Tax Court Excludes Back Pay Received for Age Discrimination
In a reconsideration of a prior opinion, Tax Court, in a reviewed opinion, allowed an exclusion for all damages, including back pay, received as a result of age discrimination. In Downey v. Commissioner, 100 T.C. No. 40 (June 29, 1993), the court ruled 11-6 that all damages received under the Age Discrimination in Employment Act (ADEA) qualify as "tort-like personal injury" damages. "Tort-like personal injury" under IRC Sec. 104(a)(2) was interpreted by the U.S. Supreme Court in S. v. Burke, 112 S.Ct. 1987 (1992). Downey is a major development because in Burke the Supreme Court ruled that back pay received under Title VII of the Civil Rights Act of 1964, which prohibits employment discrimination based on race, sex, religion, and national origin, is taxable.
Prior to Burke, the Tax Court originally decided Downey in 11, 97 T.C. 150 (1991). (The 1991 decision will be referred to as Downey I and the 1993 decision as Downey II.) Downey, an airline pilot, settled an ADEA suit with his employer for $60,000 back pay and $60,000 liquidated damages. The Tax Court ruled in Downey I that all damages were excludable because the violation of discrimination statutes is a tort, not a breach of contract, though back pay is one of the remedies. (Downey I was discussed in the November, 1991, issue of The CPA Journal in "Tax Court Allows Back Pay Exclusion.") After Burke, the IRS requested that the Tax Court reconsider Downey.
IRC Sec. 61(a) taxes all income unless otherwise excludable IRC Sec. 104(a)(2) excludes from gross income "the amount of any damages received on account of personal injuries." "Personal injury" is not defined in the IRC, but the regulations, Sec. 1.104-1(c), specify that the taxpayer's claim must be a tort-type (tort-Like) claim. A tort is a wrong, other than breach of contract, for which a court awards damages. In IRC Sec. 104(a)(2) cases, taxpayers have argued that back pay awards and other damages based on discrimination statutes qualify as tort-like. The IRS has maintained that the back pay is a contractual claim and therefore taxable.
A NEW STANDARD
In Burke, the Supreme Court added a new requirement. The Court ruled that to be a tort-like personal injury for purposes of IRC Sec. 104(a)(2), a claim must be based on a statute or other legal claim that allows the traditional tort remedies of compensatory and punitive damages. Compensatory damages are designed to put the injured party in the same position that he or she would have been in if the wrong had not occurred. They include back pay and money for intangible or nonpecuniary losses such as emotional distress, pain and suffering, and humiliation. Punitive damages are awarded to punish the defendant for intentional or reckless conduct. Prior to 1991 amendments (which were too recent to apply to the plaintiffs in Burke), Title VII allowed an employee injured by sex discrimination to recover back pay, but not compensatory or punitive damages. Therefore, the Supreme Court ruled that the back pay under the unamended Title VII was taxable Burke did not discuss the applicability of its ruling to the ADEA since age discrimination was not an issue in Burke.
The ADEA, passed by Congress in 1967, prohibits age discrimination in employment. Employers who violate the ADEA are liable for back pay and, for willful violations, liquidated damages. "Willful" in this context means "not merely negligent." For non-willful violations, only back pay is available under the ADEA.
The nature of liquidated damages is somewhat controversial. In Downey I, the Tax Court held that "from the victim's perspective" liquidated damages compensate the victim for nonpecuniary losses (emotional distress, pain and suffering, etc.). In Downey II, the court held that they serve two functions: to compensate the victim for nonpecuniary losses and to serve a deterrent or punitive purpose. …