Tax aspects of personal injury awards.

A new law says punitive damages and nonphysical injury awards are taxable.

Congress has finally ended years of litigation concerning the taxability of punitive damages and damages for nonphysical injuries such as gender and age discrimination. The Small Business Job Protection Act (SBJPA) that President Clinton signed into law on August 20, 1996, includes rules regarding the Internal Revenue Code section 104 exclusion from income of awards received for injuries. Under the new provisions, punitive damages-- whether or not related to physical injury--cannot be excluded from gross income. Awards for nonphysical injuries are excludable only to the extent of amounts paid for medical care that are attributable to emotional distress. (A glossary appears on page 40.)

CPAs with clients involved in injury litigation need to be aware of how these awards are taxed. Accountants for companies involved in these lawsuits also need to be aware of how awards are taxed so they can withhold the appropriate taxes from the settlements they pay.

THE WAY IT WAS

To better understand the changes the SBJPA made and the situations to which they apply, it's important for CPAs to be aware of the confusion that led Congress to propose new rules, including some of the court decisions that highlighted the need for clarification.

Before IRC section 104(a)(2) was amended by the SBJPA, damages received as a result of personal injury or sickness were excluded from gross income. (Damages received is defined by regulations section 1.104.-1(c) as amounts received through prosecution of a legal suit or action based on tort or tort-type rights or through a settlement agreement entered into instead of filing suit.) This seemingly straight-forward provision has met with several Internal Revenue Service challenges in recent years involving awards for lost wages, punitive damages, damages to reputation and gender, race and age discrimination.

Similarly, the tax treatment of punitive damages for nonphysical injury was a matter of litigation until the Revenue Reconciliation Act of 1989. For taxable years ending after July 10, 1989, only punitive damages for personal injury recoveries involving physical injury or sickness were excludable from income.

One area where taxpayers had some success in excluding damages was gender discrimination. However, in United States v. Burke (92-1 USTC P50,254), the U.S. Supreme Court reversed the Sixth Circuit Court of Appeals, holding that amounts received for gender discrimination under Title VII could not be excluded under section 104(a)(2).

Exclusion for age discrimination awards also met with differing results in the courts. In Commissioner v. Downey (94-2 USTC P50,441), the Seventh Circuit Court of Appeals held that amounts received for age discrimination were not excludable from gross income. In Schmitz v. Commissioner (94-2 USTC P50,455), the Ninth Circuit Court of Appeals held that damages received in settlement of an Age Discrimination in Employment Act of 1967 (ADEA) lawsuit were excludable from gross income.

The excludability of age discrimination awards reached the U.S. Supreme Court with the Schleier case (95-1 USTC P50,309). Under established policies, United Airlines fired Erich Schleier when he reached age 60. Schleier filed a complaint in federal district court alleging that his termination violated the ADEA, which generally made it unlawful for an employer to discharge anyone between the ages of 40 and 70 because of age. After lengthy litigation, the parties reached a settlement. Schleier received a substantial award, half attributable to "back pay" and the balance to "liquidated damages." The Tax Court and the Fifth Circuit Court of Appeals held that Schleier's settlement was excludable from gross income under section 104(a)(2).

Because the appeals courts had reached inconsistent conclusions about the taxability of ADEA recoveries, the Supreme Court agreed to hear the Schleier case. Relying on "the plain language of section 104(a)," the text of the regulation implementing that section and the Court's own reasoning in Burke, the Court decided that a recovery under ADEA was not excludable from gross income. In a split decision, the Supreme Court held that both back pay and liquidated damages received under ADEA were includable in income. The Court said a taxpayer must meet two independent requirements before a recovery could be excluded under section 104(a)(2): (1) the underlying cause of action giving rise to the recovery must be based on tort or tort-type rights and (2) the damages must have been received on account of personal injury or sickness. The majority said Schleier failed both tests.

As originally issued, revenue ruling 93-88 (1993-2 C.B. 61) said compensatory damages and back pay recoveries were excludable from gross income as damages for personal injury under section 104(a)(2) when received for gender discrimination claims, racial discrimination claims and disability claims in some cases. However, in light of the Supreme Court's Schleier decision, the IRS suspended revenue ruling 93-88 in August 1995 (Notice 95-45, 1995-2 C.B.330) and asked for public comments.

After these decisions and the withdrawal of revenue ruling 93-88, there was little hope that awards for nonphysical injuries would be excludable from income. Congress's enactment of the new' law was a mere formality.

WHAT THE NEW LAW DOES

Under the new law, certain amounts are now included in gross income.

* Punitive damages received on account of personal injury or sickness whether or not related to a physical injury, or physical sickness. (See below for certain punitive damages received in a wrongful death action.)

Example. John Smith was awarded $500.000 for physical injuries received in an industrial accident in bas employer's plant. Half of the award was for his actual physical injuries and the remainder was punitive as a result of repeated unsafe working conditions in the plant. Smith must include the punitive portion of the award in his gross income but would exclude the $250,000 payment for actual physical injuries.

* Damage recoveries for nonphysical injuries. The new law says the exclusion from gross income applies only to damages received on account of a personal physical injury or physical sickness. Emotional distress is not considered a physical injury or physical sickness. Thus, damages received (other than for medical expenses, as discussed below) based on an employment discrimination claim or injury to reputation accompanied by a claim of emotional distress must be included in income.

Example. Mary Jones was awarded $50,000 for sexual harassment by her employer. The entire award was for pain and suffering. Since the payment was for a nonphysical injury, the entire amount would be included in her gross income.

The new law also provides that certain amounts are now excluded from gross income, including

* Nonpunitive damages received on account of physical injury or physical sickness.

Example. Sarah Gordon was awarded $100,000 for physical injuries received in an automobile accident while making a sales call for her employer. The entire award was for the actual physical injuries she suffered and therefore would be excluded from gross income.

* Nonpunitive damages for emotional distress and other nonphysical injuries or sickness to the extent attributable to a physical injury or sickness.

Example. Harold and Karen Brown were awarded $500,000 for physical injuries Harold received in an industrial accident in his employer's plant. Half of the award was for his actual physical injuries. The remainder was for Karen's loss of consortium with her husband resulting from his injuries. (Loss of consortium is the loss of society, affection, assistance and conjugal fellowship.) The entire award would be excluded from the Brown's gross income because the action had its origin in a physical injury.

* Nonpunitive damages for nonphysical injuries to the extent of the amount paid for medical care attributable to emotional distress.

Example. Judy Allen was awarded $75,000 for sexual harassment by her employer. Of that amount, $50,000 was for pain and suffering and $25,000 was for medical expenses resulting from treatment of the emotional distress caused by the harassment. The $25,000 payment for medical expenses would be excluded from Allen's gross income; she must include the remaining $50,000 for pain and suffering in income.

Wrongful death actions. Prior law continues to apply to punitive damages received in a wrongful death action if the applicable state law in effect on September 13, 1995 (the date the personal injury bill was first presented to the House Ways and Means Committee), provides--or has been construed to provide by a court decision issued on or before that date--that only punitive damages may be awarded in a wrongful death action.

Effective date. The new law generally applies to amounts received after the date of the enactment, August 20, 1996, in taxable years ending after that date. Prior law applies to amounts received under a written binding agreement, court decree or mediation award in effect on (or issued on or before) September/3, 1995.

A SIMPLER LAW

After years of costly litigation, Congress has simplified the laws relating to punitive damages and to awards for nonphysical damages such as age or gender discrimination. Although the new- rules produce the same basic result as recent court decisions, the incentive for litigation should be substantially reduced, saving participants considerable money in unnecessary legal fees.

EXECUTIVE SUMMARY

* THE SMALL BUSINESS JOB PROTECTION Act, signed by President Clinton on August 20, 1996, ended years of litigation concerning the taxability of punitive damages and damages for nonphysical injuries such as gender and age discrimination.

* UNDER THE ACT, PUNITIVE DAMAGES-- whether or not related to physical injury--are not excludable from gross income. Awards for nonphysical injuries are excludable only to the extent of amounts paid for medical care attributable to emotional distress.

* UNDER PRIOR LAW, damages received as a result of personal injury or sickness were not included in gross income. This provision had been challenged by the Internal Revenue Service in recent years when the awards were for lost wages, punitive damages, damages to reputation and gender, race and age discrimination.

* THE NEW LAW GENERALLY APPLIES TO amounts received after the date of enactment, August 20, 1996, in taxable years ending after that date. Prior law applies to amounts received under a written binding agreement, court decree or mediation award in effect on (or issued on or before) September 13, 1995.

DALE R. PULLIAM, CPA, PhD, is a professor of accounting at West Texas A&M University at Canyon, Texas. J. KATHLEEN ANDERSON is a graduate student at West Texas A&M University She is a staff accountant for Seagull Midcon Corporation in Amarillo, Texas. DARLENE A. SMITH, CPA, PhD, is an associate professor of accounting at the University of Tulsa at Tulsa, Oklahoma.

Glossary

Damages. Monetary compensation for a loss or damage.

Nonphysical injury. Mental distress, fright or emotional disturbance. In the context of this legislation, congressional committee reports specifically refer to emotional distress, including the physical symptoms resulting from such distress, and to employment discrimination or injury to reputation accompanied by a claim of emotional distress.

Nonpunitive damages. Compensatory or actual damages that compensate an injured party for the injury sustained and that make good or replace the loss caused by the wrong or injury.

Physical injury. Bodily harm or hurt, excluding mental distress, fright or emotional disturbance.

Punitive damages. Damages awarded over and above the amount necessary to compensate an injured party for the actual loss. Damages awarded as punishment for willful, malicious or fraudulent behavior.