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Taxation of personal injury awards.

Taxation of Personal Injury Awards

Section 104(a)(2) of the Internal Revenue Code provides 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. However, until the enactment of the Revenue Reconciliation Act of 1989, neither the Code nor the regulations provided guidance regarding the tax treatment of awards received for 1) physical vs. non-physical injuries, 2) damage to personal vs. business reputation or 3) compensatory vs. punitive damages. This lack of guidance has led to litigation between taxpayers and the IRS. Furthermore, over the years both the Service and the courts have changed their positions on the taxation of damage awards.

Recent legislation, as part of the Revenue Reconciliation Act of 1989, may have settled some of the other areas of disagreement. The legislation provides that the exclusion for personal injury awards does not apply to any punitive damages in connection with a case not involving physical injury or physical sickness.(1) Thus, it would appear that all damages, both compensatory and punitive received for physical injuries will be excluded from gross income. Only compensatory damages received for non-physical injuries will be excludable from gross income. Punitive damages received for non-physical injuries will be taxable. The new provision is effective for amounts received after July 10, 1989, in tax years ending after that date, unless a binding agreement, decree or award is in effect before then.

Despite the clarifying legislation, areas for disagreement between taxpayers and the IRS still exist regarding the nature of non-physical injury awards involving libel or defamation of character. Let's examine the statutory provisions, administrative pronouncements and judicial interpretations affecting the taxation of awards for libel or defamation of character.

Non-Physical Injuries

In recent years, there has been considerable disagreement between the courts and the Service regarding the exclusion of awards for non-physical injuries such as defamation of character. The controversy has centered primarily on two issues: 1) whether or not awards made because of injury to a taxpayer's personal reputation should receive different tax treatment from awards for injury to the taxpayer's business reputation and 2) whether or not punitive damage awards for such injuries should be taxed differently than compensatory damage awards. While the issue should have been settled by the Revenue Reconciliation Act of 1989, differences still exist regarding this issue.

Business vs. Personal Reputation

Until recently, the Tax Court and the Service have been in agreement that it is appropriate to distinguish between injury to one's personal and business reputations in cases of defamation of character. In Wallace,(2) a self-employed beautician settled a suit for defamation of character. The Tax Court ruled that the proceeds could be regarded as a return of capital to the extent that they were allocable to a loss of business reputation, which the Court likened to goodwill. However, the Court could find no basis on which to allocate the proceeds between personal and business reputations. As a result, it treated all proceeds as relating to the business. Moreover, the taxpayer was unable to establish any cost basis for the goodwill, and the entire net proceeds from the settlement were held to constitute taxable income. This case provides support for the IRS position that defamation awards should be allocated between injury to personal reputation and business reputation, if possible, and that the business portion constitutes taxable income.

In Roemer,(3) the Tax Court continued to view defamation awards in this manner. Roemer, an insurance broker in California, was the victim of a defamatory report by a credit reporting company. He received a jury award of $40,000 for compensatory damages and $250,000 for punitive damages. Roemer claimed that the defamatory report had damaged his business reputation, resulting in a loss of business.

The Tax Court determined that the major issue in this case was whether a distinction should be drawn between personal reputation and business or professional reputation for purposes of determining excludability under Code Sec. 104(a)(2). The Court ruled that such a distinction should be made. It further provided that damages for injury to personal reputation are compensatory in nature and not taxable while damages for injury to business reputation represent lost income and are taxable.

The Tax Court ruled that Roemer failed to prove that the compensatory damages were received on account of personal injuries. Rather, the damages were the result of injury to Roemer's business reputation. The compensatory damages were therefore not excludable from gross income under Code Sec. 104(a)(2). Additionally, the Court found that the punitive damages were associated with the compensatory damages and as such constituted taxable income.

The distinction between damage to personal versus business reputation was recapitulated by the Tax Court in Church.(4) While serving as the attorney general for the state of Arizona, Church was labeled a "communist" by a local newspaper. Church sued the newspaper and eventually received compensatory damages, punitive damages and interest.

The Court concluded that the jury did not intend to compensate Church for injury to his professional or business reputation to the extent that it affected past or future income. Therefore, since the award was intended to compensate Church for damage to his personal reputation, it was determined to be awarded for personal injuries within the meaning of Sec. 103(a)(2) and exempt from gross income.

Recent Tax Court and appeals court decisions have held that no distinction should be made between damage to a taxpayer's business reputation and damage to his personal reputation. The Ninth Circuit Court of Appeals found that the Tax Court had used faulty reasoning in Roemer when it ruled that a distinction should be made between damages for injury to personal and business reputation.

The Ninth Circuit reversed the Tax Court decision in Roemer, stating that the Tax Court confused personal injury with its consequences and illogically distinguished physical from non-physical personal injuries. The appellate court determined that the distinction should be made between personal and non-personal injuries, not between physical and non-physical injuries.

Moreover, the court felt that Sec. 104(a)(2) provides that damages received on account of personal injuries are excludable. Because the Code did not distinguish between physical and non-physical injuries, the court also declined to do so.

As further support for its position, the Ninth Circuit cited a pronouncement by the Service {Rev. Rul. 75-45, 1975-1 C.B. 47} that all damages injury, compensatory as well as punitive, are excludable from taxable income. The ruling did not discuss the issue of physical versus non-physical injuries.

To determine whether or not the award qualified as damages for personal injury (and exclusion from gross income), the court stated that the nature of tort of defamation must be examined. According to the court, under California law, all defamatory statements are viewed as an attack on the good name of the individual, and the injury to the person should not be confused with the consequences of the may include loss of reputation in the community and a resulting loss of income. Non-personal consequences such as loss of future income were viewed by the court as often the most persuasive means of proving the extent of the injury that was suffered. Nonetheless, the court felt that the personal nature of an injury should not be determined by its effect.

Since the defamation of an individual is a personal injury under California law, the court ruled that the damages received by Roemer in his defamation suit were excludable from gross income under Sec. 104(a)(2). The fact that the damages were received for non-physical injuries and the primary effect of the personal injury was a resulting loss of business income was not relevant.

The Service refused to follow the ruling of the Ninth Circuit in Roemer that damages received for defamation of the plaintiff's business reputation were due to personal injury and therefore excludable from gross income.(5) It maintained that the libelous statements were directed primarily against Roemer's business reputation with a resulting loss of business income. The loss of business income was viewed by the Service as a business loss rather than a personal loss under Sec. 104(a)(2). Because the award was for loss of business income, the Service ruled that it should be taxable under Sec. 61.

Threlkeld

Threlkeld was the codefendent in a suit brought by Williams in Tennessee alleging fraud in connection with a real estate contract.(6) Threlkeld counter-claimed against Williams seeking specific performance of the contract. Both the counterclaim and a subsequent appeal were won by Threlkeld. Later, Threlkeld filed suit against Williams claiming malicious prosecution on the part of Williams. Threlkeld was awarded damages for injury to his professional and credit reputations and for injury to his peace of mind.

Following the lead of the Ninth Circuit in Roemer, the Tax Court decided in Threlkeld to abandon distinctions drawn in earlier cases between damage awards received for injuries to personal reputation and those received for injuries to professional reputation. The Court felt that the appropriate question for purposes of Sec. 104(a)(2) is whether the damages were received on account of personal injuries. Consequently, it had to decide on the nature of "personal injuries." The Tax Court affirmed the position taken by the Ninth Circuit that the nature of the claim is important in determining whether damages are for personal injuries. With the exception of Roemer, the Tax Court noted that it has never relied, as the sole basis for deciding the case, upon the distinction drawn between damages received for injury to personal reputation and those for injury to professional or business reputation. The Court cited the regulations under Sec. 104(a)(2) to the effect that damages received arise from prosecution of tort or tort-type rights. For damage awards to be excludable under Sec. 104(a)(2), the Tax Court concluded that the award must be based upon some sort of tort claim against the payor.

After reviewing the applicable Tennessee state law, the Tax Court determined that an action for malicious prosecution, as in this case, would be classified as an action for personal injury. Because the damages were awarded on account of personal injury, the Tax Court ruled that the damages were excludable from gross income. No distinction was made between damages awarded for injury to personal reputation and damages awarded for injury to professional reputation.

B.A. Miller (1989)

In B.A. Miller,(7) the Tax Court affirmed the position that it had taken in Threlkeld that, in cases of personal injury, no distinction should be made between damage to one's personal or business reputation.

Miller had been falsely accused of embezzlement by her employers to cover up their bribery payments to government contractors. Miller brought an action for defamation against her employers. The employers alleged that Miller was having sexual relations with persons dealing with the employers, and that was why she brought the defamation action. Miller brought a second action for defamation. The first action resulted in an award to her for both compensatory and punitive damages. Upon subsequent negotiations, she received a final settlement award. Again, the Tax Court held that the nature of a taxpayer's claim determines whether damages are excluded from gross income. Because defamation is a tort under the controlling state law (Maryland), it is an action for personal injury. Therefore, the damages are excludable under Sec. 104(a)(2).

Rejecting the position of the IRS, the Tax Court refused to distinguish between damage to personal reputation and damage to professional reputation. The Tax Court noted that the Code does not make such a distinction in Sec. 104(a)(2) where it excludes "any damages received...on account of personal injury or sickness." The results of Roemer, Threlkeld, and B.A. Miller indicate a new trend on the part of the Tax Court and one appeals court to refuse to distinguish between injury to personal and business reputation when deciding cases of defamation of character. This action would appear to strengthen a taxpayer's position that awards for such damages are excludable from gross income.

Compensatory vs. Punitive

Damages

In the Revenue Reconciliation Act of 1989, Congress appears to have settled the question of whether or not punitive damages awarded on account of defamation of character are excludable from gross income. As indicated earlier, Congress provided that the exclusion from gross income for awards due to personal injury does not apply to punitive damages in connection with a case not involving physical injury or physical sickness. Thus, we may conclude that punitive damages received for non-physical injuries such as libel or defamation of character must be included in gross income. This provision was added to the Code to clarify the intent of Congress regarding this issue because of disagreements between the courts and the IRS in Roemer, Threlkeld, and B.A. Miller.

Prior to the enactment of this provision, it was well-settled law that punitive damages awarded in a business-related case were includable in gross income. The IRS has often cited Glenshaw Glass Co.(8) as authority for the taxation of such awards. Based on that case, Reg. Sec. 1.61-14 provides that punitive damages such as treble damages under the anti-trust laws and exemplary damages for fraud are gross income. However, neither Glenshaw Glass nor the Regulations address the issue of whether or not all punitive damages such as those received in connection with libel or defamation of character are includable in gross income.

The position of the IRS and the courts has changed over the years regarding the taxation of punitive damages. In Rev. Rul. 75-45,(9) the IRS broadly interpreted Sec. 104(a)(2) and concluded that all damages received on account of a wrongful death action were excludable from gross income. The IRS emphasized that "any damages" meant any damages. As a result, the Service concluded that under Sec. 104(a)(2), any damages, whether compensatory or punitive, received on account of personal injuries or sickness are excludable from gross income. The ruling did not specifically distinguish between physical and non-physical personal injuries, such as defamation of character.

However, after losing the Roemer appeal, the Service revoked Rev. Rul. 75-45 with Rev. Rul. 84-108,(10) and indicated as it had in Rev. Rul 58-418(11) that all punitive damages are subject to taxation.

The Service again cited Glenshaw Glass Co. as partial support for including punitive damages in taxable income. Moreover, it reasoned that damages paid for personal injuries are excluded from gross income under Sec. 104(a)(2) because in effect, they restore a loss of capital. An award of punitive damages was seen, however, as a means of punishing the wrongdoer rather than compensating the taxpayer for a loss. Thus, punitive damages were viewed as not awarded on account of personal injury and not excludable from gross income.

The issue of exclusion of punitive damages did not arise in Threlkeld because all of the damages awarded were considered to be compensatory. However, in B.A. Miller, the Tax Court announced that it would follow the Ninth Circuit's reasoning in Roemer that all damages, including punitive damages, received on account of personal injury are excludable from gross income.

The Court noted that the practice of awarding punitive damages had long been in existence at the time of the enactment of the predecessor of Sec. 104(a)(2). Although Congress could have specifically excluded only compensatory damages from gross income, it did not. Thus, the Court concluded that the wording of Sec. 104(a)(2) excluding from gross income "any damages received...on account of personal injury," should be interpreted to mean all damages, including punitive damages.

Conclusion

Through the Revenue Reconciliation Act of 1989, Congress has settled the issue of how personal injury awards are to be taxed. That is, all damages awarded for physical injuries, including compensatory as well as punitive awards, are excludable from gross income. For non-physical injuries, only compensatory damages are to be excluded from gross income. Punitive damages will be taxable.

However, Congress has not addressed the issue of whether or not injury to one's business reputation qualifies as a personal injury. It appears that the courts and the IRS will continue to disagree on this issue and that taxpayers will be uncertain as to how damage awards from such injuries will be taxed.

Given the opposing positions of the courts and the Service on this issue, taxpayers would be prudent when presenting their defamation cases to emphasize the damage done to their personal reputations rather than their business reputations. Naturally, characterizing the requested damages primarily compensatory in nature, where supported by the facts, rather than punitive would strengthen the taxpayer's position for exclusion.

Footnotes

(1) Sec. 104(a).

(2) 35 TCM 954 (1976).

(3) 79 TC 398 (1902), rev'd, 716 F.2d 693, 83-2 USTC %9600 (9th Cir. 1983).

(4) 80 TC 1104 (1983).

(5) Rev. Rul. 85-143, 1985-37 IRB 7.

(6) 87 TC 1294 (1986).

(7) 93 TC ,No. 29, CCH Dec. 46,021.

(8) 18 TC 860 (1952), nonacq. 1953-1 C.B. 7, aff'd, 211 F.2d 928 (3d Cir. 1954), rev'd, 348 U.S. 426 (1955).

(9) 1975-1 C.B. 47.

(10) 1984-2 C.B. 32.

(11) 1958-2 C.B. 18.

Steven C. Colburn, PhD, is assistant professor of accounting at Georgia State University, Atlanta, Georgia.

Ted D. Englebrecht, PhD, is a KPMG Peat Marwick professor of accounting at Georgia State University in Atlanta, Georgia.
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Author:Colburn, Steven C.; Englebrecht, Ted D.
Publication:The National Public Accountant
Date:Dec 1, 1990
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