Supreme Court decides back pay taxability.

• Author: Barton, Peter C.

For the first time, the U.S. Supreme Court has ruled on whether back pay awarded to taxpayers under a Federal discrimination statute is taxable. In Burke, 112 Sup. Ct. 1867 (1992), rev'g 929 F2d 1119 (6th Cir. 1991), the Court overruled the Sixth Circuit and ruled that the Sec. 104(a)(2) exclusion did not extend to back pay in a pre-1991 Title VII sex discrimination suit. However, the Court's reasoning suggests that discrimination awards in most future cases will be excludible.

This ruling resolves a conflict over the taxability of damages resulting from the nonphysical injury of discrimination. The lower court decisions have focused on whether back pay awarded to employees who have been victims of discrimination is taxable. Burke is important for advising clients who either receive or pay money as a result of discrimination, whether by court order or settlement.

While Sec. 61(a) taxes all income unless otherwise excludible, Sec. 104(a)(2) excludes from gross income "the amount of any damages received on account of personal injuries." Contractual damages and punitive damages, when received for a nonphysical injury, are not excludible. Personal injury is not defined, but Regs. Sec. 1.104-1(c) specifies that the taxpayer's claim must be a tort-type claim. The taxpayers in Sec. 104(a)(2) cases have argued that back pay awards based on discrimination are torts, and consequently, any back pay awards should be construed as resulting from personal injuries and therefore should not be taxed. In contrast, the IRS has consistently sought to apply a narrower, more limited view of personal injury.

In Burke, several hundred women sued their employer for sex discrimination under Title VII of the Civil Rights Act of 1964, claiming that they had been underpaid based on sex from 1981 to 1984. Title VII prohibits employment discrimination based on sex, race, color, religion or national origin. The parties ultimately settled for $5 million.

Before 1991, Title VII allowed an employee injured by discrimination to recover back pay, but not compensatory or punitive damages, and did not allow jury trials. Compensatory damages are designed to put the injured party in the same position that he would have been in if the wrong had not occurred. They can include money for back pay, emotional distress, pain and suffering, and humiliation. In some statutes, compensatory damages for the intangible effects of discrimination, such as emotional distress, pain and suffering...