William J. Broedel and Joan C. Broedel - Page 9




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          that the amount of the settlement was negotiated by the parties             
          and was intended to be “tax free”.                                          
               Gross income does not include the amount of any damages                
          received on account of personal injuries or sickness.  See sec.             
          104(a)(2).7  “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.  In order for              
          damages to be excludable from gross income under section                    
          104(a)(2), the taxpayer must demonstrate that:  (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, 337 (1995).                                                            
               Where amounts are received pursuant to a settlement                    
          agreement, the nature of the claim that was the actual basis for            
          settlement and not its validity controls whether such amounts are           
          excludable from gross income under section 104(a)(2).  See Seay             
          v. Commissioner, 58 T.C. 32, 37 (1972).  “[T]he critical question           



               7The Small Business Job Protection Act of 1996, Pub. L. 104-           
          188, sec. 1605(a), 110 Stat. 1838, amended sec. 104(a)(2) to                
          limit the exclusion, inter alia, to “personal physical injuries             
          or physical sickness.”  The amendment does not apply to damages             
          collected before the date of its enactment and has no bearing               
          here.                                                                       





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