Recent Developments concerning the Taxation of Damages under Section 104(a)(2) of the Internal Revenue Code
Nicholson, Brent B., Albany Law Review
From its infancy, the Internal Revenue Code has contained an exclusion from taxable income for damages received on account of personal injuries. For decades, courts have worked at deciphering its meaning, dealing with issues such as what constitutes a personal injury, whether there should be a distinction between physical and non-physical personal injuries, and whether punitive damages were also excluded. The last decade has largely focused on the taxability of awards under federal statutes prohibiting discrimination, specifically Title VII of the Civil Rights Act of 1964(1) and the Age Discrimination in Employment Act (ADEA),(2) as well as the taxability of punitive damages.
In its 1992 decision, United States v. Burke,(3) the United States Supreme Court held Title VII damages taxable. The Court determined that because of its limited remedies available to successful plaintiffs the statute did not redress a tort or tort-type injury.(4) In 1991, however, in a change not addressed in Burke, Congress amended Title VII to provide a more expansive list of remedies and remediable injuries.(5)
In the midst of lower court struggles with the Burke legacy, the Supreme Court added to the confusion by its reasoning in a 1995 ADEA case.(6) Holding both the backpay and the liquidated damage components of the award taxable, the Court rather unpersuasively opined that the ADEA redressed neither tort or tort-type rights nor a personal injury.(7) It further held that, contrary to Burke, these were separate tests ("based upon tort or tort type rights" and "received on account of personal injuries or sickness"), that ADEA's liquidated damages were punitive in nature, and that the ADEA's more generous (than Title VII) remedies were not extensive enough to meet Burke's requirements for excludability.(8) The better reasoned dissent of Justices O'Connor, Souter, and Thomas took serious issue with the majority's revisionist reading of Burke. As part of the background to the recent developments, the Scheiler case will be discussed.
Another contentious issue over the last decade has been the taxability of punitive damages. A 1989 congressional attempt at resolution of the issue was leas than successful. That legislation made punitives paid for nonphysical injuries taxable.(9) In the latter half of 1996, however, the Supreme Court(10) and Congress(11) seemed to have taken the requisite definitive steps to making all these awards taxable. Importantly, the congressional Act amending Internal Revenue Code [sections] 102(a)(2) generally made damages paid for nonphysical personal injuries taxable.(12) A review of the O'Gilvie v. United States(13) decision and the new legislation highlight the resolved and remaining unresolved areas.
Yet another high visibility area within [sections] 104(a)(2) involves settlement agreement allocations between taxable and nontaxable components. Frequently, parties enter such agreements without tax forethought. After signing off on a general release they are forced to argue allocation issues in hindsight. Alternatively, the agreement may contain an allocation which the Internal Revenue Service challenges. The issue in these cases is the enforceability of the designated allocation. Recent cases on these points will be discussed.
Often linked to the allocation issue is the issue of the taxability of statutory pre-judgment interest. Two courts of appeals have dealt with the question, both finding it taxable, although the First Circuit clearly has left the door open to revisit the issue. These cases will likewise be explored.
After explicating these issues, the Article analyzes the state of the law and makes several recommendations. Future problem areas are mentioned, as well as some suggestions for a plaintiff's tax or litigation counsel. A short concluding section ends the Article.
I. The Scope of [sections] 104(a)(2)
Prior to August 21, 1996, [sections] 104(a)(2) provided:
(a) In General. …