1 Unless otherwise indicated, section references

hereafter are to the Internal Revenue Code in effect for the year

at issue. All Rule references are to the Tax Court Rules of

Practice and Procedure.

T.C. Summary Opinion 2003-93

UNITED STATES TAX COURT

DeFOREST AND ROSE M. DORROH, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 3701-01S. Filed July 18, 2003.

DeForest and Rose M. Dorroh, pro se.

Gerald L. Brantley, for respondent.

COUVILLION, Special Trial Judge: This case was heard

pursuant to section 7463 in effect when the petition was filed.1

The decision to be entered is not reviewable by any other court,

and this opinion should not be cited as authority.

Respondent determined a deficiency of $15,822 in
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2 At trial, respondent conceded that $5,000, representing

attorney's fees paid by petitioner in recovering the $60,000, is

excludable from gross income pursuant to decisions of the Court

of Appeals for the Fifth Circuit to which this case would be

appealable were it not a small tax case. Srivastava v.

Commissioner, 220 F.3d 353, 365 (5th Cir. 2000), affg. in part,

vacating and remanding in part T.C. Memo. 1998-362; Cotnam v.

Commissioner, 263 F.2d 119 (5th Cir. 1959), affg. in part and

revg. in part 28 T.C. 947 (1957); Golsen v. Commissioner, 54 T.C.

742, 757 (1970), affd. 445 F.2d 985 (10th Cir. 1971). 

Additionally, petitioners conceded unreported interest income of

$344.

3 Petitioners are husband and wife and filed a joint

Federal income tax return for 1997. The principal issue, the

$55,000, involves only Mrs. Dorroh.

petitioners' Federal income tax for 1997 and a penalty under

section 6662(a) in the amount of $3,164.

The issues for decision are: (1) Whether $55,000 of a

$60,000 payment received by Rose M. Dorroh (petitioner) from her

former employer during 1997 is excludable from gross income under

section 104(a)(2), and (2) whether petitioners are liable for the

penalty under section 6662(a).2

Some of the facts were stipulated. Those facts, with the

annexed exhibits, are so found and are incorporated herein by

reference. At the time the petition was filed, petitioners were

legal residents of San Antonio, Texas.3

Petitioner was an employee of the Defense Finance and

Accounting Service (DFAS), an agency in the U.S. Department of

Defense. At the time her employment with that agency was

mutually terminated during 1997, petitioner had completed
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approximately 18-1/2 years of service as a Federal employee. 

Petitioner was a data transcriber or a voucher examiner for DFAS

at Kelly Air Force Base at San Antonio, Texas. In essence,

petitioner's duties were to examine vouchers or bills submitted

by commissary vendors and approve them for payment. Petitioner's

relations with her immediate supervisors at DFAS were not good. 

During a confrontation with one of her superiors on September 24,

1994, petitioner sustained an injury on the job when she fell,

injuring her head, neck, and back. The injury was disabling, and

petitioner came under the care of a doctor. She was unable to

work for intermittent periods and qualified for worker's

compensation benefits under the Federal Worker's Compensation

Act. Petitioner, however, continued her work with DFAS and

received worker's compensation benefits when she was unable to

work. After her employment with DFAS was mutually terminated in

1997, petitioner continued receiving worker's compensation

benefits. At trial, petitioner had a claim pending for total and

permanent disability benefits.

During the course of her employment, petitioner filed

numerous complaints within and without the chain of command in

DFAS complaining of various workplace conditions. Apparently not

satisfied with whatever actions, if any, that were taken by DFAS

to address these complaints, petitioner contacted a counselor

with the Equal Employment Opportunity Commission (EEOC) at least
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three times during 1995 complaining that DFAS had discriminated

against her based on her race, gender, and in reprisal for having

successfully prevailed against DFAS in an earlier proceeding (the

nature of which was not explained at trial). Petitioner

complained that, as a result, DFAS supervisors made adverse

employee reviews of her, increased her workload, and did not

provide her office accommodations equivalent to those of other

coworkers. Petitioner engaged the services of an attorney, and

an informal complaint of discrimination was filed with EEOC. In

this informal complaint, the relief petitioner sought was (1) a

finding of discrimination, (2) a job performance evaluation of

exceptional with a cash performance award, and (3) compensatory

damages of $300,000 for discrimination in violation of the Civil

Rights Act of 1991, Pub. L. 102-166, sec. 1981, 105 Stat. 1071. 

Petitioner's informal complaint did not seek any relief for

physical injury or sickness or any corrective relief relating to

the September 24, 1994, incident when petitioner injured her back

at work.

The EEOC counselor was not able to resolve informally

petitioner's complaint and advised that she could file a formal

complaint with EEOC. Petitioner, through her attorney,

thereafter filed two formal complaints with EEOC, the first in

1995 and the second in 1997. In both formal complaints,

petitioner alleged approximately 40 instances or occurrences in
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which she was discriminated against based on race, color,

national origin, sex, and reprisal for prior complaint activity. 

Neither of petitioner's formal complaints involved allegations of

personal physical injuries or physical sickness. After an

investigation by EEOC of the first formal complaint, it was

determined that petitioner had established a prima facie case

that DFAS had discriminated against petitioner on the basis of

race and reprisal. Before an investigation by EEOC was concluded

on the second formal complaint, the parties, DFAS and petitioner,

agreed to submit the case to mediation. An EEOC investigator was

the mediator. Petitioner's attorney represented petitioner in

the mediation proceedings. In due course, a settlement agreement

was reached and signed by the parties on April 2, 1997. In the

agreement, petitioner agreed to resign from her employment with

DFAS and not seek "employment with any DFAS activity world wide". 

Petitioner further agreed that she would not file any suit

against DFAS for any violation of the Civil Rights Act of 1964 or

under any other Federal or State law in connection with any of

the formal and informal complaints she had filed with the EEOC

against DFAS. In consideration for petitioner's concessions,

DFAS agreed to pay petitioner $60,000, agreed to various

corrections to petitioner's personnel records, cancellation of

any pending disciplinary actions against her, and give only

"neutral references" in any future employer inquiries of
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petitioner. DFAS paid petitioner the $60,000 during 1997.

The mediation agreement listed each of the formal and

informal complaints petitioner had filed with the EEOC, and the

agreement, by its terms, was for the express settlement of these

complaints. The agreement concluded that it represented the "sum

total" of the provisions made by the parties with each party

"having had the opportunity to read and raise questions about its

meaning prior to signing." Petitioner and her attorney signed

the agreement along with a representative of DFAS and the

mediator. The agreement makes no references to settlement of any

claims by petitioner for physical injuries or sickness or

emotional pain and suffering, nor does the agreement make

reference to petitioner's worker's compensation case and the

worker's compensation benefits she was receiving at that time. 

The agreement, however, includes an attachment, not referenced or

identified in the agreement, which is a Standard Form 50-B, U.S.

Office of Personnel Management, entitled Notification of

Personnel Action. That form lists petitioner's resignation from

DFAS on April 4, 1997, which was approved by DFAS on April 15,

1997. The "Remarks" portion of the form states: "I am officially

resigning from Federal service for medical and mental and

physical trauma. Please see my Dr. statement that will

officially be a part of my SF 50."

For the year 1997, DFAS issued to petitioner a Form 1099 for
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nonemployee compensation in the amount of $60,000 representing

the amount paid by DFAS pursuant to the mediation agreement. 

Petitioners did not include this payment as income on their 1997

Federal income tax return. In the notice of deficiency,

respondent determined that the $60,000 payment constituted gross

income and further determined petitioners failed to report $344

in interest income on their 1997 Federal income tax return. As

noted earlier, petitioners conceded the unreported interest

income adjustment, and respondent conceded that $5,000 of the

$60,000 payment was excludable from gross income.

Section 104(a)(2) excludes from gross income "the amount of

any damages (other than punitive damages) received (whether by

suit or agreement and whether as lump sums or as periodic

payments) on account of personal physical injuries or physical

sickness". Section 1.104-1(c), Income Tax Regs., defines

"damages received" as "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." Amounts are

excludable from gross income only when (1) the underlying cause

of action giving rise to the recovery is based on tort or tort

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

personal injuries or sickness. Commissioner v. Schleier, 515

U.S. 323, 337 (1995).
- 8 -

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 under

section 104(a)(2). United States v. Burke, 504 U.S. 229, 237

(1992). Determination of the nature of the claim is a factual

inquiry and is generally made by reference to the settlement

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

affd. in part and revd. in part 70 F.3d 34 (5th Cir. 1995). 

"[W]here an amount is paid in settlement of a case, the critical

question is, in lieu of what was the settlement amount paid". 

Bagley v. Commissioner, 105 T.C. 396, 406 (1995), affd. 121 F.3d

393 (8th Cir. 1997). An important factor in determining the

validity of the agreement is the "intent of the payor" in making

the payment. Knuckles v. Commissioner, 349 F.2d 610, 613 (10th

Cir. 1965), affg. T.C. Memo. 1964-33. If the payor's intent

cannot be clearly discerned from the settlement agreement, the

intent of the payor must be determined from all the facts and

circumstances of the case, including the complaint filed and

details surrounding the litigation. Robinson v. Commissioner,

supra at 127.

Although the taxpayer must show that the damages were

received "on account of personal injuries or sickness" under the

second requirement of Commissioner v. Schleier, supra, subsequent
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4 Small Business Job Protection Act of 1996, Pub. L. 104-

188, sec. 1605, 110 Stat. 1838, effective for amounts received

after Aug. 20, 1996.

to that decision, Congress amended section 104(a)4 to provide

that amounts are excludable only if received "on account of

personal physical injuries or physical sickness". Sec. 104(a)(2)

(emphasis added). The flush language in section 104(a) further

provides that "emotional distress shall not be treated as a

physical injury or physical sickness".

Under section 104(a)(2), as amended and in effect for 1997,

the mediation agreement pursuant to which the $60,000 was paid to

petitioner clearly was not a settlement of personal physical

injuries or physical sickness. The agreement is very explicit to

the effect that the payment was in consideration of (1) the

resignation of petitioner as an employee of DFAS, and (2)

petitioner's agreement not to file suit against DFAS for

violations of the Civil Rights Act of 1964. Petitioner, however,

sustained a personal injury in 1994 in the course of her

employment; however, that injury is not addressed in the

mediation agreement, and, moreover, petitioner was otherwise

compensated for that injury through worker's compensation

benefits she was receiving at the time of the agreement and even

at the time of trial. Petitioners argue that, because Standard

Form 50 is attached to the mediation agreement, the language in
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5 As noted earlier, SF 50, in the Remarks portion, stated

that petitioner was resigning her employment because of "medical,

mental, and physical trauma".

SF 50 is part and parcel of the mediation agreement and,

therefore, establishes that the $60,000 represented payment for

personal physical injuries.5 The Court rejects that argument. 

The mediation agreement carefully recites the various bases upon

which settlement was reached. Petitioner's on-the-job injury is

not listed in the mediation agreement. Indeed, if petitioner's

contention is correct, and the work-related injury is deemed to

have been part of the mediation agreement, such a conclusion

could seriously impair petitioner's entitlement to worker's

compensation benefits because the agreement was intended to

settle all differences between the parties. Petitioner, however,

at the time of trial, continued pursuing her worker's

compensation case. On this record, the Court is satisfied that

the $60,000 payment to petitioner by DFAS did not include any

amount for physical injuries or physical suffering. Respondent,

therefore, is sustained on this issue.

The final issue is whether petitioners are liable for the

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

understatement in tax or for negligence or disregard of rules and

regulations. Section 6662(a) provides that, if it is applicable

to any portion of an underpayment in taxes, there shall be added
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to the tax an amount equal to 20 percent of the portion of the

underpayment to which section 6662 applies. Under section

6664(c), however, no penalty shall be imposed under section

6662(a) with respect to any portion of an underpayment if it is

shown that there was a reasonable cause for the portion, and that

the taxpayer acted in good faith with respect to the portion of

the underpayment.

Under section 6662(b)(2), there is a substantial

understatement of income tax if the amount of the understatement

exceeds the greater of (1) 10 percent of the tax required to be

shown on the return, or (2) $5,000. Sec. 6662(d)(1)(A). For

purposes of section 6662(d)(1), "understatement" is defined as

the excess of tax required to be shown on the return over the

amount of tax that is shown on the return, reduced by any

rebates. Sec. 6662(d)(2)(A).

Section 6662(d)(2)(B) provides that the amount of the

understatement shall be reduced by that portion of the

understatement that is attributable to the tax treatment of any

item by the taxpayer if there is or was substantial authority for

the treatment, or any item with respect to which the relevant

facts affecting the item's tax treatment are adequately disclosed

in the return or in a statement attached to the return, and there

is reasonable basis for such treatment.

The tax that was required to be shown on petitioners' 1997
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6 The Court recognizes that, because of respondent's

concession that $5,000 of the $60,000 settlement is excludable

from gross income and petitioners' concession of $344 in

unreported interest income, the exact amount of the

understatement will be determined in the Rule 155 computation.

return, based on respondent's adjustments, was $20,761. 

Petitioners' return showed a tax of $4,939. Petitioners

understated their tax by $15,822, which clearly exceeds the

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

on the return (i.e., $2,076.10). It follows that petitioners'

understatement of tax was substantial for purposes of section

6662(d)(1)(A).6

The determination of whether a taxpayer acted with

reasonable cause and in good faith depends upon the facts and

circumstances of each particular case. Sec. 1.6664-4(b)(1),

Income Tax Regs. Relevant factors include the taxpayer's efforts

to assess his or her proper tax liability, the knowledge and

experience of the taxpayer, and reliance on the advice of a

professional, such as an accountant. Drummond v. Commissioner,

T.C. Memo. 1997-71. The most important factor is the extent of

the taxpayer's effort to determine the taxpayer's proper tax

liability. Sec. 1.6664-4(b)(1), Income Tax Regs. An honest

misunderstanding of fact or law that is reasonable in light of

the experience, knowledge, and education of the taxpayer may

indicate reasonable cause and good faith. Remy v. Commissioner,
- 13 -

T.C. Memo. 1997-72. 

Petitioners did not act with reasonable cause and in good

faith in failing to include the DFAS settlement as gross income

on their 1997 return. Prior to filing their return, petitioners,

through their attorney, contacted DFAS about the Form 1099 issued

by DFAS requesting that it be corrected. Petitioners were

advised in two letters from the attorney for DFAS that the

payment to them was not for personal injuries and could not be

excluded from gross income under section 104(a)(2). There is no

showing that petitioners contacted any other professional

advisors on this question. They simply chose to ignore the Form

1099 and did not include the payment as income on their 1997 tax

return. Respondent, therefore, is sustained on this issue.

Reviewed and adopted as the report of the Small Tax Case

Division.

 Decision will be entered

 under Rule 155.