New hope on nonphysical injury taxes.

Only a year after passage of a provision that taxed as income damages compensating certain nonphysical injuries, the first bills to reduce or eliminate this unfair tax have been introduced. The tax was included in the Small Business Job Protection Act, an omnibus bill with tax cuts and an increase in the minimum wage that became law in August 1996. (See ATLA Advocate, Oct. 1996, for more on the passage of this legislation.)

The provision applies only to cases that originate in a non-physical injury, like employment discrimination cases. It does not apply to damages received for causes of action based on physical injuries, including nonphysical injuries like wrongful death or emotional distress, that stem from a physical injury.

Two approaches

Rep. Barney Frank (D-Mass.) has introduced H.R. 2802, which would restore the exclusion from income tax for nonphysical injury damages. This bill straightforwardly restores the status quo ante to the tax code. The bill has attracted early support from several important Democrats, including members of the tax-writing Ways and Means Committee, and is likely to attract more support early in the next session of Congress, beginning January 20.

A different approach has been taken by Rep. Gerald Solomon (R-N.Y.), chairman of the powerful House Rules Committee. Solomon's bill would address only cases based on employment discrimination. The bill thus treads the middle ground between the flat repeal of the tax advocated by Frank and the seriously flawed legislation that was enacted during last year's session.

Solomon's legislation would address a number of problems that were created by the 1996 bill and some that were the result of recent Supreme Court decisions, notably Commissioner of Internal Revenue v. Schleier. (115 S. Ct. 2159 (1995).) This decision held that the statutory right of action under the Age Discrimination in Employment Act did not fall under the exclusion from gross income in Internal Revenue Code [sections] 104(a)(2) and was therefore taxable.

A review of problems created by the Small Business Job Protection Act and the proposed solutions follow:

* Tax on attorney fees. The 1996 bill left open the question of whether attorney fees were deductible from taxes. The best information from tax experts is that the fees could be taken as a miscellaneous deduction--but that is subject to a 2 percent floor. A provision in Solomon's legislation would allow for 100 percent of attorney fees to be deducted. Like other provisions in the bill, this one is retroactive to December 31, 1995.

* Alternative minimum tax. Many who have been affected by the nonphysical injury tax have found that even with sizable deductions for attorney fees on their regular taxes, they have also been hit by the alternative minimum tax. This tax, which was intended to prevent high-income taxpayers from using loopholes to avoid paying their fair share of taxes, would prevent victims of discrimination from receiving fair compensation. The Solomon bill would ensure that the alternative minimum tax would still allow a deduction for attorney fees in these cases.

* "Back pay" taxes. The 1996 bill taxes not only back pay--amounts intended to compensate for wages lost as a result of employment discrimination, which if they had been received as income would have been subject to income tax--but also amounts received to compensate for emotional distress and other injuries. The most significant provision of the Solomon bill would limit the tax to only the back pay part of any recovery for nonphysical injuries based on unlawful discrimination.

* Income averaging for back pay. A serious problem caused by the receipt of several years' income as a lump sum is caused by the graduated tax system. Since the 1996 tax provision treats all damages as current income, it makes no distinction between a person receiving five years' worth of back pay of $50,000 per year and another person receiving an annual income of $250,000. The marginal tax rates are, therefore, much higher than would have been the case had the money been paid over five years. The Solomon bill would allow the income to be averaged over the period of time it is intended to compensate, significantly reducing the marginal rate.

The Solomon legislation is certainly not perfect. It would still maintain the unjustified distinction in the 1996 act between physical and nonphysical injuries for tax purposes. Further, damages for significant categories of torts, such as injuries to reputation, would still be completely taxable.

However, the explicit inclusion of age discrimination would have the effect of reversing the Schleier decision by making the exclusion from income specifically apply to discrimination cases. Once again, damages paid for emotional distress in age discrimination cases would be nontaxable.

Roll back the tax

Interest in both bills is growing as word gets out to groups concerned about the issues. Congress is expected to take up broad tax legislation in the 1998 session, and there is movement toward including language to address the problems in the 1996 bill in it. ATLA, along with consumer, business, structured settlement, and civil rights groups, will work to roll back this unfair tax.

Philip Buchan is an associate director of ATLA Public Affairs.