Back Pay Taxed in Racial Discrimination Case
Barton, Peter, Sager, Clayton, The CPA Journal
In the last four years, there have been several Tax Court and Court of Appeals cases that have applied IRC Sec. 104(a)(2) personal injury exclusion to awards made under federal race, sex, and age discrimination statutes. In these cases the courts have become increasingly liberal in their interpretation of the exclusion, culminating in the Tax Court's allowing the exclusion for back pay in Downey (97 T.C. 150(1991)). (See "Tax Court Allows Back Pay Exclusion," Federal Taxation department, November 1991, The CPA Journal.) However, in Sparrow v. Commissioner (90-1151, 91-2 USTC 50567 (November 26, 1991)), the Washington, D.C. Circuit reversed this trend by unanimously denying the exclusion. The D.C. Circuit based its decision on a narrow, technical point that is out of the mainstream of a whole line of Sec. 104(a)(2) cases, both in approach and result.
As background, Sec. 104(a)(2) allows taxpayers to exclude "the amount of any damages received (whether by suit or agreement) on account of personal injuries or sickness." The regulations define "damages received" to mean "an amount received...through prosecution of a legal suit or action based upon tort or tort-type rights" (Reg. 1.104-1(c)). In applying the statute and regulations, courts have inquired into the nature of the claim that is the basis for the payment. If the claim is a tort-type personal injury, the damages are excluded. If the award is based on a contract-type claim, the damages are taxable.
One of the remedies available to an employee under the discrimination statutes is an award of back pay. There is agreement in all of the cases that crimination claims (age, sex, race, national origin) under federal statutes are tort-type claims. However, some courts have focused on back pay to carve out an exception by ruling that it is taxable as a contract-type claim. There are two types of back pay: 1) back pay for work that the taxpayer did not do because he or she was fired due to illegal discrimination; and 2) back pay for work done where the taxpayer was underpaid due to discrimination. Most of the cases have involved back pay of the first type. The Tax Court and the Court of Appeals in the 3rd, 6th, 9th, and 10th Circuits have ruled that the first type of back pay is excludable under Sec 104(a)(2). The rationale used by the courts in these cases also supports excluding the second type of back pay from taxable income. In a recent case involving the second type, Burke v. United States (929 F.2d 1119(6th Cir. 1991)), the 6th Circuit allowed the exclusion for payment of a prior discriminatory underpayment since the back pay claim was made under federal discrimination statutes.
THE SPARROW DECISION
In Sparrow, the employee claimed that his employer fired him because of his race in violation of Title VII of the federal Civil Rights Act of 1964, which provides relief for employees who are discriminated against on the basis of race, sex, religion, or national origin. As a result, the parties settled for $92,300. The Tax Court, in a 1989 decision, ruled that the entire amount of this award was for "back pay." Sparrow argued that the Sec. 104(a)(2) exclusion should apply because racial discrimination is a personal injury. The court disagreed, holding that the $92,300 was taxable since back pay under Title VII does not constitute damages. The court reasoned that damages are a legal remedy, but Title VII allows only equitable relief. Therefore, back pay under Title VII cannot qualify for the Sec. 104(a)( 2) exclusion since the exclusion only applies to damages. Using this approach, the court did not have to decide whether the back pay was a tort-type claim because this question does not arise if the employee does not receive damages. …