Schleier requires Congress to clarify when damages received for discrimination are not taxable.

• Author: Cohen, Philip G.
• Position: Commissioner v. Schleier

1. Introduction

   In a much anticipated opinion, the Supreme Court held earlier this year in Commissioner v. Schleier(1)(*) that section 104(a)(2) of the Internal Revenue Code(2) does not authorize a former United Airlines pilot to exclude from his gross income the amount received in settlement of a claim for back pay and liquidated damages under the Age Discrimination in Employment Act of 1967.(3) Unfortunately, the decision creates needless complexities and inequitable disparate treatment with respect to when damages received by victims of discrimination can be excluded from gross income. This article examines Schleier and how it affects both the 1992 Supreme Court decision, United States v. Burke,(4) which addressed the taxability of damages received under Title VII of the Civil Rights Act of 1964(5) (prior to its amendment by the Civil Rights Act of 1991(6)) and the IRS's ruling interpreting Burke, Rev. Rul. 93-88.(7) The article also discusses the need to modify section 104 to exclude all damages (except punitive damages) received by victims of discrimination -- regardless of the nature of the discrimination, the statute giving rise to the cause of action, whether the discrimination is intentional, when the action is brought, whether the harm suffered is physical or financial, or how the monetary relief was determined.

2. Section 104(a)(2) and Treas. Reg. [sections] 1.104-1(c)

   Section 104(a)(2) provides that gross income does not include "the amount of any damages received (whether by suit or agreement and whether as lump sum or periodic payments) on account of personal injuries or sickness." The rationale behind the statute is apparently that the payment does not result in economic gain or profit to the injured recipient, but instead roughly corresponds to a return of capital compensating the taxpayer for his loss.(8) As a result of an amendment by the Omnibus Budget Reconciliation Act of 1989, the exclusion in section 104(a)(2) "shall not apply to any punitive damages in connection with a case not involving physical injury or physical sickness."(9)

   Treas. Reg. [sections] 1.104-1(c) defines "damages received on account of personal injuries or sickness" as "an amount received (other than workmen's compensation) rough 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." The term "based upon tort or tort type rights' was the subject of the Supreme Court's decision in Burke.

3. United States v. Burke

   In Burke, the Supreme Court held that backpay awards, in settlement of a sex discrimination claim brought under Title VII prior to its amendment by the Civil Rights Act of 1991, are not excludable from gross income under section 104(a)(2). The taxpayers in Burke were employees of the Tennessee Valley Authority (TVA) who filed a Title VII claim alleging that the TVA had unlawfully discriminated in the payment of salaries based on sex. A union representing TVA employees, including the taxpayers, intervened in the action. The plaintiffs sought injunctive relief as well as backpay. A settlement was reached by the parties pursuant to which the taxpayers received backpay, subject to withholding for federal income taxes. The taxpayers filed claims for refund, alleging that the settlement payments should be excluded from gross income under section 104(a)(2). The taxpayers were unsuccessful at the district court level,(10) but the United States Court of Appeals for the Sixth Circuit, in a divided vote, reversed the decision on the basis that the claim of unlawful sex discrimination was "personal and tort-like in nature."(11) Certiorari was granted to resolve a conflict among the circuits.(12)

   Writing for the Court, Justice Blackmun began his analysis with section 104(a)(2) and its legislative history He noted that neither the statute nor the legislative history offers any explanation of the term "personal injuries."(13) He then turned his attention to Treas. Reg. [sections] 1.104-1(c), which links the statutory requirement of "damages received ... on account of personal injuries or sickness" to the concept of "tort or tort type rights." The Court stated that the appropriate inquiry for purposes of section 104(a)(2) is "the nature of the claim underlying respondents' damages award" and that taxpayers must show "that Title VII, the legal basis for their recovery of backpay, redresses a tort-like personal injury." The Court further noted that "the concept of a `tort' is inextricably bound up with the remedies -- specifically damages actions."(14) Thus, the Court believed that the key focus should be on the remedies available for discrimination actions brought under Title VII. The Court concluded that because the damages available under Title VII, prior to its amendment by the Civil Rights Act of 1991, are limited to the wages properly due claimants and do not permit compensatory or punitive damages, the claim could not be characterized as based upon tort. Therefore, the payment was taxable. The Court added, however, that this does not preclude an exclusion from gross income under section 104(a)(2) for damages received as a result of discrimination claims made under another statute that provided tort-like remedies.(15)

   The Court noted that the Civil Rights Act of 1991 provides victims of intentional discrimination the right "to a jury trial, at which it may recover compensatory damages for future pecuniary losses, emotional pain, suffering, inconvenience, mental anguish, loss of enjoyment of life and other nonpecuniary losses, as well as punitive...