What Schleier and amended s. 104(a)(2) mean to your practice: tax considerations in pleadings and settlement agreements.

The landscape of Internal Revenue Code [sections]104(a)(2), which deals with the taxation of damages received on account of personal injury or sickness, has been radically changed in the past 18 months by two events--the Supreme Court's 1995 decision in Commissioner v. Schleier(1) and the amendments to [sections]104(a)(2) enacted as part of the Small Business Job Protection Act of 1996.(2)

Taken together, Schleier and the legislative amendments have considerably narrowed the scope of the provision. The seeming invitation conveyed until recently by 9104(a)(2) to craft as tax-free virtually all tort-related relief has been withdrawn. In its place is a much more limited provision, one that grants an exclusion from income only to "nonpunitive" damages received "on account of" personal "physical" injury or sickness.

Nonetheless, the new judicial and legislative limits raise both limited opportunities and new issues. In so doing, they provide guidance and underscore the need for considerable care in analyzing personal injury claims, identifying appropriate bases for relief, and drafting pleadings and settlement agreements.

In Schleier, a United Airlines pilot had been fired when he reached the age of 60. He argued that the back pay and liquidated damages received in settlement of a claim under the Age Discrimination in Employment Act (ADEA) were excludable under 9104(a)(2), which at the time did not restrict exclusion to physical injury or sickness.

Reversing a Fifth Circuit court decision in the taxpayer's favor, the Supreme Court emphasized that exclusion under [sections]104(a)(2) requires satisfaction of a two-pronged standard. First, the claim resulting in a damage award or settlement must be tort or tort-type in nature.(3) Second, the damages must be received "on account of a personal injury."

In an earlier decision, United States v. Burke, the Court had addressed the first prong of this standard.(4) It concluded that for an action to be considered tort or tort-type, a broad range of damages must be available to compensate a plaintiff for personal injuries.

In this Title VII sex discrimination case, the Court reasoned that the taxpayers' action was not tort or tort-type because Title VII--which at the time allowed only back pay and equitable relief--did not purport to "recompense a . . . plaintiff for any of the other traditional harms associated with personal injury, such as pain and suffering, emotional distress, harm to reputation, or other consequential damages."(5)

In Schleier, the Court focused on the second prong of the standard, the statutory language "on account of personal injuries." The Court stressed the importance of properly identifying not only the personal injury sustained but also the relationship between that injury and the damages received. The Court concluded that neither the back pay nor the liquidated damages the plaintiff received bore the requisite relationship to a personal injury.

What Is a Personal Injury?

In a key part of the opinion, the Court reasoned that neither attaining the age of 60 nor being discharged from employment on account of age itself constituted a personal injury. Although the Court acknowledged that age discrimination could cause a personal injury, for example, psychological harm, the Court emphasized that the amount of back wages recoverable under the ADEA "is completely independent of the existence or the extent of any personal injury."(6) Because the back wages were not "attributable" to any personal injury, the Court concluded exclusion was not permitted under [sections]104(a)(2).

The Schleier Court found likewise that the necessary relationship did not exist between the liquidated damages and any personal injury that the plaintiff might have suffered. According to the Court, ADEA liquidated damages are like punitive damages, intended to punish an employer for egregious conduct rather than compensate the employee. As such, the liquidated damages were not awarded "on account of" any personal injury.

The Court contrasted an ADEA action to a personal injury action brought by someone injured in a car accident. As a result of the accident, the person "suffer[ed] (a) medical expenses, (b) lost wages, and (c) pain, suffering, and emotional distress that cannot be measured with precision."(7)

The Court also noted that settlement amounts for lost wages, as well as amounts for medical expenses and pain and suffering, would be excludable "no' simply because the taxpayer received a tort settlement, but rather because each element of the settlement satisfied the [sections]104(a)(2) requirement, i.e., the dam ages were received `on account of personal injuries or sickness.'"(8)

The Schleier Court interpreted the "on account of" language far more narrowly than the Tax Court and a number of circuit courts had.(9) The Court's approach indicates that the statutory language creates a causation standard, but the Court declined to interpret it as a "but for causation standard--that is, one asking whether the taxpayer would have received the damages if, in fact, there had not been a personal injury.

Instead, the Court appears to have adopted a "sufficient causation" standard, one that essentially requires that the taxpayer show the damages received are intended to compensate for a personal injury and any direct consequences of that injury, for example, lost wages because of an inability to work.(l0)

In addition to emphasizing the close relationship that must exist between the damages received and a personal injury, the Court subtly suggested that more careful attention must be paid to identifying the alleged injury. As previously noted, the Court emphasized that the mere act of discharging someone on account of age--and presumably on account of sex, or race, or national origin--in and of itself does not constitute a personal injury. Rather, the employer's action may cause a personal injury.

This interpretation of "personal injury" thus departed from the broad standard the Tax Court had announced in Threlkeld v. Commissioner(11) that a personal injury consists of "any invasion of right" granted by virtue of being a person in the eyes of the law. The significance of this departure, however, has been reduced by the "physical" injury requirement added by the 1996 legislation. The Schleier Court's message seemed to be that personal injury will not be assumed merely because an employer has violated a law such as Title VII, the ADEA, or the Americans with Disabilities Act (ADA).

Although the Schleier debate, involving the tax treatment of employment discrimination damages not involving physical injury, would now be mooted by the 1996 statutory changes, Schleier nonetheless still offers a road map indicating the route to excludability under [sections]104(a)(2). As will be discussed below, trial attorneys drafting pleadings, settlement agreements, and related documents such as demand letters ought to draft them with an eye toward satisfying the requirements of [sections]104(a)(2), both as amended and as interpreted by Schleier.

Amendments

The 1996 amendments to [sections]104(a)(2) had two main purposes: first, to eliminate the exclusion for damages received on account of nonphysical injury or sickness, and, second, to establish that, subject to a limited exception, punitive damages are not excludable regardless of whether they are received in connection with a physical injury. As amended, the statute now provides that gross income does not include:

(2) the amount of any damages

(other than punitive damages)

received . . . on account of

personal physical injuries or

physical sickness.... For purposes

of paragraph (2), emotional

distress shall not be treated as a

physical injury or physical

sickness. The preceding sentence

shall not apply to an amount of

damages not in excess of the

amount paid for medical care

(described in subparagraph (A) or

(B) of [section]213(d)(1) attributable to

emotional distress.

The conference report echoes the plain language of the statute by declaring that the exclusion does not apply to punitive damages whether or not related to physical injury or sickness. (Prior law had been dear that punitive damages not involving physical injury or sickness enjoyed no exclusion, but uncertainty existed where the punitive damages involved physical injury or sickness.)

Under the 1996 amendments, moreover, prior law continues to apply to a limited category of punitive damages, namely to punitive damages received in a wrongful death action if the "applicable state law (as in effect on September 13, 1995, and without regard to any modification after such date) provides . . . that only punitive damages may be awarded in such an action."(12)

The more controversial aspect of the 1996 amendments is the restriction of the exclusion to "physical" injury or sickness, along with the explicit direction that "emotional distress" is not to be treated--save only for a taxpayer's related medical care expenses--as a physical injury or sickness. It seems obvious that discrimination claims were the principle target of these provisions and that recoveries under these claims are intended to be taxable.

Furthermore, the conference report appears to anticipate an argument that a nonphysical injury--for example, one arising out of employment discrimination--may sometimes produce physical manifestations in the victim. To sort this out, the conference report appears to rely on "origin-of-the-claim" notions, in conjunction with the rule that emotional distress, a statutorily undefined term, is not a physical injury or sickness. Thus, the report provides that

if an action has its origin in a

physical injury or physical

sickness, then all damages (other

than punitive damages) that flow

therefrom are treated as payments

received on account of physical

injury or physical sickness

whether or not the recipient of the

damages is the injured party. For

example, damages (other than

punitive damages) received by an

individual on account of a claim

for loss of consortium due to the

physical injury or physical

sickness of such individual's

spouse are excludable from gross

income.(13)

The report goes on to note that since emotional distress is not a physical injury or physical sickness,

the exclusion from gross income

does not apply to any damages

received (other than for medical

expenses . . .) based on a claim of

employment discrimination or

injury to reputation accompanied

by a claim of emotional distress ....

[T]he exclusion ... applies to any

damages received based on a

claim of emotional distress that is

attributable to a physical injury or

physical sickness."(14)

Emotional distress, according to the report, is intended to include "physical symptoms (e.g., insomnia, headaches, stomach disorders) which may result from such emotional distress."(15)

The 1996 amendments, as they are filtered through the conference report, thus place enormous weight on whether the "origin" of a claim lies in a physical injury and deny this all-important physical injury status to a significant, but undefined, range of physical "symptoms" grouped under the term "emotional distress." In light of Schleier and these amendments, how should the trial lawyer approach the new playing field of [sections]104(a)(2) in drafting pleadings and negotiating settlements?

Pleading the Case

The case law has long emphasized the role of pleadings in determining the applicability of [sections]104(a)(2)(16) With respect to pleadings, Schleier and the recent amendments to [sections]104(a)(2) indicate that it is incumbent on counsel to plead an action that sounds in tort, identify specifically the physical injuries suffered and their consequences, and establish the requisite relationship between the damages sought and physical injuries alleged.

* Tort or tort-type requirement. In light of Burke, counsel must carefully evaluate the kinds of remedies available for any contemplated cause of action. The amendments to [sections]104(a)(2) may have simplified this matter by limiting the exclusion to those damages resulting from an action that had its origin in a physical injury.

With physical injury as a focus, trial attorneys will presumably include in their pleadings claims based on traditional tort theories such as battery and negligence, ensuring the requirement is satisfied.

* Physical injury. The second requirement for exclusion is the identification of specific physical injuries and the damages that flow from those injuries. The amendments and the conference report indicate the importance of establishing that one's claim has its origin in a physical injury.(17)

As previously noted, however, the amended statute permits the exclusion of all medical expenses paid, even without a showing of a physical injury other than emotional distress and the physical manifestations thereof. These points become critical in drafting pleadings. Consider the following two hypothetical situations:

Situation A: Boss continually invites Secretary on dates and makes suggestive comments about her attire. Secretary refuses Boss's advances and warns him that she will report him to the company's management. Boss subsequently fires Secretary. Secretary can establish that she has suffered significant emotional distress as a result of Boss's action and has incurred expense for both medical and psychological care associated with her emotional distress problems.

Situation B: Assume all the facts of Situation A and, in addition, that the day before the Boss fired Secretary an incident occurred in which Boss walked up behind Secretary and began rubbing her shoulders and fondling her. Enraged by Boss's conduct, Secretary left the office and did not return to work that day. Fearing that Secretary might report him, Boss fired her the next day.

In Situation A, no exclusion exists for any damages received on account of Secretary's emotional distress and its consequences except for medical expenses. Given the continuing exclusion for medical care expenses, however, the attorney representing Secretary in Situation A should emphasize in the pleadings (and negotiation settlements) Secretary's past and ongoing medical care expenses related to emotional distress.

By contrast, in Situation B, the attorney may presumably craft a claim for relief that has its origin in a physical injury, that is, the illegal physical contact.(18) To the extent that Secretary's attorney can establish that the offensive touching resulted in Secretary's emotional distress, all damages for the physical contact and resulting emotional distress are excludable. Under these circumstances, it is imperative that the pleadings specify that Secretary's emotional distress problems were a consequence of the illegal physical contact.

Given the potential for radically different tax consequences between Situations A and B as a result of the physical injury requirement, one would expect thorough trial attorneys to search for and occasionally find a plausible physical injury that their discrimination clients have also sustained. In this regard, trial attorneys must be mindful of their professional responsibilities, including their responsibilities to the courts, and not be persuaded by clients to fabricate physical injury claims or otherwise distort their cause of action to bring any possible settlement or award within the parameters of [sections]104(a)(2)

* Requisite link. Having pleaded with some specificity the physical injuries sustained by the plaintiff and their consequences, counsel must draft the pleadings so as to establish the necessary link between the damages sought and the personal injuries alleged. In many cases, this will be easily accomplished. For example, in a case in which the plaintiff has suffered a physical injury and resulting psychological problems, the pleadings will say that the damages sought are intended to compensate the plaintiff for those specific conditions.

The more difficult challenge will arise with respect to economic damages, for example, lost wages. As suggested by the Schleier Court in its car crash hypothetical, exclusion applies if the wages were lost as a consequence of plaintiff's inability to work because of injuries from the collision.

By contrast, the lost wages (back pay) in Schleier were not causally linked or "attributable" to any personal injury but were caused by the act of discrimination itself.

In drafting pleadings, counsel seeking damages for economic loss should therefore specify the causal connection between the physical injury and the economic losses.

In some cases, however, that link may be difficult to establish. Consider, for example, Situation B above and assume that part of the award is for the economic loss (lost income) suffered by Secretary because of being fired. Is the lost income a damage flowing from the physical injury? Perhaps. If the taxpayer cannot work because of the psychological injury that has been sustained, the necessary causal link that Schleier requires would seem to exist.

By contrast, however, if the economic loss is a function of Secretary not being able to find a job and merely compensates her for the income she would have received had she not been illegally fired, there does not appear to be causal link to the physical injury. The importance of careful factual development and drafting is obvious.

Allocating Settlements

Like pleadings, settlement agreements involve many of the same concerns and must be carefully crafted. In Rickel v. Commissioner, the Tax Court outlined the basis for evaluating whether a settlement was for a personal injury and therefore excludable under [sections]104(a)(2).(19) The Rickel standard applies equally in evaluating settlements under amended [sections]104(a)(2). The Tax Court stated that it would look first to the terms of the settlement agreement and ultimately to the payer's intent.(20)

Again, from a tax standpoint, an understanding of Burke, Schleier, and the amendments to [sections]104(a)(2) is critical to effective settlement negotiations. Given Burke, any settlement award must be related to an action sounding in tort. Thus, from the plaintiff's vantage point, the focus in the settlement agreement should be on the tort or tort-type claims rather than those based on contract.

In view of Schleier and the amendments to [sections]104(a)(2), the plaintiff will obviously want most if not all of the settlement allocated to pain and suffering, medical care costs, and lost wages directly resulting from the physical injury rather than to punitive damages or other damages not directly linked to the physical injury, for example, back pay.

As suggested by the analysis of Situation A above, many victims of employment discrimination, sexual harassment, and other illegal acts will be required to include their recoveries in income for federal (and, likely, state) income tax purposes. Trial lawyers should give careful attention to structuring settlements so that the income element is spread over a number of tax years rather than subjected to tax in the current year.

This arrangement may also be to a plaintiff's advantage in that the tortfeasor should be willing to pay more depending on the length of the term over which the settlement is payable. Careful attention, however, must be paid to structuring the payout to avoid the plaintiff being deemed in constructive receipt of the entire settlement amount.

As in the case of pleadings, a strong incentive exists for framing the settlement agreement in a manner that if respected would ensure the benefits of [sections]104(a)(2). Schleier suggests that allocation of awards will be necessary in appropriate cases.

For example, in Situation B above, assume that Secretary's attorney succeeds in negotiating a recovery compensating Secretary for (a) the illegal physical contact, resulting emotional distress, and related medical care costs and (b) lost income resulting from her firing and her inability to locate comparable employment (as opposed to being a consequence of the physical injury).

Under a Schleier analysis, one would assume that the amounts received as compensation for the physical and psychological injuries and related medical costs would be excludable under [sections]104(a)(2). Presumably, the lost income would not be excludable since it is not attributable to the physical injury. An incentive thus exists for plaintiff's counsel to attribute the entire award or settlement to the physical injury and the resulting damages with nothing to lost income.

Clearly, the IRS, as it demonstrated in McKay v. Commissioner,(21) Robinson v. Commissioner,(22) and Bagley v. Commissioner,(23) is prepared to dispute allocations resulting from settlement negotiations that are not arms-length. Establishing the arms-length nature of allocations, however, may be quite difficult.

In the typical case, the payer, unlike the payee, will be indifferent to the settlement allocation.(24) Usually an employer or business, the payer in these cases may generally deduct the entire settlement amount regardless of how it is allocated between personal and nonpersonal injuries. Trial attorneys should therefore assume that the IRS will carefully scrutinize any allocations the parties agree to. Under the circumstances presented in Situation A, one would expect the IRS to challenge the allocation and insist that some, if not most, of the settlement be allocated to lost income.(25)

One can easily imagine the enormous difficulty associated with allocating settlements in situations in which multiple claims for relief are alleged. In its amicus curiae brief in Schleier, the Equal Employment Advisory Council, arguing in favor of excluding ADEA awards, posited a hypothetical in which the plaintiff in an employment discrimination case is a disabled, 55-year-old African American woman.(26) The brief notes that "there are at least four causes of action to which the settlement could be allocated: ADEA, ADA, Title VII, and [sections]1981, not to mention state statutory and tort claims that may offer other remedies."(27)

Moreover, "even if the parties undergo extensive discovery of the facts, it often will be impossible to unravel this 'bundle' of rights in order to place a separate value upon each specific claim the plaintiff might have asserted in the charge or complaint."(28)

The brief argues that the IRS is illequipped to conduct allocation investigations and the very threat of such investigations will distort, if not chill, the negotiation process.(29) Those concerns seem well-founded.

Allocation of settlement amounts may require more than a careful weighing of the relative strength of different claims. For example, in McKay, the defendant's desire to avoid admitting Racketeer Influenced and Corrupt Organizations Act violations resulted in its agreeing to compensate the taxpayer on certain claims for relief and not others.

Presumably, it will be quite difficult for the IRS to determine when a defendant's stated concerns are genuine and when they merely represent accommodation of a plaintiff.(30) In addition, because the parties will want some certainty regarding tax treatment, the threat of the IRS challenging the allocations in cases involving multiple claims may so distort the settlement negotiation process that one or both parties may insist on going to trial.

In any event, a close reading of McKay, Robinson, and Bagley reveals that a settlement allocation is most likely to be respected if plaintiff's counsel:

1. allocates the settlement consistent with the relative strengths of the claims pleaded and the jury award, if any;

2. documents the adversarial nature of the negotiations, emphasizing the stakes, including nontax considerations, that both parties have in the allocation;

3. specifies in the settlement agreement the allocations the parties agreed to; and

4. identifies in the agreement any claim for which no compensation is provided and documents the reasons.

There is a decided irony in the fact that the amendments to [sections]104(a)(2) are part of a bill intended to reduce the tax barriers that hinder small U.S. businesses from growing and creating jobs. One would expect that a bill with this purpose would seek to reduce the amount of litigation, encourage negotiations, and lessen the litigation costs of small businesses. It is doubtful those ends will be accomplished. Indeed, the contrary results seem probable.

Considering that a broad range of settlements excludable under prior law will now be includable in gross income, negotiated settlements of employment discrimination cases will likely be fewer, the number of cases will probably not decrease, and amounts demanded and ultimately recovered by injured employees may be greater than ever. Victims of employment discrimination, recognizing that they will likely be subject to both federal and state income taxes on their recoveries in addition to standard attorney fees,(31) may seek larger recoveries and be unwilling to settle cases at levels common under the prior law.

The good news for the trial bar may well be that rather than attorneys being maligned for taking 30 percent to 40 percent of a recovery as fees, the government will be viewed as the culprit as the combined federal and state income tax burden on certain recoveries approaches or exceeds 50 percent. One suspects that after experiencing this aspect of the protection afforded small businesses under this act, the businesses themselves will ask Congress to return them to the "good old days."

Notes

(1) 115 S. Ct. 2159 (1995) (2) Small Business Job Protection Act of 1996 Pub. L. No. 104-188, 110 Stat. 1755 (1996). (3) Compensation for Injury or Sickness, 26 C.F.R [sections]1.104-1(c) (1996), interpreting [sections]104(a)(2) provides: "The term 'damages received . . .' means an amount received . . . through 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." (4) 504 U.S. 229 (1992). (5) Id. at 239. (6) 115 S. Ct. 2159, 2164. The Supreme Court's conclusion is buttressed by a range of nontax decisions holding that the ADEA does not allow introducing evidence of personal injury See, e g., Pfeiffer v. Essex Wire Corp., 682 F.2d 684, 688, cert. denied, 459 U.S. 1039 (1982). Thus, presumably, an ADEA plaintiff would be entitled to back wages even without a personal injury. (7) 115 S. Ct. 2159, 2164. (8) Id . (9) See, e.g., Rickel v. Commissioner, 92 T.C. 510 (1989), aff'd in part and rev'd in part, 900 F.2d 655 (3d Cir. 1990), Pistillo v. Commissioner, 57 T.C.M. (CCH) 874 (1989), rev'd, 912 F.2d 145 (6th Cir. 1990). (10) .See, e.g., Commissioner v. Miller, 914 F.2d 586 589, 590 (4th Cir. 1990). Applying this sufficient causation standard, the circuit court held that punitive damages were not excludable because the fact that "a plaintiff seeking punitive damages has to show egregious conduct by the defendant indicates that plaintiff's injury was not a sufficient cause of the punitive damages." (11) 87 T.C. 1294, 1308 (1986), aff'd, 848 F.2d 81 (6th CIL 1988). (12) Small Business Job Protection Act of 1996, [sections]1605. (13) Conference Report on Small Business Job Protection Act of 1996 (H.R 3448), at 142, 143. (14) Id. at 143. (15) Id. (16) See, e,g., Knuckles v. Commissioner, T.C. Memo 1964-33, aff'd, 349 F.2d 610 (10th Cir. 1965) (taxpayer pleads breach of contract and only after settlement claims a personal injury). In the Rickel case, the Tax Court noted, "Similarly, in the context of a suit, if the trier of fact does not indicate the basis on which an award was made, it is necessary to examine the allegations contained in the taxpayer's complaint, the evidence presented, and the arguments made in the earlier court proceeding to ascertain the true nature of the damages." 92 T.C. 510, 516. (17) In standard injury cases (e.g., car accidents), this requirement will not present a problem. It becomes a huge, but not necessarily insurmountable, obstacle in cases involving intangible personal harms such as discrimination. (18) The amendments leave "physical injury" and "physical sickness" undefined. Their interpretation is judicially and administratively open. For example, will all, including minimal, physical contacts support a claim for excluding settlement proceeds? The terms are central to the new 9104(a)(2), and definitional limitations will be significant. (19) 92 T.C. 510. (20) Id. at 516. (21) 102 T.C. 465 (1994). Following a substantial jury award, the parties settled. Seventy-five percent was allocated to the plaintiff's wrongful discharge claim and the balance to his contract claims. The court rejected the IRS's challenge to the allocation, emphasizing the adversarial nature of negotiations. (22) 102 T.C. 116 (1994), aff'd in part and rev'd in part, 70 F.3d 34 (5th Cir. 1995). The court rejected the plaintiffs' allocation of 95 percent of a large settlement to certain personal injury claims in an action against a bank for failing to release a lien on taxpayers' properly. (23) 105 T.C. 396 (1995). The agreement in this case allocated the entire settlement to actual personal injuries and none to punitive damages. The court rejected the allocation. (24) Interestingly, some incentive may exist for the employer in Situation B who does not want to pay the employment taxes on amounts characterized as back pay or lost income. (25) In both Robinson and Bagley, the IRS emphasized chat allocations must reflect the merits of a case and suggested it would weigh the evidence in each case to determine if allocations were appropriate. The Tax Court in both cases adopted the IRS's approach. (26) Amicus curiae brief of the Equal Employment Advisory Council in Support of Respondents, at 20. (27) Id. (28) Id. (29) Id. at 20, 21. (30) Another instructive case in which the court respected a specific allocation in a settlement agreement is v. Commissioner, T.C.M. (CCH) 409 (1987). The settlement agreement, entered into after a jury verdict, provided chat none of the settlement constituted prejudgment interest. The court concluded it was not unreasonable for the parties to negotiate a settlement chat did not include interest. (31) To the extent chat the recovery is includable in income, the plaintiff will be enticed to claim a deduction for attorney fees.

J. Martin Burke is a professor of law at the University of Montana. Michael K.. Friel is a professor of law at the University of Florida.