Carranza v. Comm'r

T.C. Summary Opinion 2009-28

UNITED STATES TAX COURT

LUIS H. AND MARGARITA M. CARRANZA, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 7969-06S. Filed February 26, 2009.

Luis H. and Margarita M. Carranza, pro sese.

Jonathan H. Sloat, for respondent.

GERBER, Judge: This case was heard pursuant to the

provisions of section 74631 of the Internal Revenue Code in

effect when the petition was filed. Pursuant to section 7463(b),

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

1
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for 2003, the taxable year
under consideration, and all Rule references are to the Tax Court
Rules of Practice and Procedure.
 - 2 -

and this opinion shall not be treated as precedent for any other

case.

Respondent determined a $19,714 income tax deficiency for

petitioners’ 2003 tax year and a $3,943 accuracy-related penalty

under section 6662(a). Respondent, pursuant to section 6214(a),

filed an answer and an amended answer in which he sought a

$15,503 increase in the income tax deficiency and a $3,100.40

increase in the accuracy-related penalty, for a total deficiency

of $35,217 and a total accuracy-related penalty of $7,043.40.

The initial income tax deficiency was based on petitioners’

failure to report, as income, Social Security benefits and

settlement proceeds of a wrongful termination action brought by

Luis Carranza. The increased deficiency also stems from the

settlement of the wrongful termination action. The questions

remaining for our consideration are whether any of the proceeds

of the wrongful termination action are includable in petitioners’

gross income and whether petitioners are liable for an accuracy-

related penalty.

Background

Petitioners resided in California at the time their petition

was filed. Luis H. and Margarita M. Carranza received Social

Security benefits of $13,710 and $12,294, respectively, for the

taxable year 2003 but failed to report these amounts as income on

their joint return for that year. Mr. Carranza worked for Spears
 - 3 -

Manufacturing Co. (Spears) as a foreman/supervisor 6 days a week

and 10 hours per day. Spears manufactured mainly plastic, but

also some brass, pipe fittings used for plumbing. Mr. Carranza

was in charge of Spears’s production operation, and these

responsibilities burdened him greatly and caused him to come home

exhausted. Spears’s employees worked three shifts, and Mr.

Carranza supervised the foremen of all three shifts. He was

often called at home to deal with problems that occurred during

the night shift. Mr. Carranza had worked for Spears for 25 years

and was well liked by the owner, Wayne Spears. The pressure of

his job led to anxiety and hypertension, which, in turn, may have

caused a central arterial occlusion and loss of sight in Mr.

Carranza’s left eye during 1999.

Sometime before 2000 Mr. Carranza developed a hematoma in

his leg which affected nerves and muscles so that it was

difficult for him to walk. In time his leg atrophied, and he

lost the ability to control it. He became unable to walk stairs

and to function effectively in his supervisory position at

Spears. On or about November 5, 2001, upon the advice of a

doctor, he was assigned lighter responsibilities at Spears. Mr.

Spears and others made demands on Mr. Carranza that were beyond

his lessened physical capabilities, expecting his performance to

be at the same level as before his physical problems. In

addition, comments were made about his lessened physical
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capabilities that caused him great humiliation. On April 29,

2002, he was dismissed from his position at Spears. His anxiety

became more severe after he was dismissed. Mr. Carranza was in

the care of three different psychiatrists and because of his

mental and physical condition was unable to obtain another job.

After Mr. Carranza was dismissed, Mrs. Carranza negotiated a

severance agreement with Spears under which he was paid $1,000

per week for 19 weeks. Around this time Mr. Carranza contacted

an attorney. On or about July 11, 2002, Mr. Carranza commenced

an action against Spears in Los Angeles County Superior Court.

The complaint sought damages for violations of the California

Fair Employment and Housing Act, including disability

discrimination, age discrimination, wrongful termination in

violation of public policy, and breach of implied contract due to

wrongful termination of employment.

In the complaint Mr. Carranza alleged that he was “disabled”

because of the medical conditions of vascular embolic disease,

hypertension, and glaucoma and that he had been suffering from

these conditions since June 1999. He also specifically alleged

he was disabled because of the hematoma in his left leg. Mr.

Carranza sought judgment against Spears for all medical expenses,

general damages for emotional distress and mental suffering,

exemplary and punitive damages, and attorney’s fees.
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Mr. Carranza also applied for disability payments from the

Social Security Administration, and on December 1, 2002, he was

advised of his entitlement to a monthly disability check. He

also filed a claim for workers compensation with the State of

California, which on August 9, 2005, resulted in a $49,000

settlement, with $45,000 being paid to him and a net recovery of

$38,250 after the payment of $6,750 in legal fees.

During 2003 the suit against Spears was settled for

$162,500. Of the $162,500, $97,500 was paid directly to Mr.

Carranza “for personal injury in the form of emotional distress

damages”. The remaining $65,000 was paid directly to his

attorney as “a payment for the attorney’s fees incurred on

* * * [Mr. Carranza’s] behalf”. The parties agreed that the

$97,500 “in settlement of claims for personal injury in the form

of emotional distress damages resulting from the conduct that is

the subject of tort or tort-like claims” was to be reported on a

Form 1099-MISC, Miscellaneous Income, but that no withholding tax

would be taken from the payment. With respect to the $65,000

paid to Mr. Carranza’s attorney, a Form 1099-MISC would be sent

only to the attorney. Of the $97,500 settlement amount, Mr.

Carranza received a net amount of $93,554.24 after reduction of

$3,945.76 for costs assessed against him.

Petitioners’ 2003 Form 1040, U.S. Individual Income Tax

Return, was prepared by a professional income tax return preparer
 - 6 -

(preparer) who had been preparing their income tax returns for a

few years before 2003. Petitioners provided the preparer with

the Form 1099-MISC and other information about the settlement of

the suit with Spears and with all of the medical records. The

preparer concluded that the $97,500 settlement amount Mr.

Carranza received was not includable in income, and petitioners

relied upon his judgment with respect to that decision.

Petitioners provided their preparer with information about the

receipt of Social Security payments during 2003, but no part of

it was reported on their tax return. Even if it had been, it

would not have been taxable according to the amount of income the

preparer reported on the return. Petitioners’ 2003 income tax

return did not include their Social Security payments, the

$97,500 settlement proceeds they received, or the $65,000 Mr.

Carranza’s attorney received.

Discussion

In general the Commissioner’s determination in a notice of

deficiency is presumed correct. Welch v. Helvering, 290 U.S.

111, 115 (1933). In pertinent part, Rule 142(a)(1) provides the

general rule that “The burden of proof shall be upon the

petitioner”. Petitioners bear the burden of showing the

settlement is not includable in income as respondent determined

it is. There is no dispute about the burden of proof or the

shifting of same under section 7491. Respondent bears the burden
 - 7 -

of proof with respect to the increased deficiency and the

increased accuracy-related penalty. See Rule 142(a)(1).

Respondent also bears the burden of production with respect to

the section 6662(a) accuracy-related penalty. See sec. 7491(c).

Petitioners have stipulated that they received Social

Security payments during 2003 that were not included in their

income on their return. Such payments have been held to be

taxable and are includable in income in an amount determined

under a statutory formula. Sec. 86(a), (b), and (c); see, e.g.,

Green v. Commissioner, T.C. Memo. 2007-217. The remaining issues

we consider are whether any portion of the settlement with Spears

is includable in petitioners’ 2003 income and whether they are

liable for an accuracy-related penalty with respect to any

portion of a resulting understatement.

Mr. Carranza became progressively unable to perform his

duties at Spears. His physical problems began during 1999 and

became progressively worse until his dismissal during 2003. He

also suffered emotionally because of his physical problems and

from humiliation experienced at Spears. Mr. Carranza sued Spears

and alleged that he was “disabled” because of the medical

conditions of vascular embolic disease, hypertension, hematoma in

his left leg, and glaucoma and that he had been suffering from

these conditions since June 1999. In the complaint Mr. Carranza

sought judgment against Spears for all medical expenses, general
 - 8 -

damages for emotional distress and mental suffering, exemplary

and punitive damages, and attorney’s fees.

Mr. Carranza and Spears settled the suit and entered into a

settlement agreement laying out the basis for the settlement.

Although Mrs. Carranza testified that Mr. Carranza’s settlement

and recovery from Spears were for physical injuries caused by his

working conditions, the settlement agreement unambiguously

attributed the settlement to his “personal injury in the form of

emotional distress damages resulting from conduct that is the

subject of tort or tort-like claims”. Section 104, as is

pertinent to this case, provides:

SEC. 104. COMPENSATION FOR INJURIES OR SICKNESS.

(a) In General.--Except in the case of amounts
attributable to (and not in excess of) deductions
allowed under section 213 (relating to medical, etc.,
expenses) for any prior taxable year, gross income does
not include–-

(1) amounts received under workmen's
compensation acts as compensation for personal
injuries or sickness;

(2) 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 104(a)(2) makes it clear that for damages to be

excluded from gross income, they must be received “on account of

personal physical injuries or physical sickness”. Section 104(a)

also specifically provides that “For purposes of paragraph (2),
 - 9 -

emotional distress shall not be treated as a physical injury or

physical sickness.” The circumstances in this case are somewhat

convoluted because Mr. Carranza received Social Security benefits

because of physical disability. He also sought California

workers compensation and received a settlement for his physical

disability. With respect to his suit against Spears, however, he

did not seek damages for physical disability caused by his

working conditions. Instead, he sought damages for emotional

distress and mental suffering. Likewise, the settlement of the

litigation with Spears was for emotional distress damages.

In order for the Spears settlement proceeds to qualify for a

section 104(a)(2) exclusion, petitioners must show that: (1) The

underlying cause of action giving rise to the recovery was

“‘based upon tort or tort type rights’”; and (2) the “‘damages

were received * * * on account of personal [physical] injuries or

[physical] sickness.’” See Commissioner v. Schleier, 515 U.S.

323, 336-337 (1995) (adjusted to comport with subsequent

legislation) (quoting United States v. Burke, 504 U.S. 229, 234

(1992)).

There is no question about whether the damages were for

“tort or tort type rights”. The question we consider is whether

the damages were for a physical injury. When damages are paid

under a settlement agreement, courts generally first look to the

express language of the agreement. Rivera v. Baker West, Inc.,
 - 10 -

430 F.3d 1253, 1257 (9th Cir. 2005). Mr. Carranza’s agreement

with Spears expressly attributes the settlement to emotional

distress and mental suffering. Moreover, he did not allege in

his complaint initiating the settled litigation that Spears

employees or work conditions had caused him physical injury.

There is some evidence in this record that could support a

finding that his work conditions were a contributing factor to

some of his physical problems, but that was not the focus of the

litigation and, clearly not the purpose of the settlement. See

id. at 1257-1258. With such compelling and explicit language, we

cannot find otherwise. Accordingly, we find that Mr. Carranza’s

settlement with Spears was not for physical injury.

We now consider the portion of the settlement that

petitioners are required to include in income. The total

settlement, agreed to between Mr. Carranza and Spears, was

$162,500. The $162,500 constituted “the entire monetary

consideration provided to” Mr. Carranza, as agreed to by the

parties. Of that amount, $97,500 was paid directly to Mr.

Carranza for personal injury due to emotional distress, and a

Form 1099-MISC was issued to him for $97,500. The remaining

$65,000 was paid directly to Mr. Carranza’s attorney for his

services, and a Form 1099-MISC was issued to the attorney in that

amount. Accordingly, the parties intended by their settlement

that the attorney be accountable for the $65,000.
 - 11 -

Respondent, in the deficiency notice and on the basis of the

Form 1099-MISC, initially included only $97,500 in petitioners’

income for 2003. That adjustment, along with the unreported

Social Security benefits, was the basis for the $19,714 income

tax deficiency and the $3,943 accuracy-related penalty.

Respondent, by an answer and amended answer, sought a total

increase in the income tax deficiency of $15,503 and a total

increase in the accuracy-related penalty of $3,100.40. Those

increases are attributable to inclusion of the $65,000 in

petitioners’ gross income for 2003.2

Until 2005 there had been differing treatment by courts with

respect to the attorney’s fees portion of damage settlements

and/or litigation. Some courts treated the attorney’s fees

portion as the taxpayer’s income, even though paid directly to

the attorney. Others treated the attorney’s fees portion as not

includable in the taxpayer’s income. In Commissioner v. Banks,

543 U.S. 426 (2005), the Supreme Court resolved those differences

and held that the portion of the settlement paid to attorneys was

income to the taxpayer under the anticipatory assignment of

income doctrine established in Lucas v. Earl, 281 U.S. 111

(1930).

2
Respondent also allowed petitioners an offsetting
miscellaneous itemized deduction for the $65,000 attorney’s fees
subject to the 2-percent threshold and the alternative minimum
tax limitations on certain deductions, which are computational
issues. See secs. 56(b), 67.
 - 12 -

The increased income tax deficiency is based on both the

inclusion of the $65,000 paid directly to Mr. Carranza’s attorney

and the alternative minimum tax that is generated, in part, by

the attorney’s fees itemized deduction not being allowed for

computation of the alternative minimum tax. See, e.g., Benci-

Woodward v. Commissioner, 219 F.3d 941, 944 (9th Cir. 2000),

affg. T.C. Memo. 1998-395.

The facts of this case reflect that Mr. Carranza was

entitled to the entire $162,500 and that the $65,000 paid

directly to his attorney was money to which Mr. Carranza was

entitled under the settlement. Under these circumstances and

because of the current state of the law, petitioners are liable

for the determined income tax deficiency and an increased

deficiency in income tax based on the inclusion of the $65,000,

the deduction for attorney’s fees, and the application of the

alternative minimum tax provisions.

Respondent also determined a 20-percent accuracy-related

penalty under section 6662(a) on the entire underpayment of tax.

Respondent determined that petitioners are liable for the penalty

because they substantially understated their income tax within

the meaning of section 6662(b)(2) and (d)(1).

In order for the penalty to apply, the understatement must

exceed the greater of 10 percent of the tax required to be shown

on the income tax return or $5,000. Sec. 6662(d)(1)(A).
 - 13 -

Petitioners’ 2003 income tax return reported no (zero) income tax

liability. Accordingly, the understatement of tax decided in

this case is substantial.

An accuracy-related penalty is not imposed on any portion of

the understatement as to which the taxpayer acted with reasonable

cause and in good faith. Sec. 6664(c)(1). Reliance on the

advice of a tax professional may constitute reasonable cause and

good faith if under all the facts and circumstances the reliance

is reasonable and in good faith. Neonatology Associates, P.A. v.

Commissioner, 115 T.C. 43, 98 (2000), affd. 299 F.3d 221 (3d Cir.

2002); sec. 1.6664-4(c)(1), Income Tax Regs. To qualify for this

exception, a taxpayer must prove by a preponderance of the

evidence that: (1) The adviser was a competent professional who

had sufficient expertise to justify reliance, (2) the taxpayer

provided necessary and accurate information to the adviser, and

(3) the taxpayer actually relied in good faith on the adviser’s

judgment. Neonatology Associates, P.A. v. Commissioner, supra at

98-99.

Petitioners, who have no expertise in or understanding of

the tax laws, used and relied upon a professional preparer to

prepare their 2003 income tax return. They had used the same

preparer for prior years’ returns. The preparer was called by

respondent to testify at trial about the circumstances under

which he prepared petitioners’ income tax return. Considering
 - 14 -

Mrs. Carranza’s testimony and that of the preparer, we conclude

that he was a competent professional with sufficient expertise to

prepare petitioners’ tax return. We also conclude that the

preparer had accurate and sufficient information from which to

evaluate whether petitioners’ Social Security benefits and the

Spears settlement proceeds were includable in petitioners’ gross

income. Finally, we conclude, under the circumstances of this

case, that it was reasonable for petitioners to rely on their

preparer.

The evidence shows that Mr. Carranza was physically disabled

and unable to work. It also shows that he suffered anxiety and

severe mental distress. Mr. Carranza received Social Security

benefits because of his disability. Mrs. Carranza provided the

preparer with Mr. Carranza’s substantial medical records that

reflected a pattern of illness and physical conditions that could

have been related to his working conditions. The preparer’s

conclusion, which was based upon the information petitioners

provided, was that Mr. Carranza’s disability and hence the Spears

settlement were due to physical injury and that the settlement

proceeds were excludable from gross income under section 104.

The preparer reached this conclusion in view of a Form 1099-MISC

reflecting miscellaneous income of $97,500. We also note that

Mr. Carranza did not receive a Form 1099-MISC for the $65,000

paid to the attorney. As noted earlier in this opinion, there is
 - 15 -

a reasonable amount of evidence that could support the conclusion

that Mr. Carranza’s physical condition (injury) was work related.

With respect to the Social Security benefits, once the

preparer concluded that the $97,500 settlement Mr. Carranza

received was excluded from petitioners’ 2003 income, the Social

Security benefits would not have been includable in petitioners’

income. Although the preparer’s failure to report the benefits

does not strictly follow usual reporting protocol, it was

reasonable for petitioners, who were not versed in such matters,

to rely on the preparer’s judgment in the preparation of their

income tax return.

We therefore hold that petitioners are not liable for an

accuracy-related penalty under section 6662(a).

To reflect the foregoing,

Decision will be entered

under Rule 155.