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Supreme Court decides back pay taxability.

For the first time, the U.S. Supreme Court has ruled on whether back pay awarded to taxpayers under a Federal discrimination statute is taxable. In Burke, 112 Sup. Ct. 1867 (1992), rev'g 929 F2d 1119 (6th Cir. 1991), the Court overruled the Sixth Circuit and ruled that the Sec. 104(a)(2) exclusion did not extend to back pay in a pre-1991 Title VII sex discrimination suit. However, the Court's reasoning suggests that discrimination awards in most future cases will be excludible.

This ruling resolves a conflict over the taxability of damages resulting from the nonphysical injury of discrimination. The lower court decisions have focused on whether back pay awarded to employees who have been victims of discrimination is taxable. Burke is important for advising clients who either receive or pay money as a result of discrimination, whether by court order or settlement.

While Sec. 61(a) taxes all income unless otherwise excludible, Sec. 104(a)(2) excludes from gross income "the amount of any damages received on account of personal injuries." Contractual damages and punitive damages, when received for a nonphysical injury, are not excludible. Personal injury is not defined, but Regs. Sec. 1.104-1(c) specifies that the taxpayer's claim must be a tort-type claim. The taxpayers in Sec. 104(a)(2) cases have argued that back pay awards based on discrimination are torts, and consequently, any back pay awards should be construed as resulting from personal injuries and therefore should not be taxed. In contrast, the IRS has consistently sought to apply a narrower, more limited view of personal injury.

In Burke, several hundred women sued their employer for sex discrimination under Title VII of the Civil Rights Act of 1964, claiming that they had been underpaid based on sex from 1981 to 1984. Title VII prohibits employment discrimination based on sex, race, color, religion or national origin. The parties ultimately settled for $5 million.

Before 1991, Title VII allowed an employee injured by discrimination to recover back pay, but not compensatory or punitive damages, and did not allow jury trials. Compensatory damages are designed to put the injured party in the same position that he would have been in if the wrong had not occurred. They can include money for back pay, emotional distress, pain and suffering, and humiliation. In some statutes, compensatory damages for the intangible effects of discrimination, such as emotional distress, pain and suffering, and humiliation, are called "liquidated damages." Two kinds of back pay are available under Title VII: (1) for work done by the taxpayer (as in Burke) and (2) for work that the taxpayer did not do because he was fired. The Burke analysis covered both types. The Supreme Court held in Burke that a pre-1991 Title VII claim was not a tort-type claim because it allowed neither compensatory or punitive damages nor a jury trial. Since Title VII awarded only back pay, it did not provide the broad range of damages characteristic of a tort-type statute. Therefore, Title VII claims did not qualify for the Sec. 104(a)(2) exclusion, and the $5 million was taxable.

The Burke decision does not greatly limit the Sec. 104(a)(2) exclusion for future cases, because most Federal discrimination statutes now in effect have tort-type characteristics. Therefore, with the exception of punitive damages, all amounts received under these statutes, including back pay, are excludible. Even Title VII now satisfies the Burke requirements, after amendments made by the Civil Rights Act of 1991 (CRA), effective Nov. 21, 1991. These amendments permit compensatory and punitive damages and jury trials. The Americans With Disabilities Act of 1990 (ADA) was similarly converted into a tort-type statute by the CRA. The ADA, which became effective on July 26, 1992, prohibits discrimination against 43 million disabled individuals. Other discrimination statutes that satisfy the tort-type requirements of Burke are 42 USC 1981, which prohibits employment discrimination based on race and national origin, and the Age Discrimination in Employment Act (ADEA), covering employees over the age of 40.

Burke resolves much of the uncertainty that has existed in this area. Tax professionals can advise their clients that all amounts paid to employees as a result of discrimination are excludible, unless the awards are back pay under Title VII and are due to lawsuits decided or settled before Nov. 21, 1991. This ruling allows employers to negotiate a smaller payment because the award qualifies for the exclusion. The net award to employees should be unaffected, since a smaller tax-free award (without the added cost of litigating the tax status) is equivalent to a larger taxable award.

The Service might dispute two points. First, it might claim that back pay under the ADEA is taxable since the ADEA does not allow punitive damages. However, since the ADEA allows compensatory damages and jury trials, it has most of the tort-type features specified by the Supreme Court in Burke. Since punitive damages have not been awarded in any employment discrimination case, this deficiency appears to be irrelevant.

Second, the IRS might claim that back pay is taxable under the amended Title VII and the ADA because the Supreme Court in Burke did not explicitly rule that it would be excludible. The Court did however very strongly imply that such amounts would be excludible.

In conclusion, tax professionals should advise clients who are making payments to employees under the ADEA or the amended Title VII to negotiate smaller payments, and that taxes should not be withheld on these payments. Since Burke provides substantial authority for claiming the exclusion in these circumstances, taxpayers claiming the exclusion would not be liable for the Sec. 6662 accuracy-related penalty.
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Author:Sager, Clayton R.
Publication:The Tax Adviser
Date:Mar 1, 1993
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