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By Kenneth F. Abramowicz, PhD, CPA, University of Alaska, Fairbanks

After years of litigation related to the taxability of damages received on account of personal injury or sickness, Congress finally decided the issue when it passed the Small Business Jobs Protection Act of 1996 (SBJPA). Under the new law, all punitive damages are taxable. In addition, most damages received for nonphysical injuries are also included in income. Thus, it will be important to consider the distinction between compensatory and punitive damages when negotiating future settlements. Furthermore, firms may need to withhold taxes from the damage awards they pay.

Prior Law

Before the recent amendment by the SBJPA, IRC section 104(a)(2) excluded any damages received in a law suit or in an outside-of-court agreement on account of personal injury or sickness. Some courts had interpreted this exclusion broadly to cover awards for personal injury that do not relate to a physical injury or physical sickness. Courts have also differed as to whether the exclusion applied to punitive damages received in connection with cases involving physical injury or physical sickness. Two Supreme Court cases have recently clarified the taxation of damages attributable to age discrimination and gender discrimination.

In a 1992 case, Burke v. U.S. (69 AFTR 2d 92-1293), the Supreme Court held that amounts received as a result of sex discrimination were taxable. While the damages in Burke were not excludable, the IRS believed that the Supreme Court made it clear that discrimination would constitute a personal injury if the relevant cause of action provides a tortlike remedy. In response to Burke, the IRS issued Rev. Rul. 93-88, saying that damages received in satisfaction of gender, race, and disability discrimination claims are excludable from gross income.

Later, in the l995 case of Schleier v. Commissioner (75 AFTR 2d 95-2675), the Supreme Court held that damages received in an age discrimination case were taxable. Furthermore, the Supreme Court stated that its earlier decision in Burke established two requirements that must be met for damages to be excluded: l ) The underlying cause of action giving rise to the recovery must be "based upon tort type rights," and 2) the damages must have been received "on account of personal injuries or sickness." Schleier effectively eliminated the exclusion of damages from all discrimination cases and limited IRC section 104(a)(2) to physical injuries or sickness. Reacting to the favorable ruling in Schleier, the IRS suspended Rev. Rul. 93-88. Thus, the SBJPA is essentially a codification of the Supreme Court's ruling that damages from nonphysical injuries are taxable.

Current Law

Punitive damages are above and beyond the amount needed to make a victim whole. Since punitive damages are a windfall to the taxpayer, Congress believes they should not be excluded from income. In addition, Congress feels that taxation of damages in cases not involving physical injury or physical sickness should not depend on the type of claim made. The SBJPA modified section 104 to remedy these perceived problems.

Under the new law codified by the SBJPA, all punitive damages are now taxable. Only compensatory damages received on account of a personal physical injury or physical sickness are excluded from income. All other damage awards for nonphysical damages such as age discrimination, gender discrimination, and injury to reputation are taxable.

If an action has its origin in a physical injury or physical sickness, then all compensatory damages are excluded, including compensatory damages paid to someone other than the injured party. For example, assume Mike injures his back in an auto accident and receives a $1,000,000 award for medical expenses and lost wages related to his physical injuries suffered in the accident. Nicole, Mike's wife, also receives a $500,000 award for loss of consortium due to Mike's back injury. Since the origin of the claim was a physical injury, Nicole and Mike are allowed to exclude the full $1,500,000 from their gross income.

Congress was careful to point out that emotional distress itself is not considered a physical injury or physical sickness, thus, damages received on account of emotional distress are generally taxable. Since, however, all damages received on account of physical injuries or physical sickness are excludable from gross income, the exclusion also applies to any damages received based on a claim of emotional distress that is attributable to a physical injury or physical sickness. Assume that in the previous example, Mike received an additional $500,000 award to compensate him for the emotional distress caused by his back injury. Since the emotional distress is attributable to a physical injury, this additional $500,000 would also be excludable from gross income.

To prevent financial hardship, Congress created an exception allowing the exclusion of amounts received for medical care attributable to emotional distress, regardless of its cause. For example, assume Gordon is successful in an age discrimination suit brought against his employer and receives the following damages: $400,000 for lost wages, $100,000 for emotional distress caused by losing his job, and $20,000 for medical expenses resulting from treatment of the emotional distress. Since the origin of the action is not physical injury or physical sickness, the $500,000 is taxable. The $20,000, however, is excluded from gross income because it is for medical care attributable to emotional distress.

In some states, only punitive damages may be awarded in certain personal injury cases; compensatory damages are not available as a remedy. Since all punitive damages are taxable under the new IRC section 104, all damages in these cases, including damages that are essentially compensatory in nature, would be taxable. Congress codified a special exception to correct this inequity. Under the new law, if the applicable state law provides that only punitive damages may be awarded in such a case, then punitive damages received in a wrongful death action are still excluded from income.

Effective Date of Tax Law Changes

The new law is effective for amounts received after the date the SBJPA was enacted, August 20, 1996. However, even if an amount is received after August 20, 1996, the SBJPA provides that prior law applies to any amount received under a written binding agreement, court decree or mediation award in effect on (or issued on or before) September 13, 1995.

The practical significance of these two grandfather clauses, however, has been limited by recent Supreme Court decisions. The conference committee report explicitly states that Congress intends no inference as to the application of the exclusion to punitive damages prior to the effective date of the bill in connection with a case involving physical injury or physical sickness. Likewise, the committee report states that Congress intends no inference with respect to the excludability of damages prior to August 21, 1996, in connection with cases not involving physical injury or physical sickness. Thus, it seems clear that Congress intended to allow court interpretations to determine the excludability of damages from personal injury claims received prior to August 21, 1996.

The Supreme Court ruling in Schleier eliminated the excludability of all damages from nonphysical injuries or sickness. On December 10, 1996, four months after Congress passed the SBJPA, the Supreme Court ruled in O'Gilvie v. U.S. that punitive damages received in a case for personal physical injury or sickness are taxable. The husband and two children of a woman who died of toxic shock syndrome received a jury award of $1,525,000 actual damages and $10,000,000 punitive damages in a tort suit. Holding that the punitive damages were not received "on account of" personal injuries, the court ruled that the $10 million punitive damages were taxable.

In 1989, Congress amended IRC section 104 to specifically state that the personal injury exclusion shall not apply to any punitive damages in connection with cases not involving physical injury or physical sickness. Taxpayers in O'Gilvie argued that this amendment implies that Congress intended punitive damages in physical injury cases are excludable. The court rebutted this argument; furthermore, the court emphasized that a view of a later Congress cannot control the interpretation of an earlier enacted statute. Thus, O'Gilvie casts significant doubt as to the exclusion of all punitive damages not subject to the new SBJPA tax laws. While no official IRS guidance has been issued on this topic yet, it seems likely that the IRS may seize the Supreme Court's decision in O'Gilvie as authority to tax the millions of dollars of punitive damages that were received in open tax years. *

Edwin B. Morris, CPA
Rosenberg, Neuwirth & Kuchner

Contributing Editor:
Richard M. Barth, CPA

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