Schleier requires Congress to clarify when damages received for discrimination are not taxable.

I. Introduction

In a much anticipated opinion, the Supreme Court held earlier this year in Commissioner v. Schleier(1)(*) that section 104(a)(2) of the Internal Revenue Code(2) does not authorize a former United Airlines pilot to exclude from his gross income the amount received in settlement of a claim for back pay and liquidated damages under the Age Discrimination in Employment Act of 1967.(3) Unfortunately, the decision creates needless complexities and inequitable disparate treatment with respect to when damages received by victims of discrimination can be excluded from gross income. This article examines Schleier and how it affects both the 1992 Supreme Court decision, United States v. Burke,(4) which addressed the taxability of damages received under Title VII of the Civil Rights Act of 1964(5) (prior to its amendment by the Civil Rights Act of 1991(6)) and the IRS's ruling interpreting Burke, Rev. Rul. 93-88.(7) The article also discusses the need to modify section 104 to exclude all damages (except punitive damages) received by victims of discrimination -- regardless of the nature of the discrimination, the statute giving rise to the cause of action, whether the discrimination is intentional, when the action is brought, whether the harm suffered is physical or financial, or how the monetary relief was determined.

II. Section 104(a)(2) and Treas. Reg. [sections] 1.104-1(c)

Section 104(a)(2) provides that gross income does not include "the amount of any damages received (whether by suit or agreement and whether as lump sum or periodic payments) on account of personal injuries or sickness." The rationale behind the statute is apparently that the payment does not result in economic gain or profit to the injured recipient, but instead roughly corresponds to a return of capital compensating the taxpayer for his loss.(8) As a result of an amendment by the Omnibus Budget Reconciliation Act of 1989, the exclusion in section 104(a)(2) "shall not apply to any punitive damages in connection with a case not involving physical injury or physical sickness."(9)

Treas. Reg. [sections] 1.104-1(c) defines "damages received on account of personal injuries or sickness" as "an amount received (other than workmen's compensation) rough 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." The term "based upon tort or tort type rights' was the subject of the Supreme Court's decision in Burke.

III. United States v. Burke

In Burke, the Supreme Court held that backpay awards, in settlement of a sex discrimination claim brought under Title VII prior to its amendment by the Civil Rights Act of 1991, are not excludable from gross income under section 104(a)(2). The taxpayers in Burke were employees of the Tennessee Valley Authority (TVA) who filed a Title VII claim alleging that the TVA had unlawfully discriminated in the payment of salaries based on sex. A union representing TVA employees, including the taxpayers, intervened in the action. The plaintiffs sought injunctive relief as well as backpay. A settlement was reached by the parties pursuant to which the taxpayers received backpay, subject to withholding for federal income taxes. The taxpayers filed claims for refund, alleging that the settlement payments should be excluded from gross income under section 104(a)(2). The taxpayers were unsuccessful at the district court level,(10) but the United States Court of Appeals for the Sixth Circuit, in a divided vote, reversed the decision on the basis that the claim of unlawful sex discrimination was "personal and tort-like in nature."(11) Certiorari was granted to resolve a conflict among the circuits.(12)

Writing for the Court, Justice Blackmun began his analysis with section 104(a)(2) and its legislative history He noted that neither the statute nor the legislative history offers any explanation of the term "personal injuries."(13) He then turned his attention to Treas. Reg. [sections] 1.104-1(c), which links the statutory requirement of "damages received ... on account of personal injuries or sickness" to the concept of "tort or tort type rights." The Court stated that the appropriate inquiry for purposes of section 104(a)(2) is "the nature of the claim underlying respondents' damages award" and that taxpayers must show "that Title VII, the legal basis for their recovery of backpay, redresses a tort-like personal injury." The Court further noted that "the concept of a `tort' is inextricably bound up with the remedies -- specifically damages actions."(14) Thus, the Court believed that the key focus should be on the remedies available for discrimination actions brought under Title VII. The Court concluded that because the damages available under Title VII, prior to its amendment by the Civil Rights Act of 1991, are limited to the wages properly due claimants and do not permit compensatory or punitive damages, the claim could not be characterized as based upon tort. Therefore, the payment was taxable. The Court added, however, that this does not preclude an exclusion from gross income under section 104(a)(2) for damages received as a result of discrimination claims made under another statute that provided tort-like remedies.(15)

The Court noted that the Civil Rights Act of 1991 provides victims of intentional discrimination the right "to a jury trial, at which it may recover compensatory damages for future pecuniary losses, emotional pain, suffering, inconvenience, mental anguish, loss of enjoyment of life and other nonpecuniary losses, as well as punitive damages."(16) The added remedies accorded victims of intentional discrimination under this law "cannot be imported back into the analysis of the statute as it existed at the time of the lawsuit."(17) The Court implied, however, that the result would be different with respect to intentional discrimination claims (but not disparate impact claims(18)) brought under Title VII after its amendment by the Civil Rights Act of 1991 because of the full range of compensatory damages now available to such plaintiffs.

Four justices disagreed with some or all of the majority opinion in Burke. In a concurring opinion, Justice Scalia stated that Treas. Reg. [sections] 1.104-1(c) went beyond the ambit of section 104(a)(2). In his view, the words "personal injuries or sickness" requires some sort of physiological effect, i.e. some harm to the victim's physical or mental health.(19) Justice Souter declined to join the majority in holding that "the tort-like character of a claim should turn solely on whether the plaintiff can recover for `intangible elements of injury."' Justice Souter, however, seemingly supported the ultimate decision to tax the backpay because of the "similarity between Title VII and contract law."(20) Justice O'Connor in a dissenting opinion joined by Justice Thomas rejected the notion that the statutory remedies fix the character of the right they seek to enforce." Specifically addressing Justice Souter's comment about the similarity between Title VII and contract law, she noted that, "Title VII makes employment discrimination actionable without regard to contractual arrangements between the employer and the employee."(21)

IV. Revenue Ruling 93-88

Consistent with the reasoning of Burke, Rev. Rul. 93-88 provides that victims of disparate treatment discrimination may exclude all compensating damages, including backpay, from gross income because the Civil Rights Act of 1991 provides such victims a broad range of remedies not previously available to plaintiffs. The ruling also states that the section 104(a)(2) exclusion applies to backpay and other compensating damages received in connection with claims brought under 42 U.S.C. [sections] 1981 because of the statute's tort-like remedies, The same result applies to claims for intentional discrimination brought under the Americans with Disabilities Act.(22) The ruling does not address the tax treatment with respect to recoveries under other nondiscrimination statutes.

Thus, Rev. Rul. 93-88 appeared to be a relatively noncontroversial restatement of the post-Burke law. To the surprise of many observers, however, the IRS's efforts were rewarded with the following comment in Schleier: Revenue rulings "may not be used to overturn the plain language of a statute."(23)

V. United States v. Schleier

This brings us to the decision in Schleier. Erich Schleier, a United Airlines pilot, was fired under a company policy when he reached 60. He filed a complaint alleging that his termination violated the Age Discrimination in Employment Act of 1967 (ADEA); his complaint was consolidated with a class action brought by other former United employees terminated under similar circumstances. The parties eventually entered into a settlement under which Schleier received $145,629, half of which was attributed to "backpay" and half to "liquidated damages."

When Schleier filed his tax return, he included as gross income the backpay portion of his settlement, but excluded the portion attributable to liquidated damages. Thereafter, the IRS issued a deficiency notice with respect to taxes for the liquidated damages and Schleier, in turn, sought a refund for the tax paid with respect to the backpay recovery. The Tax Court and the Court of Appeals for the Fifth Circuit held that the entire settlement was excluded from gross income under section 104(a)(2). The Supreme Court granted certiorari because of inconsistent decisions reached on this issue by the circuit courts.(24)

In an opinion by Justice Stevens, the Court held that the entire payment should be included in gross income. With respect to backpay, the Court reasoned that section 104(a)(2) requires that damages be received "on account of personal injuries or sickness" (emphasis added). While acknowledging that age discrimination may cause some psychological injury, the Court explained that the loss of wages is not "on account of" this injury." The employer's discrimination may cause psychological injury to the employee, analogous to pain and suffering caused by an automobile accident. In the Court's opinion, however, these lost wages and psychological injury are not directly linked to each other, i.e., the psychological injury does not cause the loss of the wages. The Court stated, however, that compensation received on account of "intangible harms of discrimination" may be excludable in certain circumstances.(26)

As to the liquidated damages Schleier received, the Court rejected the notion that these damages were intended to compensate the plaintiff for personal injury. Instead, citing its decision in Trans World Airlines, Inc. V. Thurston,(27) the Court called the ADEA liquidated damages provision punitive. The Court continued that while the IRS's position had been inconsistent, the IRS was correct in arguing that the reference in Treas. Reg. [sections] 1.104-1(c) to "tort or tort rights" does not dispense with the need for damages to be received "on account of personal injuries or sicknes

The Court called its decision consistent with its reasoning in Burke. In the Court's view, Schleier's damages under the ADEA are not based upon "tort or tort type rights' because monetary remedies under the ADEA are limited to backpay and liquidated damages, neither of which serves a compensatory function.(29) In addition, the Court asserted that Burke's inquiry into "tort or tort type rights' is merely the first prong of a two-part test to meet the requirements of section 104(a)(2); the second prong is whether the damages are received on account of the injury or sickness.

In a well reasoned dissent, Justice O'Connor lampooned the Court for creating needless and irrational complexity. Citing the Tax Court decision in Threldkeld u. Commissioner,(30) Justice O'Connor noted that at one time determining whether damages accrued from a lawsuit are excludable is a "fairly straightforward task" because the damages are excludable "so long as they were received `on account of" any invasion of rights that an individual is granted by virtue of being a person in the sight of the law.'" She reiterated her criticism of Burke, i.e., "the remedies available ... do not fix the character of the right they seek to enforce."(31)

Justice O'Connor was also critical of the Court's conclusion on what constitutes a personal injury. The injury is not the psychological harm that results from being discriminated against, she said; rather, the act of the discrimination itself inflicts the personal injury.(32) That is to say, the proverbial "kick-in-the-teeth" occurs when a victim is illegally discriminated against. The injury is not something that may or may not develop analogous to the whiplash suffered in Justice Stevens's automobile accident hypothetical.

In Part II of her dissent, Justice O'Connor found the Court's decision at variance with its holding in Burke. A suit based on the ADEA meets the Burke standards for "tort or tort type rights," she argued, because the statute both authorizes jury trials and gives the courts the right to grant "such legal or equitable relief as will effectuate the purposes of the Act."(33) She chided the majority for permitting the Commissioner to ignore 35 years of interpreting Treas. Reg. [sections] 1.104-1(c) as setting forth one test: Does the applicable statute involve tort or tort type rights?

VI. What Has Schleier Wrought?

Under Schleier, no part of the damages received as a result of an ADEA violation is excludable from gross income. With respect to discrimination claims in general, plaintiffs will have to jump through two hoops. First, they must base their claim on statutes that provide tort-like remedies, jury trials and punitive damages being insufficient in this regard.(34) Second, they must establish that the damages received are provided to compensate them for some injury, e.g., psychological harm resulting from the illegal discrimination.

Thus, the tax treatment of the recovery for illegal discrimination may depend on a whole range of factors, including under what statute the claim is brought under, when the claim is brought, whether the discrimination is intentional, and whether the harm done is physical or financial. Furthermore, as a corollary of Schleier, victims of discrimination have an additional barrier to overcome when compared with those injured in Justice Stevens's hypothetical automobile accident. The latter may exclude from gross income recoveries from loss wages resulting from the accident, but the former, assuming they meet the first hurdle (i.e., the statute has tort-like remedies), have the additional requirement of proving the damages were for physical or mental injuries caused by the illegal discrimination. In other words, the tax treatment accorded plaintiffs who suffer a harm because they were the victim of a tort will differ for a number of reasons that do not appear fair or rational. Ironically, as a result of Schleier, a new caste system has been established, albeit not as invidious as a classification based on race, sex, and age, but just as irrational.

VII. The Remedy

In view of this unfair and unnecessary labyrinth resulting from the Court's decision in Schleier, congressional action is required. Congress should rewrite section 104(a)(2), based on Justice O'Connor's eloquent dissents in Burke and Schleier. Section 104(a)(2) should be amended to make it clear that damages (except punitive damages) "received on account of any invasion of rights that an individual is granted by virtue of being a person in the sight of the law" are excluded from gross income. This will eliminate needless complexity and, more important, restore fundamental fairness in this area. Section 104(a)(2) would thus be consistent with the philosophy behind the anti-discrimination statutes and would eradicate artificial barriers to attaining justice. Victims will not be taxed differently because of the statute they sue under, how the damages are calculated (except for punitive damages), whether the discrimination is the result of disparate impact or treatment, whether they suffer mental anguish or "mere" financial harm, and whether the harm is caused by a drunk driver or a prejudiced employer.

There is a wall this writer is not convinced should be leveled -- the treatment of punitive damages. There are strong policy arguments for including such damages in gross income. The victim's position is not simply restored; it is enhanced.(35) Presumably, this philosophy underlies the section 104(a) modification in 1989 that the exclusion of damages from gross income under section 104(a)(2) does not apply to punitive damages in connection with a case not involving physical injury or sickness." Why should there be a distinction between punitive damages received in connection with physical injuries, and those received as a result of illegal acts of discrimination? While there is a conceptual basis for excluding punitive damages from the favorable tax treatment accorded those who suffer injuries,(36) the distinction made under current law between different types of victims is arbitrary.

One day, it is possible Justice O'Connor's eloquence will win the day. Hope springs eternal. Alternatively, Congress can do the right thing and redraft the statute to treat recoveries received for discrimination and other tort actions in an even-handed manner with only one distinction, the recovery of punitive damages.

Notes

(1) 115 S.Ct. 2159 (1995). (2) Unless otherwise noted, all section references are to the Internal Revenue Code of 1986, as amended. (3) Pub. L. No. 90-202, 81 Stat. 602, 29 U.S.C. [subsections] 621, et seq. (4) 504 U.S. 229 (1992). (5) Pub. L. No. 88-352 [subsections] 701-716, 78 Stat. 241, 253 (codified as amended at 42 U.S.C. [subsections] 2000(e) to 2000(e)-17 prior to the Civil Rights Act of 1991). Title VII makes it unlawful for an employer "to discriminate against any individual with respect to his compensation, terms, conditions or privileges of employment, because of such individual's race, color, religion, sex or national origin." 42 U.S.C. [sections] 2000e-2(a)(1). (6) Pub. L. No. 102-166, 105 Stat. 1071. (7) 1993-2 C.B. 61. (8) See Boris I. Bittker and Lawrence Lokken, Federal Taxation of Income, Estates and Gifts 13-9 (2d ed. 1989). See also Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955), where the Court held that money received as exemplary damages for fraud and the punitive two-thirds portion of a treble-damage antitrust recovery is included in gross income for federal income tax purposes. While the 1939 Code predecessor to section 104(a)(2) was not applicable to the case, the Court wrote that "[t]he long history of departmental rulings holding personal injury recoveries nontaxable on the theory that they roughly correspond to a return of capital cannot support exemption of punitive damages .... Damages for personal injury are by definition compensatory only Punitive damages, on the other hand, cannot be considered a restoration of capital for taxation purposes." 348 U.S. at 432 n.8. See note 35 for a discussion of cases and rulings regarding the tax treatment of punitive damages. (9) Omnibus Budget Reconciliation Act of 1989, Pub. L. 101-239, [sections] 7641(a), 103 Stat. 2106, 2379. (10) 90-1 U.S.T.C. [paragraph] 50,203 (E.D. Tenn. 1990). (11) 929 F.2d 1119, 1121 (6th Cir. 1991). (12) In Sparrow v. Commissioner, 949 F.2d 434 (1991), the Court of Appeals for the District of Columbia Circuit held that damages received in settlement of a Title VII action are includable in gross income. (13) 504 U.S. at 232. (14) Id. at 237 & n.7. (15) Id. at 239-46. The Court noted that 42 U.S.C. [sections] 1981 permits tort-like remedies and, therefore, implies that damages received with respect to claims brought under this statute would be excluded from gross income. Id. at 240. (16) Id. at 241 n.12. (17) Id. at 241. (18) Claims for intentional acts of discrimination are known as "disparate impact claims." The courts have recognized that the principles of Title VII go beyond such intentional acts. Since the landmark case, Griggs v. Duke Power Co., 401 U.S. 424 (1971), the courts have recognized the claims for relief under Title VII can also apply if the practice, procedure, or test of the employer is fair on its face, but "discriminatory in operation." This theory, referred to as "disparate impact," is codified into Title VII as part of the Civil Rights Act of 1991. See Joel Wm. Friedman & George M. Strickler, Jr., The Law of Employment Discrimination 196-201 (3d ed. 1993). (19) 504 U.S. at 242-45. (20) Id. at 247. (21) Id. at 249, 250. Justice O'Connor also rejected the view that Title VII liability is "quasi-contractual" since it is "irrelevant for purposes of Title VII that an employer profits from [the] discriminatory practices." Id. at 251. (22) 42 U.S.C. [subsections] 12101-12213. As a result of section 102(a)(2) of the Civil Rights Act of 1991, claimants under the Americans with Disabilities Act may recover compensatory and punitive damages in connection with claims for intentional discrimination or for failure to make reasonable accommodation (subject to a good faith exception). With respect to 42 U.S.C. [sections] 1981, see note 15. (23) 115 S. Ct. at 2167 n.s. As a result of Schleier, the IRS issued Notice 95-45, suspending Rev. Rul. 93-88. The notice invites public comments regarding "Schleier's impact on: (1) the treatment of recoveries, including those arising under the statutes described in Rev. Rul. 93-88; (2) the allocation of the excludable and nonexcludable portion of lump-sum awards and settlements; and (3) the extent to which [sections] 7805(.b) relief should be granted in the event that guidance previously issued by the Service is modified." The notice also amplified Rev. Proc. 95-3, 1995-1 I.R.B. 85, to provide that rulings and determination letters will not be issued pending the issuance of public guidance. (24) Compare Downey v. Commissioner, 33 F.3d 836 (7th Cir. 1994) (settlement award resulting from the termination of an ADEA settlement against United is not excludable from gross income under section 104(a)(2)), with Schmitz v. Commissioner, 34 F.3d 790 (9th Cir. 1994) (such settlement payments are excludable). (25) 115 S. Ct. at 2164. (26) Id. at 2165 n.6. The Court stated, however, that "to acknowledge that discrimination may cause intangible harms is not to say that the ADEA compensates for such harms, or that any of the damages received were on account of those harms." Id. at 2165. Later in the opinion, the Court specifically noted that any recovery received under the ADEA would not be excludable from gross income because the statute is not one that is "based upon tort or tort type rights." Id. at 2166. (27) 469 US. 111 (1985). (28) 115 S. Ct. at 2165. (29) Id. at 2166. The Court acknowledged Burke's emphasis on the lack of a jury trial and provision for punitive damages in the preversion 1991 of Title VII as grounds for why the claims are tort-like. Burke did not state, however, that the presence of either or both of these rights would make the damages received be considered based upon "tort or tort type rights." Id. at 2166. (30) 87 T.C. 1294 (1986). (31) 115 S.Ct. at 2168 (citing Threldkeld, 87 T.C. at 1308). See also Wilson v. Garcia, 471 U.S. 261, 277 (1985) (the violation of the plaintiffs' civil rights is an injury to the person of the plaintiff and an action based on such a violation is kindred to a personal injury). (32) Id. at 2169. (33) Id. at 2170 (quoting 29 U.S.C. [sections] 626(c)(1)). (34) Presumably, disparate impact claims brought under post-1991 Title VII are based on tort-type rights, since such plaintiffs may be awarded a broad range of compensatory damages including future pecuniary losses, emotional pain and suffering, inconvenience, mental anguish, loss of enjoyment of life, and other nonpecuniary losses. 42 U.S.C. [sections] 1981A(b)(3). This is also true with respect to claims of intentional discrimination or failure to make reasonable accommodation under the Americans with Disability Act. 42 US.C. [sections] 12112. (35) See note 8. See also Miller v. Commissioner, 914 F.2d 586 (1990), rev'g 93 T.C. 330 (1989), where the Fourth Circuit found punitive damages to be a windfall beyond the scope of section 104(a)(2). In this regard, the author agrees with the reasoning in Schleier to the extent the Court implies that all punitive damages are taxable because they are not received "on account of personal injuries or sickness." 115 S.Ct. at 2165. It should be noted that the decisions regarding the taxability of punitive damages have been inconsistent and even the IRS's position has been less than uniform. See, e.g., Roemer v. Commissioner, 716 F.2d 693 (9th Cir. 1983) (punitive damages received in a libel case excluded from income); Horton v. Commissioner, 33 F.3d 625 (6th Cir. 1994) (punitive damages awarded as a result of personal injury excluded from gross income); Reese v. Commissioner, 24 F.3d 228 (Fed Cir. 1994) (punitive damages received in settlement of a suit involving a claim for gender discrimination, sexual harassment and intentional infliction of emotional harm were taxable); Wesson u. United States, 95-1 U.S.T.C.[paragraph] 50,186 (5th Cir. 1995) (punitive damages awarded to an individual's estate in a bad faith action against an insurance company were not excludable from gross income because the damages were not on account of personal injury; Moore v. Commissioner, 95-1 U.S.T.C. 50,299 (5th Cir. 1995) (punitive damages awarded under state law in a malicious prosecution suit are taxable because they are not compensatory); and Rev. Rul. 84-108, 1984-2 C.B. 32, revoking Rev. Rul. 75-45, 1975-1 C.B. 47 (punitive damages received under an Alabama wrongful death statute are includable in gross income). (36) The author recognizes that an argument can be made that any time a victim receives damages for lost wages, he receives a windfall to the extent that the recovery will not be subject to taxation.

PHILIP G. COHEN is General Tax Counsel for Unilever United States, Inc. and an adjunct assistant professor of taxation at Pace University's Lubin School of Business in White Plains, New York. Mr. Cohen is a member of TEI's New York Chapter and has served on the Institute's Federal Tax Committee and Communications Committee (which he currently chairs) for a number of years.