Personal Injury Exclusion

• Publication year: 2021

76 Nebraska L. Rev. 51. Personal Injury Exclusion

51

Patrick E. Hobbs*

The Personal Injury Exclusion: Congress Gets Physical but Leaves the Exclusion Emotionally Distressed

TABLE OF CONTENTS

I. Introduction 51

II. Part II: A Questionable Beginning 56

A. The Physical Injury Exclusion 56

B. The Nonphysical Personal Injury Exclusion 67

C. Silent Merger 69

D. Congress' 1989 Amendment: An Unusual
Imprimatur 74

E. Employment Discrimination: The Return to
Physical 75

III. The 1996 Amendment: Congress Gets Physical 82

A. Pre-1996 Act Awards 84

B. Physical/Nonphysical: Drawing the Line 87

C. Amended Section 104(a)(2): Did Congress Go Far
Enough? 89

IV. Conclusion 93

I. INTRODUCTION

Shortly after the income tax became a permanent part of the federal tax landscape in 1913,(fn1) Congress added a provision to the Internal Revenue Code ("the Code"),(fn2) allowing taxpayers to exclude from

52

income "any damages" received "on account of personal injury or sickness."(fn3) Since its enactment, § 104(a)(2) has been the subject of intense scrutiny(fn4) and constant litigation.(fn5) Both the Treasury

53

Department and the courts have struggled to determine the scope of the terms "personal injury" and "any damages." This debate has centered around two pivotal issues: (1) whether the term "personal injuries" extends to nonphysical injuries, such as dignitary torts and employment discrimination, and (2) whether the term "any damages" encompasses the punitive as well as the compensatory portion of a personal injury award.(fn6)

In 1989, Congress seemed to answer both questions when it amended the personal injury exclusion to provide that punitive damages awarded for a nonphysical injury are taxable.(fn7) Beyond answering this question expressly, many thought Congress had implied that punitive damages awarded for physical injuries were not taxable.(fn8)Moreover, by amending the statute to limit damages excludable for nonphysical injuries, Congress made clear its assumption that the term "personal injury" extended to nonphysical as well as physical injuries. The debate, however, was far from over.

54

Twice in the last five years, the Supreme Court limited the application of the personal injury exclusion in cases involving nonphysical injuries.(fn9) In United States v. Burke(fn10) and Commissioner v. Schleier,(fn11) the Court rejected efforts by taxpayers to employ § 104(a)(2) to exclude amounts received in employment discrimination suits. Additionally, despite the negative inference of the 1989 amendment, lower courts continued to debate the exclusion of punitive damages awarded for physical injuries.(fn12)

On August 20, 1996, President Clinton signed into law the Small Business Job Protection Act providing tax relief for small business owners.(fn13) The 1996 Act also contained a series of unrelated provisions designed to provide revenue offsets for the tax relief provided.(fn14) Section 1605 of the Act amended § 104(a)(2) to limit the personal injury exclusion to cases involving physical injury or physical sickness.(fn15)The new provision, which affects all personal injury judgments and settlements rendered after August 20, 1996, provides:

SEC. 104 COMPENSATION FOR INJURIES OR SICKNESS

(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 (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness . . .

For purposes of paragraph (2), emotional distress shall not be treated as a physical injury or physical sickness. The preceding sentence shall not apply to an amount of damages not in excess of the amount paid for medical care (described in subparagraph (A) or (B) of section 213(d)(1)) attributable to emotional distress.(fn16)

55

As amended, § 104(a)(2) now provides that the personal injury exclusion shall apply only to compensatory damages received on account of a physical injury or physical sickness.(fn17) Some will undoubtedly argue that Congress' action resolves once and for all the issues surrounding the personal injury exclusion. However, just as the 1989 amendment did not end the debate, neither does Congress' latest effort. Old questions have been left unanswered and new ones have been raised.

For example, the Act leaves unresolved the tax treatment of pre-enactment awards. The new statute would seem to indicate that compensatory awards for nonphysical injuries and punitive damages awarded for physical injuries were within the ambit of the prior statutory provision and therefore should be excluded from income. However, the new Act contains an express refusal by Congress to address the scope of the prior provision. Indeed, Congress not only declined to discuss the scope of preenactment § 104(a)(2), it specifically stated that no inference can be drawn from the new statute when determining the scope of the prior provision. Therefore, as courts continue to grapple with the application of preamendment § 104(a)(2) to thousands of unresolved preenactment settlements and awards, they must do so without considering the effect of the new statute.

More importantly, however, the 1996 Act raises questions concerning future awards. The line between physical and nonphysical injuries and sickness is more difficult to draw than appears at first glance. One concern arises out of Congress' attempt to carve out a limited nonphysical injury exclusion for emotional distress. The language employed achieves a result far different than intended: instead of providing a limited nonphysical injury exclusion, the language further narrows the exclusion for physical injuries. Furthermore, neither the statute nor the legislative history address the application of the exclusion when physical sickness results from a nonphysical injury.

In addition to the interpretative problems associated with amended § 104(a)(2), policy considerations also surround the new provision. In the past, the personal injury exclusion was justified under a "human capital" rationale.(fn18) In essence, human capital theorists assert that personal injury recoveries represent a return of human capital and should not be taxed as income. This theory laid the foundation for the original personal injury exclusion and continues to receive support today. Now that Congress has limited the personal injury exclu

56

sion to physical injuries, this theoretical justification must be reexamined.

This Article is divided into three parts. Part II reviews the history of the personal injury exclusion. It finds that, at its inception, the exclusion actually constituted two separate exclusions: a statutory exclusion for physical injuries and a nonstatutory exclusion for nonphysical injuries. It examines the policy rationale for both exclusions and determines that each resulted from a questionable use of precedent by early tax policymakers. Eventually, the two exclusions were merged, first by the courts and then by Congress, as a result of the 1989 amendment. This historical review leads to two conclusions. First, if Congress, by amending § 104(a)(2), is stating that the exclusion never was intended to apply to nonphysical injuries, despite the 1989 amendment, then Congress' position is correct and both the Service and the courts should reject the extension of § 104(a)(2) to non-physical injuries in all preenactment cases. Second, and more importantly, history reveals that the original justification for the physical injury exclusion was seriously flawed and should have been rejected by both Congress and the courts.

Part III then examines amended § 104(a)(2) and questions whether Congress' decision to draw a line between physical and nonphysical injuries and sickness can be applied sensibly. Congress' attempt to provide a limited exclusion for the nonphysical injury of emotional distress creates serious interpretive difficulties that courts are likely to wrestle with in the near future. Finally, Part IV asks the question: Did Congress go far enough? It reviews human capital theory and its recent metamorphosis and suggests that this theory remains a suspect foundation for the personal injury exclusion. Consequently, Part IV concludes that Congress was wrong; the only appropriate congressional action with respect to § 104(a)(2) was repeal.

II. PART II: A QUESTIONABLE BEGINNING

A. The Physical Injury Exclusion

Although the modern income tax dates from 1913,(fn19) the personal injury exclusion did not appear in the Code until five years later.(fn20)Prior to this amendment, the Treasury Department decided the tax treatment of amounts received as reimbursements, awards, or settlements for personal injuries and accidents.

Treasury initially indicated that such amounts were taxable.(fn21) In Treasury Decision 2135, the Department stated that monies received

57

by a taxpayer under an accident insurance policy were income.(fn22) Although Treasury Decision 2135 did not address personal injury awards in general, it did contain the following statement: "An amount received as a result of suit or compromise for `pain and suffering' is held to be such income as would be taxable under the provision of law that includes `gains or profits and income derived from any source whatsoever.'"(fn23) Treasury equated amounts received for pain and suffering with proceeds paid under accident insurance policies.(fn24) Treasury Decision 2135 was silent with respect to the tax treatment of damages received for anything other than pain and suffering as a result of a personal injury.(fn25) Nevertheless...