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March 1994

Tax court excludes back pay received for age discrimination. (Federal Taxation)

by Sager, Clayton

    Abstract- The Tax Court reconsidered a previous judgment and came up with the conclusion that damages such as back pay received as a result of age discrimination are excludable. After deliberating on 'Downey v. Commissioner,' the court opined that damages collected under the Age Discrimination in Employment Act can be considered as 'tort-like personal injury damages. Thus, they are excludable from taxable gross income as provided under IRC Sec 104(a)(2). The decision is a landmark victory as the Supreme Court judged in 'Burke' that back pay received under Title VII of the Civil Rights Act of 1964, which outlaws discrimination in employment based on race, sex, religion and national origin, is taxable.

Prior to Burke, the Tax Court originally decided Downey in 1991, 97 T.C. 150 (1991). (The 1991 decision will be referred to as Downey I and the 1993 decisio as Downey II.) Downey, an airline pilot, settled an ADEA suit with his employer for $60,000 back pay and $60,000 liquidated damages. The Tax Court ruled in Downey I that all damages were excludable because the violation of discrimination statues is a tort, not a breach of contract, though back pay is one of the remedies. (Downey I was discussed in the November, 1991, issue of Th CPA Journal in "Tax Court Allows Back Pay Exclusion.") After Burke, the IRS requested that the Tax Court reconsider Downey.

IRC Sec. 61(a) taxes all income unless otherwise excludable. IRC Sec. 104(a)(2) excludes from gross income "the amount of any damages received on account of personal injuries." "Personal injury" is not defined in the IRC, but the regulations, Sec. 1.104-1(c), specify that the taxpayer's claim must be a tort-type (tort-like) claim. A tort is a wrong, other than breach of contract, for which a court awards damages. In IRC Sec. 104(a)(2) cases, taxpayers have argued that back pay awards and other damages based on discrimination statutes qualify as tort-like. The IRS has maintained that the back pay is a contractual claim and therefore taxable.

A New Standard

In Burke, the Supreme Court added a new requirement. The Court ruled that to be a tort-like personal injury for purposes of IRC Sec. 104(a)(2), a claim must be based on a statute or other legal claim that allows the traditional tort remedies of compensatory and punitive damages. Compensatory damages are designe to put the injured party in the same position that he or she would have been in if the wrong had not occurred. They include back pay and money for intangible o nonpecuniary losses such as emotional distress, pain and suffering, and humiliation. Punitive damages are awarded to punish the defendant for intentional or reckless conduct. Prior to 1991 amendments (which were too recen to apply to the plaintiffs in Burke), Title VII allowed an employee injured by sex discrimination to recover back pay, but not compensatory or punitive damages. Therefore, the Supreme Court ruled that the back pay under the unamended Title VII was taxable. Burke did not discuss the applicability of its ruling to the ADEA since age discrimination was not an issue in Burke.

The ADEA, passed by Congress in 1967, prohibits age discrimination in employment. Employers who violate the ADEA are liable for back pay and, for willful violations, liquidated damages. "Willful" in this context means "not merely negligent." For nonwillful violations, only back pay is available under the ADEA.

The nature of liquidated damages is somewhat controversial. In Downey I, the Ta Court held that "from the victim's perspective" liquidated damages compensate the victim for nonpecuniary losses (emotional distress, pain and suffering, etc.). In Downey II, the court held that they serve two functions: to compensat the victim for nonpecuniary losses and to serve a deterrent or punitive purpose Because of this broad interpretation of liquidated damages, the Tax Court then concluded that the ADEA satisfies the Burke tort-like requirements, and therefore all damages, including back pay, awarded under the ADEA are excludable. In addition, the Tax Court's ruling in Downey II extends the exclusion to ADEA cases where the age discrimination is nonwillful and only bac pay is available.

The IRS will probably either appeal Downey II or appeal a future ADEA case wher the age discrimination is nonwillful and therefore no liquidated damages are awarded. The majority in Downey II has taken a very strong position in allowing the exclusion of back pay even for nonwillful violations where only back pay is available. Although this appears to violate Burke, the ADEA, unlike Title VII (prior to the 1991 amendments), does allow liquidated damages for willful violations. Therefore, in Downey II the Tax Court is basing its ruling on the entire ADEA statute instead of considering willful and nonwillful violations as in effect, separate statutes.

The six judges not voting with the majority in Downey II argued that the back pay should be taxable for nonwillful violations of the ADEA because such violations do not satisfy the tort-like requirements of Burke. Also, three of these judges would tax the back pay even where the violations were willful. However, all nineteen judges would exclude the liquidated damages.

A recent Federal District Court nonwillful ADEA case supports and goes farther than these dissenting opinions. In Maleszewski v. U.S., 93-1 USTC 50,358 (June 4, 1993), the District Court held that all ADEA damages are taxable, whether th violation is willful or nonwillful. The court reasoned that the liquidated damages are wholly punitive in nature and do not compensate the victim for the intangible effects of discrimination. Lacking such compensatory damages, the District Court concluded that the ADEA does not satisfy the Burke tort-like standard.

An issue not raised in Downey II, but that the IRS will probably raise in a future case, concerns punitive damages. In Downey II, the court held that the liquidated damages served a punitive as well as compensatory purpose. The taxation of punitive damages under IRC Sec. 104(a)(2) is complicated. If the injury is physical, punitive damages are excluded, as are punitive damages for nonphysical injury for amounts received, settlements finalized, or suits filed on or before July 10, 1989 |See Horton v. Commissioner, 100 T.C., No. 8 (1993) After July 10, 1989, punitive damages for nonphysical injury are taxable due to an amendment to IRC Sec. 104(a)(2) enacted in 1989. (This change does not apply to Downey because Mr. Downey settled his ADEA claim in 1985.) Discrimination is a nonphysical injury. Since the Tax Court ruled that the liquidated damages serve a punitive as well as a compensatory purpose, the IRS could very plausibl argue that part of the liquidated damages are taxable under the 1989 amendment.

Age discrimination in employment suits are likely to increase in the future because of the aging work force and corporate downsizing and restructuring. Although Downey II is a very favorable ruling for employees and employers, the IRS is likely to appeal, arguing that the back pay does not satisfy the tort-like requirements of Burke. In addition, it could argue that the liquidate damages also do not meet the Burke standard. The IRS has a good chance of prevailing on the back pay issue, especially in cases involving nonwillful violations. Finally, the 1989 amendment adds uncertainty for recent awards and settlements for part of the liquidated damages. Therefore, planning in this are will remain difficult until the courts render more decisions on these issues. (Downey is appealable to the seventh Circuit and Maleszewski to the Eleventh.)

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