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The applicable regulations provide that “The 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. 1.104-1(c), Income Tax Regs.
Thus, in order to exclude damages from gross income pursuant to
section 104(a)(2), the taxpayer must prove: (1) The underlying
cause of action is based upon tort or tort type rights, and (2) the
damages were received on account of personal injuries or sickness.
See Commissioner v. Schleier, 515 U.S. 323, 336-337 (1995).
Where amounts are received pursuant to a settlement agreement,
the nature of the claim that was the actual basis for settlement
controls whether such amounts are excludable from gross income
under section 104(a)(2). 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). This
determination is a factual inquiry. See Robinson v. Commissioner,
102 T.C. 116, 127 (1994), affd. in part, revd. in part on another
ground and remanded 70 F.3d 34 (5th Cir. 1995).
We now turn our attention to the settlement that Mr. Norton
received by virtue of the release agreement. Mr. Norton testified
that he believed that the settlement was made on account of
personal injuries. On the other hand, the attorney for the State
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