Back pay awarded in employment discrimination dispute is taxable.

• Author: Persellin, Mark B.

The Supreme Court Ruling in Burke Does Not Resolve the Dispute for Other Taxpayers

The Supreme Court recently held that a back pay award resulting from a Title VII claim for sex-based employment discrimination is not sheltered from taxation under the Sec. 104(a)(2) exclusion for personal injury damages. The Court's decision in Burke(1) addresses an issue that has been the source of much contention in the lower courts. The back pay issue is one that is inherent in all employment discrimination actions and the Court's opinion could result in millions of dollars in tax revenue for the GovernMent. Additionally, the Court's focus on the remedies available under Title VII in resolving Burke may represent an additional test for resolving other personal injury disputes in which damages are based (wholly or partially) on lost income (e.g., damages for professional defamation).

In order to offer sound tax planning and compliance services, practitioners must familiarize themselves with the Burke decision and its effect on the taxation of damages derived in employment discrimination disputes. This article will examine the current status of Sec. 104(a)(2) in light of the Supreme Court's decision in Burke; analyze the controversy surrounding the taxation of back pay awarded in employment discrimination actions and the Court's apparent resolution of this dispute; address the possible extension of the Court's decision to other personal injury actions in which damages are determined with reference to lost income; and discuss the planning requirements associated with ensuring the nontaxability of a personal injury award.

Sec. 104(a)(2)

Since its inception, significant uncertainty has surrounded the exclusion for personal injury damages.(2) This confusion has reigned over the years despite the apparent clarity of the statutory language. The relevant language of Sec. 104(a)(2) provides for the exclusion 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." (As a result of an amendment included in the Omnibus Budget Reconciliation Act of 1989, the exclusion does not extend to punitive damages derived from nonphysical injuries.) Neither the statute nor its legislative history(3) defines the term "personal injuries." Instead, regulatory and judicial authority must be examined to determine what injuries are "personal" within the scope of Sec. 104(a)(2). Regs. Sec. 1.104-1(c) is the focal point in resolving disputes in the area:

The term "damages received (whether by suit or agreement)" means 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. (Emphasis added.)

The courts have consistently stressed the need for the presence of a tort-type claim for any application of Sec. 104(a)(2). A tort is a "private or civil wrong or injury, other than breach of contract, for which the court will provide a remedy in the form of an action for damages."(4) Although most actions giving rise to excludible damages will involve a tort right under common or state law, Sec. 104(a)(2) is not limited to such actions. The exclusion also extends to "suits or actions which involve a legal right that is more analogous to a tort-type right than to any other legal category of rights."(5)

"Nature of Claim" Is Proper Inquiry

The controlling factor in determining the applicability of Sec. 104(a)(2) to damages received in a dispute is the nature of the claim asserted, not its validity.6the facts surrounding a payment determine whether the amount redresses a tort-type claim or some nontort (e.g., contractual) claim.(7) State or Federal law under which a claim is asserted determines whether the claim is of a tort-type nature.(8)

* Court-awarded damages

In the case of court-awarded damages, the basis for which the jury or judge arrived at the award will determine the applicability of Sec. 104(a)(2).(9) When it is unclear as to why damages were awarded by a court, the facts and circumstances surrounding the dispute will be examined to determine the nature of the claim. Relevant factors for this purpose include the allegations contained in the petitioner's complaints, the evidence presented and the arguments made in the state or Federal court proceeding.(10)

* Settlement damages

More frequently, damages are paid as the result of a settlement agreement. The statute specifically acknowledges the excludability of personal injury damages awarded in settlement agreements. In applying the nature of the claim test to settlement damages, the express language of the agreement will generally be determinative.(11) Damages specifically noted in an agreement as being paid to settle a personal injury claim should be excludible under Sec. 104(a)(2). Conversely, an award that is specifically noted in the settlement agreement as redressing a contractual (or other nontort) claim will be taxable.(12)

When an agreement is silent or ambiguous about the purpose of the payment, the courts look to the intent of the payor to determine the nature of the claim settled.(13) The facts surrounding the settlement will establish whether the payor intended to settle a tort-type claim.14a taxpayer may be hard pressed to assert the nontaxability of a settlement payment if the payor steadfastly refused to acknowledge any liability for a tort-type injury.(15)

Injuries Falling Within Sec. 104(a)(2)

The Sec. 104(a)(2) exclusion clearly applies to damages received on account of both physical and nonphysical personal injuries.(16) Not surprisingly, taxpayer disputes with the IRS about Sec. 104(a)(2) almost invariably pertain to damages resulting from claims for nonphysical injuries. Not long ago, damages awarded for injuries to a taxpayer's professional reputation ("professional defamation") attracted much of the IRS's attention in the area. Recently, however, the predominant share of the litigation involving Sec. 104(a)(2) has concerned damages derived in employment discrimination disputes. The legal theories expounded in professional defamation cases have served as the basis for resolving the more recent employment discrimination cases.

* Defamation of professional character

The IRS has long distinguished between damages received for injury to a taxpayer's "professional" reputation and damages received for injury to a taxpayer's "personal" reputation.(17) The IRS's position is that some or all of the damages derived from a professional defamation action represent business income lost as a result of the defamation and that such lost profits are not excludible under Sec. 104(a)(2).(18) The courts, while vacillating on the issue...