Exclusion of punitive damages under sec. 104(a)(2).

Sec. 104(a)(2) provides for an exclusion from gross income for damages received, whether by suit or agreement, on account of personal injuries or sickness. Although neither this provision nor its legislative history offers any explanation of the term "personal injuries," several courts, including the Supreme Court in Burke, 112 Sup. Ct. 1867 1992), have held that the term encompasses both physical and nonphysical injuries. Furthermore, relying on Regs. Sec. 1.104-1(c), the Supreme Court in Burke specifically required that for income to be excluded under Sec. 104(a)(2), the legal basis for the receipt of damages must be the redress of a tort-like personal injury.

The issue is whether punitive damages awarded to a taxpayer in a personal injury case are excluded from gross income. The Omnibus Budget Reconciliation Act of 1989 (OBRA) amended Sec. 104(a) to provide that Sec. 104(a)(2) does not apply to punitive damages awarded for nonphysical injuries. Thus, the question becomes whether punitive damages for physical injuries are excluded from gross income.

In Miller, 93 TC 330 (1989) (reviewed by the court), rev'd, 914 F2d 586 (4th Cir. 1990), a state court jury awarded a taxpayer $500,000 in compensatory damages and $450,000 in punitive damages for defamation. After the verdict, the taxpayer and defendants settled the suit, with the taxpayer receiving $525,000. The amounts were received before the effective date of the 1989 amendment to Sec. 104(a).

The Tax Court held that punitive damages received in connection with a claim for personal injuries were excluded under Sec. 104(a)(2), essentially interpreting the phrase "on account of personal injuries or sickness" to imply "but for" causation. Since the punitive damages would not have been awarded "but for" the taxpayer's personal injury (i.e., the injury was necessary for punitive damages to be awarded), those damages must be "on account of" those injuries and thus excluded under Sec. 104(a)(2).

In reversing the Tax Court, the Fourth Circuit rejected the "but for" causation rationale in favor of a "sufficient" causation approach. Although personal injury was a prerequisite to the award of punitive damages, it was not sufficient. In particular, the taxpayer had to establish egregious conduct by the defendants in order to be awarded punitive damages. Under this approach, the fact that a personal injury was a prerequisite to punitive damages did not imply that the damages were "on account of" the injury. Thus, the punitive damages were outside the scope of Sec. 104(a)(2) and therefore were included in gross income.

It is important to note that the conflict between the Tax Court and the Fourth Circuit survives the 1989 amendment to Sec. 104(a). Although Miller involved a nonphysical injury (defamation), the rationale of both courts applies to punitive damages awarded for physical injuries. Recently, in fact, the Tax Court reaffirmed its Miller holding (and its conflict with the Fourth Circuit) in Horton, 100 TC No. 8 (1993) (a reviewed decision, with three dissents).

In addition, the 1989 enactment of the specific provision that would preclude Sec. 104(a)(2) protection for punitive damages awarded in connection with a nonphysical injury does not imply congressional approval for excluding punitive damages for physical injuries. The House version of the bill would have removed all damages for nonphysical injuries from Sec. 104(a)(2) protection; the Senate bill contained no provision. The final version was a compromise between the two. There is no evidence that Congress had ever considered physical injury situations. Thus, any negative inference of congressional intent with respect to physical injuries would be highly questionable.

Interestingly, however, in a footnote to Burke, the Supreme Court stated that OBRA "amended section 104(a) to allow the exclusion of punitive damages only in cases involving |physical injury or physical sickness.'" (Emphasis omitted.) More interestingly, the IRS Office of the Chief Counsel made the same statement on brief to the Tax Court in Horton. Taken on its face, the statement would appear to resolve the issue in favor of exclusion. On the other hand, it may be interpreted to mean only that punitive damages may be excluded, if at all, in physical injury cases. In any event, the statement is not binding on taxpayers, the IRS or the courts.

Recently, the Service opened a regulation project on this issue, presumably to reexamine its published view that punitive damages for personal injuries are not excluded from gross income (Rev. Ruls. 84-108 and 85-98). In addition, additional guidance may be forthcoming if the IRS appeals Horton to the Sixth Circuit.