Vol. 4, No. 5, Pg. 14. IRC Section 1 04(a)2 Is Your Client's Award or Settlement Taxable.

AuthorBy Thomas 0. Wells

South Carolina Lawyer

1993.

Vol. 4, No. 5, Pg. 14.

IRC Section 1 04(a)2 Is Your Client's Award or Settlement Taxable

14IRC § 1 04(a)2: Is Your Client's Award or Settlement Taxable?By Thomas 0. WellsOne recent hot topic in taxation has been the exclusion of litigation awards and settlements from income under § 104(a)(2) of the Internal Revenue Code of 1986, as amended (IRC or Code). Last summer the United States Supreme Court in United States v. Burke, 504 U.S. 112 S.Ct. 1867 (1992), held that settlement proceeds paid on a claim under Title VII of the Civil Rights Act of 1986, as it existed before its 1991 amendment, must be included in the gross income of the recipient. In 1990 the Fourth Circuit held that punitive damages that serve no compensatory purpose were includable in gross income. C.I.R. v. Miller, 914 F.2d 586 (4th Cir. 1990).

This article will discuss the taxation of litigation awards and settlements and offer some related tax planning strategies. The article will also focus on payment of back pay awards or settlements as wages and consider how such payments can adversely affect either the defending employer or its insurance company.

Provisions in the Code and Regulations

Code § 104(a)(2) provides that "gross income does not include the amount of any damages received (whether by suit or agreement or as lump sums or periodic payments) on account of personal injuries or sickness." Damages include both compensatory and punitive damages. In 1989, Congress limited the exclusion of punitive damages from gross income to punitive damages received "in connection with a case involving a physical injury or physical sickness."

The IRS interprets damages excludable from gross income under § 104(a)(2) as being "an amount received (other than workers' compensation) through the 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." Treas. Reg. § 1.104-1(c). Therefore, the analysis of whether damages are received on account of personal injuries and are excludable from gross income depends on whether a tort or tort type cause of action has been raised.

The statutory and regulatory analysis of whether awards or settlements are excluded from gross income under Code § 104(a)(2) can be summarized as follows:

* For compensatory damages (i.e., recovery that does not generate a gain or profit but only makes the taxpayer whole by compensating him for a loss), a tort or tort type cause of action must be raised.

* For punitive damages (damages that do not compensate the plaintiff for harm suffered but rather are exemplary in nature and are over and above any award or compensatory damages), a tort or tort type cause of action must be raised and the action must involve a physical injury or illness.

Tort Type Claims as Defined in Burke

United States v. Burke is the seminal case in determining what is a tort claim under § 104(a)(2). In Burke, employees of the Tennessee Valley Authority (TVA) filed an action under Title VII of the Civil Rights Act of 1964 alleging that TVA had discriminated unlawfully in the payment of salaries on the basis of sex. TVA agreed to pay the affected employees a total of $5 million, to be distributed...

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