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Severance payments as personal injury awards.

Sec. 104(a)(2) states that gross income does not include "the amount of any damages received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal injuries or sickness." Regs. Sec. 1.104-1(c) defines the term "damages received" as "an amount received (other than workmen's compensation) 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." To eliminate much of the confusion over the "personal injuries or sickness" language, Congress amended Sec. 104(a) in 1989, adding that See. 104(a)(2) would not apply to any punitive damages in connection with a case not involving physical injury or physical sickness.

Case law has varied widely on the excludability of personal injury claim awards, depending on the basis for the suit or settlement agreement. Awards have been held to be excludible in actions based on emotional distress, injury to reputation, sex, age or race discrimination, wrongful termination, alienation of affections and wrongful death. Under present law, courts are required to focus on the nature of the underlying claim to determine whether an award or settlement meets the tort or tort-type requirement set forth under Regs. Sec. 1.104-1(c).

The Supreme Court has ruled on Sec. 104(a)(2) on only one occasion. In Burke, 112 Sup. Ct. 1867 (1992), the Court reviewed the excludability of damages received under a sex discrimination suit pursuant to Title VII of the Civil Rights Act of 1964. Holding that the Civil Rights Act of 1964 failed to provide all the tort-like remedies available, any award would not be excluded under Sec. 104(a)(2). The Court did indicate that the result would most likely have been different if the suit had been litigated under the new Civil Rights Act of 1992, which provides for all the tort-based remedies.

Unfortunately, the Burke decision has done little to clear the Sec. 104(a)(2) waters. Opinions continue to be split on the question of whether employment-related damage awards or settlements qualify for the Sec. 104(a)12) exclusion. In addition to the divergent opinions on the subject, Congress has made the issue more difficult by passing new antidiscrimination legislation over the last few years (e.g., the Age Discrimination in Employment Act (ADEA) and the Americans With Disabilities Act (ADA)). Two recent Circuit Court decisions, both examining ADEA awards, dramatically point out this divergence.

In Schmitz, 34 F3d 790 (1994), the Ninth Circuit decided that such liquidated damages were excluded from income, while in Downey, 33 F3d 836 (1994), the Seventh Circuit decided that such damages must be included in income and therefore subject to tax. Both cases arose out of discrimination suits against the same employer, and both involved settlements in which half of the amount was attributed to back pay and the other half to liquidated damages.

In Schmitz, the court applied a two-part test. First, it found that, because discrimination constituted a personal injury and the ADEA provided for a jury trial and compensatory or punitive damages, a tort-like cause of action was established. Second, the liquidated damages were paid "on account of" the personal injury because they were intended to compensate the victim for that injury. The court rejected the argument advanced by the IRS that because such damages are allowed by the ADEA only if a violation has been willful, they are therefore punitive and not paid on account of the injury. Liquidated damages could have both a compensatory and a punitive purpose.

In Downey, however, the Seventh Circuit held that the ADEA did not create a tort-like cause of action. The court stated that under the Burke decision, to constitute a tort-like personal injury and thereby receive tax-exempt treatment under Sec. 104(a)(2), the ADEA would have to provide compensatory damages for intangible elements of personal injury, such as pain and suffering or emotional distress. Concluding that the ADEA did not allow for the recovery of damages for such intangible elements of injury, the court found that the damages awarded lacked an essential element of a tort-like claim and therefore could not be excluded from income under See. 104(a)(2).

While the issue in the Schmitz case focused on the nature of the portion of the settlement attributed to liquidated damages, it was also noted that the exclusion from income of the amount attributed to back pay was not even questioned. In Downey, however, the court concluded that, because the ADEA did not create a tort-like personal injury, no part of the award was excludible and the amount attributed to back pay, as well as that attributed to liquidated damages, was to be included in income and subject to tax.

A third case, decided recently by the Sixth Circuit, addressed the question of excludability from income under Sec. 104(a)(2) of punitive damages, based not on the ADEA but on a tort action of negligence. In Horton, 33 F3d 625 (1994), the court rejected the Service's contention that punitive damages were not received "on account of" the personal injuries, stating that Sec. 104 "simply does not permit a distinction between punitive and compensatory damages.

In light of the personal injury requirement of Sec. 104(a)(2), any proposed severance package should contemplate the taxability of payments made to the terminated employee. One final case is illustrative of the dangers of excluding settlement awards under a Sec. 104(a)(2) analysis. The Second Circuit recently held in Taggi, 35 F3d 93 (1994), that a severance package in which the employee signed a general release barring suit against his employer would not qualify for Sec. 104(a)(2) exclusion. Since there was no prosecution of a suit, the agreement would have to qualify as a settlement agreement in lieu of prosecution. Because the terminated employee had made no tort-like claims against his employer before signing the release, the severance payment could not be excluded from gross income under Sec. 104(a)(2). Since general releases are a common element of postsettlement negotiations, further caution is warranted to ensure Sec. 104(a)(2) treatment.
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Author:Dunn, Bill
Publication:The Tax Adviser
Date:Apr 1, 1995
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