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Back pay to settle discrimination claim not excludable.

Sparrow sued his former employer, the Department of the Navy, alleging racial discrimination under Title VII of the 1964 Civil Rights Act. The complaint ultimately was settled. Sparrow received about $90,000 over a three-year period and reported none of it as income. The IRS claimed Sparrow owed tax on the payments.

In the Tax Court, Sparrow argued all the settlement payments were excludable from gross income under IRC section 104(a)(2), which excludes "damages . . . on account of personal injuries." The Tax Court ruled in the IRS's favor, finding (1) the entire settlement constituted back pay and (2) none of it was excludable because Title VII only authorizes equitable, not legal remedies and amount received pursuant to equitable remedies are not excludable under section 104(a)(2).

Result: The back-pay award was not excludable. The District of Columbia Circuit based its conclusion on the purely legal distinction between legal and equitable remedies. The section 104(a)(2) exclusion, it said, is limited to damages recoverable in an action at law (legal damages) and does not cover equitable relief. Since the court found back-pay awards under Title VII to be equitable relief and not legal damages, the award was not excludable, and Sparrow had to pay tax on it.

Sparrow (DC Cir., 1991).

Note: This decision conflicts with the Sixth Circuit's decision in Burke, that back-pay awards under Title VII are excludable under section 104(a)(2). It also conflicts with the reasoning used in the Third Circuit (Rickel), which found back-pay awards under the federal Age Discrimination in Employment Act (ADEA) excludable. The Third Circuit looked only to the nature of the claim (whether it stems from personal injury) to determine excludability and did not draw the equitable-versus-legal distinction. (Damages under ADEA, according to the D.C. Circuit, are legal damages, and would, it seems, pass its excludability test.)
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Article Details
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Title Annotation:Sparrow, D.C. Cir. 1991
Author:Wagenbrenner, Anne
Publication:Journal of Accountancy
Article Type:Brief Article
Date:Feb 1, 1992
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