Court Opinion

ID: 7804935
Source: CourtListenerOpinion
Date Created: 2022-08-30 19:03:32.0329+00
Date Added: 2024-06-11T16:29:55.506550
License: Public Domain

United States Tax Court

                                T.C. Memo. 2022-90

                 THOMAS J. DERN AND PEGGY M. DERN,
                             Petitioners

                                            v.

               COMMISSIONER OF INTERNAL REVENUE,
                           Respondent

                                      —————

Docket No. 7595-20.                                           Filed August 30, 2022.

                                      —————

Thomas J. Dern and Peggy M. Dern, pro sese.

Laura L. Bates and Vladislav M. Rozenzhak, for respondent.

            MEMORANDUM FINDINGS OF FACT AND OPINION

       VASQUEZ, Judge: With respect to petitioners’ 2017 federal
income tax, respondent determined a deficiency of $99,215 and a section
6662(a) accuracy-related penalty of $19,843. 1 After concessions, 2 the
issue for decision is whether any part of a legal settlement petitioner
husband received from his former employer is excludable from income
under section 104(a)(2).

        1 Unless otherwise indicated, all statutory references are to the Internal
Revenue Code (Code), Title 26 U.S.C., in effect at all relevant times, all regulation
references are to the Code of Federal Regulations, Title 26 (Treas. Reg.), in effect at all
relevant times, and all Rule references are to the Tax Court Rules of Practice and
Procedure.
        2 Respondent concedes that petitioners (1) are not liable for the accuracy-

related penalty, (2) are not liable for self-employment tax with respect to the
settlement proceeds, and (3) did not have unreported Social Security income.

                                  Served 08/30/22
                                    2

[*2]                      FINDINGS OF FACT

       Some of the facts have been stipulated and are so found. We
incorporate the First Stipulation of Facts and accompanying exhibits by
this reference. Petitioners resided in California when the Petition was
filed.

       From the early 1990s to March 2016, petitioner Thomas J. Dern
worked as a sales representative for P.F.I., Inc. (PFI), a manufacturer
and distributor of paint and paint-related products. Mr. Dern sold PFI’s
products in exchange for a commission, health insurance, and a $500
travel stipend pursuant to a sales representative agreement with the
company.

      On September 19, 2015, Mr. Dern was hospitalized for acute
gastrointestinal bleeding and a resulting heart attack. Mr. Dern’s acute
gastrointestinal bleeding was unrelated to his work for PFI. Although
his initial hospital stay lasted for three days, Mr. Dern was
intermittently hospitalized over the next few weeks. Accordingly, he
was unable to perform his sales duties for PFI during October and
November 2015. In December 2015 Mr. Dern resumed his sales duties
but did so by email and phone in lieu of in-person sales calls.

       The following month Steven Holst, an officer of PFI, asked Mr.
Dern to resume making in-person sales calls. However, apart from one
date in January 2016, Mr. Dern continued to perform modified sales
duties by email and telephone. On January 27, 2016, PFI notified Mr.
Dern that it was terminating their sales representative agreement. The
letter stated: “[Y]our prolonged health conditions have unfortunately
had a significant impact on your ability to effectively represent the
Company and perform the duties of a sales representative.”

       Subsequently, Mr. Dern retained an attorney to represent him in
a lawsuit against PFI, Mr. Holst, and other affiliated entities
(collectively, PFI defendants). The lawsuit alleged the following causes
of action: (1) willful misclassification in violation of California Labor
Code § 226.8; (2) disability discrimination in violation of the California
Fair Employment and Housing Act (California FEHA), California
Government Code § 12940, et seq.; (3) failure to accommodate disability
in violation of the California FEHA; (4) failure to engage in the
interactive process in violation of the California FEHA; (5) age
discrimination in violation of the California FEHA; (6) failure to take all
reasonable steps to prevent discrimination in violation of the California
                                         3

[*3] FEHA; (7) wrongful termination in violation of public policy;
(8) intentional infliction of emotional distress; (9) failure to timely pay
all wages upon separation from employment; and (10) breach of contract.

       In 2017 Mr. Dern and the PFI defendants agreed to settle all
claims, which they memorialized in a settlement agreement and mutual
release of claims (settlement agreement). Under the settlement
agreement, the PFI defendants agreed to pay $550,000 (gross
settlement) “to compensate [Mr. Dern] for alleged personal injuries,
costs, penalties, and all other damages and claims.” Further, the
agreement provided that it was “for and on account of [Mr. Dern’s]
claims alleging compensatory damages, emotional injuries, penalties,
and punitive damages.” The settlement agreement also included a
general release of claims which was “intended to include in its effect,
without limitation, all claims known or unknown at the time of the
execution” of the settlement agreement.

      On September 8, 2017, Mr. Dern’s attorney sent him a check for
$327,416.31, which was calculated in the following manner:

 Gross settlement                                                   $550,000.00
 Attorney’s fees                                                    (220,000.00)
 Costs (filing fee, court reporter, and                               (3,803.81)
 videographer)
 Balance from settlement payment                                     326,196.19
 Reimbursement of previous trust account                               1,220.12
 balance
  Total                                                             $327,416.31

Mr. Dern’s attorney filed Form 1099–MISC, Miscellaneous Income, with
the Internal Revenue Service reporting nonemployee compensation of
$330,000 (gross settlement of $550,000 less attorney’s fees of $220,000).3

      On April 15, 2018, respondent received petitioners’ 2017 joint
Form 1040, U.S. Individual Income Tax Return. Thereon petitioners
reported nonemployee compensation of $6,000 pertaining to an

        3 To the extent that the amount reported as compensation to Mr. Dern and

includible in his gross income should have included attorney’s fees, respondent
concedes that Mr. Dern would have been entitled to a deduction for such fees pursuant
to section 62(a)(20). Respondent likewise concedes that Mr. Dern is entitled to a
deduction of $3,803.81 under section 62(a)(20) for court costs paid in an action
involving a claim of unlawful discrimination.
                                            4

[*4] appraisal business. They did not report as income any part of the
gross settlement.

       On January 6, 2020, respondent issued a notice of deficiency to
petitioners for 2017. Therein respondent determined, on the basis of the
Form 1099–MISC issued by Mr. Dern’s attorney, that petitioners had
unreported nonemployee compensation of $324,000. 4 Petitioners timely
filed a Petition with this Court alleging that the settlement payment
was received for “personal physical injuries and personal physical
sickness” and thus not taxable under section 104(a)(2). A remote trial
was held at a Los Angeles, California, Trial Session of the Court.

                                      OPINION

I.      Preliminary matter

       Petitioners attached several documents to their Simultaneous
Opening Brief, Simultaneous Answering Brief, and a Letter filed
April 1, 2022. Some of those documents are duplicates of exhibits we
admitted at trial; others are not part of the trial record. In his
Simultaneous Answering Brief, respondent objected to the inclusion of
documents that were not received into evidence.

        Reopening the record for the submission of additional evidence
lies within the discretion of the Court. Butler v. Commissioner, 114 T.C.
276, 286–87 (2000). The policy of the Court is to try all of the issues
raised in a case in one proceeding to avoid piecemeal and protracted
litigation. Markwardt v. Commissioner, 64 T.C. 989, 998 (1975).
Petitioners were given ample opportunity to provide evidence both
before and at trial, and they have not explained why they did not proffer
certain documents until after trial. Under these circumstances, we
decline to receive additional evidence.

II.     Burden of proof

      The Commissioner’s determinations in a notice of deficiency are
generally presumed correct, and the taxpayer bears the burden of

        4 In determining unreported income of $324,000, respondent subtracted $6,000

(the amount petitioners reported as nonemployee compensation) from $330,000 (the
amount shown on the Form 1099–MISC). Because the $6,000 of reported income
pertains to an unrelated appraisal business, respondent’s calculation appears to have
been in error. Respondent has not asked us to correct this error, which is in petitioners’
favor.
                                          5

[*5] proving those determinations erroneous. 5 See Rule 142(a)(1); Welch
v. Helvering, 290 U.S. 111, 115 (1933); Merkel v. Commissioner, 192 F.3d
844, 852 (9th Cir. 1999), aff’g 109 T.C. 463 (1997). In cases involving
failure to report income, the Court of Appeals for the Ninth Circuit, to
which an appeal in this case would ordinarily lie, see § 7482(b)(1)(A), has
held that the Commissioner must establish “some evidentiary
foundation” linking the taxpayer to an alleged income-producing activity
before the presumption of correctness attaches to the deficiency
determination, Weimerskirch v. Commissioner, 596 F.2d 358, 361–62
(9th Cir. 1979), rev’g 67 T.C. 672 (1977). Once the Commissioner has
established such a foundation, the burden of proof shifts to the taxpayer
to prove by a preponderance of the evidence that the Commissioner’s
determinations are arbitrary or erroneous. See Hardy v. Commissioner,
181 F.3d 1002, 1004–05 (9th Cir. 1999), aff’g T.C. Memo. 1997-97.

       Because petitioners stipulated that they received the settlement
proceeds, respondent has established an evidentiary foundation linking
them to the unreported income at issue. Accordingly, respondent’s
determination of unreported income is presumed correct, and
petitioners have the burden of proving that the determination is
erroneous. See Rule 142(a)(1); Welch v. Helvering, 290 U.S. at 115.

III.   Analysis

      Section 61(a) provides that gross income includes all income from
whatever source derived unless otherwise excluded by the Code. See
Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 429–30 (1955).
While section 61(a) broadly applies to any accession to wealth, statutory
exclusions from gross income are to be narrowly construed. See
Commissioner v. Schleier, 515 U.S. 323, 328 (1995); United States v.
Burke, 504 U.S. 229, 233 (1992). Petitioners must bring themselves
within the clear scope of any statutory exclusion. See Commissioner v.
Schleier, 515 U.S. at 336–37; Burke, 504 U.S. at 233–34.

      One exclusion from gross income is found in section 104(a)(2),
which provides that gross income does not include “the amount of any
damages (other than punitive damages) received (whether by suit or

        5 Section 7491(a) provides that if, in any court proceeding, a taxpayer

introduces credible evidence with respect to any factual issue relevant to ascertaining
the liability for tax and meets other prerequisites, the burden of proof rests on the
Commissioner as to that factual issue. See Higbee v. Commissioner, 116 T.C. 438, 440–
41 (2001). Petitioners have neither claimed nor shown that they satisfied the
requirements of section 7491(a) to shift the burden of proof to respondent.
                                    6

[*6] agreement and whether as lump sums or as periodic payments) on
account of personal physical injuries or physical sickness.” For these
purposes, “emotional distress shall not be treated as a physical injury or
physical sickness.” § 104(a) (flush text). The legislative history for the
section states: “It is intended that the term emotional distress includes
symptoms (e.g., insomnia, headaches, stomach disorders) which may
result from such emotional distress.” H.R. Rep. No. 104-737, at 301 n.56
(1996) (Conf. Rep.), reprinted in 1996-3 C.B. 741, 1041.

       Treasury Regulation § 1.104-1(c) defines the term “damages” as
“an amount received (other than workers’ compensation) through
prosecution of a legal suit or action, or through a settlement agreement
entered into in lieu of prosecution.” The taxpayer is required to prove
that the damages were received on account of physical injuries or
physical sickness. See Lindsey v. Commissioner, 422 F.3d 684, 688 (8th
Cir. 2005), aff’g T.C. Memo. 2004-113. There must be “a direct causal
link” between the damages received and the physical injury or sickness
sustained. Id.

       To justify exclusion from income under section 104(a)(2), the
taxpayer must show that his or her settlement proceeds were in lieu of
damages for physical injuries or physical sickness. See Green v.
Commissioner, 507 F.3d 857, 867 (5th Cir. 2007), aff’g T.C. Memo.
2005-250; Bagley v. Commissioner, 105 T.C. 396, 406 (1995), aff’d, 121
F.3d 393 (8th Cir. 1997). The nature of the claim that was the actual
basis for settlement guides our determination of whether such payments
are excludable from income. See Burke, 504 U.S. at 237. In evaluating
the nature of the underlying claim, a key question to be asked is: “In lieu
of what were the damages awarded?” Robinson v. Commissioner, 102
T.C. 116, 126 (1994) (quoting Raytheon Prod. Corp. v. Commissioner,
144 F.2d 110, 113 (1st Cir. 1944), aff’g 1 T.C. 952 (1943)), aff’d in part,
rev’d in part, 70 F.3d 34 (5th Cir. 1995).

       Petitioners contend that Mr. Dern’s settlement payment was
received on account of physical injuries or physical sickness.
Respondent contends that it was not, and we agree. The settlement
agreement contains no terms indicating that PFI issued the settlement
payment on account of Mr. Dern’s physical injuries or physical sickness.
While the settlement agreement provides for a payment “to compensate
[Mr. Dern] for alleged personal injuries,” it does not specify whether
those injuries were physical. Instead, it provides for a broad general
release by Mr. Dern of “all claims known or unknown.” This general
release does not specifically allocate any part of the settlement
                                         7

[*7] agreement to personal physical injuries or physical sickness. The
nature of Mr. Dern’s claim cannot be determined from such a release.
See Green v. Commissioner, T.C. Memo. 2014-23, at *11.

       In the absence of an express statement of what the settlement
proceeds were intended to compensate, 6 we consider the intent of the
payor on the basis of all facts and circumstances in this case. See
Knuckles v. Commissioner, 349 F.2d 610, 613 (10th Cir. 1965), aff’g
T.C. Memo. 1964-33; Robinson, 102 T.C. at 127. The settlement
agreement provides that the payment was made “to compensate [Mr.
Dern] for alleged personal injuries, costs, penalties, and all other
damages and claims.” However, Mr. Dern’s complaint alleged only
violations of California’s labor and antidiscrimination laws, wrongful
termination, breach of contract, and intentional infliction of emotional
distress. Mr. Dern did not assert any claims premised upon physical
injury or illness. Thus, we cannot conclude that the PFI defendants
intended to compensate Mr. Dern for any such injury or illness.

       Petitioners argue that the settlement falls within the provisions
of section 104(a)(2) because Mr. Dern’s physical illness caused PFI to
terminate him. However, section 104(a)(2) requires a “direct causal
link” between Mr. Dern’s illness and the settlement payment. See
Lindsey v. Commissioner, 422 F.3d at 688. Petitioners failed to prove
that such a link exists. Petitioners provided evidence that Mr. Dern was
physically ill but did not provide evidence that PFI caused or
exacerbated his illness. To the contrary, petitioners stipulated that Mr.
Dern’s acute gastrointestinal bleeding was unrelated to his work for
PFI. Thus, because PFI did not compensate Mr. Dern for physical injury
or physical sickness, the settlement payment is not excludable pursuant
to section 104(a)(2).

       We are sympathetic to petitioners’ situation and do not doubt that
the circumstances of Mr. Dern’s termination caused them emotional and
economic harm. However, we are not a court of equity, and we cannot
ignore the law to achieve an equitable end. See Commissioner v. McCoy,
484 U.S. 3, 7 (1987); Stovall v. Commissioner, 101 T.C. 140, 149–50
(1993); Paxman v. Commissioner, 50 T.C. 567, 576–77 (1968), aff’d, 414
F.2d 265 (10th Cir. 1969).

        6 When a settlement agreement includes a clear allocation of settlement

proceeds, the allocation is generally binding for tax purposes to the extent that the
parties to the agreement negotiated at arm’s length in an adversarial context and in
good faith. Robinson, 102 T.C. at 127.
                                  8

[*8] Accordingly, we sustain respondent’s determination that the
settlement payment petitioners received is not excludable from gross
income under section 104(a)(2). In reaching our holding herein, we have
considered all arguments made, and to the extent not mentioned above,
we find them to be moot, irrelevant, or without merit.

      To reflect the foregoing and respondent’s concessions,

      Decision will be entered under Rule 155.