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Personal injury recoveries after Burke.

Title VII of the Civil Rights Act of 1964 is one of several Federal statutes designed to eliminate invidious discrimination in the work place. The appropriate tax treatment under Sec. 104(a)(2) of recoveries under Title VII has given rise to much litigation in recent years. In fact, a split developed in the circuits over the proper resolution of this issue. Finally, in May 1992, the Supreme Court resolved this split when it held that recoveries won under Title VII by several female employees who were subject to employment-related sex discrimination were taxable; the recoveries did not constitute damages received on account of personal injuries (Burke, 112 Sup. Ct. 1867 (1992)).

At first blush, this decision seems far-reaching, given the wealth of discrimination lawsuits being brought under Title VII, as well as under the Age Discrimination Employment Act (ADEA), the Fair Labor Standards Act (FLSA) and comparable state laws. On further examination, however, it becomes clear that the Burke decision is a narrow one; although it resolves a conflict among the circuits with respect to the taxation of Title VII recoveries under the Civil Rights Act of 1964, it resolves little else. Quite to the contrary, the Court's opinion arguably provides taxpayer with firm footing on which to rest their claims that recoveries under Title VII, as amended by the Civil Rights Act of 1991, as well as claims under other Federal and state antidiscrimination laws, are not taxable under Sec. 104(a)(2).


Sec. 104(a)(2) provides that gross income does not include "the amount of any damages received (whether by suit or agreement and whether as lump sums or periodic payments) on account of personal injuries or sickness." Regs. Sec. 1.104-1(c) explains that "damages received" means an amount received through prosecution of a legal suit or action based on tort or tort type rights, or through a settlement agreement entered into in lieu of such prosecution. Thus, the availability of a recovery in tort is generally the sine qua non for relief under Sec. 104(a)(2). A tort is generally a civil wrong (not including a breach of contract) for which a court will provide a remedy in the form of an action for damages.

In recent years, the courts have been called on to interpret what Congress meant in Sec. 104(a)(2) by the phase, "damages received ... on account of personal injury or sickness" in the context of a recovery for employment-related discrimination under Title VII of the Civil Rights Act of 1964. As a result, a split developed in the circuits, with the Fourth Circuit and the D.C. Circuit holding that such awards constituted taxable back pay recoveries, while the Sixth Circuit found that a Title VII recovery was not taxable, constituting damages received on account of personal injuries (within the meaning of Sec. 104(a)(2)).

The Fourth Circuit, in Thompson, 866 F2d 709 (1989), held that the taxpayer's Title VII recovery for back pay was in the nature of a breach of contract claim, and thus was not tort-like recovery eligible for the Sec. 104(a)(2) exclusion. The plaintiff's back pay award in Thompson was based on a pay differential that resulted because male employees received higher pay than similarly situated female employees. The Fourth Circuit also held that the plaintiff's claim for back pay under the Equal Pay Act was taxable; however, the court found that the plaintiff's claim for liquidated damages under the Equal Pay Act satisfied the requirements of Sec. 104(c)(2) since it was in fact a tort-type claim for personal injuries.

In the D.C. Circuit's decision in Sparrow, 949 F2d 434 (1991), the plaintiff in a race discrimination suit recover back pay that he would have received had he not been wrongfully discharged. In addition, he received the additional pay he should have received had he not been improperly classified at a lower levels pay scale (i.e., GS 9 instead of GS 11). The court held that a Title VII back pay award is an equitable remedy for restitution rather than a legal remedy for damages. Based on this equitable/legal distinction, the court concluded that the plaintiff's back pay awarded under Title VII was not eligible for the exclusion under Sec. 104(a)(2).

Finally, in Burke, 929 F2d 1119 (1991), the Sixth Circuit held that backs pay award received in settlement of a sex discrimination claim under Title VII could be excluded from gross income under Sec.104(a)(2). The court, citing the Tax Court's decision in Threlkeld, 87 TC 1294 (1986), aff'd, 848 F2d 81 (6th Cir. 1988), explained that to determine whether an injury (and related claim) were personal and tort-like in nature, an inquiry had to be made into the origin and character of the claim, not into the consequences that resulted from the injury. Following this reasoning, the court concluded that should not matter whether an award, Title VII or otherwise, was for back pay, compensatory damages or punitive damages; rather the inquiry should focus on whether the injury was personal in nature. Unlawful discrimination, according to the Sixth Circuit, results in injuries to an individual's rights and dignity, whether brought under Title VII, ADEA or in any other tort-like lawsuits. Such injuries, in the court's view, are personal within the meaning of Sec. 104(a)(2). Merely because damages were measured in terms of lost wages did not change the nature of the injury from personal to nonpersonal.

The Supreme Court's decision

The Supreme Court reversed the Sixth Circuit's decision, and held that back pay awards received under Title VII of the Civil Rights Act of 1964 were taxable. The Court acknowledged that employment discrimination was "an invidious practice that causes grave harm to its victims." The mere fact that harm resulted, however, did not necessarily imply the presence of a tort-type personal injury for Federal tax purposes. The Court explained that discrimination could result in a personal injury within the meaning of Sec. 104(a)(2) "if the relevant relevant cause of action evidenced a tort-like conception of injury and remedy." The Court proceeded to examine the remedies available under Title VII.

The remedies provided by Title VII of the Civil Rights Act of 1964 as in effect for the tax years in question were limited to backs pay, injunctions and other equitable relief; a Title VII claimant could not be compensated for other traditional harms associated with personal injuries (such as pain and suffering, emotional distress, harm to reputation, etc.). Therefore, since the remedies available in Title VII stood in marked contrast to traditional tort law (as well as several other Federal antidiscrimanation statutes), the Court concluded that Congress had decline to recompense victims of Title VII discrimination for anything other than lost wages. Consequently, the Court held that recoveries under Title VII were excludible from income under Sec. 104(a)(2).

After Burke

The Supreme Court's decision resolves the conflict among the circuits and provides certainty as to the taxability of back pay awards received under Title VII as in effect before Nov. 21, 1991. Beyond that, the Court holding should have a limited impact on the taxation of personal injury recoveries. Effective Nov. 21, 1991, Title VII was amended by the Civil Rights Act of 1991 to allow Title VII claimants to recover for compensatory damages (including damages for emotional pain, suffering, mental anguish, inconvenience and loss of enjoyment of life), as well as for punitive damages. Thus, Title VII now provides for the tort-like redress that the Supreme Court found lacking in Burke. Based on the Court's reasoning, it seems clear that a recovery resulting from a discrimination claim under Title VII made after the effective date of the 1991 amendments should constitute damages from a tort-type personal injury that falls within the scope of Sec. 104(a)(2). It is unclear, however, whether such a recovery could be subject to an allocation between a taxable back pay recovery and a nontaxable personal injury recovery.

In addition to Title VII, discrimination claims are frequently made under the under the ADEA, The FLSA, the Equal Pay Act, state antidiscrimination statutes and state tort laws generally. The ADEA and FLSA both provide "for such legal or equitable relief as may be appropriate," including lost wages and liquidated damages. Liquidated damages can also be awarded under the Equal Pay Act. Although the Court's decision in Burke is limited to "old" Title VII, its reasoning should extend to claims brought under any antidiscrimination statute, or any other law that provides redress for victims of discrimination in the form of damages that are compensatory or (punitive) in nature. Any such recovery should be eligible for full or partial exclusion from income under Sec. 104(a)(2).

Note: Keep in mind that tax-free recoveries under Sec. 104(a)(2) are not subject to FICA, FUTA or income tax withholding; thus, for example, both the employer and the employee have an incentive to structure a settlement as a recovery under Sec. 104(a)(2) rather than as a taxable back pay award.
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Title Annotation:awards to female victims of discrimination are taxable
Author:Cohen, Robert L.
Publication:The Tax Adviser
Date:Dec 1, 1992
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