Ninth Circuit misinterprets Schleier.

The Supreme Court, in Schleier, 115 Sup. Ct. 2159 (1995), addressed whether back pay and liquidated damages awarded under the Age Discrimination in Employment Act of 1967 (ADEA) were excludible from gross income under Sec. 104(a)(2). In holding that they are not, the Court articulated two independent requirements a taxpayer must meet before a recovery may be excluded. First, the taxpayer must demonstrate that the underlying cause of action giving rise to the recovery is "based upon tort or tort type rights"; and second, the taxpayer must show that the damages were received "on account of personal injuries or sickness."

Unfortunately, the two-part test is not a model of clarity. Recently, in fact, the Ninth Circuit, in Banks, 81 F3d 874 (1996), aff'g DC Wash., 1994, may have misinterpreted Schleier by deciding that payments to a taxpayer to settle a claim of breach of duty of fair representation were excludible from gross income under Sec. 104(a)(2).

Tort-Type Rights

In Burke, 504 US 229 (1992), the Supreme Court stated that a "hallmark" of traditional tort liability was the availability of a broad range of damages to compensate the plaintiff. The Schleier Court clarified that the availability of compensatory damages for intangible harms (e.g., pain and suffering, emotional distress, harm to reputation, or Other consequential damages) was a primary characteristic of such a broad range. The Schleier Court concluded that, since monetary remedies under ADEA were limited to back wages and liquidated damages, recovery under ADEA was not based on tort or tort-type rights.

On Account of Personal Injuries

The Schleier Court made clear that compensatory monetary damages must be directly linked to a personal injury in order to be received on account of that injury for Sec. 104(a)(2) purposes. For example, proceeds of a settlement for medical expenses, lost wages and pain and suffering arising from an automobile accident are excludible from gross income. The portion of the settlement for medical expenses and pain and suffering is clearly on account of personal injury; the part received for lost wages is also on account of personal injuries (provided the lost wages resulted from lost work time due to injuries sustained in the accident).

On the other hand, no part of Schleier's ADEA settlement (for back wages) was excludible from gross income. Although the age discrimination caused both personal injury (comparable to pain and suffering) and lost wages, "neither [was] linked to the other." In other words, the amount of back wages recovered was independent of the existence and extent of the personal injury.

The Banks Case

Banks worked in a mill owned by Bethlehem Steel. One day he arrived at work with a fan to provide himself with some relief from temperatures that exceeded 100 degrees. A fellow worker tried to take the fan from Banks, a fight ensued, and Banks needed 32 stitches on his head. Pursuant to Bethlehem's policy against fighting, both Banks and his fellow worker were suspended with intent to discharge. A grievance was filed by the United Steel Workers of America, which negotiated a settlement. Banks, however, vehemently objected to the terms of the settlement and brought suit against both the union and the company. Banks alleged that Bethlehem had discharged him without just cause and that the union had breached its duty of fair representation.

After much litigation, Banks ultimately prevailed. He was awarded damages of $134,532, measured by an estimation of his past and future wages. There is no indication that Banks's estimated lost wages resulted from being out of work because of any intangible personal injuries. Before the entry of judgment, however, the parties settled: Bethlehem made a payment to Banks to settle the wrongful discharge claim, and the union made a payment to Banks to settle the claim for breach of duty.

Banks included in gross income the amount received from Bethlehem, but excluded the amount received from the union: The IRS disagreed with the exclusion. A Ninth Circuit panel, by a split vote, agreed with the taxpayer that the recovery from the union should be excluded from gross income.

The Ninth Circuit panel majority initially gave lip service to the Schleier two-part test for excludibility of the recovery. It then declared, curiously, "Schleier, however, was determined by the specific limitations of the ADEA and has no application here [in Banks] where neither punitive damages nor back wages were offered in the settlement." Looking to the "nature of the injuries that were being compensated," the court summarily concluded that the settlement payment from the union was of a tort-like cause of action and on account of personal injuries, and was thus excludible from gross income.

The court's decision seems to be in conflict with Schleier, and its rationale may be faulty. First, it never analyzed the district court's conclusion that Banks's recovery for breach of duty of fair representation was based on tort or tort-type rights as construed in Burke (and Schleier), viz., whether there was a sufficiently broad range of damages (especially for intangible harms) to compensate Banks. A thorough appellate analysis was especially appropriate since the decision of the district court was rendered prior to Schleier (although after Burke).

Second, and more importantly, neither the district court nor the appellate court ever established the direct link that Schleier seems to require between the settlement and the personal injury The union's breach of duty of fair representation may have caused a personal injury (perhaps comparable to pain and suffering), but the amount of the settlement apparently was completely independent of the existence or extent o f that injury. ("[The union] paid damages to compensate for its unfair and arbitrary treatment of Banks[,] conduct that [was] found to be in bad faith and in violation of the [u]nion's duty to fairly represent Banks.") Thus, the necessary personal injury/recovery direct link did not exist. As such, the settlement for breach of duty of fair representation should not be excludible from Banks's gross income, contrary to the court's holding.

Conclusion

Although Banks is "authority" for purposes of the Sec. 6662 substantial authority standard, practitioners, especially when advising clients outside the Ninth Circuit, should be wary of relying on this decision. The court's decision and its rationale seem to be in conflict with the Supreme Court in Schleier.

Note: Section 1605 of the Small Business Job Protection Act of 1996 (PL 104-188, enacted Aug. 20, 1996) amended Sec. 104(a)(2) to apply only to damages (other than punitive damages) received on account of a personal physical injury or physical sickness. Emotional distress (including physical symptoms resulting from such distress) is generally not considered a physical injury or physical sickness; amounts paid for medical care attributable to emotional distress, however, are excludible from gross income.

For example, damages received after Aug. 20, 1996, based on a claim of breach of duty of fair representation, even if accompanied by a claim of emotional distress, appear generally to be included in gross income. On the other hand, all damages (including emotional distress, but not punitive damages) that flow from an action that has its origin in a physical injury or physical sickness are excludible. These new rules do not apply to amounts received under a written binding agreement, court decree or mediation award in effect on (or issued on or before) Sept. 13,1995.

From Kenneth N. Oreach, CPA, Florida Atlantic University, Boca Raton, Fla.