Taxability of damage awards for sex/gender discrimination.

The Small Business Job Protection Act of 1996 (SBJPA) made significant changes to the Code exclusion-from-income provisions for damage awards resulting from personal physical injury or physical sickness claims. The SBJPA made two amendments that affected Sec. 104(a)(2). The exclusion for punitive damages was eliminated, even if the damages are paid as a result of a personal physical injury or physical sickness. (This was not the case under prior law.) Further, the SBJPA specifies that emotional distress is not intended to be defined as a personal physical injury or sickness. The result is that damages awarded in cases originating from gender discrimination suits will no longer be excludible from income.

While the SBJPA cleared up some of the confusion surrounding the proper treatment of damage awards received under a variety of circumstances and issues, it may have also created new issues and conflicts. For instance, it appears that the treatment of damage awards associated with age discrimination and wrongful employment issues may have been settled, while issues dealing with damage awards and settlements for emotional distress have been made more complicated.

Types of Awards

Several types of judgments are associated with legal actions giving rise to damages, including compensatory damages, punitive damages and prejudgment interest; also included are damages for pain and suffering, loss of consortium, back pay, payments for emotional distress and for lost wages or profits. To be eligible for exclusion from income, damages must be sought through some legal action, giving rise to a tort or tort-like claim. This definition has been the focal point for damages arising from gender discrimination lawsuits. The focus is on determining the nature of the underlying action that results in a claim.

In general, damage amounts fall into two or three classifications with a specific intent behind the settlement feature. Damages for lost wages or profits (or amounts received as back pay) are generally categorized as compensatory in nature. Compensatory damages are amounts received arising out of tort or tort-like claims and may be pursued under the applicable legal statutes (such as the Age Discrimination in Employment Act or Title VII of the Civil Rights Act of 1964 and 1991, as amended (CRA)).

Compensatory damages include damages for physical injuries, emotional distress and physical sickness. Likewise, damage amounts received for loss of consortium or for medical payments related to physical injury or sickness are also considered compensatory in nature. Amounts awarded to punish or that serve to prevent future behavior are generally punitive-type damages and are not received as a result of tort or tort-like claims. Punitive damages are more economic than personal in nature.

Title VII under the CRA provides for damages arising from gender or racial discrimination acts or both, as defined therein. Amendments adopted in 1991 provide for other remedies, including punitive damages and awards for pain and suffering (i.e., emotional distress). Under other similar statutes, damages include amounts awarded for wrongful termination, breach of contract and severance pay. Damage awards may also be paid as a result of actions brought for libel, slander and defamation of character, involving personal and professional reputation (which have been considered personal injuries in the past), Remedies for personal injury affecting personal reputation could include damages for emotional distress resulting from personal humiliation and shame. In general, the taxability of damages received is related to the underlying nature of the item for which the damages are paid.

Controversy of Damage Awards and Excludibility

Current law seemingly makes clear what is and is not excludible from income by specifically addressing punitive damages (no longer excludible) and by modifying the language in the Code that denies exclusion of damages received (except in cases that arise from only personal physical injury or physical sickness).

However, a close reading of the SBJPA Committee Reports reveals that damages received for emotional distress, when awarded as a result of an action originating from a personal physical injury or personal physical sickness, should still be excludible. Therefore, a plausible argument can be made that a damage award based on emotional distress is still an area in which the law may be challenged. Even though the SBJPA committee reports show clear intent that damage awards for emotional distress are not to be excluded, the symptoms of emotional distress take on physical characteristics (such as headache and nausea). Sec. 104(a) states that damages received (not in excess of amounts paid for medical care) attributable to emotional distress are excludible. In addition, damages received for emotional distress as a direct result of a personal physical injury or personal physical sickness are fully excludible. (Note: Currently, there is a proposal in the House (H.R. 1923) to restore the income exclusion for damage awards for emotional distress.)

Damage awards received for emotional distress (such as pain and suffering) have been held to be excludible from income in the past. This is so partly because of the interpretation of the specific wording of the statute prior to the SBJPA and partly because different courts have imposed different interpretations on the meaning of personal injury and sickness. Contributing to this confusion is the variance in court decisions about how damage awards for emotional distress are categorized. Some courts hold that damages associated with emotional distress are clearly personal in nature and, therefore, excludible, while others look only to the underlying cause of the action giving rise to settlement damages (and not the nature of the payment).

The courts reason that, if the cause of action is personal in nature, damages awarded for such claims (including punitive damages) are excludible from income. However, over time, the focus shifted to whether or not certain punitive damages should be excluded from income. Before any damage awards can be excludible from income, they first must result from a tort or tort-like action. Further, the remedies for such claims must be specifically provided for in an applicable statute (for gender discrimination, the CRA) and must be compensatory in nature (as opposed to punitive).

Two tests for determining the applicability of the exclusion have been established. The first asks if the underlying cause of action leading to an award is the result of a tort or tort-like claim; the second test asks if the damages awarded are "on account of a personal injury or sickness." Both tests must be met for damages to be excluded. The reasoning goes to whether the damages are punitive in nature. If punitive, they could not, by definition, be personal in nature and, therefore, not due to personal injury or sickness. Current law changes the focus from looking to the nature of the settlement award to focusing on the nature of the underlying claim to determine if the award is excludible.

Current law denies exclusion for damage awards based on gender discrimination, because such discrimination does not embody personal injury or sickness, such damage awards do not stem from tort or tort-like claims, and the award itself does not compensate for personal injury. Even punitive damage awards for emotional distress are not excludible; punitive damages do not compensate injury, but are private fines designed to punish reprehensible conduct and act as a deterrent of future similar behavior.

Structure and Settlement Issues/Future Implications

It is clear from the history of damage awards that how amounts paid are defined or stated in a settlement agreement goes a long way in determining whether they are taxable. Potential tax planning positions may hinge on how well tax advisers craft settlements. For instance, proper tax treatment depends on whether structured settlements include compensatory (and not punitive) damages; these settlements should be structured, to the extent possible, so that the highest amount possible can be allocated to compensatory damages.

To the extent that specific statutes limit compensatory amounts and amounts considered punitive, only limited tax planning is possible. However, out-of-court settlements might be structured so that the taxpayer can gain maximum advantage. One would want to carefully consider the language and structure of the settlement terms (to the extent possible). Clearly, settlement awards from a personal physical injury or sickness should be structured so that the largest amounts possible fall under the category of compensatory damages. This would also apply to medical payments specifically associated with any emotional distress arising from a physical injury.

Damage awards received for gender discrimination will be fully taxable to the recipient, unless it can be shown that certain amounts are reimbursements resulting from physical injury or physical illness (such as medical payments for emotional distress). This is without regard to whether the payment is compensatory or punitive in nature. Only damage awards or structured settlements that include amounts designated for emotional distress are open to debate as to whether they will be taxable.

Conclusion

Currently, most gender discrimination settlements or awards are fully taxable, including damages awarded for emotional distress and punitive damages. With Congress contemplating changing this law in the future, it is important for CPAs to be keenly aware of current legal positions when advising clients as to the taxability of awards and settlements in gender discrimination cases.

FROM ARTHUR D. CASSILL, PH.D., CPA, ASSOCIATE PROFESSOR OF ACCOUNTING, UNIVERSITY OF NORTH CAROLINA AT GREENSBORO, GREENSBORO, NC, AND RHONDA SUGARMAN, MS, CPA, PRODUCT DEVELOPMENT MANAGER, AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS, JERSEY CITY, NJ (NEITHER ASSOCIATED WITH BDO SEIDMAN)