Recent developments concerning the taxation of damages under section 104(a) (2) of the Internal Revenue Code.

• Author: Nicholson, Brent B.

Introduction

From its infancy, the Internal Revenue Code has contained an exclusion from taxable income for damages received on account of personal injuries. For decades, courts have worked at deciphering its meaning, dealing with issues such as what constitutes a personal injury, whether there should be a distinction between physical and non-physical personal injuries, and whether punitive damages were also excluded. The last decade has largely focused on the taxability of awards under federal statutes prohibiting discrimination, specifically Title VII of the Civil Rights Act of 1964(1) and the Age Discrimination in Employment Act (ADEA),(2) as well as the taxability of punitive damages.

In its 1992 decision, United States v. Burke,(3) the United States Supreme Court held Title VII damages taxable. The Court determined that because of its limited remedies available to successful plaintiffs the statute did not redress a tort or tort-type injury.(4) In 1991, however, in a change not addressed in Burke, Congress amended Title VII to provide a more expansive list of remedies and remediable injuries.(5)

In the midst of lower court struggles with the Burke legacy, the Supreme Court added to the confusion by its reasoning in a 1995 ADEA case.(6) Holding both the backpay and the liquidated damage components of the award taxable, the Court rather unpersuasively opined that the ADEA redressed neither tort or tort-type rights nor a personal injury.(7) It further held that, contrary to Burke, these were separate tests ("based upon tort or tort type rights" and "received on account of personal injuries or sickness"), that ADEA's liquidated damages were punitive in nature, and that the ADEA's more generous (than Title VII) remedies were not extensive enough to meet Burke's requirements for excludability.(8) The better reasoned dissent of Justices O'Connor, Souter, and Thomas took serious issue with the majority's revisionist reading of Burke. As part of the background to the recent developments, the Scheiler case will be discussed.

Another contentious issue over the last decade has been the taxability of punitive damages. A 1989 congressional attempt at resolution of the issue was leas than successful. That legislation made punitives paid for nonphysical injuries taxable.(9) In the latter half of 1996, however, the Supreme Court(10) and Congress(11) seemed to have taken the requisite definitive steps to making all these awards taxable. Importantly, the congressional Act amending Internal Revenue Code [sections] 102(a)(2) generally made damages paid for nonphysical personal injuries taxable.(12) A review of the O'Gilvie v. United States(13) decision and the new legislation highlight the resolved and remaining unresolved areas.

Yet another high visibility area within [sections] 104(a)(2) involves settlement agreement allocations between taxable and nontaxable components. Frequently, parties enter such agreements without tax forethought. After signing off on a general release they are forced to argue allocation issues in hindsight. Alternatively, the agreement may contain an allocation which the Internal Revenue Service challenges. The issue in these cases is the enforceability of the designated allocation. Recent cases on these points will be discussed.

Often linked to the allocation issue is the issue of the taxability of statutory pre-judgment interest. Two courts of appeals have dealt with the question, both finding it taxable, although the First Circuit clearly has left the door open to revisit the issue. These cases will likewise be explored.

After explicating these issues, the Article analyzes the state of the law and makes several recommendations. Future problem areas are mentioned, as well as some suggestions for a plaintiff's tax or litigation counsel. A short concluding section ends the Article.

Background

1. The Scope of [sections] 104(a)(2)

   Prior to August 21, 1996, [sections] 104(a)(2) provided:

   (a) In General. Except in the case of amounts attributable to (and not in excess of) deductions allowed under section 213 (relating to medical, etc., expenses) for any prior taxable year, gross income does not include --

   (2) 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;(14) The section limits the exclusion of damages to natural persons.(15) The amount of damages received are excluded from gross income whether the award results from a final judgment or from a compromise settlement.(16) The language had been interpreted to include damages from all personal injuries without distinguishing between physical and non-physical injuries.(17) As the statutory text indicates, the exclusion is also applicable whether payment is made in a lump sum or over a period of time.(18) Significant changes made to this section in 1996 will be discussed later in this Article.(19) Those changes narrowed the scope of the exclusion.

2. United States v. Burke

   In 1992, the United States Supreme Court in United States v. Burke held that an award of backpay damages for sex discrimination pursuant to Title VII of the Civil Rights Act of 1964 was not excludable.(20) The Court reasoned that Title VII, prior to its amendment in 1991, did not redress a tort or tort-type injury because its limited remedies of backpay, injunction, and equitable relief were inconsistent with traditional tort-type remedies such as compensatory damages for pain, suffering, emotional distress, injury to reputation, and consequential and punitive damages.(21) Two Tax Court memorandum decisions, rendered post-Burke and filed before the 1991 amendment, held that Title VII amounts awarded for racial discrimination were includable in income.(22) The Burke holding, however, is now quite limited. Congress amended Title VII in 1991(23) to provide a broader range of remedies but then eviscerated the tax effect of the expanded remedies with the Small Business Job Protection Act of 1996,(24) discussed below.(25)

3. Commissioner v. Schleier(26)

   The first relevant United States Supreme Court decision after Burke came in June 1995 in Commissioner v. Schleier. The six to three decision involved a claimed exclusion of the settlement proceeds of an Age Discrimination in Employment Act (ADEA)(27) claim. The majority held both the backpay and liquidated damage components taxable, reversing the Tax Court(28) and Fifth Circuit determinations.(29) Because it is one of only two post-Burke Supreme Court decisions on the taxability of damages, it is worthy of some discussion.

   Justice Stevens' opinion favoring taxability rested on two primary arguments: (1) an ADEA claim is not based on tort or tort-type rights, and (2) the ADEA damages were not received on account of personal injuries or sickness, both required by [sections] 104(a)(2) according to the opinion.(30) With respect to the personal injury question, the majority found that neither the backpay nor the liquidated damage amounts were paid on account of personal injuries.(31) The backpay portion, according to the majority, was not based upon any personal injury the complainant may have suffered.(32) Further, the items that were tied to backpay (being laid off on account of age) were not of a personal injury type.(33) Apparently, the Court thought the conclusion self-evident because it offered nothing in support. The liquidated damage portion was likewise not paid on account of a personal injury because it was punitive, not compensatory, in nature.(34)

   The taxpayer then sought to exclude the settlement proceeds on the basis of the regulation which states that excludable damages are those received by suit or settlement based on tort or tort-type claims.(35) The Court rejected that proposition on two grounds: to be excludable the damages must nevertheless be on account of a personal injury or sickness, an argument the Court had just rejected; and ADEA awards were not based on tort or tort-type rights.(36)

   To sustain the first point, the Court relied on the Commissioner's current, but admittedly inconsistent, reading of her own regulation.(37) Conceding that the Commissioner had read the regulation previously as though the tort requirement encapsulated the personal injury requirement, Justice Stevens conveniently found that the current reading was correct and more faithful to the statutory language.(38) In other words, the regulation was now being read to require that payment be made on account of a personal injury or sickness and for a tort or tort-like claim -- separate and independent standards.(39) As discussed above, the Court rejected the proposition that ADEA damages were paid on account of personal injuries. Failure to satisfy that standard was alone fatal to excludability.

   The majority also rejected the taxpayer's assertion that Burke required exclusion of the ADEA settlement proceeds.(40) While conceding that Schleier was a closer case than Burke, the Court determined that ADEA remedies were still not sufficiently broad to make ADEA claims tort or tort-like per the Burke analysis.(41) Although the availability of jury trials and punitive damages under the ADEA were among the missing tort-like remedies mentioned in Burke, they were found insufficient to change the result.(42) Like Title VII remedies, ADEA remedies lacked compensation for "pain and suffering, emotional distress, harm to reputation, or other consequential damages.'"(43) The Court also reiterated that Burke's analysis did not eliminate the "on account of personal injuries or sickness" requirement of the statute.(44) Thus, even if the Court had found ADEA claims to be tort or tort-like under Burke, the taxpayer would still have failed the "on account of" a personal injury test.

   Justice O'Connor, joined by Justices Thomas and Souter, filed a better reasoned dissent. O'Connor began with a refutation of the majority's primary holding -- she unequivocally...