Congress's Amendment to Section 104 of the Tax Code Will Not Clarify the Tax Treatment of Damages and Will Lead to Arbitrary Distinctions
| Jurisdiction | United States,Federal |
| Citation | Vol. 21 No. 01 |
| Publication year | 1997 |
Introduction
In August 20, 1996, Uncle Sam once again raised taxes. The vehicle for this tax increase was the Small Business Job Protection Act (Small Business Act) of 1996.(fn1) The Small Business Act involved tax provisions for small businesses,(fn2) provided various tax credits for parents who adopt a child,(fn3) and increased the minimum wage.(fn4) Although the Act appears innocuous, there are controversial changes to the tax code tucked away in the revenue provision of the act, including the amendment of the Internal Revenue Code (I.R.C.) § 104.(fn5) In making the amendment to section 104, Congress hoped to raise an additional $662 million over a period of ten years.(fn6)
The purpose of the amendment was to clarify the tax treatment of damages.(fn7) In doing so, the amendment deals with three areas of the law: taxation of physical injury damages, taxation of emotional distress damages, and taxation of punitive damages.(fn8) Although the amendment addresses punitive damages, a recent decision by the Supreme Court has rendered the issue moot.(fn9) Thus, punitive damages are not discussed in this article.
Prior to the amendment of I.R.C. § 104, the manner in which damages were treated for tax purposes depended on the nature of the claim;(fn10) to avoid taxation, a claim had to be either a tort or a violation of a tort-type right.(fn11) Consequently, to avoid taxation, attorneys creatively argued that their clients' claims were torts.(fn12)
In an effort to solve this problem, Congress sought to clarify the tax treatment of damages so that the taxation of damages would not depend on the nature of the claim.(fn13) However, the amendment merely replaced one vague phrase with another. The ambiguous term "personal injury" has been replaced by "personal physical injury," a term that is equally ambiguous.(fn14)
Accordingly, the tax treatment of damages will still depend on the nature of the claim. In order to avoid taxation, a claim must be characterized as one involving a "personal physical injury." This is problematic because the amendment does not define what constitutes a "personal physical injury." Instead, the meaning of "personal physical injury" is left to the courts and attorneys to determine. Undoubtedly, this will result in much needless litigation to decide the definition of "personal physical injury." Therefore, Congress's goal of clarifying the tax treatment of damages will not succeed.
This Note examines the recent amendment of I.R.C. § 104 and argues that the amendment will not clarify the tax treatment of damages, but will instead lead to inequitable results and arbitrary distinctions. Part I explores the policy justifications for the exclusion of damage awards from gross income and provides a brief overview of section 104. Next, in Part II, the Article reflects upon the tax treatment of damages prior to the recent amendment. In doing so, Part II focuses on the relevant case law and revenue rulings. Turning toward the tax treatment of damages under the new amendment, Part III examines Congress's intent in amending section 104. Finally, Part IV discusses the ramifications of the new amendment on damages for physical injuries and damages for emotional distress and illustrates that the new amendment is problematic. This article concludes that the amendment to section 104 will not clarify the tax treatment of damages as intended by Congress and ends with suggestions on how section 104 could be amended so as to achieve the clarity sought by Congress.
Part I
Although the tax code defines income broadly,(fn15) the Internal Revenue Code, for tax and public policy reasons, has many exclusions to income. One such exclusion is found in section 104 for damages received "on account of personal physical injuries or physical sickness."(fn16) The most common policy explanations for this exclusion are (1) the return of capital theory;(fn17) (2) the involuntary nature of the transaction theory;(fn18) (3) the compassion or humanitarianism theory;(fn19) (4) the imputed income theory;(fn20) and (5) the bunching of income theory.(fn21)
The return of capital theory is the most common explanation for the section 104 exclusion.(fn22) Return of capital is a payment received that equals a taxpayer's investment or basis in an item.(fn23) As such, a taxpayer can have capital in his or her body, which consists of physical and mental health. Under this approach, damage awards are considered to be a return of capital. When a taxpayer's mental or physical health is injured, a damage award compensates a taxpayer for the injury and, in doing so, returns the lost capital.(fn24) This mirrors a traditional principle in tort law that the purpose of compensatory damages is to put the injured party in the position that he or she would have been had the party not been injured.(fn25) Thus, the damages make the injured party whole.(fn26)
Nonetheless, this theory has been criticized.(fn27) In order to have a return of capital, a taxpayer must first have a basis in his or her body.(fn28) However, a taxpayer cannot be said to have a basis in his or her body because human bodies are not purchased.(fn29) Furthermore, a person's basis in his or her body cannot be the cost to maintain that body because a taxpayer deducts those costs in the annual personal exemption.(fn30) Accordingly, the return of capital theory alone cannot adequately explain the policy underlying the section 104 exclusion.
A second policy explanation for the exclusion of damage awards is based on the involuntary nature of the transaction. In short, a plaintiff does not ask to be injured.(fn31) Therefore, under this theory, section 104 is analogous to other sections of the tax code that afford special tax treatment to involuntary transactions.(fn32) For example, I.R.C. section 1033 allows a taxpayer to postpone gain after an involuntary conversion of property.(fn33) Under this section, if a taxpayer's property is destroyed, the taxpayer can exclude any gain received from insurance, but only if the taxpayer reinvests the money into a replacement property.(fn34) However, sections 104 and 1033 are not analogous. Even though section 1033 allows for a postponement of gain, section 1033, unlike section 104, does not create an exclusion from income. Consequently, this policy is inadequate for explaining the exclusion under section 104.
A third theory that has been put forth to explain the exclusion for damages is based on the principles of compassion and humanitarian-ism.(fn35) Under this rationale, section 104 excludes a taxpayer's damages because the taxpayer is considered to have suffered enough.(fn36) Under this theory, the exclusion for damages under section 104 is compared to section 101 of the code,(fn37) which excludes from gross income all amounts "received . . . under a life insurance contract."(fn38) Thus, under the theory of compassion or humanitarianism, an analogy is drawn between Congress's compassion for a bereaving family member and Congress's compassion for an injured taxpayer.(fn39) Additionally, the compassion theory might explain the tendency for courts to expand the section 104 exclusion, a tendency that runs contrary to the usual judicial practice of narrowly interpreting exclusions from income.(fn40) However, this theory cannot adequately explain section 104's exclusion for the simple reason that not all damages awarded to an injured taxpayer are excluded from income.(fn41)
A fourth possible explanation for the exclusion rests on the imputed income theory.(fn42) There are two types of imputed income. One type is income derived from the use of "household durables."(fn43) Under this type of imputed income, the owner of a house is said to have imputed income because if the taxpayer did not own the house, the taxpayer would have to pay a landlord rent.(fn44) This saving of rent payments is considered imputed income. The second type of imputed income involves the taxpayer who enjoys the fruits of his or her labor.(fn45) For example, when a lawyer writes his or her own will rather than paying someone else to write it, this savings in payment is imputed income to the lawyer. However, in both cases the IRS does not include this amount in gross income.(fn46)
The imputed income theory has been used to explain the exclusion of damages from gross income.(fn47) An example of such an exclusion would be when a jury awards a husband damages for the loss of consortium for the death of his wife. Inherent in such a damage award is an amount for the loss of the wife's services, and this amount is considered imputed income. Therefore, under existing tax policy, it would not be taxed. However, the use of the imputed income theory as a basis for excluding damages for income has been criticized because the decision by the IRS not to tax imputed income is based on valuation problems.(fn48) But, tort-related damages are paid in cash so there is no problem of valuation.(fn49)
A fifth policy justification for the section 104 exclusion is based on the bunching of income theory.(fn50) The bunching of income theory is based...
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