The IRS continues to litigate and to appeal cases involving exclusion from taxable income of certain types of damage awards. The authors describe recent cases in which the circuit courts have consistently widened the exclusion. They also present suggested methods for favorable tax treatment of settlements and damage awards, and remind practitioners of the likelihood of litigation by the IRS in certain situations.

In recent years, the courts have dramatically expanded the definition of personal injury damages excludable under IRC Sec. 104(a)(2). However, during the same period, the IRS has aggressively fought expansion of that exclusion.

Sec. 104(a)(2) states that "damages received on account of personal injuries" are excluded from gross income, but does not provide any definition of the term "on account of personal injuries." Some clarification is provided in Reg. 1-104(c), which defines personal injury damages as those received "based upon a tort or tort-type claim," but does not define "tort or tort-type claims." Because of unclear legislative intent, the courts have been forced to define, or attempt to do so, the terms "on account of personal injuries" and "tort-type claim."

Gradually, the courts have expanded the definition of "tort or tort- type claims" and have resisted IRS attempts to narrow the parameters of the Sec. 104(a)(2) exclusion.

The primary issues litigated can be summarized into four categories:

* What is a tort or tort-type claim? * How are damages for injury to business or professional reputation to be treated? * How are damages measured by lost wages treated? * How are amounts received that represent a mixture of both includable and excludable claims to be treated?

TORT OR TORT-TYPE CLAIM

In 1983, two court decisions began the trend toward a more expansive definition of the types of damages excludable under Sec. 104(a)(2). In the case of Roemer v. Commissioner, the Ninth Circuit Court held that damages received from a defamation lawsuit that injured the plaintiff's personal and business reputation were excludable as "damages received on account of personal injuries." Roemer overruled a Tax Court determination that since the award was based primarily upon loss of earning capacity, due to the damage to professional reputation, the damages were not excludable "on account of personal injuries" but were a substitute for income and therefore includable as income pursuant to Sec. 61(a). The Roemer Court made two important findings that changed the nature of the analysis under Sec. 104(a)(2):

* Personal injury damages are not limited to actual physical injuries; and * The proper analysis for Sec. 104(a)(2) is to look to the nature of the claim, not the nature of the award.

In applying these findings in Roemer, the court determined that the nature of a defamation action is for injury to a person's reputation, which is clearly personal in nature and clearly a tort action under state law. As such, the damages were excludable under Sec. 104(a)(2) even though there was no actual physical injury and some of the damages were based upon impairment of the plaintiff's earning capacity because his business reputation was damaged.

It is worth noting that in Rev. Rul. 85-143 the IRS announced that it would not follow the decision in Roemer, and to date has not altered that position.

The other significant 1983 decision was Church v. Commissioner, in which the Tax Court adopted an analysis similar to the Roemer decision. In Church, the taxpayer was awarded $250,000 compensatory damages and $235,000 punitive damages in a defamation lawsuit. The Court again focused on the nature of the claim and determined that the nature of a defamation award was compensation for humiliation, ridicule, and embarrassment. Such injuries are clearly a personal injury of a tort or tort-type nature. The Court also noted that personal injuries are not limited to physical trauma, but also include mental pain and suffering. The Court concluded by stating:

"In summary, we find the award

herein was intended to compensate

petitioner for the mental pain and

suffering he experienced as a result of

the malicious publication of a

newspaper editorial labeling him a

"communist." Even the money award

cannot erase the stigma petitioner must

carry for the rest of his life. We hold

the entire $250,000 compensatory

damages is exempt from income since

it was received on account of personal

injury within the meaning of Sec.

104(a)(2)."

In the 1988 Sixth Circuit Court of Appeals' decision of Threlkeld v. Commissioner, the IRS appealed a Tax Court decision holding that $21,500 received as part of a settlement of a malicious prosecution (improper use of the judicial system) action for damages to the taxpayer's professional reputation was excludable under Sec. 104(a)(2). Following the reasoning in Roemer and Church, the Sixth Circuit concluded that the determination must be made by looking at the underlying nature of the action, not the nature of the award. As the underlying malicious prosecution action was one for "indignity, humiliation, inconvenience, and pain and distress of mind" it is an action "on account of personal injuries." In affirming the Tax Court's exclusion of these damages, the Sixth Circuit Court stated:

"We agree with the Ninth and the

Third Circuits that the nonpersonal

consequences of a personal injury,

such as the loss of future income, are

often the most persuasive means of

proving the extent of the injury that

was suffered and that the personal

nature of the injury should not be

defined by its effect. Injury to a

person's hand or arm is a personal injury.

This is so even though it may affect a

person's professional pursuits. All

income in compensation of that injury is

excludable under Sec. 104(a)(2).

Similarly, the injury to a taxpayer's

reputation in this case was personal injury.

This is so even though it affected his

professional pursuits. All the income

in compensation of that injury is

excludable under Sec. 104(a)(2)."

When the issue arises out of a state law action, the Tax Court, Federal District Courts and Circuit Courts have generally held that state law must be used to analyze the nature of the underlying claim to determine if it is a tort or tort-type action, and whether it is personal in nature. The Tax Court has stated that the damages are excludable under Sec. 104(a)(2) "if compensatory damages are received on account of any invasion of the rights that an individual is granted by virtue of being a person in the sight of the law."

Application of this definition has led to the exclusion of damages received as the result of negligence, assault, battery, infliction of emotional distress, invasion of privacy, alienation of affection, wrongful death, and as previously discussed, defamation and malicious prosecution. On the other hand, the exclusion has not been extended to damages based upon such torts as trade disparagement, interference with contract, invasion of rights based upon copyrights and patents, and all damages recovered by a corporation.

Federal Issues are More Difficult

More difficult issues have arisen in the application of Sec. 104(a)(2) to actions arising out of federal statutes or the U.S. Constitution, as categorizing as a tort or non-tort is more difficult. Again, the courts have attempted to look to the nature of the underlying action to ascertain applicability of Sec. 104(a)(2).

In the 1986 case of Bent v. Commissioner, the Tax Court was presented with the following facts: the taxpayer was employed as a high school teacher. In the course of that employment he was very outspoken as to his views on various issues. Ultimately, he was dismissed allegedly because of this propensity of often taking a position opposed to the views of the school board. He brought an action based upon abridgement of his First Amendment rights of free speech pursuant to 42 U.S.C. Sec. 1983. The case was settled for $24,000 plus costs. The IRS contended that the amount was not excludable under Sec. 104(a)(2), as it was job related and really in the nature of a contract dispute and therefore not "on account of personal injuries." The taxpayer contended that it was damages arising out of a "tort or tort-type" action and therefore excludable. Relying upon a previous U.S. Supreme Court decision categorizing constitutional actions as claims for personal injuries for other purposes, the Tax Court held the settlement had arisen from a tort-type action, involving the right to freedom of speech, and therefore the damages were excludable.

The Tax Court decision was appealed by IRS to the Third Circuit Court of Appeals which upheld the Tax Court and stated that "the denial of a civil right, such as the right of free speech, involves a personal injury just as much as a physical assault. While the injury is not physical, it may well involve mental or psychic pain and suffering." The Court concluded that this was a settlement "on action of a personal injury" and therefore excludable under Sec. 104(a)(2), even though the measurement of damages was based upon lost wages.

In 1989, the Fourth Circuit rendered its decision in Thompson v. Commissioner. In this case, the IRS appealed a Tax Court decision that held the liquidated damages awardable in a Fair Labor Standards Act action based upon gender discrimination were the result of a tort or tort-type action, and therefore excludable under Sec. 104(a)(2). In the case, the taxpayer was awarded $66,795 as back pay, which was clearly includable in gross income, and an additional $66,795 as liquidated damages provided under the act.(1) The IRS contended that these liquidated damages were in the nature of back pay or damages for a breach of the employment contract and not "on account of personal injury." The Fourth Circuit court upheld the Tax Court and determined that the nature of the underlying action is one tort, or at least is a tort-type action as it is designed to prevent females from being paid less for the same position as a male counterpart. The court determined that the underlying nature of the action is that of the right to be free from gender discrimination, which certainly is personal in nature, and tort-like.

A similar decision was reached by the Tax Court in 1989 in the case of Rickel v. Commissioner that determined awards based upon the Age Discrimination in Employment Act were also personal in nature and tort- like as they were designed to prevent discrimination based upon age, which is again a protectable individual right, therefore properly excludable under Sec. 104(a)(2).

Courts and IRS Continue to Differ

The cases presented, and others, clearly indicate a trend by the Tax Courts and Federal Circuit Courts to expand the definition of Sec. 104(a)(2) to include most types of awards and settlements that result from the injury to, or violation of, what we would consider personal rights. There are clear indications that this trend will be followed when reviewing awards and settlements for similar actions.

It is equally clear that the IRS intends to continue its efforts to minimize expansion of Sec. 104(a)(2) and apparently will continue to aggressively litigate decisions it believes expand the exclusions. Prudent tax planning would include consideration of the possibility that use of Sec. 104(a)(2) exclusion in cases involving actions not yet held to be "on account of personal injuries" may necessitate litigation to successfully exclude amounts received from taxable income.

Among the issues that appear ripe for potential litigation are the treatment of damages received in wrongful discharge settlements or awards. In some states, wrongful discharge is treated as a tort action, while in others it is treated as a breach of contract. Still others allow both potential causes of action, tort and contract. In such cases, would recipients in states classifying the action as a tort receive exclusion under Sec. 104(a)(2), while recipients in states classifying it as a contract action have the amounts included in income?

Obviously, this treatment would lead to disparate results based upon essentially the same legal action, depending upon how states classify the cause of action. Dicta in the case of Byrne v. Commissioner seems to indicate that the Tax Court would determine the inclusion or exclusion based upon the state law categorization of the action.

DAMAGES TO BUSINESS AND PROFESSIONAL REPUTATION

Prior to the Roemer decision, the Tax Court consistently held that damages received for injury to a taxpayer's business or professional reputation were not excludable under Sec. 104(a)(2). As noted, the IRS currently still takes this argument. However, the vast majority of court decisions reject this argument and look to the underlying nature of the action. If the underlying nature is personal and a tort or tort-type action, the amounts received are generally excludable as "on account of personal injury."

In the cases of Roemer, Church, and Threlkeld, the IRS successfully argued that amounts received for injury to a taxpayer's business or professional reputation were not properly excludable.

In Roemer, the taxpayer, a successful insurance broker, was defamed by a grossly slanderous credit report that questioned his honesty. In his complaint for libel, taxpayer claimed the defendant's publication was written "with intent to damage his reputation, and to injure him or his business profession and occupation. In the closing argument, the jury was told that Roemer lost $136,000 in prospective income. Ultimately, he was awarded $40,000 in compensatory damages and $250,000 in punitive damages.

In reversing the Tax Court holding that all the compensatory damages were taxable, the U.S. Ninth Circuit Court stated:

"As we find that Roemer's

defamation suit was brought to remedy a

personal injury and that the award

should not be differentiated on the

basis of the resulting damage to his

personal life and professional career,

all of Roemer's compensatory

damages are excludable from gross

income under IRC Sec. 104(a)(2)."

Disparagement or Defamation

The Court did note that it is sometimes difficult to distinguish between disparagement and defamation. Damages for a disparagement action for an attack on a property or business interest would not be excludable as not "on account of personal injuries." However, in the present case, the Court noted it was a defamation action which is personal in nature and that categorization will control the application of Sec. 104(a)(2), not the effect, i.e., the award for loss of business reputation and prospective income.

A similar decision was reached by the Tax Court in Church, indicating the Tax Court's shift from its earlier position. In Church, the taxpayer was awarded $250,000 compensatory damages and $235,000 punitive damages from a newspaper that called him a "communist." The story apparently "marked the end of a promising political career."

In determining the entire $250,000 compensatory damage award was properly excludable, the Court noted:

We find no basis for

distinguishing between that injury and the

mental distress, pain, and suffering that

flowed therefrom... In our opinion,

shattered dreams, ruined careers, and

the mental anguish that follow are just

as personal as, for instance, loss of a

limb."

In Threlkeld, the U.S. Sixth Circuit Court more specifically addressed the issue of awards for damages to business reputation. As part of a $300,000 settlement for a malicious prosecution action (improper use of the judicial process), the taxpayer was specifically awarded $21,500 for damages to his professional reputation as part of a settlement. The Tax Court held the $21,500 was properly excludable and the IRS appealed that finding.

In upholding the Tax Court's exclusion of the damages, the Court again looked to the underlying action and found that malicious prosecution is a "tort or tort-like" action that can be brought for both personal injuries and injuries to property interests. The Court decided the underlying nature of the action in this case was personal in nature and that the award was excludable as an effect of a personal injury action.

It seems reasonably well settled that in actions the Court feels are personal in nature and founded in tort, damages received for injury to business or professional reputation are properly excludable under Sec. 104(a)(2).

DAMAGES MEASURED BY LOST WAGES

Generally, reimbursement for loss of income is taxed the same as the income replaced. But, Sec. 104(a)(2) now clearly excludes compensation for lost wages if the result of "personal injuries." However, damages measured by lost wages still present classification problems.

Many federal statutes provide for recovery for lost wages, including the Equal Pay Act, Title VII of the Civil Rights Act of 1964, and the Age Discrimination in Employment Act. Awards based upon back pay provisions of these statutes have clearly been held to be includable in taxable income and not excluded under Sec. 104(a)(2) as they are considered a contractual claim for accrued wages. These statutes also generally provide an additional potential award equal to the back pay amount as liquidated damages. Extensive litigation has occurred to determine the nature of these additional damages and the applicability of Sec. 104(a)(2).

In 1987, the Tax Court was asked to determine the application of Sec. 104(a)(2) to awards paid to the taxpayer under the Equal Pay Act for back pay and liquidated damages in Thompson v. C.I.R.

The Court first addressed the award of back pay. In rejecting the taxpayer's position that those wages were on account of personal injuries, the Court determined they were in the nature of a contract award designed to measure the differences between what was paid and what should have been paid. The Court concluded:

"The Equal Pay Act places an

obligation on the employer to pay an

equal amount for equal work

regardless of sex. If an employer violates this

obligation placed on it, it is required

under the enforcement provisions to

pay the back pay "owing" to the

employee doing the equal work in the

amount "withheld." In our view, an

amount paid as back pay under this

provision is more in the nature of a

payment for a contract violation than

for a tort-type right."

Liquidated Damages or Back Pay

The liquidated damage award presented the court with a more difficult issue. Liquidated damages are automatically payable by an employer found to have violated the Equal Pay Act unless the judge determines that the employer has reasonable grounds for believing there was no violation of the Act.

The Court viewed these damages as awarded for a violation of the right to be free from gender discrimination, which is clearly a personal right, and the fact that the damages are measured by lost wages does not change the nature of the claim. As the nature of the claim is for a personal tort or tort-type claim, the damages are excludable under Sec. 104(a)(2).

The U.S. Fourth Circuit affirmed the holding of the Tax Court in Thompson and stated:

"In contrast to the award of back

pay, Thompson's liquidated damage

award was not earned income. Rather

it served both as a deterrent to ensure

compliance with the Act and as

compensation for the retention of a

workman's pay which might result in

damages too obscure and difficult to

prove... As such, the liquidated

damages award constituted compensation

received through a tort or tort-type

action for personal injuries."

The 1989 case of Rickel presents essentially the same issue as Thompson except under the Age Discrimination in Employment Act. In Rickel, the taxpayer settled an age discrimination action for $180,000, that was not allocated among the various claims. The Court used a similar analysis as that used in Thompson to determine that a logical conclusion would allocate half the settlement to back pay, therefore includable in gross income, and half to settlement of a personal injury action for age discrimination, and therefore excludable.

It's the Claim that Counts

It seems clear from these and other cases that the courts will no longer look to how the damages are measured, but to the underlying claim. If, as in Thompson and Rickel, the claim is for violation of a personal, tort-type right, the courts will find that the damages are on "account of personal injuries," and therefore excludable.

INCLUDABLE AND EXCLUDABLE CLAIMS

Numerous cases have been litigated in which there were both excludable and non-excludable claims presented, with no clear allocation of damages. In these situations, the courts have been forced to fashion a reasonable and consistent method to determine the tax consequences. Generally, the courts have used a "facts and circumstances test" to determine application of Sec. 104(a)(2). This test considers the pleading, evidence, and intent of the payer.

In the 1988 case of Madison v. Commissioner, the taxpayer filed an equal protection and breach of contract action based upon his termination as police chief. The case was ultimately settled for $41,000 with no allocation as to the claims. Here, the Court stated that the most important fact in categorizing the payment was the intent of the payer. Since the payer's insurance company paid the claim and the payer was not covered for contract claims, the Tax Court held the payment must have been "on account of personal injuries" and, therefore, excludable under Sec. 104(a)(2).

The 1989 case of Maltray v. Commissioner demonstrates that often allocations are quite arbitrary, at best. The taxpayer was awarded $300,000 for personal injury, termination of employment, and injury to his business reputation. The Tax Court determined that $109,000 was for personal injuries and the remainder was for nonexcludable injuries like breach of contract. The Court really didn't explain its allocation except to state that some of the award is for personal injury and must be excludable.

In Byrne v. Commissioner, the taxpayer settled an action potentially based upon the Fair Labor Standards Act and other contract and tort claims for $20,000. The terms of the release were broad enough to cover both contract and tort claims. The Court determined that half of the $20,000 should be included in gross income as income or income substitute, and half excluded as "on account of personal injuries." It is not clear how the court arrived at this decision, but since this was essentially a Fair Labor Standards Act case, it indicates how a recovery under that act would have been treated.

Exactly what the courts will do in cases where there are both includable and excludable claims is impossible to determine from existing case law. It is clear, however, that the courts will attempt to make some reasonable allocation between the two aspects of the judgment or settlement.

In Sealy v. Commissioner, the taxpayer was terminated in the second year of a five-year employment contract. When he refused to vacate his office, the employer filed an eviction lawsuit that received extensive media coverage. In settlement, the parties signed an agreement that proved the taxpayer would receive $60,000 as a salary equivalent and $45,000 in compensation for personal embarassment, mental and physical strain, and injury to health and personal reputation in the community.

The Tax Court upheld the agreement as there was no evidence that the allocation was not what was intended by the parties; $60,000 was includable as income and $45,000 was excludable.

A contrary result was reached in the case of Fono v. Commissioner based upon the following facts: the taxpayer originally settled the case for $425,000, allocated $325,000 to termination of employment agreements and $100,000 to termination of royalty agreements. Several years later the agreement was restructured to provide $258,000 of the $425,000 for physical and emotional distress. The Tax Court had little troubled deciding that the original settlement represented the true intent of the parties, therefore the entire $425,000 was taxable as "not on account of personal injuries."

The Courts are Reasonable

It is clear from a review of cases that a valid allocation of damages between the parties in a settlement agreement or by a jury in a judgment will generally be honored by the courts, provided it is not a mere sham to obtain the maximum tax benefit. It is equally clear that when there are both excludable and includable claims involved in a settlement or judgment and there is no clear allocation between claims, the courts will attempt to arrive at some fair allocation based upon all evidence available. However, when the courts are forced to make this allocation, there is no clear formula the taxpayer can rely on.

CONCLUSION

The extensive litigation relating to the application of Sec. 104(a)(2) has clarified many issues, and expanded the types of judgments and settlements that may be excluded under the section. The courts are apparently ready to extend the exclusion to virtually any judgment or settlement that is based on the violation of a personal right and is either founded in tort or is tort-like.

Maximum tax benefits can be obtained by insuring that tort-type claims are included with contract claims in the pleading of a case; that evidence of tort violations is presented during trial; that judgments spell out as clearly as possible how much of the award is based upon personal injuries; and that settlements clearly allocate the amount between excludable and includable claims.

It is also apparent that the IRS is continuing its aggressive stance against expansion of the exclusions under Sec. 104(a)(2), and will attempt to deny exclusion to all payments not clearly "on account of personal injuries." It is essential that the taxpayer clarifies what the judgment or settlement represents, and is prepared to litigate issues not already decided or not accepted by the IRS.

Wayne R. Wells, JD, LLM, is a Visiting Associate Professor of Accounting at St. Mary's University, San Antonio, TX, and Professor of Business Law and Taxation at St. Cloud State University, St. Cloud, MN. Kent W. Royalty, JD, CPA, is an Associate Professor of Accounting at St. Mary's University, San Antonio, TX.