The topic of personal injury damages was discussed in detail in the November 1990, issue of The CPA Journal in the article "Litigation to Avoid Taxation of Personal Injury Damages." The Tax Court in Downey has changed only the taxation of back pay under Sec. 104(a)(2). However, damage awards to employees typically include back pay when awards are made under federal discrimination statutes for sex, race, national origin, age, or handicap.

Sec. 104(a)(2) allows taxpayers to exclude amounts received "on account of personal injury." The regulations specify that to qualify as a personal injury the taxpayer's claim for damages must be a tort or tort-type claim. Prior to Downey, the Tax Court had accepted the IRS position that back pay damages were more like a contract that a tort claim. Therefore, the Sec. 104(a)(2) exclusion did not apply, and the back pay was taxable for income and social security tax purposes. The Tax Court had previously held that back pay was taxable even in cases where the taxpayer's claim was partly asserted solely under race, sex, or age discrimination statutes. The opinions in these cases were not well-reasoned because the damages were for the personal injury tort of discriminaton even though such damages were labeled "back pay."

Decision in Downey

In Downey, the taxpayer, a pilot, was fired by his employer, United Airlines, in violation of the federal age discrimination statute. Downey sued United under this statute, requesting reinstatement, employee benefits, back pay, and liquidated damages. In two similar cases against United, the federal District Court had previously awarded damages to the plaintiffs. Before Downey's case was heard by the court, he and United settled. The settlement agreement allocated $60,000 to liquidated damages (damages for the intangible effects of discrimination) and $60,000 to non-liquidated damages (other damages including back pay). Taxes were withheld on the non-liquidated portion, which covered the back pay and benefits claims.

The Tax Court found that United paid Downey the $12,000 to settle his age discrimination suit. The court ruled that since age discrimination is a tort-type personal injury claim for purposes of Sec. 104(a)(2), no further inquiry is needed. The fact that part of the damage award was for back pay is simply a consequence of the discrimination and does not change the personal injury tort-type nature of the discrimination claim. In Downey, the Tax court adopted the reasoning of Rickel, 900 F.2d 655 (3rd Cir. 1990), which provided the rationale for excluding back pay.

Downey received the award because United violated a federal statute. No breach of contract claim was involved in Downey's suit or his settlement. If there had been such a claim, in addition to the age discrimination claim, then part of the damages would have been taxable since a contract claim is not a tort-type claim. Frequently, breach of contract claims are involved in employment cases, and Downey does not change the taxability of any damages based on them.

In Downey, the back pay was for work Downey did not do because he was fired. However, the reasoning of Downey would alos allow the Sec.104(a)(2) exclusion for taxpayers who received back pay damages as a result of being underpaid due to discrimination. In a settlement of a sex discrimination claim, the 6th Circuit ruled in Burke, 929 F.2d 1119 (6th Cir. 1991), that airline stewardesses could exclude the back pay adjustment for work that they had done.

Downey also received liquidated damages from United. Such damages are allowed in the federal discrimination statutes. The issue with these damages is whether they are compensatory or punitive for the purposes of Sec. 104(a)(2). The distinction is important because punitive damages in non-physical personal injury cases are taxable. Although the IRS argued in Downey that the liquidated damages are punitive, all of the judges (in both the majority and the dissent) held that the liquidated damages compensate the employee for the intangible consequences of the discrimination. As such, they are for tort-type personal injuries and are excludable under Sec, 104(a)(2).

IRS Response

The IRS has not yet announced whether it will appeal Downey. Probably it will appeal since Downey affects all taxpayers receiving back pay due to their employers' violation of discrimination statutes. Also, the appeal would be to the 7th Circuit, which has not yet ruled on the back pay issue. Since the Tax Court was split 11-6, the IRS may decide to appeal cases in all circuits except the 3rd and 6th. If the IRS wins in a few circuits, it would probably appeal to the Supreme Court. However, it is doubtful whether the IRS could prevail in any circuit since the majority opinion in Downey is well-reasoned and the IRS position is supported only by a desire to tax back pay.

Who are the Winners?

Downey simplifies the taxation of damages under Sec. 104(a)(2). All except punitive damages are excluded if they are awarded for discrimination claims. If, however, contract claims are involved--as they frequently are in wrongful discharge cases--damages awarded for breach of contract are taxable. In any suits or settlements, however, employees receiving back pay, except for breach of contract, should exclude it.

Employers and employees are the winners in Downey and the IRS is the loser. Until employers realize the implications of Downey, employees will benefit from receiving tax-free back pay. Once employers realize that the back pay will be excluded, they will reduce damage awards. Of course, CPAs advising an employer who must pay back wages due to discrimination should advise the employer to pay a smaller amount since it is tax-free to the employee. Since Downey does not affect the employer's ability to deduct the payment, the IRS loses since it allows the employer to deduct an amount that is tax-free to the employee.