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T.C. Memo. 2009-103 UNITED STATES TAX COURT DEBORAH L. WATTS, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent Docket No. 6056-06. Filed May 18, 2009. Robert M. Walsh, for petitioner. Daniel P. Ryan, for respondent. MEMORANDUM FINDINGS OF FACT AND OPINION GALE, Judge: Respondent determined a deficiency in petitioner's 2002 Federal income tax of $10,705 and additions to tax under section 6651(a)(1) of $2,408, under section 6651(a)(2) of $1,605, and under section 6654(a) of $357. Unless otherwise noted, all section references are to the Internal Revenue Code of 1986, as in effect for the year in - 2 issue, and all Rule references are to the Tax Court Rules of Practice and Procedure. All dollar amounts have been rounded to the nearest dollar. After concessions,1 the issues for decision are: (1) Whether a $52,896 payment petitioner received in 2002 in connection with the settlement of a class action lawsuit against her automobile insurer is includible in gross income; (2) whether $9,396 petitioner received from the Social Security Administration in 2002 is includible in gross income under section 86(a); (3) whether petitioner was required to file a Federal income tax return for 2002; (4) whether petitioner is 1 Respondent has conceded that petitioner is not liable for a sec. 6654(a) addition to tax. Petitioner claimed entitlement to a medical expense deduction in the petition but presented no evidence relating to this issue and did not address it on brief. We therefore deem it to have been abandoned. See Estate of Atkinson v. Commissioner, 115 T.C. 26, 35 (2000), affd. 309 F.3d 1290 (11th Cir. 2002); Stringer v. Commissioner, 84 T.C. 693, 708 (1985), affd. without published opinion 789 F.2d 917 (4th Cir. 1986). Respondent determined in the notice of deficiency that petitioner had total unreported gross income for 2002 of $60,882 in connection with payments from State Farm Mutual Automobile Insurance Co. (State Farm) and the Social Security Administration. On brief respondent takes the position that petitioner had unreported income of $52,896 from State Farm and $9,396 from the Social Security Administration, for total unreported income of $62,292. Respondent did not move to amend his answer to assert an increased deficiency. In any event, the discrepancy in the unreported income respondent asserted has no significance, given that we have redetermined that petitioner had unreported income from State Farm and the Social Security Administration of only $2,896 and $6,455, respectively. - 3 entitled to a dependency exemption deduction under section 151(c); (5) whether petitioner is entitled to a child tax credit under section 24(a); and (6) whether petitioner is liable for additions to tax under section 6651(a)(1) and (2). FINDINGS OF FACT Some of the facts have been stipulated and are incorporated by this reference. At the time the petition was filed, petitioner resided in New Hampshire. I. State Farm Settlement Payment A. Petitioner's Automobile Accident Petitioner married on October 8, 1990. On February 22, 1992, while living in Tuscon, Arizona, with her husband, petitioner was injured in an automobile accident, the fault of an uninsured motorist. As a result of her injuries, petitioner was unable to work for over a year. At the time of the accident petitioner and her husband had two vehicles insured under separate automobile liability insurance policies through State Farm Mutual Automobile Insurance Co. (State Farm). Both insurance policies were purchased by petitioner and/or her husband and had endorsements for uninsured and underinsured motorist (UM/UIM) coverage with policy limits of $50,000. - 4 B. Petitioner's Claim Against State Farm Although petitioner filed a lawsuit against the motorist who was at fault in her accident, her counsel ascertained that the defendant had no significant assets nor any insurance. Petitioner submitted a claim under her UM/UIM coverage to State Farm for compensation for her injuries in the automobile accident. State Farm took the position that petitioner was entitled to recover under the UM/UIM coverage of only one of the two policies held by her and her husband, resulting in an effective policy limit on recovery of $50,000. In taking this position State Farm relied on anti-stacking provisions in its insurance contracts with petitioner and her husband, under which the insured was purportedly precluded from aggregating or \"stacking\"2 his or her UM/UIM coverages under multiple State Farm policies. Petitioner thereafter agreed to settle her claim with State Farm for $32,973 and, after satisfaction of attorney's fees and costs, she and her husband received a payment of $21,887 on or about February 2, 1996.3 At the time she settled her claim, petitioner anticipated incurring future medical expenses on account of the automobile accident but concluded that the 2 \"Stacking\" is \"the practice by which insureds may seek indemnification from the same coverage under two or more policies.\" State Farm Mut. Auto. Ins. Co. v. Lindsey, 897 P.2d 631 (Ariz. 1995) (citing Widiss, Uninsured and Underinsured Motorist Insurance, sec. 40.1, at 237 (2d ed. 1995)). 3 This 1996 payment is not at issue in this case. - 5 settlement was advisable in view of the costs of further litigation and State Farm's position that the limit on her recovery was $50,000. C. Class Action Lawsuit Against State Farm After petitioner had agreed to settle with State Farm, the Arizona Supreme Court decided State Farm Mut. Auto. Ins. Co. v. Lindsey, 897 P.2d 631 (Ariz. 1995), in which it held that antistacking provisions in certain other State Farm automobile liability insurance policies, similar to those that State Farm had invoked against petitioner, were ineffective to preclude stacking. Id. at 331-332. After the Lindsey decision petitioner became a member of the plaintiff class in a class action lawsuit against State Farm that had been filed on July 21, 1995, in Pima County Arizona Superior Court (superior court). The class action plaintiffs alleged that \"State Farm's refusal to allow Plaintiffs to 'aggregate' or 'stack' multiple uninsured and/or underinsured motorist coverages provided by State Farm policies constitutes a breach of contract.\" The plaintiffs also raised claims for relief based on breach of covenant of good faith and fair dealing in connection with their contracts of insurance with State Farm, fraud in connection with the denial of benefits under the plaintiffs' policies, violation of the Arizona Consumer Fraud Act (A.R.S. 441522(A)) in connection with the denial of stacking of uninsured - 6 coverage in multiple policies, breach of fiduciary duty, and racketeering as proscribed by A.R.S. 13-2301(D)(4). The plaintiffs requested as relief compensatory damages, treble damages, punitive damages, attorney's fees and costs, and prejudgment interest. D. Class Action Settlement Agreement The class action lawsuit was settled on September 6, 2001, by means of a written settlement agreement (settlement agreement). Pursuant to the settlement agreement, State Farm deposited into trust $45,062,945, of which $29,873,750 constituted \"Class Member Settlement Funds\" (settlement funds) to be used to pay certain of the plaintiffs; namely, \"Eligible Class Members\".4 Under the settlement agreement, each Eligible Class Member was entitled to receive a pro rata share of the settlement funds (plus interest accruing before disbursement) provided the Eligible Class Member executed and returned an individual release to State Farm. Eligible Class Members included those plaintiff class members whom the superior court had ruled met the following criteria, as described in the settlement agreement: Any person (and each person who has a claim for the wrongful death of a person) who is, or was, 4 The remaining funds were allocated to (1) \"Seventh Year Class Members\" whose claims apparently were subject to a greater litigation hazard that State Farm would prevail in a statute of limitations defense, and (2) attorney's fees and costs. - 7 (A) insured under multiple automobile liability insurance policies that: (i) were purchased by one insured[5] on different vehicles; (ii) included uninsured (\"UM\") and/or underinsured (\"UIM\") motorist coverage; and (iii) were delivered or issued for delivery in Arizona by State Farm with respect to a motor vehicle registered or principally garaged in Arizona; (B) who sustained injury or death as a result of the fault of an insured [sic6] and/or underinsured motorist; and (C) who was paid * * * the UM and/or UIM motorist coverage limits on one automobile liability policy issued by State Farm, but received no payment from any other UM and/or UIM coverage provided by any other automobile liability policy described above. The settlement agreement excluded from the category of Eligible Class Members: (1) \"Identified Plaintiffs\"; i.e., those class members whom the superior court concluded had policies with anti-stacking clauses that were valid and enforceable; and (2) \"Fully Compensated Plaintiffs\"; i.e., those class members whom the superior court concluded were fully compensated for their injuries and not entitled to any recovery in the litigation. 5 We assume in deciding this case that petitioner was treated by State Farm and the Pima County Arizona Superior Court (superior court) as meeting the \"one insured\" requirement in connection with the policies purchased by her and/or her husband by virtue of Arizona's community property laws. See State Farm Mut. Auto. Ins. Co. v. Lindsey, 897 P.2d at 634. 6 Given the context, we find that the use of the term \"insured\" in this clause of the settlement agreement was a typographical error and that \"uninsured\" was intended by the parties to the agreement. - 8 As noted, an Eligible Class Member was required to execute a prescribed individual release in order to receive his or her pro rata share of the settlement funds. The terms of the prescribed individual release are not in the record. However, pursuant to the settlement agreement, every Eligible Class Member, regardless of whether he or she executed an individual release and received settlement funds, became subject to a general class release which released State Farm \"from any and all claims, demands, suits, causes of action, damages, costs, fees, expenses, and civil liabilities of any nature whatsoever in law or equity arising from the transaction or occurrence giving rise to the claims in the [class action] Complaint\". E. Receipt of Payment Petitioner was one of 568 Eligible Class Members who received pro rata disbursements from the settlement funds that, with accrued interest, had grown to $30,041,902 as of January 31, 2002. Sometime in 2002 petitioner received a $52,896 payment pursuant to the settlement agreement as her pro rata portion of the settlement funds. During that year petitioner was issued a Form 1099-MISC, Miscellaneous Income, reflecting the payment. II. Social Security Administration Payments During 2002 petitioner was disabled as a result of reflex dystrophy syndrome. She received payments totaling $9,396 from the Social Security Administration on account of this disability - 9 and was issued a Form SSA-1099, Social Security Benefit Statement, reflecting the payments. During 2002 petitioner and her husband were married but were experiencing marital difficulties. III. Dependency Exemption Deduction and Child Tax Credit Petitioner and her husband had two children during their marriage--TJM and TDM.7 New Hampshire. Sometime around 2000 petitioner moved to As noted, petitioner remained married throughout 2002. She and her husband obtained a final decree of divorce in 2005. They had no written agreement concerning the custody of TJM and TDM during 2002. IV. Tax Advice Petitioner consulted an accountant as to the proper tax treatment of the $52,896 payment from State Farm. The accountant advised petitioner that the payment might or might not be taxable and that petitioner should make further inquiry into its tax consequences. V. Notice of Deficiency Petitioner did not file a Federal income tax return for 2002. Respondent prepared a substitute for return and on December 27, 2005, issued a notice of deficiency to petitioner for 2002 in which he determined that petitioner had unreported 7 TJM was born on Sept. 13, 1993, and TDM was born on Dec. 17, 1996. - 10 income of $60,882 as disclosed by third-party payors.8 Respondent further determined that petitioner's filing status was single, that petitioner was entitled to one personal exemption and no credits, and that petitioner was liable for additions to tax under section 6651(a)(1) and (2) as previously described. Petitioner filed a timely petition for redetermination. OPINION Generally, the determinations in the notice of deficiency are presumed correct, and taxpayers bear the burden of proving that the determinations are in error. Helvering, 290 U.S. 111, 115 (1933). See Rule 142(a); Welch v. Petitioner has not claimed or shown entitlement to any shift in the burden of proof pursuant to section 7491(a). As discussed infra, respondent bears the burden of production with respect to the additions to tax he determined, pursuant to section 7491(c). Generally, gross income includes all income from whatever source derived unless excluded by a specific provision of the Internal Revenue Code. Tax Regs. See sec. 61(a); sec. 1.61-1(a), Income Section 61(a) broadly applies to any accession to wealth; statutory exclusions from income are to be narrowly construed. See Commissioner v. Schleier, 515 U.S. 323, 327 (1995); United States v. Burke, 504 U.S. 229, 233 (1992); Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955). 8 See supra note 1. A - 11 taxpayer must demonstrate that he or she is within the clear scope of any statutory exclusion. See Commissioner v. Schleier, supra at 336-337; United States v. Burke, supra at 233. I. Unreported Income A. State Farm Settlement Payment We first decide whether petitioner must include in her 2002 gross income the $52,896 payment she received pursuant to the settlement agreement with State Farm. 1. Applicable Internal Revenue Code Provision Petitioner contends that the settlement payment is excludable from gross income under section 104(a)(2) because it constitutes damages received on account of personal physical injuries she suffered in an automobile accident. Respondent counters that the payment was not to settle a tort claim or to pay petitioner on account of personal physical injuries but rather to redress contract claims. Thus, respondent argues the payment fails the two-part test under Commissioner v. Schleier, supra at 337, and therefore is not excludable from gross income under section 104(a)(2). We believe the parties have miscast the issue as governed by section 104(a)(2). Section 104(a)(2) provides an exclusion from gross income for \"the amount of any damages (other than punitive damages) received (whether by suit or agreement * * * ) on - 12 account of personal physical injuries or physical sickness\". The regulations interpreting section 104(a)(2) provide: Section 104(a)(2) excludes from gross income the amount of any damages received[9] (whether by suit or agreement) on account of personal injuries or sickness. The [statutory] term \"damages received (whether by suit or agreement\" means 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. 1.1041(c), Income Tax Regs.; emphasis added.] Petitioner did not bring a suit, or settle one, based on tort or tort type rights. The suit and settlement at issue were not against the motorist whose fault caused her injury or against that motorist's insurer. Petitioner sued her own insurer concerning a disagreement over the contractual terms of policies she and her spouse had purchased--specifically, whether antistacking clauses in those policies entitled State Farm to deny coverage under the second policy. The settlement petitioner reached with State Farm was therefore not a \"settlement agreement entered into in lieu of\" a prosecution \"based on tort or type rights\"; it was a settlement of a contract dispute concerning the terms of an insurance policy she had purchased that purported to indemnify her against injury caused by an uninsured motorist. 9 The regulations do not reflect the 1996 amendment of sec. 104(a)(2) wherein the phrase \"(other than punitive damages)\" was added after \"damages\". See Small Business Job Protection Act of 1996, Pub. L. 104-188, sec. 1605(a), 110 Stat. 1838. - 13 Section 104(a)(3) generally provides an exclusion10 from gross income for amounts received through accident or health insurance * * * for personal injuries or sickness (other than amounts received by an employee, to the extent such amounts (A) are attributable to contributions by the employer which were not includible in the gross income of the employee, or (B) are paid by the employer) * * * The regulations interpreting section 104(a)(3) provide: Section 104(a)(3) excludes from gross income amounts received through accident or health insurance for personal injuries or sickness (other than amounts received by an employee, to the extent that such amounts (1) are attributable to contributions of the employer which were not includible in the gross income of the employee, or (2) are paid by the employer). * * * If, therefore, an individual purchases a policy of accident or health insurance out of his own funds, amounts received thereunder for personal injuries or sickness are excludable from his gross income under section 104(a)(3). * * * [Sec. 1.104-1(d), Income Tax Regs.] Accordingly, under the regulations, where an individual has purchased an accident or health insurance policy, the section 104(a)(3) exclusion applies to amounts \"received thereunder for personal injuries or sickness\". The regulations under section 104(a)(3) do not address the situation where the insured receives amounts only after initiation and settlement of a lawsuit against the issuer of the accident or health insurance policy. The parties apparently believe that the interposing of a lawsuit between the insured and 10 The exclusion does not extend to amounts attributable to deductions allowed under sec. 213 for any prior taxable year. - 14 the insurer in this case causes the payment petitioner received from State Farm to constitute \"damages\" that may be excluded from income only by satisfying the requirements of section 104(a)(2). We disagree. As more fully discussed below, we conclude that petitioner's settlement payment from State Farm was received \"through\" accident or health insurance \"for\" personal injuries or sickness within the meaning of section 104(a)(3) and is therefore excludable, up to the policy limits, under that section. To decide whether the settlement payment petitioner received is excludable under section 104(a)(3), we must determine whether it constitutes an amount received (1) \"through\" (2) \"accident or health insurance\" (3) \"for\" personal injuries or sickness. See Marsh v. Commissioner, T.C. Memo. 2000-11, affd. 23 Fed. Appx. 874 (9th Cir. 2002). 2. Whether Petitioner's Automobile Liability Policy Was \"Accident or Health Insurance\" We believe there can be no serious dispute that petitioner's automobile liability policy on which State Farm denied coverage was \"accident or health insurance\" within the meaning of section 104(a)(3).11 In Marsh v. Commissioner, supra, we assumed that an amount received in settlement of litigation over a claim under the uninsured motorist coverage of an automobile liability 11 There is also no dispute in this case that the State Farm policies at issue were purchased by petitioner or her spouse and not by any employer of either. - 15 insurance policy was in theory excludable under section 104(a)(3).12 The Commissioner has taken a similar position in a published revenue ruling that disability payments received under a \"no fault\" automobile insurance policy are excludable under section 104(a)(3). See Rev. Rul. 73-155, 1973-1 C.B. 50. We accordingly hold that the uninsured motorist coverage in the State Farm automobile liability insurance policies at issue is \"accident or health insurance\" within the meaning of section 104(a)(3). 3. Whether the Payment Was an Amount Received \"Through\" Accident or Health Insurance Section 104(a)(3) requires that an excluded amount be received \"through\" accident or health insurance. The regulations further clarify that an amount is excludable if an individual has purchased the policy and the amounts are received \"thereunder\". Sec. 1.104-1(d), Income Tax Regs. Marsh v. Commissioner, supra, likewise involved a claim by an insured taxpayer for indemnification for a personal injury under the uninsured motorist coverage of his automobile liability policy. As in this case, the insurer denied coverage on grounds subsequently found invalid by the State's highest court in other proceedings. 12 In Marsh Fed. Appx. 874 sec. 104(a)(3) settled by the insured. The v. Commissioner, T.C. Memo. 2000-11, affd. 23 (9th Cir. 2002), we held that an exclusion under was not available because the claim that had been insurer was based on a false statement by the - 16 taxpayer thereupon sued, and the insurer ultimately settled with the taxpayer for approximately $68,000, which the taxpayer sought to exclude under section 104(a)(3) or (2).13 A key difference in Marsh was our finding that the taxpayer's claim of personal injury was based on his false statement. As a result, we held that the payment was not excludable under section 104(a)(3) because it was not \"for\" personal injuries or sickness. We did not suggest that the payment's being a product of litigation with the insurer raised an issue under the requirement that the payment be received \"through\" accident or health insurance. Indeed, we assumed that a payment in these circumstances would be \"under an insurance policy\".14 Petitioner received the $52,896 payment at issue as her share of the settlement of a class action lawsuit against State Farm. In order to be eligible to receive the payment, petitioner was required to have been (1) insured under multiple (two or 13 We found the taxpayer's position on brief unclear as between the two subsections, but the Commissioner's arguments assumed that the taxpayer was claiming an exclusion under sec. 104(a)(3). 14 In this regard, we stated: section 104(a)(3) provides an exclusion from gross income of \"amounts received through accident or health insurance for personal injuries or sickness\". (Emphasis added.) The mere fact that amounts in question are paid by an insurance company under an insurance policy does not establish that such amounts were actually paid for injuries or sickness. * * * [Marsh v. Commissioner, supra.] - 17 more) insurance policies purchased from State Farm with UM/UIM coverage, (2) injured through the fault of an uninsured or underinsured motorist, and (3) denied payment under one of the foregoing policies while receiving payment under another. We are satisfied that these prerequisites establish that petitioner received the settlement payment \"through\" accident insurance, or under such a policy, within the meaning of section 104(a)(3) and the regulations. Petitioner's claim against State Farm in the class action lawsuit was at its core a demand for payment under the second of the two policies purchased by her and her husband with respect to which State Farm had denied coverage. That petitioner had to litigate to establish her rights to payment under the second policy does not change the conclusion that the payment was received \"through\" accident insurance. It is apparent that a primary issue in the litigation was the proper interpretation of the contractual terms of petitioner's policies. Certain members of the plaintiff class, the \"Identified Plaintiffs\