Planning for the Tax Exclusion of Employment-related Damages
| Publication year | 1993 |
| Pages | 2415 |
| Citation | Vol. 22 No. 11 Pg. 2415 |
1993, November, Pg. 2415. Planning for the Tax Exclusion of Employment-Related Damages
Under the Code's statutory scheme, all "accessions to wealth" are taxable income under § 61 unless otherwise excluded under another Code provision.(fn2) Section 104(a)(2) provides such an exclusion from gross income for "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." Reg. § 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."
Some version of § 104(a)(2) has been in the Code since 1918.(fn3) Although the courts and the Internal Revenue Service ("IRS") have agreed that the term "personal injuries or sickness" encompasses a broadrange of physical and nonphysical injuries to personal interest,(fn4) this area has been heavily litigated in recent years in cases involving nonphysical injuries.
Congress resolved some of the controversy in 1989 when it prospectively amended § 104(a)(2) to provide that the exclusion does not cover punitive damages received in cases which do not involve physical injuries or sickness.(fn5) Prior to this amendment, lower courts had reached conflicting conclusions about the excludibility of punitive damages under § 104(a)(2).(fn6)
The Supreme Court joined the fray in 1992 with Burke.(fn7) The Burke case involved the taxability of amounts received in settlement of sex discrimination employment claims brought under Title VII of the Civil Rights Act of 1964 ("1964 CRA").(fn8)
Regulation § 1.104-1(c) requires a recovery to be "on account of some type of tort right for purposes of Code § 104(a) (2). Accordingly, most lower courts prior to Burke focused on common law tort concepts to determine whether a recovery was based on a tort-type right.(fn9) If the damages were not for the violation of tort-type rights, the § 104 (a)(2) exclusion did not apply.(fn10)
If a taxpayer was able to establish the basis of his or her claim as a tort, the entire settlement qualified for the § 104(a) (2) exclusion, regardless of the specific consequences resulting from the injury. As the Ninth Circuit said, "[t]he personal nature of an injury should not be defined by its effect."(fn11) Nonetheless, in employment cases, which often include back pay or lost wages as a component of a lump-sum award or settlement, the IRS consistently had argued that any claim for "back pay" is based on contract-type rights and therefore taxable, even though the IRS had conceded that § 104 does not distinguish between physical and nonphysical injuries.(fn12)
Most circuit courts were at odds with the IRS's position, holding that rather than representing a separate contract claim, back wages are simply an easily quantifiable foundation for measuring damages.(fn13) Thus, in the majority of pre-Burke court decisions, the entire amount of the award, including any back pay, was excluded from income, contrary to the position taken by the IRS.
In Burke, the Supreme Court endorsed the "nature of the underlying claim" standard applied by several of the lower courts, but with the proviso that the remedial scheme in question is critical to that inquiry. The taxpayers in the Burke case received funds as part of a settlement agreement stemming from an action against the Tennessee Valley Authority ("TVA"). In their lawsuit, the plaintiffs alleged unlawful sex discrimination
in the payment of salaries and sought injunctive relief and back pay under § 2000e-5(g) of the 1964 CRA.(fn14) In analyzing whether Title VII granted relief for a tort-like personal injury, the Supreme Court focused on the remedies available under Title VII. The Court adopted this approach because
the concept of a "tort" is inextricably bound up with remedies---specifically damages actions. . . . Thus, . . . consideration of the remedies available under Title VII is critical in determining the "nature of the statute" and the "type of claim" brought by respondents for purposes of § 104(a)(2).(fn15)
Title VII as applicable in Burke did not allow jury trials, nor did it allow awards for compensatory or punitive damages. Instead, it limited available remedies to back pay, injunctions and other equitable relief.(fn16) The Supreme Court noted that victims of physical injury torts are typically permitted to recover not only damages for medical expenses, lost wages and similar actual losses, but also damages for...
To continue reading
Request your trial