Understanding Sparrow

As background, Sec. 104(a)(2) allows taxpayers to exclude "the amount of any damages received (whether by suit or agreement) on account of personal injuries or sickness." The regulations define "damages received" to mean "an amount received ... through prosecution of a legal suit or action based upon tort or tort-type rights" Reg. 1.104-1(c). In applyng the statute and regulations, courts have inquired into the nature of the claim that is the basis for the payment. If the claim is a tort-type personal injury, the damages are excluded. If the award is based on a contract-type claim, the damages are taxable.

One of the remedies available to an employee under the discrimination statutes is an award of back pay. There is agreement in all of the cases that discrimination claims (age, sex, race, national origin) under federal statutes are tort-type claims. However, some courts have focused on back pay to carve out an exception by rulign that it is taxable as a contract-type claim. There are two types of back pay: 1) back pay for work that the taxpayer did not do because he or she was fired due to illegal discrimination; and 2) back pay for work done where the taxpayer was underpaid due to discrimination. Most of the cases have involved back pay of the first type. The Tax Court and the Court of Appeals in the 3rd, 6th, 9th, and 10th Circuits have ruled that the first type of back pay is excludable under Sec. 104(a)(2). The rationale used by the courts in these cases also supports excluding the second type of back pay from taxable income. In a recent case involving the second type, Burke v. United States 929 F.2d 1119 (6th Cir. 1991), the 6th Circuit allowed the exclusion for payment of a prior discriminatory underpayment since the back pay claim was made under federal discrimination statutes.

The Sparrow Decision

In Sparrow, the employee claimed that his employer fired him because of his race in violation of Title VII of the federal Civil Rights Act of 1964, which provides relief for employees who are discriminated against on the basis of race, sex, religion, or national origin. As a result, the parties settled for $92,300. The Tax Court, in a 1989 decision, ruled that the entire amount of this award was for "back pay." Sparrow argued that the Sec. 104(a)(2) exclusion should apply because racial discrimination is a personal injury. The court disagreed, holding that the $92,300 was taxable since back pay under Title VII does not constitute damages. The court reasoned that damages are a legal remedy, but Title VII allows only equitable relief. Therefore, back pay under Title VII cannot qualify for the Sec. 104(a)(2) exclusion since the exclusion only applies to damages. Using this approach, the court did not have to decide whether the back pay was a tort-type claim because this question does not arise if the employee does not receive damages. The D.C. Circuit Court of Appeals affirmed this narrow intepretation of damages. In so doing, it rejected the analysis of all previous Sec. 104(a)(2) cases. In these cases, the issue was always whether back pay due to a discriminatory firing is an excludable tort-type claim or a taxable contract-type claim. In either event, the back pay awarded was assumed to constitute damages for the purposes of Sec. 104(a)(2).

The Tax Court and the Court of Appeals for the 3rd, 6th, 9th and 10th Circuits have held that back pay is a tort-type claim because discrimination is a tort-type injury. The back pay, which is a consequence of the injury to the employee, does not change the essential narure of discrimination as an action resulting in a tort-type injury. Indeed, such an injury cannot result in a contract-like claim because discriminatory actions, as activities illegal by statute, cannot be valid subjects of contract terms or negotiations.

In the dissents to case allowing the exclusion for back pay, the issue was whether a back-pay claim is a tort-type claim. In Burke, the dissent argued that it was taxable income as a contract-type claim since the back pay was earned for unpaid wages. In Downey, the dissenting Tax Court judges argued that Downey's employer had contracted to pay wages for a specified rate during the employment period. Since the contract was unlawfully terminated (in violation of the federal age discrimination statute), the back pay is for a contract claim.

Sparrow, therefore, introduces a new issue into the controversy of whether back pay received as a result of discrimination is taxable. The Sparrow approach seems inappropriate for several reasons:

* Sec. 104(a)(2) regulations state that damages are "amounts received through prosecution of a legal suit or action." Legal suit most plausibly means lawsuit; therefore, the D.C. Court's narrow interpretation of damages seems unjustified;

* Awards made using the general term "back pay" could end up being excluded from taxable income under some federal statutes (for example, age discrimination) and taxable under others (Title VII). Such a distinction is undesirable since the subject of both statutes is discrimination, and Sec. 104(a)(2) suggests no such distinction in its definition of damages excludable for tax purposes;

* In Burke, also a Title VII discrimination case, the 3rd Circuit used the phrase "back pay damages" several times in allowing the exclusion; and

* The Court's reasoning in Sparrow does not address the key issue that has been developed in the Tax Court and several circuits of the Court of Appeals; namely whether a back-pay claim is a personal injury or a contract claim.

Does Sparrow Matter Anymore?

Beginning November 31, 1991, the Civil Rights Act of 1991 allows employees to sue for limited amounts of compensatory and punitive damages under Title VII. However, the issue raised in Sparrow is still important because compensatory damages treated as awarded are for emotional pain and suffering, mental anguish, and other reasons. Nevertheless, employees will still sue for back pay, because this relief was not changed by the new statute. Also, for discrimination claims settled or decided before November 31, 1991, the new law does not apply.

The U.S. Supreme Court has agreed to decide the Burke case this Spring (1992). Hopefully, the Court will base its decision on the arguments and issues presented in Burke, thereby rejecting the narrow grounds of Sparrow and clarifying the law in this important area.