The opinion
T.C. Memo. 2000-59
UNITED STATES TAX COURT
WILLIAM A. AND ANN M. JACOBS, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
JOHN W. AND PHYLLIS M. CONNELLY, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 626-98, 627-98. Filed February 23, 2000.
Carol B. Bonebrake, for petitioners.
Robert J. Burbank, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
GERBER, Judge: These consolidated cases involve income tax
deficiencies determined by respondent for petitioners’ 1994
taxable year. Respondent determined a $14,672 deficiency for
petitioners William A. and Ann M. Jacobs, docket No. 626-98, and
a $13,200 deficiency for petitioners John W. and Phyllis M.
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Connelly, docket No. 627-98. These cases were consolidated for
trial, briefing, and opinion pursuant to Rule 141(a).1
The sole issue for our consideration is whether the portion
of petitioners’ judgment allocated as liquidated damages received
in an action under the Fair Labor Standards Act of 1938, 29
U.S.C. secs. 201, 216(b) (1994) (FLSA), is excludable from gross
income as damages received on account of personal injury or
sickness under section 104(a)(2).
FINDINGS OF FACT2
At the time their respective petitions were filed,
petitioners William A. and Ann M. Jacobs, husband and wife,
resided in Silver Lake, Kansas, and petitioners John W. and
Phyllis M. Connelly, husband and wife, resided in Wichita,
Kansas. Ann Jacobs and Phyllis Connelly are petitioners in
this case solely because they joined in filing Federal income
tax returns with their husbands. Hereinafter, references to
“petitioners” refer only to William Jacobs and John Connelly.
Petitioner Jacobs was employed by the Kansas State Highway
Patrol from 1973 to 1997. He worked as a road trooper, an
aircraft pilot, and then held a position in the highway patrol
1
Unless otherwise indicated, Rule references are to this
Court’s Rules of Practice and Procedure, and section references
are to the Internal Revenue Code in effect for the taxable year
in question.
2
The stipulation of facts and the attached exhibits are
incorporated herein by this reference.
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headquarters. Petitioner Connelly was employed by the Kansas
State Highway Patrol from 1960 until 1993. During his tenure,
he was a field trooper, field sergeant, field lieutenant, and
field captain. He retired in February 1992 and was rehired the
following day by the highway patrol as a motor-carrier
inspection lieutenant until his termination in 1993.
Jacobs and Connelly joined in a suit entitled Kinnett v.
State of Kansas, Case Nos. 90-4209-DES, 90-4214-DES, and 90-
4215-DES, filed in the U.S. District Court for the District of
Kansas in 1990 (Kinnett). Kinnett involved claims under the
FLSA for unpaid overtime compensation for employee-plaintiffs
who had been classified as exempt from the requirements of the
act.
The amended complaint alleged that the defendant had
employed the plaintiffs on an hourly basis but required them to
work in excess of the hourly levels specified in 29 U.S.C.
section 207 and did not compensate the plaintiffs for their
overtime hours. Both Jacobs and Connelly had consistently
worked in excess of 40 hours a week during their tenure. The
employee-plaintiffs’ action challenged the exempt
classification as improper because the employees did not meet
the exemption test set forth in 29 C.F.R. section 541.118
(1991) and sought “unpaid overtime compensation, * * *
liquidated damages, * * * attorney’s fee * * * and costs” under
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29 U.S.C. section 216(b). A subsequent pretrial order
contained further details of the parties’ factual contentions
and legal theories and bifurcated the action to arrange for
separate trials on the liability and damage issues. Neither
the amended complaint nor the pretrial order made any reference
to physical injuries or sickness claimed by any plaintiff. The
only claims made were based on the allegedly improper exemption
and resulting loss of overtime pay.
No trial was ever held because the parties reached a
settlement agreement and filed a Joint Motion for Judicial
Approval of Settlement Terms and Dismissal of Action With
Prejudice (joint motion), setting out the terms of the
settlement. With one exception, the plaintiffs settled their
claims for 50 percent of the amounts claimed for unpaid
overtime compensation and for an equal amount for liquidated
damages. The joint motion provided that the defendant would
provide the settlement amounts in exchange for liability
releases signed by the plaintiffs. The joint motion described
the settlement agreement as entailing a “full and final
settlement, release and waiver of any and all claims Plaintiffs
have made or could have made arising out of any and all known
and unknown economic losses or damages compensable under the
FLSA”. The actual release stated:
I * * * hereby release, acquit and forever discharge
the State of Kansas * * * of and from any and all
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actions, causes of action, claims, demands,
declaratory judgment, damages, back wages, overtime
compensation, expenses, compensation, attorneys fees,
interest, liquidated damages, costs, and all
consequential damage on account of or in any way
arising out of any and all known and unknown economic
losses or damages compensable under the Fair Labor
Standards Act resulting from or which may result from
my employment with the State of Kansas or any agency
of the State of Kansas from January 1, 1987 through
August 31, 1994.
On August 31, 1994, the U.S. District Court for the
District of Kansas entered a Journal Entry of Dismissal With
Prejudice and approved the settlement agreement. Plaintiffs
received the settlement payments in two checks, one
representing the unpaid overtime compensation and the other
representing the liquidated damages portion of the settlement.
The portion allocated to back wages had all applicable taxes
and employee contributions withheld, and the portion allocated
to liquidated damages was paid in full to the employees. The
release provided that the liquidated damages portion of the
settlement payment would be reported to the Internal Revenue
Service on a Form 1099-MISC.
The total amount due to Jacobs by the State of Kansas was
$96,134. The State issued him a W-2 in the amount of $48,067,
withheld income and FICA taxes on that amount, and paid the
balance of the $48,067 to Jacobs, which he then reported on his
1994 Federal income tax return as income. The State of Kansas
also issued him a Form 1099-MISC in the amount of $48,067 and
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paid him that amount, withholding nothing. He disclosed
receipt of those funds on his return but did not report that
amount as income.
The total amount due to Connelly by the State of Kansas
was $80,898. The State issued him a Form W-2 in the amount of
$40,449, withheld income and FICA taxes, and paid him the
balance of the $40,449, which he then reported as income on his
1994 Federal income tax return. The State also issued him a
Form 1099-MISC in the amount of $40,449 and paid him that
amount, withholding nothing. He disclosed receipt of those
funds on his return but did not report that amount as income.
Due to petitioners’ exclusion of the liquidated damages
settlement payments from income, the Commissioner issued
deficiency notices to each.
Jacobs and Connelly each claim that the liquidated damages
payments were excluded from income as compensation for personal
injuries and/or sicknesses and that they had each suffered
medical conditions while working for the Kansas Highway Patrol.
Jacobs began to have various physical problems in 1980,
including failing eyesight, elevated blood pressure, and sexual
dysfunction. He also experienced mental anguish and stress
because his job schedule and fatigue caused him to miss out on
many family activities. His physician put him on medication to
reduce his blood pressure, which decreased somewhat while he
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was working and more so after he quit his job with the highway
patrol. He also noticed that his sexual dysfunction improved
after retirement as well.
Connelly also experienced medical problems, such as loss
of hearing, lower back problems, high blood pressure, and
depression. He attributes his hearing loss to the State’s
failure to provide ear protection during firearms training and
the back problems to the physical demands placed on an officer,
such as sitting in a car for extended periods and helping
people on the road by pushing cars out of the way or pulling
people from cars. He believes that his depression resulted
from the stresses of the job. Connelly never filed a workman’s
compensation claim for any of these injuries.
OPINION
Petitioners contend that the liquidated damages portions
of their settlement payments were excludable from gross income
pursuant to section 104(a)(2) as compensation paid “on account
of personal injuries or sickness”. Respondent counters that
petitioners’ liquidated damages payments do not qualify for the
section 104(a)(2) income exclusion because they were not paid
as compensation for personal injuries or sickness and/or
because liquidated damages under FLSA are punitive. Section
104(a)(2) states that gross income shall not include “the
amount of any damages received (whether by suit or agreement
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and whether as lump sums or as periodic payments) on account of
personal injuries or sickness”. Section 104(a) further states
that section 104(a)(2) “shall not apply to any punitive damages
in connection with a case not involving physical injury or
physical sickness.”
We first consider whether the payments petitioners
received as settlement for liquidated damages in the Kinnett
litigation settlement are excludable from their 1994 taxable
income pursuant to section 104(a)(2) as damages received on
account of personal injuries or sickness.
Section 61 includes in gross income all income from
whatever source derived. This section is broadly constructed,
and any statutory exclusions from income must be narrowly
construed. See Commissioner v. Schleier, 515 U.S. 323, 328
(1995). Section 104(a)(2) provides an exclusion for damages
paid as compensation for personal injuries or sickness. If the
damages are paid in settlement, the amount is excludable only
if (1) it is received “on account of personal injuries or
sickness”, and (2) it is received for claims “based upon tort
or tort type rights”. See Commissioner v. Schleier, supra at
333.
Where damages are received pursuant to a settlement
agreement, as here, the nature of the claim that was the basis
for settlement controls whether such damages are excludable
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under section 104(a)(2). See United States v. Burke, 504 U.S.
229, 237 (1992); Thompson v. Commissioner, 89 T.C. 632 (1987),
affd. 866 F.2d 709 (4th Cir. 1989); Threlkeld v. Commissioner,
87 T.C. 1294 (1986), affd. 848 F.2d 81 (6th Cir. 1988). The
determination of the nature of a claim is factual. See Fabry
v. Commissioner, 111 T.C. 305 (1998). The crucial question is
“in lieu of what was the settlement amount paid”? Bagley v.
Commissioner, 105 T.C. 396, 406 (1995), affd. 121 F.3d 393 (8th
Cir. 1997). We first look to the written terms of settlement
agreements to determine the origin and allocation of settlement
proceeds. See Metzger v. Commissioner, 88 T.C. 834 (1987),
affd. without published opinion 845 F.2d 1013 (3d Cir. 1988).
We may make that determination by reference to such agreement
when it is entered into in an adversarial context, at arm’s
length, and in good faith. See Knuckles v. Commissioner, 349
F.2d 610, 613 (10th Cir. 1965), affg. T.C. Memo. 1964-33.
To support their claim that the liquidated damages portion
of the settlement was paid on account of personal injuries
and/or sickness, petitioners direct our attention to the
wording of the release and to petitioners’ testimony about
their understanding of the settlement agreement. Petitioners
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interpret the wording of the release3 so that the words “on
account of or in any way arising out of any and all known and
unknown economic losses or damages compensable under the Fair
Labor Standards Act” modifies only “all consequential damage”
rather than modifying the list of all types of relief preceding
and including “all consequential damage”. By reading the
release in this manner, petitioners claim that they gave up all
possible “actions”, “causes of action”, “claims”, “demands”,
not limited to economic losses or damages, against the State of
Kansas when they signed that release. In doing so, petitioners
contend that they settled the claims for petitioners’ medical
conditions, thereby making the settlement proceeds paid on
account of personal injury and/or sickness. We reject this
interpretation.
Petitioners’ interpretation of the release language is
untenable when considered in conjunction with the explanations
3
The actual release stated:
I * * * hereby release, acquit and forever discharge
the State of Kansas * * * of and from any and all
actions, causes of action, claims, demands, declaratory
judgment, damages, back wages, overtime compensation,
expenses, compensation, attorneys fees, interest,
liquidated damages, costs, and all consequential damage
on account of or in any way arising out of any and all
known and unknown economic losses or damages
compensable under the Fair Labor Standards Act
resulting from or which may result from my employment
with the State of Kansas or any agency of the State of
Kansas from January 1, 1987 through August 31, 1994.
[Emphasis added.]
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of the release in the settlement and the description of the
cause of action in the pretrial order. The language in the
release does not indicate that the clause at issue modifies
only the last type of relief in the list given. If that had
been the intention, the authors could have written it as
petitioners rewrote it in their briefs, with numbers clearly
delineating the types of relief and applying the modifying
clause only to the last type of relief. The pretrial order
description of the settlement agreement also belies
petitioners’ interpretation. The release is described as a
release of “any and all claims Plaintiffs have made or could
have made arising out of any and all known or unknown economic
losses or damages compensable under the FLSA”. This language
clearly excludes from the release any claims for noneconomic
injuries or for any claims for losses or damages arising out of
non-FLSA causes of action.
Petitioners testified that they understood the release to
cover all claims against the State of Kansas, including any
claims for the medical conditions they contend resulted from
their employment with the State. Although the belief of the
payee is relevant to the inquiry, the character of the
settlement payment hinges ultimately on the dominant reason of
the payor in making that payment. See Agar v. Commissioner,
290 F.2d 283, 284 (2d Cir. 1961), affg. T.C. Memo. 1960-21;
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Fono v. Commissioner, 79 T.C. 680, 694 (1982), affd. without
published opinion 749 F.2d 37 (9th Cir. 1984). That intent is
clearly expressed in the language of the release and pretrial
order. We do not need to look further.
We also find persuasive the lack of any reference to
personal injuries in the amended complaint and/or pretrial
order. Petitioners never made a claim for or reference to
personal injuries suffered on the job in either. The complaint
contained only a challenge to the exempt status of certain
State employees and asserted those employees’ rights to receive
overtime compensation. Though notice pleading is allowed by
the Kansas Code of Civil Procedure, Rules Civ. Proc., Kan.
Stat. Ann. sec. 60-208(e)(1) (1994), the short plain statement
of the claim is sufficient only if it gives the defendant “fair
notice of what the plaintiff’s claim is and the ground upon
which it rests.” Rinsley v. Frydman, 559 P.2d 334, 338 (Kan.
1977) (citing Conley v. Gibson, 355 U.S. 41, 47 (1957)).
Though it is not necessary to spell out a legal theory of
relief in the pleadings, the opponent must be apprised of the
facts that entitle the plaintiff to relief. See Oller v.
Kincheloe’s, Inc., 681 P.2d 630, 637 (Kan. 1984). Petitioners
alleged no facts that provide even a hint of personal injury or
illness. Petitioners attempt to justify the lack of facts
about injury or illness by claiming that the pretrial order had
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bifurcated the damages and liability portions of the trial4
and, therefore, claim no discovery on personal injuries was
appropriate. This reasoning is unsatisfactory because it
ignores the fact that the bifurcation happened more than 2
years after the amended complaint was filed without reference
to injury or illness.
Moreover, the settlement terms make it unlikely that the
liquidated damages payments were made to compensate specific
personal injuries or sicknesses. All plaintiffs in Kinnett
received a liquidated damages settlement amount equal to their
back wages payment. The amounts paid were paid to each
plaintiff in the action without reference to the severity or
even existence of injury.
Finally, petitioners filed their cause of action under a
Federal act that does not provide for personal injury
compensation. The FLSA was enacted to establish minimum wages
and maximum hours for employees. See Brooklyn Sav. Bank v.
O’Neil, 324 U.S. 697, 707 (1945). According to 29 U.S.C.
section 216(b) (1994), the only relief available under the FLSA
for excessive hours worked is the payment of back wages and
payment of liquidated damages, which are intended to compensate
the employee for damages too obscure or difficult to estimate
4
The pretrial order does not explain why the damage and
liability portions of the trial were bifurcated.
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caused by the delay of wage payment. See Overnight Motor
Transp. Co. v. Missel, 316 U.S. 572, 583-584 (1942). While we
do not question the existence or severity of petitioners’
medical conditions, they have failed to demonstrate that any
portion of the settlement was paid on account of those
conditions.
With no mention of personal injuries in the amended
complaint or pretrial order and given the unavailability of the
type of relief claimed by petitioners under the cause of action
they pursued, there has been no showing that the defendant
settled the claim with an intention of compensating plaintiffs
for personal injury or illness.
The income exclusion test, under section 104(a)(2), for
personal injury or sickness compensation is two-prong. Both
prongs, settlement on account of personal injury or sickness
and settlement of a tort or tortlike claim, are required.
Because petitioners cannot show that any portion of the
settlement was paid as compensation for personal injury or
sickness, the income is not excludable under section 104(a)(2).
Though there is some authority that a claim under FLSA may not
sound in contract, thereby opening the possibility of a claim
sounding in tort, it is unnecessary to consider that argument
here because both prongs of the test must be met.
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Seeking a more global holding regarding the nature of the
liquidated damages under the FLSA, respondent makes an
alternative argument that the liquidated damages are punitive
and therefore not excludable under section 104(a)(2). Because
we have already found that petitioners’ liquidated damages
payments were not compensation for personal injury or illness
and therefore not excludable under section 104(a)(2), we need
not decide whether liquidated damages under FLSA constitute
punitive damages.
To the extent not herein discussed, we have considered all
other arguments made by the parties and find them to be moot or
without merit.
To reflect the foregoing,
Decisions will be entered for
respondent.