No Exclusion for Adea Claims Under I.r.c. Sec. 104(a)(2): an Analysis of Commissioner v. Schleier - T. Mark Sandifer

• Citation: Vol. 47 No. 2
• Publication year: 1996

CASENOTES

No Exclusion for ADEA Claims Under I.R.C. Sec. 104(a)(2): An Analysis of Commissioner v. Schleier

In order to resolve inconsistent conclusions between the courts of appeals as to the taxability of damages received under the Age Discrimination in Employment Act of 1967 (ADEA), the United States Supreme Court granted certiorari in Commissioner v. Schleier.¹ After receiving damages in an ADEA settlement with United Airlines, Inc., Erich Schleier included as gross income the back pay portion of the settlement, but excluded the portion of the settlement attributed to liquidated damages on his 1986 federal income tax return.² The Tax Commissioner issued a deficiency notice, claiming Schleier should have included the liquidated damages as gross income.³ Schleier responded by initiating proceedings in Tax Court claiming that he had properly excluded the liquidated damages.⁴ In addition, Schleier sought a refund of the taxes paid on the back pay portion of the settlement.⁵ The Tax

Court agreed with Schleier, holding that the entire settlement satisfied the requirement of "damages received ... on account of personal injury or sickness" within the meaning of section 104(a)(2) of the Internal Revenue Code and was, therefore, excludable from gross income.⁶ The Fifth Circuit Court of Appeals affirmed.⁷ The United States Supreme Court reversed the Tax Court and the court of appeals, holding that recovery under ADEA was not excludable from gross income.⁸

The exclusion from gross income of damages received on account of personal injury was first codified in section 213(b)(6) of the Revenue Act of 1918.⁹ Later, Congress enacted the modern version of the personal injury exclusion, section 104(a)(2) of the 1954 Code.¹⁰ In 1960 the Internal Revenue Service issued regulations that defined the phrase "damages received (whether by suit or agreement)" to mean amounts linked to actions based on tort or tort type rights.¹¹ Against these narrowly construed codified exclusions to gross income, section 61(a) broadly provides that gross income includes "all income from whatever source derived."¹² The Supreme Court in Commissioner v. Glenshaw Glass¹³ expanded the concept of gross income to include all "accessions to wealth, clearly realized, over which the taxpayers have complete dominion."¹⁴ The Tax Court applied these prior interpretations in Threlkeld v. Commissioner¹⁵ and developed a test for determining whether damages received from a lawsuit were excludable under section 104(a)(2).¹⁶ The Court concluded that the "origin and character of the claim" determined whether the damages received from a lawsuit were excludable.¹⁷ The Court held that "[e]xclusion under section 104 will be appropriate if compensatory damages are received on account of any invasion of the rights that an individual is granted by virtue of being a person in the sight of the law."¹⁸ Following this expansive "nature of the claim" test, the United States Court of Appeals for the Third Circuit, in Rickel v. Commissioner,¹⁹ reversed the Tax Court, in part, holding that section 104(a)(2) excluded all damages received by the taxpayer on account of age discrimination from gross income.²⁰ The Tax Court had held that the liquidated portion of the award was excludable, but that the wage-related damages were based in contracts and therefore not excludable.²¹ The Third Circuit stated that "once it found that age discrimination was analogous to a personal injury and that the taxpayer's ADEA action amounted to the assertion of a tort type right, the Tax Court should have ended its analysis."²² Likewise, in Pistillo v. Commissioner,²³ the United States Court of Appeals for the Sixth Circuit reversed a Tax Court decision and held that section 104(a)(2) excluded the entire settlement from gross income.²⁴ Subsequently, in Downey v. Commissioner,²⁵ a case involving a settlement award to a United Airlines pilot, the Tax Court overruled its holdings in Rickel and Pistillo and held that section 104(a)(2) excluded both liquidated and nonliquidated damages from gross income.²⁶ In reaching its decision, the Tax Court stated that the nature of the underlying claim, rather than the claim's consequences, determines excludability, and the Tax Court articulated a two-part test requiring that (1) the claim is tort or tort-like and (2) the nature of the injury is personal.²⁷ The Tax Court applied this test and concluded that ADEA claims are tort-like and that age discrimination is a personal injury for purposes of section 104(a)-(2).²⁸ Thus, the Tax Court found both the liquidated and nonliquidated damages excludable.²⁹ However, the Supreme Court in United States v. Burke,³⁰ a non-ADEA claim settlement, held that back pay awards in settlement of pre-1991 Title VII claims are not excludable from gross income under section 104(a)(2).³¹ The Court focused its analysis on what constitutes a tort and reasoned that the availability of a broad range of damages was a critical factor in determining that a claim was tort-like.³² The Court found that pre-1991 Title VII remedies were limited to back pay, injunctions, and equitable relief; in stark contrast to those available under traditional tort law.³³ Based on the Supreme Court's decision in Burke, the Tax Court reconsidered its decision in Downey and reaffirmed its earlier holding.³⁴ The Tax Court distinguished pre-1991 Title VII claims by arguing that the ADEA offered a broad range of remedies including back pay and liquidated damages.³⁵ After the Tax Court appeared to firmly establish its position on ADEA recoveries, the United States Court of Appeals for the Seventh Circuit reversed the Tax Court in Downey and held that section 104(a)(2) does not exclude settlements resulting from ADEA actions because the damages do not compensate the taxpayer for those intangible elements of injury essential to personal injury tort actions.³⁶ In reaching its decision, the Seventh Circuit limited its analysis to the approach taken in Burke as the most pertinent teaching on the matter, ignoring previous circuit court decisions.³⁷ In contrast, the United States Court of Appeals for the Ninth Circuit in Schmitz v....