T.C. Memo. 1997-202

UNITED STATES TAX COURT

NEIL S. AND RITA E. HARDIN, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 4260-95. Filed May 5, 1997.

Allan C. Miles, for petitioners.

Margaret A. Martin, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

WELLS, Judge: Respondent determined a deficiency of $56,212

in petitioners' 1992 Federal income tax.

Unless otherwise indicated, all section references are to

the Internal Revenue Code as in effect for the year in issue, and

all Rule references are to the Tax Court Rules of Practice and

Procedure.
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1 In the notice of deficiency, respondent determined that, for

taxable year 1992, petitioners were liable for self-employment

tax in the amount of $985 and were entitled to a self-employment

tax deduction in the amount of $492. Subsequently, the parties

conceded that petitioners were not liable for the self-employment

tax and that petitioners were not entitled to the self-employment

tax deduction.

2 In the notice of deficiency, respondent allowed petitioners

a deduction in the amount of $41,395 for "Schedule C Legal Fees". 

In an Amendment to Answer, however, respondent argues that

petitioners are not entitled to the deduction of $41,395 as a

trade or business expense on Schedule C, but, rather, as a

miscellaneous itemized deduction on Schedule A, subject to

statutory limitations. Respondent bears the burden as to "any

new matter, increases in deficiency, and affirmative defenses,

pleaded in the answer". Rule 142(a). 

After concessions,1 the issues to be decided are: (1)

Whether petitioners are entitled to exclude from gross income,

pursuant to section 104(a)(2), amounts received in settlement of

a class action suit, and (2) whether petitioners are entitled to

exclude from gross income amounts paid as legal fees.2

FINDINGS OF FACT

Some of the facts have been stipulated for trial pursuant to

Rule 91. The parties' stipulations of fact are incorporated

herein by reference and are found as facts in the instant case. 

At the time they filed their petition in the instant case,

petitioners resided in Concord, California.

On June 1, 1979, a class action lawsuit, Kraszewski v. State

Farm Gen. Ins. Co., was filed against State Farm General

Insurance Co., State Farm Mutual Automobile Insurance Co., State

Farm Life Insurance Co., and State Farm Fire and Casualty Co.
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3 On Sept. 9, 1981, the District Court for the Northern

District of California certified a class in Kraszewski to

maintain the action. See Kraszewski v. State Farm Gen. Ins. Co.,

27 Fair Empl. Prac. Cas. (BNA) 27 (N.D. Cal. 1981).

(State Farm) in the U.S. District Court for the Northern District

of California.3 The class representatives alleged that State

Farm had engaged in statewide discrimination in California in the

recruiting, hiring, and training of women for sales agent trainee

positions in violation of title VII of the Civil Rights Act of

1964, 42 U.S.C. sec. 2000e et seq. (title VII). The

representatives sought backpay, as well as injunctive and

declaratory relief. 

The District Court bifurcated the litigation into a

liability and a remedy phase. On April 29, 1985, the court ruled

in the liability phase that State Farm was liable under title VII

for classwide discrimination on the basis of gender. See

Kraszewski v. State Farm Gen. Ins. Co., 38 Fair Empl. Prac. Cas.

(BNA) 197 (N.D. Cal. 1985). The court found that women who

attempted to become trainee agents were "lied to, misinformed,

and discouraged in their efforts to attain the entry level sales

position." Id. at 257. The court then ruled that the class

action suit properly included "all female applicants and deterred

applicants who, at any time since July 5, 1974, have been, are,

or will be denied recruitment, selection and/or hire as trainee

agents by defendant companies within the State of California." 

Id. at 258. 
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4 Before petitioner filed the Final Claim Form, on or around

Jan. 13, 1988, a Consent Decree Regarding Monetary Relief,

Instatement Relief, and Notice (consent decree) was filed in the

class action suit in which the parties to the class action suit,

inter alia, reached an agreement as to the remedy phase of the

litigation. Section A of exhibit 9 to the consent decree

provides, at par. IV.E.2.c., that "Negotiated Settlements are not

governed by the calculation rules for any of the types of damages

available under this [Consent] Decree."

On July 17, 1986, the court held that individual hearings

were appropriate to determine the relief for class members. The

court decided that class members were entitled to show that they

were actual victims of discrimination as to any of the vacancies

at State Farm which occurred during the period of liability and

were filled by men.

During June 1980, petitioner Rita E. Hardin (petitioner)

sought employment as a State Farm trainee agent but was deterred

from completing the application process. During 1988, petitioner

became aware of the class action suit against State Farm. 

Subsequently, petitioner executed a Final Claim Form and became a

plaintiff in the class action suit against State Farm.4 In

February of 1992, petitioner and State Farm entered into a

"Settlement Agreement and General Release" (settlement

agreement), which provided in relevant part:

1. For and in consideration of the sum of

$190,539.00, and potential additional payments of up to

$18,000.00 as provided in Paragraph 13 below, * * * less all

required payroll deductions applicable to the period of

Trainee Agency, if any, and inclusive of attorneys's [sic]

fees and costs to which * * * [petitioner] Rita Ellen Hardin

or * * * [petitioner's] Counsel is entitled on a prevailing

party basis but excluding attorneys' fees and costs as set
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forth in Paragraph 4 below, Rita Ellen Hardin * * * does

hereby completely release and forever discharge * * * [State

Farm] * * * from any claim * * * or liability of any and

every kind based on any federal, state, or local law,

statute, or regulation, excepting only claims for worker's

compensation benefits, (hereinafter "Claim") which arose

prior to the execution of this Settlement Agreement and

General Release, and which was raised, or could have been

raised in the above-captioned case, as well as any and all

Claims (including, where applicable, claims under the

federal Age Discrimination in Employment Act) arising out of

or relating to any alleged discriminatory, improper, or

unlawful act or omission of State Farm in connection with

any term or condition of employment or independent

contractor status or the process of securing or attempting

to secure employee or independent contractor status

including, without limitation, recruitment, selection,

hiring, job assignment, job transfer, training, promotion,

or termination, which arose prior to the execution of this

Settlement Agreement and General Release.

* * * * * * *

3. * * * [Petitioner] hereby agrees and promises 

* * * (3) that by entering into this Settlement Agreement

and General Release, she is waiving any and all right[s] she

may have under the terms of the Consent Decree respecting

instatement or rights to any other future class relief * * * 

* * * * * * *

5. It is understood and agreed that this is a full

and final General Release applying not only to all Claims

which are presently known, anticipated or disclosed to * * *

[petitioner], but also to all Claims which are presently

unknown, unanticipated, and undisclosed to * * *

[petitioner] and which may have arisen prior to the date of

execution of this Settlement Agreement and General Release. 

* * * [Petitioner] hereby waives any and all rights or

benefits which she may now have, or may in the future have,

under the terms of Section 1542 of the California Civil

Code, which provides as follows:

A general release does not extend to claims which

the creditor does not know or suspect to exist in his

favor at the time of executing the release, which if

known by him must have materially affected his

settlement with the debtor.
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* * * * * * *

7. It is understood and agreed that this compromise

settlement includes the compromise settlement of any and all

legal, evidentiary, discovery, and document production

issues regarding Claim No. 624 * * *. The parties further

agree and understand that neither State Farm nor * * *

[petitioner] will bring any motions, either individually or

as part of the class, relative to such Claim No. 624 issues

* * * 

13. * * * The approximate full value

of * * *

[petitioner's] claim under the Consent Decree damage formula

as of February 1, 1992, is $510,254.00, which represents 

back pay as a State Farm agent accrued from the year of the 

challenged appointment to February 1, 1992, plus six months 

of front pay from that date forward.

b. Settlement Cash at 87.5% Acceptance Rate:

State Farm offers * * * [petitioner] Settlement Cash of

$190,539.00, which is approximately 37% of the

estimated full Consent Decree value of her claim, to

release her claims against State Farm. * * * 

 * * * * * * * 

 c. Incentive Cash for Acceptance Rate Above 90%:

The Incentive Cash will be $1,800.00 per claimant for

each full percentage point by which the Acceptance Rate

* * * exceeds 90%. * * *

* * * * * * *

 e. Attorney's Fees: The payments State

Farm is offering to * * * [petitioner] include her

attorneys' fees and costs * * *. That is, * * *

[petitioner] will have to pay her attorneys' fees * * *

out of the payment State Farm makes to her. * * *

On April 15, 1992, pursuant to the terms of the settlement, State

Farm issued petitioner and her attorneys a check in the amount of

$206,739, which included an "incentive cash" payment of $16,200

(State Farm payment). Petitioner's attorneys retained legal fees
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and costs of $41,395, and the remaining $165,344 was paid to

petitioner.

On their 1992 joint Federal income tax return, petitioners

did not report the State Farm payment. Respondent determined

that the entire State Farm payment should have been included in

petitioners' gross income. Additionally, respondent asserted in

the answer that petitioners are entitled to claim legal fees in

the amount of $41,395 as a miscellaneous itemized deduction. 

OPINION

Petitioners did not file a brief in the instant case. 

Accordingly, we address the issues argued by petitioners in their

trial memorandum. 

Except as otherwise provided, gross income includes income

from all sources. Sec. 61; Commissioner v. Glenshaw Glass Co.,

348 U.S. 426 (1955). Although section 61(a) is to be broadly

construed, statutory exclusions from income must be narrowly

construed. Commissioner v. Schleier, 515 U.S. , , 115 S.

Ct. 2159, 2163 (1995).

Pursuant to section 104(a)(2), gross income does not include

"the amount of any damages received (whether by suit or agreement

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

personal injuries or sickness". The regulations provide that

The term "damages received (whether by suit or

agreement)" means an amount received * * * through

prosecution of a legal suit or action based upon tort

or tort type rights, or through a settlement agreement
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entered into in lieu of such prosecution. [Sec. 1.104-

1(c), Income Tax Regs.]

Accordingly, to exclude damages from gross income pursuant to

section 104(a)(2), the taxpayer must establish that: (1) The

underlying cause of action is based upon tort or tort type

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

injuries or sickness. Commissioner v. Schleier, 515 U.S. at ___,

115 S. Ct. at 2167.

Turning to the first requirement of Commissioner v.

Schleier, supra, we examine whether petitioner's claim was "based

upon tort or tort type rights". Citing United States v. Burke,

504 U.S. 229, 237 (1992), respondent argues that petitioner's

claim, which arose under title VII, was not based upon tort or

tort type rights. Petitioners, however, argue that the State

Farm payment was made to settle petitioner's claim of tortious

discrimination under California and Federal law. Additionally,

petitioners argue that, pursuant to the settlement agreement,

petitioner released all of her rights against State Farm,

including tort or tort type rights.

Where amounts are received pursuant to a settlement

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

settlement controls whether such amounts are excludable from

gross income pursuant to section 104(a)(2). United States v.

Burke, supra at 237. The critical question is "in lieu of what

were damages awarded" or paid. Bagley v. Commissioner, 105 T.C.
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396, 406 (1995); Bent v. Commissioner, 87 T.C. 236, 244 (1986),

affd. 835 F.2d 67 (3d Cir. 1987). Determination of the nature of

the claim is a factual inquiry. Robinson v. Commissioner, 102

T.C. 116, 127 (1994), affd. in part, revd. in part and remanded

70 F.3d 34 (5th Cir. 1995).

Petitioners first argue that the State Farm payment was made

to settle a claim of tortious discrimination under California and

Federal law. We disagree. In the instant case, although the

settlement agreement does not contain a specific reference to

title VII, the surrounding circumstances convince us that,

pursuant to the settlement agreement, the State Farm payment was

made to settle a claim under title VII. Petitioner was a

claimant in a class action suit that alleged discrimination under

title VII and sought backpay and injunctive and declaratory

relief. The District Court ruled that State Farm was liable

under title VII to all members of the class who had been

discriminated against and ordered individual hearings.

Subsequently, petitioner and State Farm entered into a

settlement agreement pursuant to which State Farm paid $206,739

to petitioner for petitioner's release of a claim "arising out of

or relating to any alleged discriminatory, improper, or unlawful

act or omission of State Farm in connection with * * *

recruitment, selection, hiring, job assignment, job transfer,

training, promotion, or termination". Additionally, the

settlement agreement expressly stated that it includes "the
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5 Claim No. 624 was the identification of petitioner's claim

against State Farm in the class action suit.

6 We do not find applicable petitioners' citation of Rojo v.

Kliger, 52 Cal. 3d 65, 82, 801 P.2d 376, 383 (1990), in which the

California Supreme Court held that a claim under the California

Fair Employment and Housing Act "does not displace any causes of

action and remedies that are otherwise available to plaintiffs." 

As discussed, supra, petitioner's claim was under title VII.

7 As petitioner's claim arose during 1975 and the class action

suit was filed during 1979, the amendments to title VII made by

sec. 102 of the Civil Rights Act of 1991, Pub. L. 102-166, 105

Stat. 1072-1074, do not apply. Landgraf v. USI Film Prods., 511

U.S. 244 (1994).

8 We note that, insofar as the State Farm payment was

attributable to a claim under the Age Discrimination in

Employment Act of 1967 (ADEA), "a recovery under the ADEA is not

one that is 'based upon tort or tort type rights.'" Commissioner

v. Schleier, 515 U.S. , , 115 S. Ct. 2159, 2167 (1995).

compromise settlement of any and all legal, evidentiary,

discovery, and document production issues regarding Claim No.

624".5 Accordingly, we conclude that the settlement agreement

represented a compromise and settlement of petitioner's rights

pursuant to her claim against State Farm alleging discrimination6

under title VII.7

Petitioners also argue that, in releasing all of her rights

against State Farm, petitioner's release included tort or tort

type rights. We, however, conclude that petitioners have failed

to establish that the State Farm payment was attributable to a

claim based upon tort or tort type rights under laws other than

title VII.8 Consequently, petitioners have failed to prove that

any part of the State Farm payment is excludable from gross
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9 We note that our opinion herein is consistent with prior

decisions of this Court, which similarly held that settlement

proceeds received pursuant to the Kraszewski litigation were not

excludable from gross income under sec. 104(a)(2). See Raney v.

Commissioner, T.C. Memo. 1997-200; Clark v. Commissioner, T.C.

Memo. 1997-156; Martinez v. Commissioner, T.C. Memo. 1997-126;

Fredrickson v. Commissioner, T.C. Memo. 1997-125.

10 Respondent bears the burden as to this issue. 

income. Accordingly, on the basis of the record in the instant

case, we conclude that, pursuant to the settlement agreement, the

State Farm payment was intended to settle petitioner's claim

against State Farm under title VII.

As we have concluded that petitioner's claim was not based

upon tort or tort type rights, we need not address the second

requirement of Commissioner v. Schleier, supra, regarding the

nature of damages. Accordingly, we conclude that petitioners are

not entitled to exclude any part of the State Farm payment

pursuant to section 104(a)(2).9

The next issue to be decided is whether petitioners are

entitled to exclude from gross income amounts paid as legal

fees.10 Petitioners contend that, as petitioner's legal fees

were paid to counsel from the settlement proceeds and petitioner

never received such fees, petitioners are entitled to exclude the

legal fees from their income. Citing Alexander v. Commissioner,

72 F.3d 938 (1st Cir. 1995) (citing with approval McKay v.

Commissioner, 102 T.C. 465 (1994), revd. on another issue without

published opinion 84 F.3d 433 (5th Cir. 1996)), affg. T.C. Memo.
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1995-51, respondent contends that petitioners may deduct

attorney's fees in the amount of $41,395 only as a miscellaneous

itemized deduction.

We agree with respondent. In Alexander, the Court of

Appeals stated that the former employer's "direct and joint

payment is 'standard operating procedure' in all types of

litigation" and that both the former employer and the taxpayer

were responsible for their respective legal costs, id. at 946,

and limited the taxpayer's deduction to a miscellaneous itemized

deduction. In the instant case, although State Farm issued a

check jointly to petitioner and her attorneys, petitioner was

responsible for her legal costs. The settlement agreement

provided, inter alia, that the State Farm payment included

petitioner's attorney's fees and that it was petitioner's

responsibility to pay her attorney's fees. Accordingly, we

conclude that petitioners are entitled to claim attorney's fees

in the amount of $41,395 as a miscellaneous itemized deduction.

We have considered all of petitioners' remaining arguments

and find them to be without merit.

To reflect the foregoing,

Decision will be entered

under Rule 155.