitioner.

     These circumstances call into question whether petitioner’s

IIED claim or Winston’s agreement to characterize the settlement

as for personal injury was bona fide.   The terms of the

settlement agreement were negotiated over a 2½-year period.

Throughout that period, the total dollar amount being offered by

Winston remained at approximately $165,000.   It is significant

that the personal injury clauses were included in proposed drafts

of a settlement agreement substantially after negotiations began

and that the $165,000 offer was not materially increased after

the insertion of the personal injury claim or clause.   The

payment offers in the March 23 and April 15, 1992, letters, and

the first four drafts of the settlement agreement characterized

the settlement as being entirely in exchange for petitioner’s

severance from Winston.   Up to that point, petitioner was

unsuccessful in negotiating an increase in the amount of benefits

for the severance.   It was only after petitioner learned from

George Leonard that settlement proceeds from personal injury

claims could be excluded from taxable income that petitioner

proposed recharacterizing a part of the settlement payment as

being for personal injury.

     Most significantly, the settlement amount received by

petitioner was not increased for personal injury claims over and
                              - 20 -

above the amount originally offered as severance pay.    It had

become clear to petitioner that Winston would not increase the

amount of its original offer approximating $165,000.

Petitioner’s motivation and purpose for proposing the personal

injury clause was to increase the net amount of money he would

realize from the settlement by attempting to reduce the tax

burden on the amount being offered.

     Equally significant is the fact that petitioner did not make

Ms. Haude or any of the Winston representatives aware of his

medical records or the details of any personal injury.    Nor did

petitioner attempt to show that Winston was the cause of any

injury.   Petitioner and Winston eventually agreed to include the

personal injury clause and to assign an amount to it without

addressing the merits of any such claim.

     The following excerpt from Ms. Haude’s testimony supports

the above conclusion:

     beginning in summer of 1993 Ed was talking about tort
     damages and could we deliver some of the money tax-
     free. And we had extended conversations about whether,
     why, and what kind of money could be deliverable tax-
     free.

     In reaching our conclusion, we also considered the fact that

petitioner’s bases for a personal injury claim were not

specifically or adequately supported in the record.    Petitioner

contends that the $116,000 lump-sum settlement payment was solely

for the release of his IIED claim.     The final agreement between
                              - 21 -

petitioner and Winston, however, included a release for

defamation and loss of personal reputation, negligent infliction

of emotional distress, and other personal injuries.

     Petitioner’s bases for section 104 treatment, over time,

have been inconsistent.   In a June 8, 1998, letter to the

Commissioner’s examining agent, petitioner claimed that the cause

of his defamation and diminishment of personal reputation claim

was certain improprieties of Winston’s managing partner at the

time petitioner left the firm.   That position changed for

purposes of trial.   In addition, the record reflects that the

improprieties of Winston’s managing partner were not disclosed

until approximately 2 years after petitioner left Winston.

During May 1994, Winston’s managing partner resigned.   Petitioner

proposed defamation and loss of personal reputation as part of

the personal injury clause on August 6, 1993.   This was

approximately 9 months before the former managing partner’s

improprieties were known to petitioner.   Accordingly, his

administrative position before the Internal Revenue Service (IRS)

was an afterthought and lacked verity.

     Even if we were to hold that petitioner’s IIED tort claim

was bona fide, it must also be shown that the settlement amount

was paid “on account of personal injuries”.   Personal injuries

that may be excluded from gross income under section 104(a)(2),

can include harms that are tangible, intangible, physical and
                                - 22 -

nonphysical.    See Commissioner v. Schleier, 515 U.S. at 329 n.4.

Intangible harms include those affecting emotions, reputation, or

character.     See, e.g., Bland v. Commissioner, T.C. Memo. 2000-98.

Because IIED is an emotional injury, petitioner’s claim is

personal in nature.

     In addition to the nature of the injuries, entitlement to

section 104(a)(2) benefits depends on the purpose of the payment.

See Bagley v. Commissioner, 105 T.C. 396, 406 (1995), affd. 121

F.3d 393 (8th Cir. 1997).    The critical question is:   “in lieu of

what was the settlement amount paid”?     Id.   Determining the

purpose or intent of a payment is a factual inquiry that takes

into account the terms of the agreement and the setting in which

it was reached and carried out.    See Stocks v. Commissioner, 98

T.C. at 11.    “If the payor’s intent cannot be clearly discerned

from the settlement agreement, his or her intent must be

determined from all the facts and circumstances of the case in

issue there.”     Robinson v. Commissioner, 102 T.C. 116, 127

(1994), affd. in part, revd. in part and remanded 70 F.3d 34 (5th

Cir. 1995).    An employer-payor’s lack of knowledge about the

claimed personal injury is indicative that the payment was not

made on account of a personal injury.    See, e.g., Keel v.

Commissioner, T.C. Memo. 1997-278.

     After a careful review of the record, we hold that Winston

did not intend to make the $116,000 settlement payment to
                                - 23 -

petitioner to release his IIED claim.    It is true that section

2(b) of the final agreement contains a reference to “intentional

and negligent infliction of emotional distress”.    That language

is part of a more generalized form of release in exchange for the

$116,000 payment.   In addition to the release of any claim for

intentional and negligent infliction of emotional distress,    Mr.

Knoll also released any claim for compensatory damages,

defamation, loss and diminishment of personal reputation, and all

other claims of personal injury.    There is no specific allocation

in the final agreement to petitioner’s IIED claim.

     Of greater significance is the fact that neither Ms. Haude

nor Winston knew of any specific injury or claim by petitioner.

Winston negotiators may have been aware that petitioner was

experiencing stress in connection with his separation and the

extended negotiations.   Ms. Haude was also advised by Ms. King-

Knoll that Winston was “destroying” petitioner.    However, Ms.

King-Knoll’s comment was, at best, ambiguous and gave no specific

indication that petitioner was experiencing psychological

problems requiring treatment.    During the negotiations,

petitioner did not assert a specific tort claim (including IIED)

against Winston.    In connection with the negotiations and

ultimate settlement, petitioner did not notify Winston or its

representatives of the fact that he was receiving treatment for

depression or of his emergency room visit, and Winston did not
                               - 24 -

initiate any factual inquiry as to the validity of an IIED claim.

The record is silent about whether the parties negotiated the

release of any specific tort claim.

     It does not appear that there was a quid pro quo for release

of any tort or personal injury claim.    In addition, it does not

appear that the parties engaged in good faith, adversarial,

arm’s-length negotiations relating to the personal injury clause.

Winston was not motivated to resist the inclusion of a personal

injury clause, and it had nothing to lose by agreeing to the

clause.    The clause did not obligate Winston to make additional

monetary payments to petitioner in excess of the original offer.

Before petitioner proposed the change to clause 2(b), personal

injury claims were already included in the general release

section of the draft agreement.    In effect nothing changed other

than Winston’s agreement to some wording concerning personal

injuries.    Winston merely agreed to a more specifically worded

personal injury release and to reallocate a portion of the same

monetary payment that was on the table for more than 2 years.

Winston did not admit any wrongdoing and was substantively in the

same position it would have been if it did not agree to the

change.9



     9
       It is also likely that the changes in the final agreement
were not intended to have any different effect on Winston’s
financial or tax reporting from those that would have resulted
had petitioner accepted Winston’s initial offers.
                               - 25 -

     In summary, Winston agreed to change the form of its

original severance offer to accommodate petitioner and facilitate

a settlement after more than 2 years of protracted negotiations.

The substance of the agreement, however, remained the same as

that of the original severance offer.     Accordingly, we hold that

the $116,000 was not paid on account of personal injuries and is

not excludable from petitioners’ gross income under section 104.

We hold further that the $116,000 was severance pay or

compensation, and, therefore includable in petitioners’ gross

income.

     D.    Year of Inclusion

     Petitioner contends, in the alternative, that if the

$116,000 is not excludable from income, the payments constitute

his share of partnership income and should be included in income

with respect to the 1995 fiscal year of the partnership, or for

petitioner’s 1995 tax year.    See sec. 706(a).   Respondent

contends that the proceeds are severance payments and should be

included in income for 1994, the year petitioner received the

payment.

     Under section 451(a) amounts received are included in gross

income for the taxable year in which received by the taxpayer,

unless it can be accounted for in a different period under an

acceptable method of accounting.    Sec. 451(a); see Keith v.

Commissioner, 115 T.C. 605, 616 (2000).
                              - 26 -

      We have held that the $116,000 in lump-sum payments was a

severance payment to petitioner.   There is no evidence that a

Form K-1 was issued by Winston with respect to the $116,000.

Indeed, petitioner and Winston attempted to treat the $116,000 as

settlement of petitioner’s personal injury claims. Petitioner was

no longer an employee or partner of Winston.   The purpose of the

negotiation was to effect the severance of petitioner’s

relationship from Winston, and the final settlement and payment

were the culmination of the severance.   Moreover, the final

settlement agreement and the $116,000 payment represented the

final settlement of all of the parties’ rights and obligations in

the relationship and in no way were intended to represent

petitioner’s share of partnership income.   Accordingly, the

receipt of both payments during December 1994 by petitioner, a

cash basis taxpayer, results in income taxable in petitioner’s

1994 tax year, and we so hold.

II.   Were Payments Totaling $48,420 Received by Petitioner
      Prior to The Final Settlement Nontaxable Loans or
      Taxable Advances?

      Petitioner contends that five payments totaling $48,420 and

received between June 1992 and January 1993 were loans from

Winston.   His contention is based on the premise that he would

have been required to repay the amounts received, if a settlement

agreement had not been reached.    Petitioner also contends that if

the advances are held to be income, they should not be considered
                              - 27 -

taxable income until the time the settlement agreement was

reached and he was no longer obligated to repay them.   Respondent

contends that the payments were not bona fide loans to petitioner

because Winston did not intend to enforce the advances as loans.

Therefore, the payments should have been included in petitioner’s

income for the tax year 1993.10

     Gross income is “construed broadly to reach any accession to

wealth realized by a taxpayer over which the taxpayer has

‘complete dominion’”.   Fla. Progress Corp. v. Commissioner, 114

T.C. 587, 598 (2000) (quoting Commissioner v. Glenshaw Glass Co.,

348 U.S. 426, 431 (1955)).   Generally, the proceeds of a loan do

not constitute income to the borrower because the benefit is

offset by an obligation to repay.   See Arlen v. Commissioner, 48

T.C. 640, 648 (1967).   Whether a bona fide debtor-creditor

relationship exists is a question of fact to be determined upon

consideration of all the pertinent facts in the case.     Haber v.

Commissioner, 52 T.C. 255, 266 (1969), affd. 422 F.2d 198 (5th

Cir. 1970); Birnbaum v. Commissioner, T.C. Memo. 1993-485.     For a

disbursement to constitute a loan at the time funds are

transferred, the recipient must intend to repay the proceeds and


     10
       Respondent maintained alternative protective positions in
the notices of deficiency by determining deficiencies
attributable to the $48,420 in the 1993 and 1994 tax years.
Petitioner did not report the amount until the 1995 year, when
the entire matter was completely settled. The parties, in their
arguments on brief, frame the ultimate question in terms of
whether the $48,420 is reportable in 1993 or 1995.
                              - 28 -

the lender must intend to enforce repayment.    See Haag v.

Commissioner, 88 T.C. 604, 615 (1987), affd. without published

opinion 855 F.2d 855 (8th Cir. 1988).

     The record reflects that Winston did not intend to enforce

repayment of the advances made to petitioner.    The most

compelling indication of this fact is that Winston included the

full amount of the advances in petitioner’s Form K-1 for the

partnership’s tax year ending January 31, 1993.    Winston also

refused Mr. Knoll’s request to recharacterize the payments as a

loan or as a payment for a release of a tort-type personal injury

claim.   In addition, section 2(f) of the final settlement

agreement allocates the $48,420 of payments as in satisfaction of

items including “salary, draw, guarantee, bonus * * * partnership

income or profits, fees, fee participation”.    These facts do not

support characterizing the proceeds as a loan.

     Other facts add additional support for the conclusion that

Winston did not intend the advances to be loans.    Petitioner

signed acknowledgments of receipt each time he received a payment

from Winston.   Notably, the forms did not include terms of

repayment, did not require petitioner to pay interest, and did

not require petitioner to pledge collateral.    While the

acknowledgments stated that each payment would be recaptured from

any lump-sum payment the firm may agree to pay petitioner, in

light of other more compelling evidence, this fact is not
                               - 29 -

sufficient to characterize the advances as loans.     There were no

restrictions or conditions precedent to petitioner’s use of the

advances.    Further, upon receipt, petitioner had dominion over

and an unfettered right to use the advances.

       Accordingly, we hold that the aggregate advance payments of

$48,420 were reportable as taxable income in petitioner’s 1993

tax year.

III.    Are Petitioners Liable for Penalties Under Section
        6662(a) for Substantial Understatement of Tax or The
        Negligent Disregard of The Rules and Regulations?

       Section 6662 provides for a 20-percent penalty on any

understatement of tax attributable to negligence or disregard of

the rules or regulations, or any substantial understatement of

income tax.11   Pursuant to section 6662(c), negligence includes

any failure to make a reasonable attempt to comply with the

Internal Revenue Code including a careless, reckless, or

intentional disregard of the Code.      A substantial understatement

of tax exists if the amount of the understatement exceeds the

greater of 10 percent of the tax required to be shown on the

return or $5,000.    Sec. 6662(d)(1)(A).   If an understatement

exists, it may be reduced by the portion of the understatement

for which the taxpayer had substantial authority, or the amount

for which the taxpayer disclosed relevant facts and had a


       11
       As previously noted, no question has been raised with
respect to the burden of proof or production under sec. 7491.
                              - 30 -

reasonable basis to support the tax treatment.   Sec.

6662(d)(2)(B).

     For the purposes of this section, a taxpayer is negligent

when he or she fails “to do what a reasonable and ordinarily

prudent person would do under the circumstances.”     Korshin v.

Commissioner, 91 F.3d 670, 672 (4th Cir. 1996), affg. T.C. Memo.

1995-46.   Whether a taxpayer acted with reasonable cause and good

faith is measured by examining the relevant facts and

circumstances, and most importantly, the extent to which he

attempted to assess his proper tax liability.    See Neely v.

Commissioner, 85 T.C. 934 (1985); Stubblefield v. Commissioner,

T.C. Memo. 1996-537; sec. 1.6664-4(b)(1), Income Tax Regs.

     The record we consider reflects that petitioner did not

reasonably attempt to properly assess his income tax liability

with respect to the $116,000 received from Winston.     The notes

taken by petitioner during the negotiations with Winston and his

trial testimony both reveal that he knew which tort claims were

and were not taxable.   Petitioner’s revision of the settlement

payment allocations toward the release of several tort claims was

motivated by the need to lessen his tax burden and not because of

any specific tort claim.   The settlement agreement and release

contain several tort claims with no specific allocation.     Years

later, at trial, petitioner attempted to narrow the list to those

tort claims that he might have a chance to substantiate.
                              - 31 -

     Petitioner also took a position at trial inconsistent with

the position he asserted with the IRS auditor.    Petitioner

asserted to the Commissioner’s examining agent that he was

compensated for claims of defamation and loss of personal

reputation and IIED.   Petitioner then abandoned the defamation

and loss of personal reputation claim at trial because he did not

have a valid argument supporting the claim.    Petitioner is a

lawyer with experience in tax-advantaged financing.    He

negotiated and structured the settlement agreement to secure tax

advantages that he knew were valid in form only and not in

substance.

     Conversely, petitioner disclosed relevant facts and had a

reasonable basis to support his tax treatment of the $48,420 in

advances he received from Winston.     Petitioner disclosed on his

1993 tax return the difference between the amount that appeared

on his Form K-1 and the amount that he reported.    He also

provided a detailed explanation for this treatment.    Further,

based on the acknowledgments he signed, petitioner could have

reasonably concluded that he would be obligated to repay the

advances if a settlement agreement had not been reached.

Accordingly, we hold that petitioner is subject to the accuracy-

related penalty under section 6662(a) for his treatment of the

$116,000 in lump-sum payments, but not subject to a penalty for

his treatment of the $48,420 in advance payments.
                        - 32 -



To reflect the foregoing,

                                Decisions will be entered

                            under Rule 155.
