T.C. Memo. 2009-116
UNITED STATES TAX COURT
HARTFORD AND JOSEPHINE SHELTON, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 16278-07. Filed May 26, 2009.
Hartford and Josephine Shelton, pro se.
Rebecca Dance Harris, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
GOEKE, Judge: Respondent determined a deficiency of $46,395
in petitioners’ Federal income tax and an accuracy-related
penalty of $9,279 under section 6662 for 2004.1 The issues for
decision are: (1) Whether pursuant to section 104(a)(2)
1
Unless otherwise indicated, all section references are to
the Internal Revenue Code.
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petitioners may exclude from their gross income the settlement
proceeds received by petitioner wife. We hold that the
settlement award is gross income and not excludable; and (2)
whether petitioners are liable for an accuracy-related penalty
under section 6662 for their failure to report the settlement
proceeds. We hold that they are not.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
The stipulation of facts and the attached exhibits are
incorporated herein by this reference. At the time they filed
their petition, petitioners resided in Virginia.
Petitioner wife was hired by the Dial Corp. (Dial) at some
time before 1999. Petitioner husband is disabled and unable to
work. While employed at Dial petitioner wife was subject to
sexual harassment by her supervisor. Petitioner wife’s
supervisor repeatedly harassed her, made references to petitioner
husband’s disability, and refused to stop after petitioner wife
rebuffed his advances. Petitioner wife complained about the
harassment to Dial’s management, but no corrective action was
taken, and petitioner wife’s employer retaliated against her. As
a result of her complaints, petitioner wife was routinely
assigned to menial labor or given the least desirable
assignments.
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Although petitioner wife was subject to harassment by her
immediate supervisor, she was also harassed by other members of
Dial’s management. Petitioner wife developed severe emotional
problems and began to receive medical help. Petitioner wife
began and continues to take antidepressants and other medication
to deal with the physical effects of her harassment.
On May 20, 1999, the Equal Employment Opportunity Commission
(EEOC) filed a complaint against Dial in the U.S. District Court
for the Northern District of Illinois. The complaint alleged
that Dial had engaged in a pattern and practice of discrimination
against a class of female employees based upon their sex by
subjecting them to a hostile and abusive work environment and
that Dial failed to remedy this situation after the company had
become aware of the alleged harassment.
On April 29, 2003, the EEOC and Dial entered into a consent
decree. The consent decree provided in pertinent part that Dial
would pay $10 million (the settlement proceeds) to be distributed
to all eligible class members. The decree also provided for
corrective action on Dial’s part to prevent future instances of
sexual harassment. Petitioner wife was a member of the class of
workers eligible for a portion of the settlement proceeds.
In order to receive the settlement proceeds, an eligible
claimant had to sign a release form discharging Dial from
liability for all past instances of sexual harassment. The
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release provided in pertinent part that the settlement proceeds
were for emotional pain, suffering, inconvenience, mental
anguish, loss of enjoyment of life, and nonpecuniary losses. The
release did not provide any information concerning the proper
treatment of the settlement funds for Federal tax purposes.
However, a claimant who signed the release acknowledged that the
settlement amount might be subject, in whole or in part, to
Federal and State income taxation. Petitioner wife signed a
release and received $123,500 from Dial in 2004. Dial issued a
Form 1099-MISC, Miscellaneous Income, to petitioner wife
reporting income of $123,500.
Petitioner wife contacted the Internal Revenue Service (IRS)
at some point after receiving the settlement proceeds to
determine their proper treatment. The IRS representative
informed petitioner wife that in some situations settlement
proceeds could be excluded from income if they were paid on
account of physical injury. Petitioner wife, having suffered
physically as a result of her supervisor’s harassment, believed
that the settlement proceeds were paid to compensate her for
those injuries.
On October 14, 2005, petitioners filed a joint Form 1040,
U.S. Individual Income Tax Return, for tax year 2004.
Petitioners’ Form 1040 was prepared by a paid return preparer.
Petitioner wife informed the return preparer that the settlement
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proceeds were paid to compensate her for physical injury. In
accordance with petitioner wife’s representations, the return
preparer did not include the settlement proceeds on petitioners’
return.
On April 23, 2007, respondent issued a notice of deficiency
(the notice) to petitioners for 2004. Respondent determined in
the notice that petitioners were required to include the
settlement proceeds in gross income and that petitioners were
liable for a section 6662 accuracy-related penalty. On July 18,
2007, petitioners timely petitioned this Court for a
redetermination of their tax liability.
OPINION
Gross income generally includes all income from whatever
source derived. Sec. 61(a). The definition of gross income is
broad in scope, while exclusions from income are narrowly
construed. Commissioner v. Schleier, 515 U.S. 323, 328 (1995).
Damages (other than punitive) received on account of personal
physical injuries or physical sickness may generally be excluded
from gross income. Sec. 104(a)(2). For the damages to be
excluded under this provision, the underlying cause of action
must be based in tort or tort-type rights, and the proceeds must
be damages received on account of personal physical injury or
sickness. Commissioner v. Schleier, supra at 337. Emotional
distress is not treated as a personal physical injury or physical
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sickness except for damages not in excess of the amount paid for
medical care attributable to emotional distress. Sec. 104(a)
(flush language).
Petitioners focus on the severity of the harassment and the
physical ailments that it caused in arguing that they are not
required to include the settlement proceeds in gross income.
Petitioner wife contends that the settlement proceeds should not
be taxable because after being harassed she was not the same
person physically. Petitioner wife points to the fact that she
sought medical help and continues to take medication to deal with
the physical effects of the harassment. Respondent does not
argue that the underlying cause of action in this case is not a
tort or tort-type right; instead, respondent argues that the
damages petitioner wife received were not on account of personal
physical injuries or physical sickness.
Although petitioners argue that petitioner wife suffered
physical injury as a result of her sexual harassment, that injury
does not meet the requirements of section 104. Petitioner wife,
although she suffered physically, was not compensated for that
physical injury. Petitioners do not claim that any portion of
the settlement proceeds were to reimburse them for amounts paid
for medical care attributable to emotional distress. See sec.
104(a) (flush language); Sanford v. Commissioner, T.C. Memo.
2008-158. The settlement proceeds were for emotional pain,
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suffering, inconvenience, mental anguish, loss of enjoyment of
life, and nonpecuniary losses, not physical injury. Damages
received on account of emotional stress, even when resultant
physical symptoms occur, are not excludable from income under
section 104(a)(2). Hawkins v. Commissioner, T.C. Memo. 2005-149.
Because petitioner wife did not receive the settlement proceeds
on account of personal physical injury or sickness, petitioners
must include those amounts in gross income. See Sanford v.
Commissioner, supra; Shaltz v. Commissioner, T.C. Memo. 2003-173.
Accuracy-Related Penalty
Respondent determined that petitioners are liable for an
accuracy-related penalty under section 6662 for negligence or
disregard of rules or regulations. Section 6662(a) and (b)(1)
imposes a 20-percent penalty on an underpayment of tax that
results from negligence or disregard of rules or regulations.
Section 6662(c) defines the term “negligence” to include “any
failure to make a reasonable attempt to comply with the
provisions of this title”, and the term “disregard” to include
“any careless, reckless, or intentional disregard.”
The section 6662 penalty is inapplicable to the extent the
taxpayer had reasonable cause for the underpayment and acted in
good faith. Sec. 6664(c)(1). The determination of whether the
taxpayer acted with reasonable cause and in good faith is made on
a case-by-case basis, taking into account the relevant facts and
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circumstances. Sec. 1.6664-4(b)(1), Income Tax Regs.
“Circumstances that may indicate reasonable cause and good faith
include an honest misunderstanding of fact or law that is
reasonable in light of all of the facts and circumstances,
including the experience, knowledge, and education of the
taxpayer.” Id. Generally, the most important factor is the
extent of the taxpayer’s efforts to assess the proper tax
liability. Id. An honest misunderstanding of fact or law that
is reasonable in the light of the experience, knowledge, and
education of the taxpayer may indicate reasonable cause and good
faith. Remy v. Commissioner, T.C. Memo. 1997-72.
Petitioners have no experience or education in tax law and
sought advice from the IRS in order to determine the proper
treatment of the settlement proceeds. The IRS employee informed
petitioner wife that in some circumstances settlement proceeds
could be excluded if they were paid to compensate for physical
injuries. Petitioner wife believed that the proceeds were paid
to compensate her for physical injury. This belief was
reasonable; as a result of the harassment petitioner wife did not
feel that she was the same physically. Petitioner wife’s belief
is supported by the fact that petitioner wife required medical
help and began taking numerous medications soon after the
harassment began. We find petitioners’ mistaken belief that the
settlement proceeds were for physical injury to be reasonable.
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Petitioners acted reasonably and in good faith when they informed
their return preparer that the settlement proceeds were paid on
account of physical injury. See Stadnyk v. Commissioner, T.C.
Memo. 2008-289; Pettit v. Commissioner, T.C. Memo. 2008-87;
Gibson v. Commissioner, T.C. Memo. 2007-224. Viewing all of the
circumstances, including the experience, knowledge, and education
of petitioners, we conclude that petitioners have demonstrated
reasonable cause for failing to report the settlement proceeds as
income and that they acted in good faith. Accordingly,
petitioners are not liable for the accuracy-related penalty.
To reflect the foregoing,
Decision will be entered
for respondent as to the
deficiency and for petitioners
as to the accuracy-related
penalty.