                  T.C. Summary Opinion 2004-60



                     UNITED STATES TAX COURT



  CARRIE DAWN MURRAY, n.k.a. CARRIE DAWN WEAVER, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 7934-02S.           Filed May 13, 2004.


     Carrie Dawn Weaver, pro se, and Jeffrey Weaver (specially

recognized), for petitioner.

     James J. Posedel, for respondent.



     GOLDBERG, Special Trial Judge:   This case was heard pursuant

to the provisions of section 7463 of the Internal Revenue Code in

effect at the time the petition was filed.   The decision to be

entered is not reviewable by any other court, and this opinion

should not be cited as authority.   Unless otherwise indicated,

subsequent section references are to the Internal Revenue Code in
                               - 2 -

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

Tax Court Rules of Practice and Procedure.

     Respondent determined a deficiency in petitioner’s Federal

income tax of $12,229, and an accuracy-related penalty of $2,446,

for the taxable year 1999.

     The issues for decision are:   (1) Whether a $50,000 payment

petitioner received in 1999 is excludable from gross income under

section 104(a)(2), and, if not, whether the portion of the

payment retained by petitioner’s attorney is includable in

petitioner’s income; and (2) whether petitioner is liable for the

accuracy-related penalty under section 6662(a) for a substantial

understatement of tax.

     Some of the facts have been stipulated and are so found.

The stipulation of facts and the attached exhibits are

incorporated herein by this reference.   Petitioner resided in

Riverside, California, on the date the petition was filed in this

case.

     In June 1996, petitioner began working as a loss prevention

agent for the May Department Stores Company, d.b.a. Robinsons-May

(“the May Company”).   On March 23, 1997, petitioner was injured

while working at one of the May Company department stores.   In

attempting to apprehend a disabled shoplifter, petitioner’s hand

became stuck in a wheelchair, causing injury to her right thumb
                                - 3 -

and index finger.    Petitioner stopped working for the May Company

on March 27, 1997.

     In November 1997, petitioner filed a discrimination charge

against the May Company with the California Department of Fair

Employment and Housing.   Petitioner subsequently was issued a

right to bring a civil action, and, on February 19, 1998, she

filed a complaint with the Superior Court of the State of

California, County of Los Angeles.      In the complaint filed

against the May Company and 10 unnamed defendants, petitioner

alleged that 2 employees of the May Company engaged in

conversation with petitioner which was “sexually demeaning,

insulting and offensive towards women”, and that they were

involved in other instances of sexual harassment toward

petitioner.   The complaint further alleged that after petitioner

had informed the May Company that she was leaving her position,

and after petitioner received a severe hand injury while

apprehending a shoplifter, petitioner was forced to abandon a

workers’ compensation claim because one of the employees who had

been harassing her was assigned to handle the workers’

compensation claim for the company.

     Petitioner’s complaint alleged three causes of action.      The

first cause of action was based upon the following:

     Pursuant to Government Code section 12490(a), (f) and (i),
     respectively, it is an unlawful employment practice for: an
     employer, because of the sex of any person, to discriminate
     against the person in compensation or in terms, conditions,
                               - 4 -

     or privileges of employment; for any employer to discharge,
     expel, or otherwise discriminate against any person because
     the person has filed a complaint, testified or assisted in
     any proceeding regarding a complaint of discrimination or
     sexual harassment; and, for any employer to fail to take all
     reasonable steps necessary to prevent discrimination and
     harassment from occurring.

Petitioner’s second and third causes of action were for a

“wrongful termination in violation of public policy” and for the

“intentional infliction of emotional distress”, both based upon

the acts related to the alleged sexual discrimination and

harassment.   Petitioner further alleged that as a result of each

of the three claims, she suffered “emotional harm, severe mental

anguish, nervous shock, grief, shame, humiliation, embarrassment,

anger, loss of income and loss of employment opportunities.”

Finally, the complaint sought judgment for past and future loss

of income and employment benefits; general, special, and punitive

damages; pre-judgment interest; and attorney’s fees and costs.

     On May 21, 1999, petitioner filed with the California court

a document titled “Plaintiff Carrie Murray’s Ex Parte Application

to Continue Status Conference Re Arbitration Completion”.     In

this document, petitioner stated that “This is an action for

sexual harassment brought by Plaintiff Carrie Murray”.   No

mention was made of the physical injury to petitioner’s hand.

     In a document prepared by the May Company titled “Mandatory

Settlement Conference Statement” and dated September 1, 1999, the

underlying case was described as “a sex harassment, hostile work
                               - 5 -

environment case.”   This document included a detailed statement

of the facts relevant to the case from the point of view of the

May Company.   The only mention of the physical injury to

petitioner’s hand was the following:

     A few weeks later, Murray stuck her finger in the spokes on
     a wheelchair while trying to apprehend a disabled
     shoplifter. She suffered a sprained finger and filed a
     workers comp claim. The claim was assigned to Ahonen
     because of his knowledge of loss prevention. He had one
     friendly conversation with Plaintiff that he documented and
     she left a pleasant voice mail to him after she abandoned
     her injury claim. * * * Murray claims that Ahonen was
     assigned to her comp claim as an act of retaliation. * * *
     Mackay had nothing to do with the assignment of the comp
     claim to Ahonen and Murray never complained to Robinsons-May
     although she reposed trust in Mackay. Whether assigning
     Ahonen to the claim is retaliation as defined in the
     government code is dubious to put it mildly.

     Finally, in petitioner’s “Mandatory Settlement Conference

Brief”, dated September 2, 1999, petitioner stated that “This

action is brought by [petitioner] to recover damages for injuries

incurred by her as the result of sexual harassment”.   The only

reference that was made to the physical injury to petitioner’s

hand was in the context of the workers’ compensation claim and

the alleged retaliatory conduct in assigning a harasser to the

claim.   However, the document stated that petitioner’s “finger is

now permanently deformed”.

     Petitioner entered into an agreement to settle her lawsuit

against the May Company in November 1999.   The agreement, titled

“Settlement Agreement and Release of All Claims”, provides in

relevant part as follows:
                         - 6 -

     WHEREAS, Murray’s [petitioner’s] employment with the
[May] Company was terminated and she was compensated at her
termination with severance pay; and
     WHEREAS, Murray claims that her termination has
resulted in her suffering financial loss and emotional
distress damages;
     WHEREAS, Murray has pending a lawsuit claiming breach
of employment agreement, breach of the covenant of good
faith and fair dealing, discrimination in violation of
California Government Code and California Constitutions and
wrongful termination in violation of California Government
Code, Intentional and Negligent Infliction of Emotional
Distress in the Superior Court of Los Angeles County * * * .

                     * * * * * * *

     WHEREAS, Murray and the Company now desire to settle
fully and finally all differences between them, including,
but in no way limited to, those differences described above;
     NOW, THEREFORE, in consideration of the mutual
covenants and promises herein contained and other good and
valuable consideration, receipt of which is hereby
acknowledged, and to avoid unnecessary further litigation,
it is hereby agreed by and between the parties as follows:

                     * * * * * * *

     SECOND:
     (a) * * * the Company will cause to be delivered to
counsel for Murray * * * $50,000.00 as payment for alleged
emotional distress. * * *

                     * * * * * * *

     (c) Murray agrees that the foregoing payment shall
constitute the entire amount of the settlement provided to
her under this Agreement and that she will not seek any
further compensation for any other claimed damage, costs, or
attorneys’ fees in connection with the matters encompassed
in this Agreement relating in any way to her termination
from employment and employment with the Company. * * * This
release encompasses the injury claimed by Murray in March,
1997, for an on the job injury arising at the Montclair
store.
     (d) Murray through her counsel will dismiss [the May
Company] * * * .
                               - 7 -

The agreement then set forth a general release of all claims of

any kind by Murray against the May Company.

     In 1999, petitioner received $26,547 of the $50,000 in

settlement proceeds.   Petitioner’s attorney retained the

remainder of the proceeds consisting of “costs advanced” of

$4,620, a 40-percent contingency fee of $18,152, and a

1.5-percent payment of $681 for costs.

     Petitioner filed an individual Federal income tax return for

taxable year 1999 on a Form 1040, U.S. Individual Income Tax

Return.   Petitioner paid a tax return preparer to prepare her

return, and she sought advice--both from this preparer and from

the attorney who had represented her in the suit against the May

Company--concerning the proper tax treatment of the settlement

proceeds.   In the space provided adjacent to line 21 of the Form

1040, “Other income”, petitioner made the following notation:

     THE MAY DEPT STORE            50,000.
     PHYS. INJURY SETTLEMENT      <50,000.>

Petitioner did not include any portion of the $50,000 settlement

in her income, nor did she claim any deduction for the legal

expenses she incurred with respect thereto.

     In the notice of deficiency, respondent determined that

petitioner was required to include in gross income the full

amount of the $50,000 settlement.   Respondent also determined

that petitioner is liable for the accuracy-related penalty under

section 6662(a) for a substantial understatement of tax.
                                - 8 -

     The first issue for decision is what portion, if any, of the

$50,000 payment petitioner received in 1999 is excludable from

gross income.   We decide this issue on the merits based on the

preponderance of evidence, without regard to the burden of proof.

See sec. 7491(a); Rule 142(a)(1).

     Section 61 provides that gross income generally includes all

income from whatever source derived.    However, section 104(a)(2)

excludes from gross income amounts received in damages, by suit

or settlement, “on account of personal physical injuries or

physical sickness”.   In determining whether damages received are

excludable under section 104(a)(2), the focus is the nature of

the claim underlying the damage award.    United States v. Burke,

504 U.S. 229, 237 (1992).   The underlying claim giving rise to

the recovery must be “based upon tort or tort type rights” and

the damages must have been received “on account of personal

injuries or sickness”.    Commissioner v. Schleier, 515 U.S. 323,

336-337 (1995).    Section 104(a)(2) was amended in 1996, effective

for amounts received after August 20, 1996, to require that the

personal injury or sickness be physical in nature; this amendment

does not otherwise change the analysis under Commissioner v.

Schleier, supra.    Prasil v. Commissioner, T.C. Memo. 2003-100.

For purposes of section 104(a)(2), emotional distress is not

treated as a physical injury or physical sickness, except for any

damages received that are not in excess of the amount paid for
                                 - 9 -

medical care attributable to such emotional distress.    Sec.

104(a).

     Where damages are received pursuant to a settlement

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

the agreement controls whether such damages are excludable under

section 104(a)(2).     Stocks v. Commissioner, 98 T.C. 1, 10 (1992);

Metzger v. Commissioner, 88 T.C. 834, 847 (1987), affd. without

published opinion 845 F.2d 1013 (3d Cir. 1988).    Where the

settlement agreement lacks express language stating what the

settlement amount was paid to settle, then the most important

factor in making that determination is the intent of the payor in

making the payment.    Stocks v. Commissioner, supra; Metzger v.

Commissioner, supra.

     Petitioner argues that the settlement proceeds represent

compensation for a physical injury and therefore are excludable

from income under section 104(a)(2).     Alternatively, if the Court

should find that the proceeds are not excludable under section

104(a)(2), petitioner argues that the portion of the proceeds

paid directly to her attorney should not be included in

petitioner’s income.

     With respect to petitioner’s first argument, we find that

the settlement proceeds do not represent compensation for a

physical injury.   Petitioner argues that the eventual settlement

was made for claims which were not made originally in the
                               - 10 -

complaint filed in the California court; namely, claims of

physical injury.   However, the settlement agreement specifically

provides that the $50,000 was to be “payment for alleged

emotional distress”.    Furthermore, assuming arguendo that

petitioner had a valid claim for damages from the injury to her

hand in excess of any amounts that the May Company had previously

paid her, it is evident from the record that petitioner had

stopped pursuing any such claim long before she entered into the

settlement agreement.   Even if her decision to do so was based

upon the alleged retaliatory action by her employer, it is

nevertheless clear that she abandoned the claim.    When petitioner

subsequently entered into the agreement with the May Company, the

intent of both parties was to settle petitioner’s sexual

harassment suit which she had filed with the California court.

     The inclusion in the settlement agreement of the provision

relating to the injury to petitioner’s hand was, in the context

of the overall agreement, merely an extension of the agreement’s

general provisions releasing the May Company from any and all

claims which petitioner had against the May Company.    The use of

these provisions reflects an intent to prevent future lawsuits

which petitioner might have been able to bring against the May

Company, but it does not reflect an intent to compensate

petitioner for any physical injury.
                              - 11 -

     Thus, we are convinced from the record as a whole that the

entire amount of the $50,000 proceeds was intended to settle

petitioner’s sexual harassment claims, as those claims are

reflected in the original complaint.    Consequently, no portions

of the proceeds received under the settlement agreement are

damages received “on account of personal physical injuries or

physical sickness”, sec. 104(a)(2), and no portions of the

proceeds are excludable from petitioner’s gross income under

section 104(a)(2).

     Petitioner makes various arguments concerning injuries, both

physical and psychological, which she asserts were caused by her

employment with the May Company.   Petitioner points to

psychological counseling that she received prior to entering into

the settlement agreement.   Petitioner also argues that her

emotional distress caused physical ailments which became manifest

after she entered into the agreement.   To this effect, petitioner

provided evidence that she visited a physician in 2002 and 2003

for treatment of abdominal pain and related conditions.   As

discussed above, damages received for certain medical care for

the treatment of emotional distress may be excludable under

section 104(a)(2).1   However, the record indicates that the


     1
      The legislative history accompanying passage of the
amendment to section 104(a)(2) clarifies that “the term emotional
distress includes symptoms (e.g., insomnia, headaches, stomach
disorders) which may result from such emotional distress.” H.
                                                   (continued...)
                               - 12 -

psychological counseling petitioner received was general in

nature and that the problems petitioner was experiencing were at

most only nominally related to the sexual harassment claims.   We

find that neither the psychological counseling nor the visits to

the physician--visits which occurred over 5 years after the

termination of petitioner’s employment with the May Company--are

related to petitioner’s sexual harassment claims.

     Petitioner further argues that the physical injury to her

hand caused her damages that occurred after she entered into the

settlement agreement, due in part to an inability to perform

certain job functions.   This argument does not address the

relevant issue in this case.   The relevant issue is the intent of

the May Company in paying the $50,000 settlement to petitioner.

See Stocks v. Commissioner, supra; Metzger v. Commissioner,

supra.   We have found that the intent behind the payment was to

settle the sexual harassment claims made in petitioner’s lawsuit.

Any harm connected with the hand injury that was suffered by

petitioner after entering into the settlement agreement could not

have affected the intent behind making the payment at the time of

the agreement.2


     1
      (...continued)
Conf. Rept. 104-737, at 301 n.56 (1996), 1996-3 C.B. 741, 1041;
see Prasil v. Commissioner, T.C. Memo. 2003-100.
     2
      At trial, petitioner cited Moe v. United States, 326 F.3d
1065 (9th Cir. 2003), for the proposition that “the chronological
                                                   (continued...)
                                  - 13 -

       We next address petitioner’s argument that the portion of

the settlement proceeds retained by her attorney should not be

included in her gross income.       This Court has consistently held

that “taxable recoveries in lawsuits are gross income in their

entirety to the party-client and that associated legal fees--

contingent or otherwise--are to be treated as deductions.”

Kenseth v. Commissioner, 114 T.C. 399, 411 (2000), affd. 259 F.3d

881 (7th Cir. 2001).       While there is a split of authority among

the Federal Courts of Appeals as to whether certain contingent

fees may be excludable from the client’s income under the laws of

certain States, in Kenseth v. Commissioner, supra, this Court has

concluded that we will continue to adhere to our holding in

O’Brien v. Commissioner, 38 T.C. 707 (1962), affd. per curiam 319

F.2d 532 (3d Cir. 1963), that contingent fee agreements “come

within the ambit of the assignment of income doctrine and do not

serve, for purposes of Federal taxation, to exclude the fee from

the assignor’s gross income.”       Kenseth v. Commissioner, supra at

412.       Furthermore, the Court of Appeals for the Ninth Circuit3


       2
      (...continued)
order of the injury and emotional distress didn’t matter.” That
case, in which the court held that psychological injury which
results in physical injury is within the scope of the Federal
Employees’ Compensation Act, 5 U.S.C. ch. 5 (2000), has no
application with respect to the provisions of sec. 104(a)(2) of
the Internal Revenue Code.
       3
      But for the provisions of sec. 7463(b), the decision in
this case would be appealable to the U.S. Court of Appeals for
                                                   (continued...)
                              - 14 -

explicitly held in Benci-Woodward v. Commissioner, 219 F.3d 941

(9th Cir. 2000), affg. T.C. Memo. 1998-395, that nothing in

California law acts to exclude the contingent fee portion of

damages from a client’s income.   Thus, petitioner must include

the entire amount of the settlement payment in her gross income,

even the portion retained by her attorney.   Sec. 61(a).   We note

that although petitioner did not physically receive the portion

of the settlement proceeds used to pay the attorney’s fees, she

did receive the benefit of those funds in the form of payment for

the services required to obtain the settlement.

     The second issue for decision is whether petitioner is

liable for the accuracy-related penalty under section 6662(a) for

a substantial understatement of tax.   We decide this issue on the

merits based on the preponderance of the evidence, without regard

to the burden of production or the burden of proof.   Sec.

7491(a), (c); Rule 142(a).

     Section 6662(a) imposes a 20-percent penalty on the portion

of an underpayment attributable to any one of various factors,

one of which is any substantial understatement of income tax.

Sec. 6662(b)(2).   A substantial understatement of income tax



     3
      (...continued)
the Ninth Circuit. Sec. 7482(b)(1)(A). This Court generally
applies the law in a manner consistent with the holdings of the
Court of Appeals to which an appeal of its decision lies, Golsen
v. Commissioner, 54 T.C. 742 (1970), affd. 445 F.2d 985 (10th
Cir. 1971), even in cases subject to sec. 7463(b).
                                 - 15 -

exists if the amount of the understatement exceeds the greater of

$5,000 or 10 percent of the tax required to be shown on the

return.    Sec. 6662(d)(l)(A).   Generally, the amount of an

understatement is reduced by the portion of the understatement

which is attributable to either (1) the tax treatment of any item

for which there is or was substantial authority, or (2) any item

with respect to which (a) the relevant facts were adequately

disclosed on the return or on a statement attached to the return,

and (b) the taxpayer had a reasonable basis for the tax treatment

thereof.   Sec. 6662(d)(2)(B).

     Section 6664(c)(1) provides that the penalty under section

6662(a) shall not apply to any portion of an underpayment if it

is shown that there was reasonable cause for the taxpayer’s

position and that the taxpayer acted in good faith with respect

to that portion.   The determination of whether a taxpayer acted

with reasonable cause and in good faith is made on a case-by-case

basis, taking into account all the pertinent facts and

circumstances.   Sec. 1.6664-4(b)(1), Income Tax Regs.    Depending

upon the other facts and circumstances of a given case, reliance

on tax professionals may constitute reasonable cause and good

faith.    Sec. 1.6664-4(b)(2) Example (1), Income Tax Regs.    The

reliance must be reasonable and the advice must be based upon all

pertinent facts and circumstances and the relevant law.     Sec.

1.6664-4(c), Income Tax Regs.
                                - 16 -

     A substantial understatement of tax exists with respect to

petitioner’s 1999 income tax.    However, petitioner relied on the

advice of both her attorney and her tax return preparer in coming

to the conclusion that the settlement proceeds were excludable

from her gross income.   Based on the record before us, we find

that this reliance was reasonable and in good faith.    We

therefore hold that petitioner is not liable for the section

6662(a) accuracy-related penalty.

     Respondent concedes that petitioner is entitled to a

miscellaneous itemized deduction for the legal fees of $23,453

which petitioner paid in connection with the lawsuit.

Miscellaneous itemized deductions are allowed to the extent they

exceed 2 percent of the taxpayer’s adjusted gross income.     Sec.

67(a).   A Rule 155 computation is required in this case to

calculate the proper amount of the deficiency taking into account

petitioner’s itemized deductions.

     Reviewed and adopted as the report of the Small Tax Case

Division.

                                     Decision will be entered

                                under Rule 155.
