T.C. Memo. 1997-25
UNITED STATES TAX COURT
E. PAULINE BARNES, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 21856-95. Filed January 15, 1997.
Kevin D. Watley, for petitioner.
C. Glenn McLoughlin, for respondent.
MEMORANDUM OPINION
DINAN, Special Trial Judge: This case was heard pursuant
to the provisions of section 7443A(b)(3) and Rules 180, 181, and
182.1
1
Unless otherwise indicated, all section references are
to the Internal Revenue Code in effect for the taxable year in
issue. All Rule references are to the Tax Court Rules of
Practice and Procedure.
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Respondent determined a deficiency in petitioner's 1992
Federal income tax in the amount of $4,219.
After concessions,2 the sole issue for decision is
whether section 104(a)(2) authorizes petitioner to exclude from
gross income the amount received in settlement of a claim for
wrongful termination of employment.
Some of the facts have been stipulated and are so found.
The stipulations of fact and attached exhibits are incorporated
herein by this reference. Petitioner resided in Bethany,
Oklahoma, on the date the petition was filed in this case.
Petitioner worked as a bookkeeper for National Livestock
Commission Association (NLCA) from May 22, 1982 until March 30,
1990. On March 29, 1990, petitioner was served with a subpoena
to give a deposition in an action involving NLCA. The next day
petitioner's employment was terminated. Petitioner received a
final paycheck in the amount of $2,203.71 for her previous 2
weeks' work plus 1-month's severance pay. NLCA withheld taxes
from this amount.
As a result of the termination of her employment, petitioner
suffered the intangible harms of embarrassment, humiliation, and
other mental distress. Petitioner contends that her mental
2
The parties agree that the issue of whether part of
petitioner's Social Security benefits are taxable is a statutory
computation controlled by our decision as to the exclusion of the
settlement proceeds.
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distress manifested itself in the appearance of precancerous
tumors which are being monitored by her doctor.
On November 26, 1990, petitioner filed a wrongful
termination action against NLCA alleging the following:
5. As a result of [the] fact that [petitioner] was
about to testify against [NLCA] and as a result of
[petitioner's] refusal to continue to engage in
illegal, unethical and/or improper business practices
[NLCA] terminated [petitioner] on March 30, 1990 in
contravention of the public policy of the State of
Oklahoma and the United States.
6. [Petitioner] further alleges that [NLCA]'s actions
were intentional, wilful and malicious. [Petitioner]
is entitled to punitive damages.
7. [Petitioner] alleges that as a direct result of
her termination she has sustained damages for past and
future lost wages as well as mental distress.
The petition in the wrongful termination action did not
allocate any specific dollar amounts to the alleged damages but
rather generally prayed for a judgment "in excess of $10,000.00,
together with interest, costs and such other relief as the Court
deems just and proper."
Petitioner's claim was settled on February 3, 1992, pursuant
to a General Release and Settlement Agreement signed by
petitioner and her attorney in that dispute. Pursuant to this
agreement, NLCA paid petitioner $27,000 by check in exchange for
her release of all claims. NLCA did not withhold any taxes from
this amount. Petitioner received a Form 1099-MISC from NLCA
showing a prize or award in the amount of $27,000. On her 1992
Federal income tax return, petitioner excluded this amount from
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her gross income. Respondent determined to the contrary that the
proceeds were taxable, and issued a deficiency notice stating so.
Respondent's determinations are presumed correct and
petitioner bears the burden of proving the determinations
erroneous. Welch v. Helvering, 290 U.S. 111, 115 (1933).
Section 61(a) broadly defines gross income as including all
income from whatever source derived. Any exceptions to the
inclusion of items of income as gross income must be narrowly
construed. Commissioner v. Schleier, 515 U.S. ___, ___, 115 S.Ct
2159, 2163 (1995); Commissioner v. Glenshaw Glass Co., 348 U.S.
426, 429-430 (1955).
Section 104(a)(2) provides that gross income does not
include the amount of any damages received on account of personal
injuries or sickness. The term "damages received" is further
defined as an amount received 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. The Supreme Court has
interpreted the foregoing statute and regulation as establishing
a two-prong test:
[There are] two independent requirements that a
taxpayer must meet before a recovery may be excluded
under section 104(a)(2). First, the taxpayer must
demonstrate that the underlying cause of action giving
rise to the recovery is "based upon tort or tort type
rights"; and second, the taxpayer must show that the
damages were received "on account of personal injuries
or sickness." * * * [Commissioner v. Schleier, 515
U.S. at ___, 115 S. Ct. at 2167.]
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Therefore, we must decide: (1) Whether the wrongful
termination claim underlying petitioner's settlement agreement
was based upon tort or tort type rights; and (2) whether the
damages paid to petitioner in settlement of such claim were
received on account of personal injuries or sickness.
We must first decide whether petitioner's settlement
agreement was based upon tort or tort type rights. State law
controls the nature of the legal interests and rights created by
State law, even though the Federal tax consequences pertaining to
such interests and rights are solely a matter of Federal law.
Commissioner v. Tower, 327 U.S. 280, 288 (1946); Lucas v. Earl,
281 U.S. 111 (1930); Brabson v. United States, 73 F.3d 1040,
1044 (10th Cir. 1996). Accordingly, we look to the law of the
State of Oklahoma for guidance as to the nature of petitioner's
wrongful termination cause of action.
The Oklahoma Supreme Court first adopted a public policy
tort exception to the Oklahoma terminable-at-will employment rule
in Burk v. K-Mart Corp., 770 P.2d 24 (Okla. 1989). In discussing
the nature of the cause of action the Court was very specific:
We recognize this new cause of action in tort. It is
well settled in Oklahoma a tort may arise in the course
of the performance of a contract and that tort may then
be the basis for recovery even though it is the
contract that creates the relationship between the
parties. An employer's termination of an at-will
employee in contravention of a clear mandate of public
policy is a tortious breach of contractual obligations.
Id. at 28. [Fn. refs. omitted].
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In addition, the Court of Appeals for the Tenth Circuit, to
which any appeal in this case lies, has consistently adhered to
the Oklahoma Supreme Court's recognition of this cause of action
as one proceeding in tort. See Dupree v. United Parcel Serv.,
956 F.2d 219 (10th Cir. 1992); see also York v. American Tel. &
Tel. Co., 95 F.3d 948, 959 (10th Cir. 1996); McKenzie v.
Renberg's, Inc., 94 F.3d 1478, 1488 (10th Cir. 1996).
Petitioner clearly satisfies the first requirement of the
Schleier test for excluding from gross income damages received
pursuant to a lawsuit. The petition filed in the wrongful
discharge case alleged that petitioner was terminated in
contravention of the public policy of the State of Oklahoma. The
settlement proceeds were received in lieu of the prosecution of
that action. Since Oklahoma law definitively treats this cause
of action for wrongful termination as one proceeding in tort, we
hold that petitioner's settlement proceeds were received as
damages through a settlement agreement entered into in lieu of
prosecution of an action based upon tort or tort type rights.
We must next decide whether the settlement proceeds satisfy
the second requirement of the Schleier test that they must be
damages received on account of personal injuries or sickness. In
cases involving settlements, the critical question is in lieu of
what kind of damages was the settlement amount paid? Bagley v.
Commissioner, 105 T.C. 396, 406 (1995). As noted above,
petitioner bears the burden of proving that respondent's
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determination that the settlement proceeds are not damages on
account of personal injuries or sickness is erroneous. Welch v.
Helvering, 290 U.S. 111, 115 (1933).
The first place we look to for a characterization of the
proceeds is the settlement agreement itself. See Bagley v.
Commissioner, supra at 406. However, the settlement agreement in
this case does not provide any indication as to what type of
damages the settlement proceeds were paid in lieu of. Rather,
the agreement generally refers to a release of all claims which
petitioner may have had in connection with the termination of her
employment, including all claims asserted in her wrongful
termination action.
Where the settlement agreement does not expressly specify an
allocation of the proceeds among the various claims, the most
important factor in deciding how to allocate the proceeds is what
motivated the payor to pay the settlement amount. Knuckles v.
Commissioner, 349 F.2d 610, 613 (10th Cir. 1965), affg. T.C.
Memo. 1964-33. In determining the intent of the payor, we may
look at the pleadings, jury awards, or any other Court orders or
judgments. Miller v. Commissioner, T.C. Memo. 1993-49,
supplemented by T.C. Memo. 1993-588, affd. without published
opinion 60 F.3d 823 (4th Cir. 1995). Again, these sources do not
provide much information. We have no jury award or Court order
or judgment in our record. The petition in the wrongful
termination case claims damages for mental distress and past and
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future lost wages, as well as punitive damages. However, as in
the settlement agreement, there is no allocation of monetary
damages among the claims. The petition merely claims damages "in
excess of $10,000.00".
We must therefore look to the record before us and examine
all of the facts and circumstances surrounding the settlement
agreement. Stocks v. Commissioner, 98 T.C. 1 (1992). The
allocation of the settlement proceeds is a question of fact.
Knuckles v. Commissioner, supra at 613. Based upon our
examination of the record and upon due consideration, we allocate
$13,500 to the mental distress claim and $13,500 to the punitive
damages claim for the following reasons.
Petitioner's attorney in the wrongful termination action and
settlement, Earl Remmel, testified that during the negotiations
with NLCA's defense counsel there was no discussion of past and
future lost wages, mental distress, or punitive damages.
However, Mr. Remmel further testified that under the
circumstances of her termination, petitioner had a strong case
for mental distress with the likelihood of punitive damages. He
also stated that her opportunity for recovery for future wages
was not that good because of her age and health condition. In
addition, petitioner had already been paid for the time she
worked at NLCA plus 1-month's severance. Although not discussed
during settlement negotiations, these factors were no doubt the
same ones which motivated NLCA to settle the case.
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Having found that the settlement proceeds were attributable
to both mental distress and punitive damages, we must now decide
whether these types of damages were received on account of
personal injuries or sickness.
Respondent argues that our decision is controlled by the
Supreme Court's holding in Commissioner v. Schleier, 515 U.S.
___, 115 S. Ct. 2159 (1995). We disagree with respondent's
assertion to the extent discussed herein. The specific holding
of Schleier was that back pay and liquidated damages recovered
under the Age Discrimination in Employment Act (ADEA) are not
received on account of personal injuries. Petitioner's case is
distinguishable in that it involves settlement proceeds received
in lieu of mental distress and punitive damages under Oklahoma's
wrongful termination tort cause of action.
In Schleier, the Supreme Court recognized that damages
received on account of personal injuries or sickness may
encompass recoveries based on intangible as well as tangible
harms. Commissioner v. Schleier, 515 U.S. at ___ n.4, 115 S. Ct.
at 2164 n.4. Although the Court acknowledged that intangible
discrimination harms can constitute personal injuries, it held
that the ADEA does not provide for recovery for such harms. Id.
at 2165 n.6. We therefore interpret Schleier as allowing the
exclusion of damages received for intangible harms such as mental
distress where the law governing the underlying action provides
for such damages. See Banks v. United States, 81 F.3d 874, 876
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(9th Cir. 1996). Oklahoma's wrongful termination tort cause of
action provides for such a remedy. Burk v. K-Mart Corp., 770
P.2d 24 (Okla. 1989).
Petitioner relies upon our decision in McKay v.
Commissioner, 102 T.C. 465 (1994), as precedent for
characterizing damages arising out of a wrongful discharge claim
as personal injuries. However, the Court of Appeals for the
Fifth Circuit, in light of Schleier v. Commissioner, supra,
vacated our decision in McKay and remanded the case almost 2
months prior to our trial of petitioner's case. McKay v.
Commissioner, 84 F.3d 433 (5th Cir. 1996), vacating without
published opinion 102 T.C. 465 (1994). The outcome of that case
on remand is still pending, and we decline to rely upon it in any
fashion.
The Supreme Court recently interpreted the meaning of "on
account of" personal injuries in the context of punitive damages
awarded in a wrongful death action. In an opinion released after
this case was submitted for decision, the Court reasoned that the
phrase required a strong causal connection between the injury and
the damages received. O'Gilvie v. United States, 519 U.S. ___,
117 S. Ct. 452 (1996). In rejecting the taxpayers' argument that
the phrase requires no more than a "but-for" connection between
the damages and personal injury, the Court adopted the
Commissioner's argument that the phrase required the damages to
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be received "by reason of" or "because of" the personal injuries.
Id. 117 S. Ct. 452, 454-455.
The Tenth Circuit has also had the opportunity to examine
the meaning of the phrase "on account of". Brabson v. United
States, 73 F.3d 1040 (10th Cir. 1996); O'Gilvie v. United States,
66 F.3d 1550 (10th Cir. 1995), affd. 519 U.S. ___, 117 S. Ct. 452
(1996). In Brabson, the Tenth Circuit held that an award of
prejudgment interest was not directly linked to the underlying
personal injury and thus not excludable under section 104(a)(2).
Brabson v. United States, 73 F.3d at 1047. Rather, the Court
found that compensation received for the lost time value of money
is caused by the delay in obtaining judgment. Id. It reasoned
that time is the relevant factor in calculating the amount of
damages for prejudgment interest, not the injury itself. Id.
Thus the phrase "on account of" requires a strong causal
connection between the personal injury sustained and the
compensation received. O'Gilvie v. United States, supra; Brabson
v. United States, supra at 1046-1047 (citing Schleier, 515 U.S.
___, 115 S. Ct. at 2164). We find that petitioner's mental
distress claim satisfies this requirement. Her wrongful
termination directly caused her mental distress for which
Oklahoma law allows a recovery in tort. The relevant factor for
calculating damages for mental distress is the injury itself.
Since this type of intangible harm may constitute a personal
injury, Commissioner v. Schleier, 515 U.S. at ___ n.4, 115 S. Ct.
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at 2164 n.4, we hold that the settlement proceeds allocable to
her mental distress claim were received on account of personal
injuries and are excludable from gross income by section
104(a)(2).
It has been established, however, that noncompensatory
punitive damages are not excludable from gross income under
section 104(a)(2). O'Gilvie v. United States, 519 U.S. ___, 117
S. Ct. 452 (1996); Commissioner v. Schleier, 515 U.S. at ___, 115
S. Ct. at 2165; Bagley v. Commissioner, 105 T.C. 396, 416 (1995).
At the time of petitioner's claim, Oklahoma law provided that a
jury could award punitive damages for the purposes of setting an
example and punishing the defendant. Okla. Stat. Ann. tit. 23,
sec. 9 (West 1987) (repealed by 1995 Okla. Sess. Laws 287); see
Okla. Stat. Ann. tit. 23, sec. 9.1 (West Supp. 1996) for current
version. Since Oklahoma law treats punitive damages as
noncompensatory, we conclude that the $13,500 of the settlement
proceeds that we allocated to punitive damages are not "on
account of" petitioner's personal injuries because they were not
"designed to compensate" petitioner for such personal injuries.
O'Gilvie v. United States, 519 U.S. ___, 117 S. Ct. at 455
(quoting Commissioner v. Schleier, 515 U.S. at ___ n.5, 115 S.
Ct. at 2165 n.5 (1995)).
We therefore hold that the punitive damages portion of the
settlement proceeds is not excludable from gross income by
section 104(a)(2).
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To reflect the foregoing,
Decision will be entered
under Rule 155.