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Recent developments in the taxation of federal statutory damages.

What are personal injuries for purposes of exclusion from gross income?

IRC Sec. 104(a)(2) allows damages received for personal injuries to be excluded from gross income. Personal injuries are not defined. Court cases in the 1980s were liberal in their interpretation. However, two Supreme Court cases in the 1990s have taken a hard line in permitting exclusion under this section.

IRC Sec. 104(a)(2) states that "damages received on account of personal injuries" are excluded from gross income. However, neither the IRC or the legislative history provide much guidance as to what damages Congress intended to exclude by the section. As such, the courts have been forced to determine what "on account of personal injuries" means.

During the 1980s, the Tax and Circuit Courts generally expanded the coverage of IRC Sec. 104(a)(2). However, the 1990s have produced two Supreme Court decisions that have limited the availability of the exclusion, and established a more difficult test to meet to qualify as damages for IRC Sec. 104(a)(2) exclusion.

Determinations of the applicability of IRC Sec. 104(a)(2) to damages received pursuant to the Civil Rights Act of 1964, Civil Rights Act of 1991, Age Discrimination in Employment Act, Fair Labor Standards Act, and Americans with Disabilities Act have been particularly inconsistent and controversial. However, the recent Supreme Court decisions may have clarified the basis for excluding damages.

Expansion During the 1980s

During the 1980s, the Tax Court and Circuit Courts of Appeal generally expanded the applicability of IRC Sec. 104(a)(2). In Roemer v. Commissioner (1983), the Ninth Circuit Court of Appeals stated that personal injury damages are not limited to actual physical injury and that the proper analysis of IRC Sec. 104(a)(2) is to look to the nature of the claim, not the nature of the award. If the underlying claim is "tort" or "tortlike," IRC Sec. 104(a)(2) would exclude the recovery from taxation.

In 1986, the Tax Court in Threlkeld v. Commissioner stated that IRC Sec. 104(a)(2) applies if "compensatory damages are received on account of any invasion of the rights that an individual is granted by being a person in the sight of the law."

In specifically applying the definitions provided in Threlkeld and Roemer to Federal statutory causes of action, the courts determined the following:

* IRC sec. 104(a)(2) excluded from taxation any portion of the damages received under the Civil Rights Act of 1964, not specifically related to back pay;

* The liquidated damage portion of awards under the Fair Labor Standards Act prohibition against gender discrimination were "tort" or "tortlike" and excludable under IRC Sec. 104(a)(2); and

* Awards based upon the Age Discrimination in Employment Act were "tortlike" and properly excludable under IRC Sec. 104(a)(2).

The clear trend of the 1980s was for the courts to gradually expand the application of IRC Sec. 104(a)(2) to include more and more damages recovered under the various Federal anti-discrimination statutes.

The 1990s

In 1992 and 1995 decisions, the Supreme Court reversed the trend of expanding IRC sec. 104(a)(2) and modified the standards for exclusion.

Burke. In 1992, the Supreme Court decided the case of U.S. v. Burke. In Burke, the Sixth Circuit Court of Appeals determined that awards made under the Civil Rights Act of 1964 were "personal" and "tortlike" and therefore excludable under IRC Sec. 104(a)(2).

In reversing the Sixth Circuit, the Supreme Court essentially established two tests that must be met:

* The action is a "tort" or "tortlike" personal injury action, and

* The statute provides for a broad range of damages to compensate the plaintiff.

Requiring this broad range of damages dramatically alters the analysis used in previous cases. The Burke Court looked to the remedies available under Title VII of the Civil Rights Act of 1964, prior to its amendment in 1991, and stated Title VII does not allow awards for compensatory or punitive damages, only back pay, injunctions, and other equitable relief. These limited damages do not purport to compensate the plaintiff for the traditional harms associated with personal injuries, like pain and suffering, emotional harm, etc. In essence, the court held that if the statute doesn't provide for a broad range of "torttype" damages, IRC Sec. 104(a)(2) doesn't apply. This approach shifts the analysis from the nature of the underlying claim to the nature of damages provided by the statute.

Civil Rights Act of 1991. In 1991, the Civil Rights Act of 1964 was significantly amended. The new legislation makes compensatory and punitive damages available in cases of intentional discrimination. The new law limits an employer's exposure for punitive and compensatory damages for future pecuniary loss and nonpecuniary losses such as emotional pain, suffering, inconvenience, mental anguish, and loss of enjoyment of life, based upon the relative size of the business. For each complainant, these damages may not exceed -

* $50,000 for businesses with 15 to 100 employees,

* $100,000 for businesses with 101 to 200 employees,

* $200,000 for businesses with 201 to 500 employees, and

* $300,000 for businesses with more than 500 employees.

Other damages (back pay, attorney fees, and expert witness fees) are in addition to the above amounts.

Rev. Rul. 93-88. In response to Burke and the Civil Rights Act of 1991, the IRS issued Rev. Rul. 93-88 that provides amounts received under post-1991 Civil Rights Act actions for intentional discrimination (disparate treatment) are excludable by IRC Sec. 104(a)(2). However, amounts received for nonintentional discrimination (disparate impact) are not subject to the exclusion. The IRS used the Burke analysis to conclude that since a wide range of compensatory damages are only available for desperate treatment (intentional discrimination) cases, IRC Sec. 104(a)(2) only applies to those damages.

Schleier. In June 1995, the Supreme Court decided the case of C.I.R. v. Schleier. In a six-to-three decision, the court held that damages received pursuant to the Age Discrimination in Employment Act (ADEA) were fully taxable and not excluded by IRC Sec. 104(a)(2).

Prior to Schleier, the Ninth Circuit, Sixth Circuit, and Third Circuit had held ADEA damages were excludable, while the Seventh Circuit had held ADEA damages were not excludable.

Schleier received $145,629 from United Airlines because he was forced to retire at age 60, in violation of the ADEA. The act provides for the recovery of lost wages and a like amount if there was a willful violation of the ADEA by the employer. Schleier's settlement was attributed half to lost wages and half to the employer's willful violation of the statute. The Tax Court had ruled that the damages received were on "account of personal injury" and therefore excluded from gross income by IRC Sec. 104(a)(2). The Fifth Circuit of Appeals affirmed the Tax Court holding.

Rather than look to the underlying claim, as courts had done in the past, the court focused on the damages potentially available and said: "Whether one treats respondent's attaining the age of 60 or his being laid off on account of his age as the proximate cause of respondent's loss of income, neither the birthday nor the discharge can be described fairly as a personal injury or sickness. Moreover, though the respondent's unlawful termination may have caused some psychological or personal injury comparable to the intangible pain and suffering caused by an automobile accident, it is clear that no part of respondent's recovery of back wages is attributable to that injury."

The court further stated: "In age discrimination, the discrimination causes both personal injury and loss of wages, but neither is linked to the other. The amount of back wages recovered is completely independent of the existence or extent of any personal injury. In short, IRC Sec. 104(a)(2) does not permit the exclusion of respondent's back wages, because the recovery of back wages was not on account of any personal injury and because no personal injury affected the amount of back wages recovered." As to the liquidated damage part of the money received, the court held it was punitive in nature, not an account of personal injury or illness, and therefore not excluded from gross income.

In deciding Schleier, the court relied heavily on Burke, which, as previously mentioned, held that damages recovered from pre-1991 Title VII of the Civil Rights Act actions were not excludable under IRC Sec. 104(a)(2), as they were not "on account of personal injury."

To determine if a claim is "tort" or "tortlike" the court again looked to the availability of a broad range of damages to compensate the plaintiff fairly for injuries caused by violation of his legal rights. Apparently, for the damages to be excluded, the underlying statute must provide for compensatory damages, pain and suffering, and perhaps punitive damages.

In an aggressive dissent, Justice O'Connor (joined by Justices Thomas and Souter) stated:

Unless the court reads S.104(a)(2) to permit exclusion only of damages received for tangible injuries...the inescapable conclusion is that ADEA damage awards are excludable.

I dissented from the court's decision in Burke because the remedies available to Title VII plaintiffs do not fix the character of the right they seek to enforce and I remain of that view today. The court's attempt to chart a path in Burke depends on arbitrary characterizations. The court today sidesteps these difficulties by laying down a new per se rule: An illegal discharge based on age cannot "fairly be described as a personal injury or sickness." To justify this conclusion, the court offers a hypothetical car crash, the injuries from which cause the taxpayer to miss work. She would be able, in such circumstances, to exclude the recovered lost wages because they would constitute damages received on account of personal injuries. By contrast, in the court's view, ADEA damages are not excludable because they are not on account of any personal injury and because no personal injury affected the amount of back wages recovered. This reasoning assumes the wrong answer to the fundamental question of this case: What is a personal injury?"

Where Do We Stand?

Burke and Schleier represent a clear trend by the Supreme Court to limit the applicability of IRC Sec. 104(a)(2) to cases where there are a broad range of "tortlike" damages available.

Apparently, to be excludable under IRC Sec. 104(a)(2), there must be damages designed to compensate an individual for things like pain and suffering and emotional harm, as now is provided under Title VII of the Civil Rights Act of 1964, as amended in 1991.

A reasonable application of the rules provided in Burke and Schleier to the various Federal anti-discrimination statutes would seem to result in disallowing the IRC Sec. 104(a)(2) exclusion to all Federal statutory anti-discrimination damages, except -

* Title VII damages for intentional discrimination,

* ADA damages for intentional discrimination, and

* The amount in excess of lost wages received under the Fair Labor Standards Act.

This result may not reflect the intent of Congress when it enacted IRC Sec. 104(a)(2), but if not, it now appears Congress will have to make its intent more clearly known by modifying the statutory language.

Wayne R. Wells, JD, LLM, is a professor of taxation and business law at St. Cloud State University, St. Cloud, Minnesota.
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Author:Wells, Wayne R.
Publication:The CPA Journal
Date:Feb 1, 1996
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