General Practice, Solo & Small Firm DivisionTechnology & Practice Guide

Taxing Matters

New Rules for Taxing Awards for Personal Injury, ADEA, and Other Torts

BY BEVERLY HELM

Beverly M. Helm is an attorney in Birmingham, Michigan, who focuses her practice on tax and retirement planning. She is chair of the General Practice Section's Tax Committee.

Employment lawyers must now be tax experts as well as litigators. The rules for taxability of damages in employment cases are in the process of changing. Clients must be informed of the changes. Successful plaintiffs must be informed of potential tax liability so that they may plan to keep sufficient cash to pay it. Defendant employers need to plan for withholding taxes from taxable judgments and settlements. If the new rules are not followed, IRS penalties may be due for plaintiffs' nonpayment of tax and for defendants' failure to withhold and pay over taxes to the IRS.

The IRS is extending its ever-reaching tentacles to attempt to tax recipients on recoveries for gender and race discrimination actions. Practitioners should expect new and creative arguments from the IRS following the Supreme Court's ruling in Schleier v. Commissioner (115 S. Ct. 507, 132 L. Ed. 294, 1995 U.S. Lexis 4044) last June that damages recovered under the ADEA are taxable. Back pay and liquidated damages were held not to qualify as "compensation for personal injuries or sickness" under IRC Section 104(a)(2) and therefore were not excludable from taxable income. Liquidated damages were taxable because they were punitive in nature. Back pay was included in income on the theory that it was attributable to termination of employment, not any personal injury. This is the "new rule," notwithstanding the fact that a plaintiff would not have claimed back pay as an element of damages, but for the discrimination resulting in termination of employment.

To be excludable from income, personal injury recoveries must now meet a new, two-pronged test. First, the underlying cause of action must be based on tort or tort-type rights; and second, damages must be "on account of personal injuries or sickness." The first part of the test narrows the window of eligibility followed since the Supreme Court's 1992 decision in United States v. Burke (504 U.S. 229 (1992)). To be nontaxable, damages must compensate for traditional harms associated with personal injury, such as pain and suffering, emotional distress, harm to reputation, or other consequential damages.

The aftermath of the Schleier case may be just beginning. I predict that if Congress has not already acted in its budget bill, the IRS will move quickly to impose new rules for taxation of awards for gender and race discrimination, ADA violations, and punitive damages. In terms of congressional action, Section 13611 of H.R. 2491, the Revenue Reconciliation Bill of 1995, would have taxed most punitive damages and emotional distress damages. The House and Senate supported this revenue-raising provision as part of the Republican effort to balance the budget, differing only on tax treatment of wrongful death cases. On December 6, 1995, President Clinton vetoed H.R. 2491, the proposed "Seven-Year Balanced Budget Act." Clinton had vowed to veto the measure for months because it contained $245 billion in tax cuts and steep reductions in the growth of Medicare (Tax Notes Today, Dec. 7, 1995).

The Burke test was first rejected over a year ago when the Supreme Court determined that the judgment interest component of damages was taxable. (See GPS Tax Committee Newsletter, September 1993.) Schleier was decided in June, and IRS Notice 85-45 was issued on August 4, 1995, less than three months later. This notice declared that previous rules on taxability of damages under Revenue Ruling 93-88 could no longer be relied upon.

The IRS has officially indicated that it is considering change by "requesting comment" from practitioners on applying the new Schleier rules. Comments were requested on whether to retroactively apply the new rules, and how to allocate damages received as includable and excludable from taxable income. Retroactive application of any rules would unfairly prejudice many litigants and cause serious problems. Plaintiffs who have spent or invested their 1994 settlements or awards will find it a hardship to learn in winter or spring of the next year that they owe taxes on these amounts by the due date of April 15. Defendants who paid damages in accordance with court-ordered judgments and negotiated settlement agreements cannot withhold taxes from amounts paid out in the past, and must be exempted from any penalties for this. Guidance will be needed on obligations to prepare and file 1099 forms on amounts paid prior to notice of the new rules.

Punitive damages in physical injury cases are on their way to being taxable. Punitive damages have always been taxable in tort cases not involving personal injury. By the time this column is published, changes will most likely have been formulated, either by Congress or the IRS. Significant changes in tax on damage awards are occurring and must be watched carefully.

New rules proposed by H.R. 2491 would have applied to payments made after December 31, 1995, if they were pursuant to an award or settlement after September 13, 1995. Settlement and allocation agreements must be drafted very carefully to comply with new standards that we cannot predict. Any salary or fringe benefits lost will be nontaxable only if the loss was caused by the discriminatory conduct. Damages clearly allocated in a reasonable manner for physical pain and suffering, mental anguish, physical impairment, and disability continue to be nontaxable. One of the most powerful settlement tools available--the ability to characterize damages from discrimination events as nontaxable--is now seriously eroded. This technique formerly allowed a settlement to be worth 30 to 50 percent over its stated value. Unfortunately, these changes will most likely make settlement more difficult, and increase litigation in the employment arena.

One thing is certain--we can expect new rules soon. Physical and mental injuries are difficult to distinguish in some cases, and do differ from the economic injury, but should this be a relevant difference under the tax code? The opinion in Congress appears to be that emotional distress is not a "real injury," and should be taxed. Practitioners must carefully monitor legislation and IRS guidance on these new issues.

Perhaps Congress and the IRS are proceeding on an unspoken mission to increase taxes on amounts not yet received, as with the tax increases on pension benefits for the past several years. This strategy minimizes opposition to tax increases, since taxpayers fail to realize that they will be adversely affected until after they become entitled to funds subject to the increased tax. This explains the lack of opposition to Section 13611 of H.R. 2491--few are aware of its contents!

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