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Damages after burke: tax-free claims.

The exclusion of damages provided for in Internal Revenue Code (I.R.C.) Section 104 constitutes f the most significant exclusions from gross e contained in the I.R.C. Controversy has arisen in recent years over the application of I.R.C. Section 104(a)(2). Of particular importance is language in Section 104 (a) (2) excluding from gross income "... the amount of any damages received (whether by suit or agreement and whether as lump sum or periodic payments) on account of personal injuries or sickness."

The challenge posed by Section 104(a)(2) lies in defining what constitutes "personal injuries." Neither the Code nor the legislative history provides a definition. Instead, making the statutory language workable has largely involved judicial attempts to construe the language of Reg. 1.104-1(c). This article examines these judicial efforts in an effort to provide a working definition for determining the tax consequences of damage awards and to enable appropriate planning.

Defining Personal Injuries

According to Reg. 1.104-1(c), damages from personal injuries include amounts received as a result of "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."

Thus, in order to apply this definition, it is necessary to determine what constitutes a tort or tort type claim. Traditionally, tort type claims have been held to encompass both physical and nonphysical injury. According to the Supreme Court this view is implicit in the actions taken by Congress with

regard to the amendment of Section 104 by the Omnibus Budget Reconciliation Act (OBRA) of 1989. Although Section 104 was amended in OBRA to limit exclusion of punitive damages to those recovered with regard to physical type injuries or sickness, a proposal limiting the exclusion of damages in general to those for physical injury or sickness was rejected.

The Federal Courts Speak

In traditional negligence cases--e.g., those arising out of injuries incurred in an automobile negligence case--little difficulty has been encountered in finding amounts recovered excludible from gross income. In these cases, both the injury incurred and the statute under which redress is sought support a tort claim.

In certain cases, however, the issue is complicated by uncertainty over whether the statute under which the claim is brought is a tort type statute. The difficulty in classifying recoveries under these circumstances is reflected in recent cases concerning employment discrimination brought under Federal statute. These cases have centered upon whether amounts recovered for employment-related discrimination should be characterized as a recovery for a violation of a duty under tort law or for a breach of contract.

Circuit courts that have dealt with the issue have largely adopted the perspective pronounced by the Tax Court in Threlkeld. In Threlkeld, the Tax Court held that amounts recovered for a lawsuit for malicious prosecution were excludable due to being a recovery for personal injuries. According to the Court, in characterizing recovery for a claim it is the nature of the injury rather than its consequences that are determinative.

Adoption of this view is evident in: * The Third Circuit finding all recoveries including

those for back pay and liquidated damages) for claims

brought under the Fair Labor Standards Act (FLSA)

and the Age Discrimination Employment Act (ADEA)

excludable due to being for tort type injuries and

emanating under operation of law rather than a

contractual relationship. * The Sixth Circuit finding recoveries under the ADEA

excludable as well as those for violation of Title VII

of the Civil Rights Act of 1964. In the Sixth Circuit's

eyes, although amounts were recovered for lost income,.

lost income was in reality evidence of the

injuries sustained. * The Ninth Circuit finding recoveries under the

ADEA excludable. * The Tax Court--after having been reversed by circuit

courts in similar cases--deciding in the case of

Downey that amounts recovered for both liquidated

and nonliquidated damages under the ADEA are


In contrast to these decisions, the Fourth Circuit and the Circuit Court of appeals for the District of Columbia have each held amounts recoverable under Title VII of the Civil Rights Act of 1964 to be includible in gross income.

Recoveries Under Title VII

Title VII of the Civil Rights Act of 1964 makes it unlawful for an employer with regard to employment "... to discriminate against any individual with respect to his compensation, terms, conditions or privilege of employment because of race, color, religion, sex or national origin."

Title VII is distinct from other Federal statutes for employment-related discrimination in the strict limitation on the type of recoveries it permits. As a general rule, if administrative remedies are unsuccessful in satisfying a Title VII claim, the aggrieved party may file suit under Title VII and seek to enjoin the employer's conduct and be reinstated and/or awarded back-pay. The remedies available under Title VII differ from those afforded in traditional tort cases in that the potential recovery of punitive or compensatory damages is unavailable. In addition, it is unlikely that a jury trial will be held.

According to the Court of Appeals decision for the District of Columbia in Sparrow, the recoveries allowed under Title VII constitute equitable remedies of relief as distinct from the damages potentially recoverable in tort cases. As a result, the court in Sparrow held back pay awarded a plaintiff in a Title VII action taxable due to not being a recovery under a tort or tort type statute.

The decision reached in Sparrow conflicts with the position taken in several court of appeals decisions wherein exclusion was allowed for recoveries of back pay under other Federal employment discrimination statutes. These courts had held that back pay awards obtained under Title VII were excludable since they resulted from a violation of dignity, which was characterized as a tort type injury.

The court in Sparrow rejected the notion expressed by other courts that the amendment of I.R.C. Section 104 by OBRA 1989 implicitly endorses an expansive interpretation of the Section exclusion provisions. Citing the Supreme Court decision in Curtin v. Loether, the court also noted that recoveries under Title VII do not constitute damages due to the limitations on remedies.


On May 26,1992, the Supreme Court handed down a decision in U.S. v. Burke that reversed a Sixth Circuit decision and held amounts recovered for back pay under Title VII taxable. Burke concerned the treatment of such an award as a result of sex discrimination. In large part, the Court followed the approach used in Sparrow in holding Title VII to not be a tort type statute.

Justices Scalia and Souter each concurred with the decision on grounds that would limit the exclusion under Section 104 more severely than suggested in the majority opinion. While the majority opinion appears limited to Title VII and statutes analogous to it, Justice Scalia would limit the exclusion under Section 104(a)(2) to physical injuries and sickness, and Justice Souter would narrowly apply the exclusion and rule it not applicable to the case at issue due to the award being a recovery analogous to that for breach of contract.

In a vociferous dissent, justice O'Connor joined by justice Thomas advocated excludability based on the following points: * The nature of the injury is typically

recognized in tort, regardless

of the nature of the statute

under which recovery is sought.

In response to the claim that the

action under Title VII more

closely resembles an action for

breach of implied contract, the

statute seeks to protect a class

from discriminatory practices

rather than a single, limited interest.

Likewise, unlike claims

under quasi-contract, recovery

is not dependent upon the employer

materially profiting from

the discriminatory act. * Statutes such as U.S.C. Section

1983 and 1981, which are analogous

to Title VII, have been held

to be tort-like statutes. * No windfall would be received

for excluding recoveries under

Title VII, as this would place the

tax treatment of these recoveries

on equal footing with recoveries

for personal injuries and recognize

the fact that an injury has

been sustained by the taxpayer. * Recent amendment of Title VII

to allow for the recovery of punitive

and compensatory damages

indicates that legislators believed

existing law is not adequate in

achieving its stated purpose

rather than that the character of

the statute has been altered.

Ramifications of Burke

According to the Supreme Court's recent decision in Burke, recoveries under Title VII of the Civil Rights Act of 1964 or a statute similar to it will be taxable. Effective November 21, 1991, Title VII was amended so claims for intentional discrimination brought under it will be allowed a jury trial and the potential recovery of punitive and compensatory damages. Under the approach in Burke, recoveries under the new statute would appear to qualify for exclusion.

With the decision in Burke to buttress the potential exclusion of damages, caution should be exercised in determining under what statute to seek recovery.


(1) See P.L. 101-239, No. 7641(a), 103 Stat 2379, 26 U.S.C. 104(a) (1988 ed. Supp.1). (2) Burke, 69 AFTR 2d 92-1289 (1992). (3) Threlkeld v. Commissioner, 87 T.C. 1294 (1986), aff'd 848 F.2d 81 (CA 6 1988). (4) Rickel v. Commissioner, 900 F.2d 655 (3rd Cir. 1990), Metzger v. Commissioner, 88 TC 834 (1987), aff'd without published opinion 845 F. 2d 1013 (3rd Cir. 1988). Se also Byrne, 883 F.2d 211 (3rd Cir.), rev'g and rem'g 90 T.C. 100 (1988). (5) See Burke, 929 F.2d 1119 (6th Cir.) and Pistillo, 90-2 USTC 50,469 (6th Cir.), rev'g and rem'g 57 TCM 874 (1989). (6) Redfield v. Insurance Company of North America, 940 F2d 542 (9th Cir., 1991). (7) Downey v. Commissioner, 97 T.C. 150 (1991). (8) Thompson v. Commissioner, 866 F.2d 709 (4th Cir.), aff'g 89 T.C. 632 (1987). (9) Sparrow, 949 F.2d 434 (CA-DC) (1991), aff'g 57 TCM 816 (1989). (10) Sparrow, 949 F.2d 434 (CA-DC) (1991) (11) Curtis v. Loether, 415 U.S. 189 (1974). (12) U.S. v. Burke, 69 AFTR 2d 92-1293 (1992), rev'g 929 F.2d 1119 (1988). (13) P.L. 102-166 (1991).

Mark A. Segal, MBA, JD, LLM, CPA, is an associate professor of accounting at the University of South Alabama. He has published numerous articles in legal and accounting journals
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Author:Segal, Mark A.
Publication:The National Public Accountant
Date:Oct 1, 1993
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