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Taxability of

By Randall K. Hanson and James K. SmithThe exclusion for personal injury is In Brief

New Limits on the Exclusion from Taxability

Damages may be recovered under either breach of contract or tort claims. Tort claims have given rise to the largest and most publicized judgments. Such claims may arise out of theories of intentional torts, negligence, or strict liability. Both intentional torts and strict liability claims may give rise to punitive damages.

Prior to amendment, IRC section 104(a)(2) allowed exclusion from taxability for any damages received on account of personal injury or sickness. The Small Business Job Protection Act of 1996 amended this section to limit this exclusion to those damages received for personal injury or physical sickness. A second change requires punitive damages to always be taxable. These changes are effective for all damages received after August 20, 1996.

The taxability of damages received prior to that date are affected by two Supreme Court decisions. In one case involving age discrimination, the court held that all damages received were taxable because they were not received because of personal injury or sickness nor was the case based on tort or tort type rights. In a second case, the court held that punitive damages were taxable because they were not received on account of personal injuries or sickness.

Within the last two years there have been major changes to the way proceeds of lawsuits are taxed. The Small Business Job Protection Act of 1996 amended IRC Sec. 104(a)(2) and the United States Supreme Court rendered two decisions clarifying how the proceeds of lawsuits are taxed. The most recent decision was decided in December 1996. Since the amended IRC Sec. 104(a)(2) and the Supreme Court decisions make more damages taxable, there will be increased pressure on attorneys and accountants to find ways to structure settlements so as to minimize the tax effect of successful claims.

The most common theories asserted in seeking to recover civil money judgments are breach of contract claims and tort claims. Of these two theories, it is tort law that is most commonly criticized and is also the theory that has given rise to the largest and most publicized judgments. Recent tort cases that have received extensive media exposure are the McDonald's spilt coffee case and the General Motors pickups with their exploding gas tanks. Cases such as these have accelerated the call for tort reform to rein in what are viewed as outrageous decisions. Legal reform is slow to develop, and, in the meantime, there are huge numbers of tort claims being commenced, litigated, and settled every day.

To fully understand and appreciate the tax rules relating to damage awards, it is important to have a working understanding of the common tort law theories and the damages commonly received for these theories. Understanding tort law concepts is also important because Treasury regulations exclude from gross income payments received as a result of tort or tort-type claims. After examining the various tort theories, we will review the taxation of these tort claim proceeds in light of the recent Supreme Court decisions. Finally we will explore settlement structure strategies.

Tort Theories and Common Damages

Torts can be defined as "civil wrongs against individuals which are not based on breach of contract claims." The basic premise is that individual rights should be protected from harm. There are three categories of tort theories that are recognized in almost every state. They are intentional torts, negligence, and strict liability. Each of these theories will be briefly examined and contrasted.

Intentional Torts. Intentional torts include a broad group of wrongs that are the result of intentional bad acts. The common theme consistent in all intentional torts is the intent to harm another person. Common examples include assault and battery, false imprisonment, defamation, trespass, malicious prosecution, invasion of privacy, intentional infliction of emotional distress, intentional interference with contract rights, and fraud.

To compensate a victim for suffering an intentional tort, various damages are recoverable. For example, assume a person intentionally strikes another with their fist. The victim's jaw is fractured and has to be surgically pinned backed together. The victim is hospitalized overnight and is bedridden for two weeks. The victim will commence a civil tort lawsuit against the aggressor, asserting the tort claims of assault and battery. The victim will seek to recover compensatory damages for personal injuries, medical bills, lost wages, pain and suffering, and any other incidental costs incurred, such as renting a neck and jaw brace. In addition, punitive damages are generally recoverable for victims of intentional torts. Since the aggressor acted with intent to harm, the legal system has determined it is appropriate to punish the wrongdoer for the improper behavior. The legal system is sending a message to the wrongdoer and the community that those actions will not be tolerated. Often punitive damages can far exceed the actual or compensatory damages awarded. (The O.J. Simpson judgment is a good example.)

Negligence. The second tort theory is negligence. A negligence claim can easily be contrasted with intentional torts in that a negligence claim does not involve an intentional wrongful act. An act of negligence basically involves failure to use reasonable care under the circumstances with someone or something being injured or damaged. If a driver loses control of his vehicle and strikes a pedestrian, the driver can be held liable for injuries under negligence even though the driver did not intend to harm the victim.

Four elements must be established if a party is to receive a judgment based on a negligence claim. The four elements of a negligence claim are as follows: a legal duty exists, a failure to meet the applicable duty of care, causation, and damages. The first element is almost always present. If a person is going to interact in society, that person has a legal duty to respect the interests of others. The second element--that there be a breach of the applicable standard of care--requires all persons must act reasonably under the circumstances. If you are driving a car, you must act as a reasonable driver; if you are an accountant, you must act as a reasonably prudent professional would act under the circumstances. If you fail to act reasonably, this element is established.

Causation requires there be a reasonably foreseeable connection between the negligent act of the wrongdoer and the injuries suffered by the victim. If the resulting injuries are too remote, the negligent party is not liable. If there is an unlikely chain of events that takes place after a negligent act occurs and the results were not foreseeable, there can be no recovery. For example, if I negligently prepare a tax return for a client and the client, in a fit of anger and frustration, commits suicide, this consequence is not foreseeable, and I will not be liable for the unforeseen consequence. Proximate cause would not be present.

The final element of a negligence claim is proof of damages. Victims have the obligation of establishing the extent of the damages suffered.

If I negligently lose control of my vehicle striking a pedestrian, the pedestrian will likely seek to recover damages for personal injuries, lost wages, medical expenses, pain and suffering, and other incidental costs. Note that punitive damages are generally not recoverable for negligence claims. The negligent party did not intend to cause any harm; there is no need to punish this wrongdoer.

The beauty of negligence from a victim's perspective is that the actions of all persons are measured against that of a reasonable person under the circumstances. Almost anytime a person is injured, it can be argued someone else caused the injuries by not acting reasonably. The tort of negligence can reach each of us in our daily activities, making this a powerful theory in the hands of a skilled attorney.

Strict Liability. The third tort theory arose because the legal system found victims with significant damages or injuries, but they were unable to recover under an intentional tort or negligence theory. Strict liability is a liability "without fault" approach. Strict liability was initially reserved for situations deemed to be inherently dangerous or deemed to be an ultrahazardous activity. Examples were demolition by blasting, keeping wild animals, or putting on fireworks displays. For example, if a company is going to destroy a building by strategically placing dynamite in different locations and a person is harmed during the demolition, they can recover for their injuries even if the demolition company used reasonable care in planning the demolition. The same logic applies to those who insist on keeping wild animals as pets. If a pet cougar harms a victim, the victim can recover from the pet owner even if the pet owner was acting reasonably.

The most important strict liability theory today is when strict liability is applied to defective or malfunctioning products. If a manufacturer puts out a product deemed defective and unreasonably dangerous, injured parties are granted a recovery. The victim need not show the manufacturer was negligent--only that the product was defective. In most states there are precise ways in which a victim may show the product was defective. The most common methods of showing a product is defective is to show it was designed in an improper way, or was put together improperly, or was packaged in an improper way, or the instructions were incomplete or improper. Once a product is shown to be defective, it is irrelevant that the victim used the product in a careless way since judgments are typically not reduced because of the victim's contributory negligence. The philosophy is that the manufacturer should not have placed a defective product on the market in the first place, and, since it did, there is no defense that the victim could have been more careful. An example of a strict liability claim would be if a company manufactures and sells a three-wheel all terrain vehicle. These products tend to tip over easily causing serious injuries. If the design is shown to be defective, it is irrelevant in most states that the victim-operator was speeding at the time of the injury.

Punitive damages are recoverable for strict liability claims especially in the case of defective products that cause personal injuries. Punitive damages would be recovered in addition to damages for personal injuries, property damages, medical expenses, lost wages, pain and suffering, and other incidental costs.

The Taxability of Damage Recoveries

When a person is harmed by another, the victim generally seeks to recover compensatory damages. The taxability of the damages received depends on the type of harm suffered by the taxpayer. Categories of compensatory damages generally include--

    * loss of income,

    * expenses incurred,

    * property destruction, and

    * personal injuries.

All damages are taxable, unless the IRC permits the exclusion of settlement proceeds. The primary section permitting exclusion is IRC Sec. 104(a)(2), which was amended by the Small Business Job Protection Act of 1996.

IRC Sec. 104(a)(2). Prior to amendment, this code section allowed exclusion for any damages received on account of personal injuries or sickness. Personal injuries or sickness were interpreted broadly to include many nonphysical injuries, such as personal embarrassment, mental pain and suffering, breach of contract to marry, injury to reputation, emotional distress, and violations of civil rights. Despite the broad interpretation of this code section, the IRS successfully challenged the rule's interpretation in several court cases.

The Small Business Job Protection Act of 1996 severely limited the types of damages eligible for exclusion under IRC Sec. 104(a)(2). The language was changed to only allow exclusion for compensatory damages received on account of personal physical injuries or physical sickness. Damages received for emotional distress or other nonphysical injuries are not considered physical injury or physical sickness for purposes of this code section and are not excludable. The only hope a taxpayer has in trying to exclude damages received as a result of nonphysical injuries is to show they had their origin in a physical injury. Damages received for loss of consortium due to physical injury or physical sickness of a spouse are an example. These damages would be excludable because they originate from physical injury or physical sickness of the spouse.

A second change to IRC Sec. 104(a)(2) requires punitive damages to always be taxable. It is no longer possible to exclude punitive damages from taxable income, even if they relate to personal physical injury or physical sickness. This was a sharp change from prior law that allowed punitive damages to be excluded if they related to personal injuries.

The changes to IRC Sec. 104(a)(2) are effective for all damages received (whether by suit or by agreement) after August 20, 1996. The taxation of compensatory and punitive damages received before August 20, 1996, in tax years ending before that date, is determined by the old law. The old rules are heavily influenced by two United States Supreme Court cases involving the interpretation of that section.

Commissioner of Internal Revenue v. Schleier. In this case, a former pilot was fired by United Airlines when he reached age 60. He sued United Airlines under the Age Discrimination in Employment Act (ADEA). The purpose of the ADEA is to prohibit age discrimination in the workplace. The act makes it illegal to discharge any employee between the ages of 40 and 70 because of age. After litigation, the parties ended up settling the dispute and Schleier received $145,629. Half of the award was attributed to "backpay" and half to "liquidated damages." The airline did not withhold any payroll or income taxes from the portion of the settlement attributed to liquidated damages.

When Schleier filed his income tax return, he included as gross income the backpay portion of the settlement and excluded the portion attributed to liquidated damages. The commissioner of the IRS issued a deficiency notice, asserting Schleier should have included the liquidated damages as gross income. The Tax Court held in favor of Schleier, ruling the entire award was excludable as "damages received on account of personal injuries or sickness" under IRC section 104(a)(2). After the 5th Circuit agreed and held for Schleier, the matter was heard by the Supreme Court.

The Supreme Court disagreed with the lower courts and held the entire award was taxable. The court took a very narrow view as to exclusions from income. The court felt that a claim based on being laid off work because of age discrimination is not a claim on account of personal injury or sickness. To clarify its interpretation of "personal injury or sickness," the court set forth a hypothetical typical tort claim. The court used an example where a victim is injured in an automobile accident. The victim suffered medical expenses, lost wages, pain, suffering, and emotional distress. If this victim settled for $30,000, the court indicated all of the award would be excluded from gross income. The medical expenses and the pain and suffering would clearly be the result of personal injuries. The lost wages would be excluded, also, as long as "the lost wages resulted from time in which the taxpayer was out of work as a result of the injuries." The court noted that in this hypothetical, each element of the settlement was received on account of personal injuries or sickness.

Since the court felt age discrimination was not a personal injury or illness, neither the backpay nor the liquidated damages could be excluded. In discussing the backpay portion of the case, the court did agree that Schleier may have suffered psychological or "personal" injury by the employment termination that may even be comparable to that suffered by an accident victim. In the court's view, this did not entitle Schleier to exclude the backpay because there was no link between the psychological injury and loss of wages. By contrast in the car accident case, the court felt there was a direct link between the car accident and loss of wages. With regard to the liquidated damage portion of the settlement, the court felt this too was taxable since it was punitive in nature and was not granted on account of injury or sickness. In reaching this conclusion, the court set up a two-step test for excluding settlements, first the claim had to be based upon tort or tort type rights and, secondly, the claim had to be based on personal injuries or sickness. In deciding if the claim was a tort-type claim, the court looked to the type of remedies recoverable under ADEA. If a claim is a tort type claim, the court expected to see recoveries allowable for pain and suffering, emotional distress, harm to reputation, or other consequential damages. Since ADEA does not provide for remedies commonly associated with personal injury, the court concluded such claims are not tort type claims.

C.O'Gilvie v. United States. In O'Gilvie, a woman died of toxic shock syndrome. Her husband and two children commenced a tort action against the maker of a Playtex tampon that caused the death. The jury awarded $1,525,000 actual damages and $10 million punitive damages. The family paid income taxes on the punitive damages and then sought a refund. The children actually received a refund. The lawsuit combined the claim of the father for a refund of taxes he paid and the government's claim for the return of the refund paid to the children of the deceased victim. The central issue of the case was whether punitive damages were taxable or not. The lower court had found in favor of the taxpayers holding that the punitive damages were received on account of personal injuries and were, therefore, nontaxable under IRC section 104(a)(2). The Court of Appeals disagreed and held the punitive damages were taxable.

The Unites States Supreme Court affirmed the decision of the Court of Appeals and held the punitive damages were taxable, even though this case involved a tort action to recover for personal injuries. In a sweeping decision, the court stated that punitive damages are issued not to compensate for injuries, but to punish reprehensible conduct and to deter its future occurrence. Since the punitive damages are issued for punishment of a wrongdoer, the damages were not received "on account of a personal injuries or sickness" and therefore had to be taxable.

The Supreme Court struggled briefly with justifying the exclusion of compensatory lost wages while taxing noncompensatory punitive damages. The court noted that while not taxing compensatory lost wages seems to give the taxpayer a windfall, this is justified since the receipt of lost wages is in response to the personal injuries suffered by the taxpayer. The receipt of punitive damages is not received because of personal injuries, but rather because of the reprehensible conduct of the defendant.

The dissenting opinion argued that the punitive damages issued in this case were issued because of the personal injuries suffered by the toxic shock victim. In the dissent's opinion, it was the personal injury suffered by the victim that led to the issuance of punitive damages.

Structuring Settlement Agreements

The new rules regarding the taxation of damages makes structuring of settlement agreements a more important issue. The bright-line tests provided by amended IRC section 104(a)(2) and the two Supreme Court decisions create a new set of incentives for taxpayers. The first incentive is to avoid punitive damages that are now always taxable. This will make voluntary settlements more attractive to plaintiffs in cases involving significant punitive damages. Instead of leaving the allocation between compensatory and punitive damages in the jury's hands, the plaintiff can ensure that no damages will be labeled as punitive by settling out of court. In voluntary settlement agreements, defendants never acknowledge fault anyway, so they clearly would not be interested in classifying damages as punitive since this indicates they engaged in reprehensible activities. Only juries will issue damages that are specifically categorized as punitive.

A second incentive is to allocate as large a portion of the damages as possible to personal physical injuries or physical sickness. In cases involving multiple claims, including personal physical injuries, this is a definite issue. In cases involving emotional distress or other nonphysical injuries, the challenge to the plaintiffs will be to show some type of physical injury resulting from stress. Examples of physical injuries resulting from emotional distress might include ulcers, headaches, insomnia, or other related maladies. Once again, plaintiffs will have an incentive to determine their own fates by settling the case and taking the decision away from the court.

The allocation of damages between compensatory and punitive, and between physical and nonphysical injuries, will surely be a heavily litigated area, as the IRS fights to limit taxpayers' creativity. It is important for the settlement to be very specific in the allocations. Allocations that are unclear are usually interpreted against the taxpayer. Another important factor is the setting in which the allocation is made. Based on prior Tax Court cases, it is clear that taxpayers have the greatest level of success when allocations are made in an adversarial setting. *

Randall K. Hanson, JD, LLM., is a
professor of business law and James K. Smith, PhD, JD, LLM, CPA, an
assistant professor of accountancy
at the University of North Carolina at Wilmington.

now more limited thanks to Uncle Sam.

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