Supreme Court denies exclusion for age discrimination damages.

In a sweeping opinion that narrowly interprets the Sec. 104(a)(2) exclusion of damages from gross income, the Supreme Court recently ruled that all amounts received by an employee as damages for an employer's violation of the Age Discrimination in Employment Act of 1967 (ADEA) were taxable (Schleier, 6/14/95). This decision reversed both the Fifth Circuit and a reviewed opinion of the Tax Court. It continues the limitation of the Sec. 104(a)(2) exclusion that the Supreme Court began in Burke, 112 Sup. Ct. 1867 (1992), a sex discrimination case.

Although the Supreme Court in Schleier clarified the taxation of age discrimination damages, the opinion raises questions about the taxation of other types of discrimination damages that CPAs believed were excludible. This topic is important because most employees in the U.S. are covered by one or more of the Federal statutes prohibiting discrimination based on age, sex, race, color, religion, national origin or disability, as well as state antidiscrimination statutes.

Background

Sec. 61(a) taxes all income unless specifically excluded by another section of the Code. Sec. 104(a)(2) excludes from gross income "the amount of any damages received (whether by suit or agreement) on account of personal injuries or sickness." "Personal injury" is not defined in the Code, but Regs. Sec. 1.104-1(c) specifies that the taxpayer's claim must be based on tort or tort-type rights.

Prior to Burke, taxpayers had argued that amouhts received from employers for the violation of discrimination statutes qualified for the Sec. 104(a)(2) exclusion, since discrimination was a tort. These amounts typically included back pay and other damages allowed under the particular discrimination statutes. The Service had maintained that back pay was a contractual claim and thus taxable. However, by 1992, the Tax Court and most appellate courts that had considered the issue accepted the taxpayers' arguments and ruled that all amounts received for the violation of discrimination statutes qualified for the Sec. 104(a)(2) exclusion.

Burke was the first case in which the Supreme Court addressed this issue. The taxpayer in this case had settled a sex discrimination suit under Title VII of the Civil Rights Act of 1964 (CRA), which prohibits employment discrimination based on sex, race, color, religion or national origin. The CRA then in effect only allowed recovery of back pay; it did not allow any other damages or provide for a jury trial. The Court ruled that to qualify as a tort-type claim under Sec. 104(a)(2), the discrimination statute must provide a tort-type remedy, such as a jury trial and compensatory and punitive damages. Compensatory damages include not only reimbursement of actual monetary loss, but damages for emotional distress, pain and suffering, humiliation and other intangible typeg, of injury as well. The Supreme Court held that Burke's back pay was not excludible under Sec. 104(a), since back pay was not a tort-type remedy.

In 1989, Congress amended Sec. 104 to tax punitive damages received in cases "not involving physical injury or physical sickness," effective for suits filed or settlements made after July 10, 1989. In 1991, Congress amended the, CRA by allowing abroad range of compensatory damages, punitive damages and a jury trial in addition to back pay, effective Nov. 21, 1991, for intentional employment discrimination based on sex, race, color, religion, national origin or disability. Although the discrimination involved in Burke preceded the effective date of the amended CRA, the Court noted that "the amended act signals a marked change in its conception of the injury redressable by Title VII."

After Burke, the IRS issued Rev. Rul. 93-88, which held that victims of unlawful gender or racial discrimination could exclude back pay and compensatory damages received pursuant to the amended CRA, since the statute provides the broad range of tort-type remedies which Burke required for the Sec. 104(a)(2) exclusion. Furthermore, the ruling held that the exclusion applied even if the victim of discrimination received only back pay. Rev. Rul. 93-88 also held that payments received pursuant to the Americans With Disability Act satisfied the Burke standard.

The ADEA and the Supreme Court's opinion in Schleier

The ADEA is a Federal statute prohibiting age discrimination in employment against employees aged 40 to 70. Employers that violate the ADEA are liable for back pay and, for willful violations, liquidated damages equal to the back pay. No other damages are allowed. "Willful" in this context means "not merely negligent"; for nonwillful violations, only back pay is available.

Schleier was fired by his employer at the age of 60. He sued under the ADEA and settled for $145,629; half of this amount was attributed to back pay and half to liquidated damages.

The Tax Court ruled that the entire $145,629 was excludible under Sec. 104(a)(2). The court followed its reviewed opinion in Downey, 100 TC 634 (1993), which applied Burke to the ADEA. In Downey, the Tax Court ruled that the ADEA's liquidated damages serve both a compensatory and punitive function. They compensate the victim of age discrimination for "certain nonpecuniary losses" and also deter additional ADEA violations. The court concluded that the ADEA possessed the tort-type remedy scheme required by the Supreme Court in Burke. In an unpublished opinion, the Court of Appeals affirmed.

The Supreme Court began its analysis by focusing on the Sec. 104(a)(2) phrase "on account of personal injuries." The Court gave an example of an automobile accident that resulted in a settlement for lost wages, medical expenses, and pain and suffering. The amounts received for all of these items were excludible since they were received "on account of personal injuries." The accident caused the injury, which in turn caused the lost wages. Thus, back pay for missing work was received on account of personal injury and excludible.

The Court then contrasted the accident in its example with Schleier's ADEA settlement. It stated that age discrimination causes both psychological or personal injury and a loss of wages, but "neither is linked to the other. The amount of back wages recovered is completely independent of the existence or extent of any personal injury." That is, the question "How long did your injury caused by the age discrimination prevent you from working?" does not make sense, but "How long did your injury caused by the automobile accident prevent you from working?" does. The Supreme Court concluded that the back pay was not received "on account of" personal injury.

The Court's focus on this auto accident/ADEA analogy may be too narrow. Back pay for missing work as a result of being fired due to age discrimination is arguably the same as back pay for missing work due to an accident; in both cases the back pay is measured by the time missed. For example, in discrimination cases this would be from the firing date until the settlement date. In any event, the Court appears to be adding a more stringent requirement to Sec. 104(a)(2) based on a subtle distinction and narrow interpretation of "on account of."

The dissent in Schleier maintained that this distinction makes sense only if "personal injury" is restricted to tangible injuries, meaning physical and mental injuries, as distinguished from the economic and stigmatic injuries from illegal discrimination. However, the majority opinion stated that "[section]104(a)(2) encompasses recoveries based on intangible as well as tangible harms." The majority also stated (in footnote 6): "We of course have no doubt that the intangible harms of discrimination can constitute personal injury, and that compensation for such harms may be excludable under [section]104(a)(2)." The dissent found these statements to contradict the majority's ruling that the back pay was not received "on account of" personal injury.

Next, the majority turned to the liquidated damages. Schleier argued that these amounts compensate plaintiffs for personal injuries that are difficult to quantify and thus qualify for the Sec. 104(a)(2) exclusion. The Court rejected this argument, ruling that liquidated damages under the ADEA are punitive in nature because they are awarded only for willful violations. Thus, the ADEA provided for only two of the three remedies that Burke required for an act to be considered a tort-type statute. The Supreme Court ruled that these two factors were insufficient. Because the "primary characteristic" of a tort-type statute was the availability of compensatory damages, and since back pay was economic and liquidated damages were punitive, the ADEA did not allow compensatory damages and was therefore not a tort-type statute.

Conclusion

The Supreme Court concluded Schleier by stating that Sec. 104(a)(2), the regulations and Burke require the taxpayer to prove that he met two independent tests to obtain the exclusion: (1) the taxpayer's damages were received "on account of personal injuries or sickness" and (1) the underlying claim was based on tort-type rights. Although Schleier clarifies the tax status of amounts received under the ADEA for age discrimination and the Burke tort-type statute requirement, it introduces uncertainty concerning other types of discrimination with its narrow interpretation of "on account of personal injury."

In footnote 8 to Schleier, the Supreme Court noted that in Rev. Rul. 93-88, the Service made the same mistake as in Schleier in interpreting Burke to mean that the tort-type requirement was the only requirement for the Sec. 104(a)(2) exclusion. The implication is that Rev. Rul. 93-88 erroneously allows the exclusion by overlooking the "on account of personal injury" requirement.

If the IRS does reconsider Rev. Rul. 93-88, it could either rule that back pay and compensatory damages under tort-type discrimination statutes are taxable or that only the back pay is taxable. A plausible interpretation of Schleier would be that only back pay does not satisfy the "on account of personal injury" requirement. Compensatory damages would seem to satisfy this requirement, since arguably there is no relevant distinction between a recovery for emotional distress, pain and suffering, humiliation, etc., from an auto accident or from discrimination. In both cases, the amounts received appear to be for these injuries. The Supreme Court did not have to rule on this issue in Schleier, since the ADEA did not provide for compensatory damages.

CPAs must advise taxpayers pursuing ADEA claims that all amounts received thereunder are now taxable (which, of course, will be an incentive to hold out for larger settlements). Also, CPAs must watch for any reconsideration of Rev. Rul., 93-88 by the Service. It is probable that the IRS will rule that back pay under tort-type discrimination statutes is taxable. What position the Service will take on the taxation of compensatory damages for the violation of these statutes is uncertain.

From Peter C. Barton, CPA, MBA, J.D., Professor of Accounting, University of Wisconsin-Whitewater, Whitewater, Wisc.