T.C. Memo. 2010-53
UNITED STATES TAX COURT
ISIDRA ELIZABETH ESPINOZA, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 28320-08. Filed March 22, 2010.
Isidra Elizabeth Espinoza, pro se.
Brooke S. Laurie, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
COHEN, Judge: Respondent determined a deficiency of $9,078
in petitioner’s 2006 Federal income tax and an accuracy-related
penalty of $1,816 under section 6662(a). The issues for decision
are whether petitioner may, pursuant to section 104, exclude
settlement proceeds from her gross income, and whether petitioner
is liable for an accuracy-related penalty under section 6662.
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All section references are to the Internal Revenue Code for the
year in issue, and all Rule references are to the Tax Court Rules
of Practice and Procedure.
FINDINGS OF FACT
Some of the facts have been stipulated, and the stipulated
facts are incorporated in our findings by this reference.
Petitioner resided in Texas at the time she filed her petition.
Petitioner worked for the Texas Department of Human Services
from 1990 to 2002. During the course of her employment,
petitioner suffered from emotional distress and incurred various
medical expenses. Petitioner commenced a suit against the Texas
Department of Human Services in the District Court of Hidalgo
County, Texas, alleging that she was subject to illegal
discrimination based on her gender, religion, and national
origin, as well as retaliation.
As the suit dragged on, petitioner’s husband, Manuel
Espinoza, discussed with petitioner’s counsel, Jesus Villalobos,
a personal injury attorney, the possibility of settling with the
Texas Health and Human Services Commission, the successor agency
to the Texas Department of Human Services. Mr. Espinoza
calculated the total cost of petitioner’s medical bills to be
$50,000 and offered to settle with the Texas Health and Human
Services Commission for that amount. Villalobos represented to
Mr. Espinoza that the settlement amount would not be taxable, so
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there was no need to increase the settlement amount to account
for Federal income tax.
Between December 13, 2005, and January 27, 2006, petitioner
and the Texas Health and Human Services Commission executed a
release and settlement agreement. The agreement stated:
1. This agreement, or any action taken pursuant to
this agreement, shall not constitute an admission of
liability by any party, and all liability is expressly
denied. This agreement is entered into to resolve and
settle all differences, disputes, and controversies
between the parties, to compromise and settle doubtful
and disputed claims, to avoid further litigation, and
to facilitate peace. This agreement specifically does
not represent an admission by any party of the merit or
lack of merit of the claims made by the Plaintiff
against the Defendant, nor shall this agreement or any
actions taken pursuant to this agreement be admissible
in any proceeding for the purpose of showing the merit
or lack of merit of those claims.
2. In full and final settlement and compromise of all
claims, but without admitting liability therefore
[sic], Defendant agrees to pay Espinoza * * * a total
amount of Fifty Thousand Dollars ($50,000). The
parties will pay their own costs.
The settlement agreement does not identify any reasons for the
settlement payment other than those listed in the first
paragraph. Nor does the settlement agreement dictate how the
money is to be spent. Notwithstanding, petitioner believed that
the settlement proceeds were reimbursement for all of her medical
costs incurred as a result of the discrimination.
Petitioner received the $50,000 settlement in 2006 along
with a Form 1099-MISC, Miscellaneous Income, from the Health and
Human Services Commission. On May 10, 2007, the Internal Revenue
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Service received petitioner’s Form 1040, U.S. Individual Income
Tax Return, for 2006, which petitioner submitted using the status
of married filing separately. Petitioner’s Form 1040 was
prepared by a paid return preparer. Petitioner and her husband
told the return preparer that the settlement proceeds were paid
to compensate petitioner for medical costs as a result of her
medical condition. The return preparer did not include the
settlement proceeds in petitioner’s gross income.
OPINION
The Settlement Proceeds
The definition of gross income under section 61(a) broadly
encompasses any accession to a taxpayer’s wealth. Commissioner
v. Schleier, 515 U.S. 323, 327-328 (1995); United States v.
Burke, 504 U.S. 229, 233 (1992). Absent an exception by another
statutory provision, settlement proceeds must be included in
gross income. Commissioner v. Schleier, supra; United States v.
Burke, supra.
Section 104(a)(2) excepts 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”. Although emotional distress is not treated as a
physical injury or physical sickness, the cost of medical care
attributable to emotional distress is. Sec. 104(a) (flush
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language); see Stadnyk v. Commissioner, T.C. Memo. 2008-289,
affd. without published opinion No. 09-1485 (6th Cir., Feb. 26,
2010).
To justify exclusion from income under section 104,
petitioner must show that 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), affg. T.C. Memo.
2005-250; Bagley v. Commissioner, 105 T.C. 396, 406 (1995), affd.
121 F.3d 393 (8th Cir. 1997); sec. 1.104-1(c), Income Tax Regs.
The nature of the settlement is a question of fact. Green v.
Commissioner, supra at 866-867. “Ultimately, the character of
the payment hinges on the payor’s dominant reason for making the
payment.” Id. at 868. “We first look to the language of the
agreement itself for indicia of purpose.” Id. at 867. Where the
agreement does not mention purpose, the Court may look at other
facts that reveal the payor’s intent, such as the amount paid,
the evidence adduced at trial, and the factual circumstances that
led to the agreement. Id. We recognize that Green and Bagley
were decided under section 104 before it was amended in 1996.
However, their holding regarding the characterization of
settlement proceeds in lieu of damages remains good law. See
Save v. Commissioner, T.C. Memo. 2009-209.
The settlement agreement between petitioner and the Texas
Health and Human Services Commission does not allocate
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petitioner’s proceeds to a claim of personal physical injury or
physical sickness. The agreement does not specify any particular
claim motivating the settlement. It therefore fails to allocate
between claims that qualify and claims that do not qualify under
section 104.
Petitioner argues that the Texas Department of Human
Services, the Texas Health and Human Services Commission, and the
Texas Attorney General’s Office were well aware of her physical
injuries. However, petitioner has failed to present objective
and credible evidence that the Texas Health and Human Services
Commission intended that any part of petitioner’s settlement
proceeds be allocated to her medical expenses and therefore has
not shifted the burden of proof to respondent under section
7491(a). In any event, the preponderance of the evidence is that
the settlement was unallocated among multiple claims, many of
which were not for physical injuries or physical sickness. We
must conclude on the evidence that the settlement proceeds are
includable in petitioner’s income for 2006.
The Accuracy-Related Penalty
Section 6662(a) and (b)(1) and (2) imposes a 20-percent
accuracy-related penalty on any underpayment of Federal income
tax attributable to a taxpayer’s negligence or disregard of rules
or regulations, or substantial understatement of income tax.
Section 6662(d)(1)(A) defines “substantial understatement of
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income tax” as an amount exceeding the greater of 10 percent of
the tax required to be shown on the return or $5,000. Under
section 7491(c), the Commissioner bears the burden of production
with regard to penalties and must come forward with sufficient
evidence indicating that it is appropriate to impose penalties.
See Higbee v. Commissioner, 116 T.C. 438, 446 (2001). However,
once the Commissioner has met the burden of production, the
burden of proof remains with the taxpayer, including the burden
of proving that the penalties are inappropriate because of
reasonable cause or substantial authority. See Rule 142(a);
Higbee v. Commissioner, supra at 446-447.
Respondent has satisfied the burden of production by showing
that there is a substantial understatement, because the amount of
the understatement, $9,078, exceeds 10 percent of the tax
required to be shown on the return and is greater than $5,000.
The accuracy-related penalty under section 6662(a) is not
imposed with respect to any portion of the underpayment as to
which the taxpayer acted with reasonable cause and in good faith.
Sec. 6664(c)(1); Higbee v. Commissioner, supra at 448. The
decision as to whether a taxpayer acted with reasonable cause and
in good faith is made on a case-by-case basis, taking into
account all of the pertinent facts and circumstances. See sec.
1.6664-4(b)(1), Income Tax Regs. “Circumstances that may
indicate reasonable cause and good faith include an honest
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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. Reliance on
professional advice may constitute reasonable cause and good
faith if, under all the circumstances, such reliance was
reasonable and the taxpayer acted in good faith. Freytag v.
Commissioner, 89 T.C. 849, 888 (1987), affd. 904 F.2d 1011 (5th
Cir. 1990), affd. 501 U.S. 868 (1991); sec. 1.6664-4(b)(1),
Income Tax Regs.
Petitioner has convinced us that she acted with reasonable
cause and in good faith. Petitioner has no experience or
education in tax law. She relied upon the advice of Villalobos,
who told her that the settlement would not be taxable. Although
Villalobos does not have tax experience, he is a personal injury
attorney, and it is reasonable for petitioner to assume that he
would be familiar with the Federal income tax consequences of
personal injury settlements. See Stadnyk v. Commissioner, supra.
Furthermore, petitioner believed that the settlement was to
compensate her for her physical injuries. This belief was
reinforced by the numerous medical expenses petitioner incurred.
We find that petitioner’s mistaken belief that the settlement
proceeds were compensation for physical injuries was reasonable
in the light of the circumstances. Petitioner acted reasonably
and in good faith when she told her return preparer that the
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settlement proceeds were paid on account of physical injury. See
Shelton v. Commissioner, T.C. Memo. 2009-116; Pettit v.
Commissioner, T.C. Memo. 2008-87. We therefore conclude that
petitioner has demonstrated reasonable cause for failing to
report the settlement proceeds as income and that she acted in
good faith. She is therefore not liable for the accuracy-related
penalty.
In reaching our decision, we have considered all arguments
made by the parties. To the extent not mentioned or addressed,
they are irrelevant or without merit.
For the reasons explained above,
Decision will be entered
under Rule 155.