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Personal Injury Awards: 104(A)(2)
Should Personal Injury Awards Be Taxed?
Student Paper by Lyle Foster
Univ of Arkansas at Little Rock School of Law
Discussion of various tax policy arguments concerning the exclusion of personal injury awards from income-taxation. Points of discusson include humanitarian aid, the "return of capital" approach, as well as potential abuses. This paper also addresses ancillary considerations for the exclusion and possible reforms.
Table of Contents
Justifications for Retaining Exclusions
Internal Revenue Code 104(a)(2) fn1 excludes from gross income amounts
received frompersonal injury awards. It provides that:
"[e]xcept in the case of amounts attributable to (and not in excess of) deductions allowed under 213 (relating to medical, etc., expenses) for any prior taxable year, gross income does not include - . . . (2) the amount of any damages received (whether by suit or agreement as lump sums or as periodic payments) on account of personal injuries or sickness . . . . " fn2
It was included in the original codification in 1918, and is about as old as the federal income tax system. fn3
Although the provision has undergone little change since it was enacted, it has caused much controversy in the courts and among legal commentators. The courts have had to create distinctions to determine what constitutes a personal injury as well as what part of the award,if any, is attributable to a personal injury. In fact, it is often difficult to classify the awards as excludable or includible. Legal commentators argue that the legislatively enacted exclusion is not within current tax policy and it should be repealed. The purpose of this paper is to delineate the arguments for and against the exclusion of personal injury awards. The last section will also discuss proposed reforms generally. This paper will be limited to the issue of compensatory damages. Punitive damages are unsettled in this area, and to discuss them would go beyond the scope of this paper.
II. JUSTIFICATIONS FOR RETAINING EXCLUSION
The justifications for excluding personal injury awards are based on several sound policy grounds. Like most policy arguments, these are not free from flaws. The overwhelming support for exclusion are based on the theories of humanitarian aid and return of capital.
Almost everyone would consider, at least arguably, that to confer a benefit upon a person who has suffered a severe loss helps satisfy our need to give humanitarian aid. In fact, more than one commentator has made the observation that 104(a)(2) and its predecessors are rooted in public policy grounds rather than strict logic. fn4 Others have gone as far as to say that "taxation of recoveries for pain and suffering would be offensive because the victim is more properly pitied than taxed." fn5 "Commentators, however, are only following a line of logic that originated elsewhere.
Several opinions have stated that Congress, by enacting 104(a)(2), intended to confer humanitarian aid to the injured party. The discussion of this topic in court decisions is usually centered around whether the jury should be instructed as to the excludability of the award. Even so, the reasoning of the court is still based upon Congressional intent. The Supreme Court of Illinois in Hall v. Chicago & Northwestern Railway Co. fn6 observed that "if the jury were to mitigate damages . . . by reason of the income tax exemption . . . then the very Congressional intent of the income tax law to give the injured party a tax benefit would be nullified." Similar reasoning can be found in Epmeier v. United States, fn7 Where the court found that 104(a)(2) was undoubtedly intended to relieve the taxpayer of a burden when becoming injured or ill.
This humanitarian aid reasoning seems to be an extension of what our human nature would like us to do. It is analogous to the exclusion of life insurance proceeds from income tax. fn8 We feel an obligation to help people in their weakest moments.
Probably the most common argument in favor of exclusion is the return of capital theory. This encompasses the tort theory of placing an injured party in as good a position as he would have been, had he not been injured. The general idea is that damages only restore the injured party to his original state. At first glance, it seems only fair that we should tax the injured party's recovery of lost earnings because we are only giving him what he otherwise would have been taxable. But, the return of capital theory strikes at a deeper cord. We are in essence stating that the damage award is compensating the injured party for the loss of a capital asset, namely the ability to earn. When the injury compensates for a lost limb, the rational behind this policy makes logical sense. It is easier to visualize that in this instance, the tortfeaser is paying for a "capital asset" of the injured party.
This exclusion precedes the enactment of 213(b)(6) of the Revenue Act of 1918, the first codification of this exclusion. In 1915, the Internal Revenue Service ("Service") ruled that proceeds received from insurance on account of an accident were taxable. From this, it only seemed reasonable that settlements from tort claims should also be taxable. However, shortly after this ruling, the Supreme Court decided four cases fn9, that distinguished taxable income from nontaxable return of capital. In the wake of these cases, especially Doyle v. Mitchell Bros. Co. fn10, the Attorney General discussed the issue of proceeds from accidents by stating: "Without affirming that the human body is in a technical sense the 'capital' invested in an accident policy, in a broad, natural sense the proceeds of the policy do substitute, so far as they go, capital which is the source of future periodical income. They merely take the place of capital in human ability which was destroyed by the accident. They are therefore 'capital' as distinguished from 'income' receipts. fn11 Shortly after this announcement, the Commissioner adopted the same position and allowed the exclusion of personal injury awards. Fn12
The loss of a limb provides a good illustration of the return of capital theory, if it is a valid theory, of course it should be applicable where no limb is lost because it is the ability to earn upon which this theory focuses. With the focus on this ability, the theory can be justified on the reasoning that there can be no taxes due because there is no way to compute gain. If in fact the ability does resemble a capital asset, what is the basis on which to compute gain? Without a way to determine the taxpayer's basis in the asset, no gain can be realized or taxed. This argument is known as the "lost asset" approach and was advanced in Solicitor's Opinion 132. fn13 Solicitor's Opinion 132 goes even further to state that these are personal rights, are non-transferrable and as such, have no market value. Fn14
It could be said that Solicitor's Opinion 132 approaches the problem incorrectly because in dealing with capital assets, we are not concerned with the market value, only basis. fn15 And since there is never a monetary amount credited to a capital account for a human body, the basis is zero. However, if the ability to earn is a capital asset, we must fully allow it all the characteristics of a capital asset. In so doing, most expenditures that further the ability to earn (capital asset), should be added to the basis. This could include things such as food, education and health care. fn16 " With this daily adjustment to the basis, even starting at zero, the basis would quickly rise. In fact, if a basis could be determined by this method, it would appear that most personal injury awards would be less than the basis and a capital loss would be appropriate.
Case law furthers the rationale of the return of capital theory. In Hawkin v. Commissioner., fn17 " the holding allowed the exclusion based on the theory that the money award only returned the injured party to the position he would have occupied. Then, in Glenshaw Glass v. Commissioner, fn18 the Court's decision classified punitive damages as taxable in some situations, of which there is still some uncertainty. However, the point at issue there was that the Court noted that personal injury awards were not taxable on the theory that they corresponded to a return of capital and that they were by definition, compensation only. Fn19
"Eisner v. Macomber fn20 " supports the "lost asset" approach indirectly. The whole underlying policy for that approach is that the proceeds are not income because there is no way to compute gain. This is slightly, if at all, different from the return of capital theory, which focuses on compensation for the lost ability. This discussion will treat the "lost profit" argument as a subset of the return of capital. Eisner dealt with the ability to tax stock dividends as income and was decided under different circumstances. However, the court held that income is "derived from capital, from labor, or from both combined; something of exchangeable value . . . ." fn21 Without a way to determine an exchangeable value, there can be no gain and hence no income.
III. JUSTIFICATION DEFECTS
All the policy reasons above have flaws. Some are more refutable than others. In addition to the direct opposition to the above reasoning, there are additional questions about the exclusion. These include the inability to find Congressional intent and potential abuse in structured settlements. Before discussing the answers to the arguments favoring the exclusion, it is necessary to understand the legislative history.
From the inception of the exclusion, there is very little Congressional history upon which to base policy. This by itself could lend itself to an argument that the exclusion is not being overlooked. By the mere avoidance to address the issue, Congress is expressing it's intent by allowing the courts to interpret. However, upon reviewing the legislative history of the act, there seems to be only one reference, and it does not deal with policy: "Under the present law it is doubtful whether amounts received through accident or health insurance, or under worker's compensation acts, as compensation for personal injury or sickness, and damages received on account of such injuries or sickness, are required to be included in gross income. The proposed bill provides that such amounts shall not be included in gross income. fn22" With this little amount of history, the courts that interpret the "Congressional intent" are only guessing. If the directive were clear, maybe no Congressional intent would be needed, but courts are having a difficult time construing exactly what is meant. Further, since there is an absence of expressed intent, the courts are obviously interjecting their own policy reasons, not the stated policy reasons for the exclusion's creation.
Aside from the fact that the legislative policy reasons are a bit scant, there are also serious defects in the general policy that supports the exclusion, such as the humanitarian aid argument. It would appear obvious that any civilized community would like to help those who have been injured. However, if this is our true policy for keeping the exclusion, it is not administered fairly to all those who should be entitled. From the exclusion itself, one who recovers an award through the tort system, be it by suit or agreement, is given a tax benefit. This does not however, give humanitarian aid to all those who have suffered. The vast majority of personal injures are never compensated. Therefore, the only victims who receive a tax benefit are those who take some successful action through the tort system. If we are in fact basing our exclusion on humanitarian needs, there should be a deduction allowed to those who do not recover tort proceeds.
We have also limited our exclusion to a class of people who receive benefits through the tort system. We do not allow any benefit to those who have accidentally injured themselves. We also do not allow any relief to those who suffer an illness not due to the fault of another. Clearly, each of these persons have had their ability to earn impaired. But, they do not fall in the correct class to receive a benefit. Here again, if we were to be basing this exclusion on humanitarian aid, these people would surely be entitled to a benefit, such as a deduction.
The second policy reason advanced above dealt with the return of capital theory. This argument must first be analyzed in light of what capital is actually being returned. The argument that we are, by awarding an injured party compensation, making him "whole again," does not equate to a return of capital. It does not equate on a conceptual basis, nor does it follow case law.
To accept the return of capital argument, there must be a basis in the so-called capital. The thought that a basis could be established by expenditures for food, shelter and the like, is inhibited by the ability to do such a task. No one keeps track of these outlays to the extent necessary to determine a basis. But, assuming arguendo that records have been kept, most of these outlays are nondeductible personal expenditures. fn23 And, by what means are we to establish what is classified as a personal expenditure and what is a capital expenditure? What possible system could tell us whether (or what portion), we should allocate clothing, food, shelter, etc. to capital expenditures? Could we include transfers from others, like parents or the government? fn24
Although there are technical difficulties, one might argue that the basis could be inferred from the amount received. fn25 This would be similar to the proposition that when the fair market value of an asset exchanged cannot be determined, it is assumed to equal the value received. fn26 Being similar to an accepted principle does not make this proposition acceptable, though. This basis equal to recovery argument does not even approximate recoveries allowed for small children. It is also inconsistent with other human capital doctrines. fn27 If one does in fact have an investment in human capital, an allowance for depreciation should be given. fn28 This allowance would be consistent with a treatment of the compensation as return of capital. This enactment would also take an affirmative stamp on the part of Congress and would allow us to truly understand what their policy reasons for the exclusion are. As mentioned above, it would also seem necessary to allow deductions for uncompensated injuries and accidents. fn29 If this lost ability to earn is capital, the uncompensated impairment of that ability should be treated as a tax loss, especially if we treat compensation for that lost ability as excluded.
It also appears that to classify a personal injury award as a return of capital would be misleading compared to what is actually being awarded. A personal injury award does not actually claim to pay for a lost limb or the lost ability to earn. Instead, compensation is awarded for medical expenses, pain and suffering and lost earnings. fn30 Although lost earnings may closely equate to lost ability, they are not the same. More accurately, the lost ability is considered to determine the amount that will not be earned. If it had been earned, it would have been subject to income tax.
Theoretical concepts are not the only areas in which the return of capital theory is disputed. The case law that is often cited as judicially interpreted policy may be misinterpreted. The two landmark cases supporting the exclusion of physical personal injury awards due to the return of capital theory, are not concerned with physical injury at all. While these two cases further the argument for exclusion for the return of capital, they concern property in which there is a determinable basis. Commissioner v. Glenshaw Glass fn31 dealt only with the issue of punitive damages in a business antitrust action. This case held that the return of capital rationale does not apply to punitive damages recovered in an injury to property. From this, it could be argued that the exclusion of compensatory physical personal injury awards can be based on the return of capital theory. But Glenshaw Glass had nothing to do with physical injury. This case dealt with injury to property, the basis of which can be determined. The same can be said for Doyle v. Mitchell Bros.Co, fn32 which dealt with the taxpayer's receipt of his original investment in the resale of merchandise.
The above discussion leads to the conclusion that the exclusion of a personal injury award cannot be supported as a return of capital on a literal, conceptual or case law basis. With this as a starting point, the exclusion lends itself to a number of other policy defects. If the compensation is in fact to replace earnings, it should be taxed because the earnings would be. A discussion of when it should be included will be addressed below. The reason it should be included is based on horizontal equity. Those with equal incomes should be taxed equally. The award is not a return of capital and so it should be classified as income, subject to tax. To hold otherwise creates a tax subsidy to the injured party. It is a Congressional decision to exclude income that would otherwise be taxable.
Structured settlements are a creation of the personal injury exclusion and have great potential for abuse. The issues involving structured settlements go beyond the scope of this paper. However, there are some concerns of the exclusion's ability to induce abuse. The first concern is the ability of structured settlements to produce an interest component that is never taxed. By the nature of the settlement, a certain amount is set aside to produce interest. Then each period the injured party is paid a portion of the award plus interest. Because periodic payments are excluded from tax, the interest component is never taxed. fn33 Since the payor can give less to satisfy the injured party, this gives the payor a leveraging tool for settlement. But, to forgo taxing the interest component is clearly at odds with horizontal equity.
A second abuse in structured settlements is the ability to represent the facts as a personal injury rather than contractual breech. Since personal injury is excluded from tax and contractual recoveries are not, it is to the benefit of both parties to agree the damages are personal. The distinction between the two types of claims can be slight. This creates a problem of policing excludable injury from contractual loss. fn34 While there is a judging standard to try to distinguish the two, there is no way to do so with assurance. Validity of a claim is not important, fn35 only the classification.
IV. ADMINISTRATIVE ANCILLARY CONSIDERATIONS
In addition to the above pro/con policy concerns, there are at least four ancillary considerations. While obviously the return of capital theory remains a pivotal point, administrative procedures must come into play. These administrative concerns include the ability to determine the amount to be taxed, taxing the "pain and suffering" element, if the tax is "fair" and retaining the status quo. These considerations are not without flaw either. Section IV(a) will offer the arguments for exclusion, while IV(b) will refute.
At a minimum, the "lost profit" element of compensatory damages should be taxed. Everyone who does earn a profit or has income, fn36 is subject to tax. Why not tax the "lost profit" element of a personal injury award? An argument to exclude even the "lost profits" portion of the award can easily be made due to administrative impracticability. To support taxation of the "lost profit" we must determine its amount. Juries do not usually assign an amount for each element. fn37 " And even if they did, do we allow them to make an even more arbitrary determination of the "lost profit" element? If so, then we are making the jury more than a "fact-finder." Not only would the parties have to prove damages, they would also have to prove by highly technical means how much of that award should be attributed to "lost profit." Assuming the case does not go to trial, but a settlement is reached, the settlement agreement may be just a waiver of claims without specifying what the compensation is being given for, making it difficult to assign a "lost profits" element. Lastly, even assuming that the "lost profits" element could be broken out in most torts, it would be almost impossible to do so in the case of certain torts such as defamation. The damages may only be representative of one's impaired reputation, not personal harm or "lost profit." fn38
The second ancillary consideration has to do with "pain and suffering," a traditional element of tort damages. What argument can the government make that it is entitled to tax those proceeds? Surely we would not be led to believe that because the injured party received an award, he was a wage earner being paid by the hour for pain. A big fear of the Government's would also be the media coverage it would receive if it were to attempt to tax this element. Even if a sound policy exists for taxing "pain and suffering," it is not the kind of publicity the Treasury Department desires. fn39 Assuming that a sound policy reason does exist, there would be no way to explain it in a way that the American people would understand and support.
Insurers are also not in favor of taxing "pain and suffering," or any other element of damage. They believe that to tax the damage award would lead to substantially higher jury verdicts. fn40 While insurers' concerns may not be a sound tax policy on which to base a decision, it does lend itself to modern concerns. The vast majority of people believe there are too many frivolous law suits filed, and bigger jury awards would certainly increase the likelihood of filing. In addition, the insurer does not absorb the ultimate cost of lawsuits, it is the shareholders and policyholders. To allow taxation of damage awards would not effect insurers as much as it would increase shareholder and policyholder exposure.
Another consideration is the general idea of fairness. Personal injury awards are, in effect, unwanted income. Given the alternative, most people would have opted not to have been injured. To tax these proceeds would be adding the so-called "insult-to-injury." It should not be within our sense of fairness to tax income that arose by an involuntary act of a victim. fn41
A second fairness argument arises out of "bunching." A lump-sum personal injury award is more likely to be uncharacteristic of what the victim's "normal" yearly income would be. Even structured settlements, with the payout over a number of years, are probably greater than the "normal" yearly income of the victim. To tax these proceeds in a single period would subject the victim to a much higher tax responsibility than would have occurred over the period of compensation for which he is being credited with earning it. To satisfy the need to lower the tax responsibility, some type of income averaging would have to be devised. However, income averaging violates not only the accountant's theoretical view of "recognized when realized" for a cash basis taxpayer, it is also inconsistent with the principles of I.R.C. 451(a). fn42
The last argument is status quo. This is the inverse of the "old taxes are good taxes" argument. While this argument is applicable to a number of taxes and tax exclusions, there are few to which it is more truly applicable than to the exclusion of personal injury awards. This exception started before the first I.R.C. codification in 1918. This tax exclusion has, for all practical purposes, been in existence since the organized tax system began. This exception is relied upon daily in settlement agreements.
These four ancillary policy considerations can be criticized. The easiest way to cure the inability to tax the "lost profits" element of the award is to subject the whole award to tax and then allow medical deductions for expenses paid. fn43 If it is deemed desirable to exclude all portions of the award except the "lost profits" element, an allocation method can be devised. This allocation method would come into effect in some jury awards and probably all settlements. This is because allocation by a jury is probably conclusive, but allocations in settlements are not. fn44 That is not to say that jury awards are conclusive, but the review would be limited to reasonableness. Creation of one more allocation would not cause many problems. Our tax system is full of hypothesized allocations now. fn45 There is even one allocation, the amount of punitive damages, already in place in the tax treatment of personal injury awards. fn46 The punitive damage element must be broken out due to the possibility that it may be taxable. fn47 The government has created a "facts and circumstances" fn48 " test to determine taxability of punitive damages and a similar test or allocation method could be created for "lost profits."
The emotional attack on taxing compensation, especially "pain and suffering," may be compassionate, but it is not sound policy. The concern over media coverage and the possibility of increased exposure by the indemnifier has no place in sound policy decisions. Taxes are not popular. Little coverage by the media will be favorable to either increased taxes or expanding the tax base. As far as increased exposure, those costs can and are passed on to those who cause the liability.
If the concern is based on the idea that we are taxing "pain and suffering," one way to alleviate that is to tax only the "lost profits" element. However, the "pain and suffering" element is compensation. It meets the definition of I.R.C. 61 income as "[any] income from whatever source derived." The idea that those not compensated should be entitled to a deduction might make theoretical sense, but it would be impractical to administer. Further, just because we do not allow a deduction for those not compensated does not justify the proposition that we should not tax those who do.
Justifying the taxing of unwanted income appears unfair. However, to some extent the injured party has control over what damages he seeks. Albeit a bit unrealistic, if he does not want the "lost profits" element, which is most closely associated to taxable income lost, he does not have to ask for it. In addition, there are many similar areas where "lost profits" are compensated and are not excluded, like unemployment income and sick pay. fn
There is a valid argument of fundamental unfairness concerning bunching of income. A personal injury award would subject the injured party to a higher tax liability than if he paid the tax in the period recovered. The bunching of income argument is not unique to personal injury awards and there are alternatives that will be discussed below. Even if there were not, with current tax rates, the additional liability is not great. The tax rates are almost flat now. fn50 Litigants could deal with this problem through structured settlements. Structured settlements could allow taxation on the amount received for that period, eliminating bunching in one year. fn51 " It would also be possible to allow the injured party to choose how much money he wishes to receive in each period. This would give him the control over the tax liability. If a structured settlement is not created, income averaging is still possible.
The final ancillary policy consideration cannot be measured against tax policy. Old taxes may be good taxes, but exclusions that are unfair to taxpayers as a whole are not "good." If it is sound policy to include personal injury awards, then to keep them excluded on the basis of history would do little to support confidence in our tax system.
V. POSSIBLE REFORMS
The above discussion outlines the competing interests involved in excluding personal injury awards. So, what can be done? Since the current law excludes, the only reform is to include. The remaining problems concern what to include. Which parts of the award are justifiably taxable, and how do we classify them? The two proposals suggest taxing the entire amount with exclusion of medical expense under I.R.C. 213 or taxing only economic proceeds (lost profits). Once one of these proposals is adopted, there still must be a determination on whether to tax the awards as ordinary income or capital gains. While each of the foregoing proposals have all of the policy pros and cons delineated above, the focus of the discussion around the proposals will highlight only the most important considerations. It will also be assumed that where proceeds are taxable as ordinary income, some action has been taken to alleviate "bunching." In case of structured settlements, the "bunching" is easily taken care of by taxing the portion of the award when received.
The first alternative would include all proceeds. Medical deductions would be allowed under I.R.C. 213. The advantage of this type of adjustment is that it would be easy to administer. It would be unnecessary to distinguish between physical or nonphysical, contract or tort. Conceptually, all should be included. This would meet the definition of I.R.C. 61 income as well as meet the Glenshaw Glass definition of accession to wealth, clearly realized over which the person has dominion and control.
The drawback of this type of plan is that it may unfairly subject the injured party to a greater share of the burden of costs and fees, in the American court systems, the parties must bear their share of fees and court costs. Since many personal injury cases are contingent, the injured party may never receive a large share of the award. Even though the injured party never receives it, under this system, he must still pay tax on it. While that is attributable to the American system, it seems unfair due to the fact that this was an involuntary act on the part of the injured party. If we assume that the whole award is being taxed because the income that would have been earned would have been taxed, we will have levied a penalty on the injured party for asking what he would have been entitled to had he not been injured. After tax dollars should not have to be used to pay for expenses that were causally linked to another party. We could allow deduction for certain fees, but that would defeat the real strong point of this system, simplicity.
The same argument could be made for the "pain and suffering" element since it will be subject to contingency fees as well. Taxing this amount is at the root of the unfairness argument. This would be levying a tax on the arbitrary dollar value assigned to a person's pain. That thought seems inconsistent with the concept of fair play. The idea that an award takes the place of freedom from pain, which is not taxed, is preposterous. If not, a tax would have to be levied against those who have suffered uncompensated pain. This in essence, would mean pain, regardless of whether compensated or not, is taxable.
An alternative argument is if we were to tax the "pain and suffering" element, we should allow a deduction to those who went uncompensated. This would be the reverse argument to taxing people on how well off they are. If the tax system collects for the personal injury award element of "pain and suffering" because the taxpayer is better off, the only reason they are is because they received an award for their pain. Therefore, those who do not, are worse off. A system of deductions would have to be established for different types of pain. This would have to be detailed to show consistency. What amount is proper for pulling a tooth? Even worse, how will the Service police establishing pain?
Another fairness argument is that the injured party is penalized for an injury that is another's fault. If we tax an award for medical expenses and then allow a deduction under I.R.C. 213, this still does not allow the injured party to be placed back in the position he was prior to the accident. This is because medical deductions are only allowable to the extent they exceed 7.5% of adjusted gross income. fn52 While this type of limitation may be fair for routine medical expenses, it is not fair to require a party injured by another to pay the additional tax. The injured party would not be in a position to need medical help but for the actions of another, so why penalize him? For these reasons this method is unacceptable. It we do decide to tax the medical expense portion, fairness would dictate allowing a full deduction for medical costs incurred in the personal injury. This may lead to further problems in determining which personal injury medical expenses are attributed to acts of others.
A second idea is to exclude all non-economic proceeds. This correlates to the idea of taxing "lost profits," and would exclude the damages awarded for medical expenses and "pain and suffering." The "lost profits" would be treated as ordinary income. With this proposal comes the "bunching" concern. It would be possible not only to average income, but in the alternative it would be possible to include only a portion of the award. It is not clear what theoretical viewpoint is advanced in only including a portion, but it does deflate the argument of "bunching."
Including only the "lost profits" element more closely resembles what would have been included in the tax base. It would be fairly simple to administer by using whatever reasonable calculations the parties used to determine what in fact was the amount lost in earnings and earnings capabilities. It might even be appropriate to require, or at least recommend, that the amount classified as "lost profits" be approved by a judge or contained in the settlement agreement. Since this proposal excludes the "pain and suffering" element, it still has an emotional ring. That is the element of "pain and suffering" is the portion of the award that was "unwanted." There is also case law that suggests that this portion of the award cannot be taxed. Starrels v. Commissioner fn53 held that "pain and suffering" represented a restoration of basis. While the arguments above clearly show the flaws in the return of capital theory as a basis for exclusion of the whole award, the exclusion of "pain and suffering" on these grounds would be the easier of the three elements to justify.
The principal complicating issue involving this type of arrangement is administrative practicability. There may still be some trouble in determining which part of the award most fairly represents the "lost profits" element. With the adoption of another test, numerous lawsuits will have to be heard to determine where arbitrary limits will be placed unless allocation is set by statute. However, if allocation is by statute, problems will arise due to inflexibility in specific cases. To base the determination on a formula would be too strict and unyielding to individual situations. While literally, the exclusion of the "pain and suffering" element does not square with the complete definition of I.R.C. 61 and Glenshaw Glass, the Code already recognizes many. fn54 Congress has been empowered to exempt even those things that otherwise would be included. If there is to be a change in the current law, this is the better alternative.
Another way to combat the "bunching" argument from the last proposal would be to treat the "lost profits" element as capital gains. Since the concept of capital gains is in itself a legal fiction, created by being in a class not otherwise prescribed, the inclusion of this element would only add another inclusion by exclusion of I.R.C. 1221.fn If the argument that the award is based on a return of capital theory does in fact have merit, perhaps this is the best way to treat the "lost profits" element. The strength in this proposal is that it would alleviate the "bunching" problem. Offsetting deductions for capital losses would be allowed, as well as, however slight, potential preferential tax treatment. fn56
Putting aside further pros and cons concerning whether any part of the award is a return of capital, there is still doubt as to whether this treatment would alleviate "bunching." While it may be true that some injured parties who recover a personal injury award get to take an offsetting capital loss or get a slight preferential tax treatment, this would not be true in most cases. For the most part, both of these benefits help wealthier people. They are the most likely people to have capital investments that generate capital losses. Further, any preferential tax treatment would only go to those who are in the highest tax bracket. This type of anti-bunching proposal would only increase the regressivity of our tax system.
Obviously unsettled, this area remains a focal point of commentators' criticism. There is policy in support of excluding personal injury awards that makes logical sense. We all would like to give a person who has suffered a loss a helping hand, and there are various fairness arguments against taxing certain elements of the award, especially "pain and suffering." However, the current exclusion is far from meeting our policy goals. It is not representative of what our tax system should be. These proceeds, at least in part, fully meet the definition of income. There is also unfairness to taxpayers in general to be paying for some of the costs of this tax exclusion as a subsidy. There does not seem to be a right, or easy, answer.
The best way to accommodate both interests would be to tax the "lost profits" element of a personal injury award. The arguments for exclusion are much stronger if limited to the "pain and suffering" element and medical expenses. Of course, a suitable income averaging plan would have to be devised. From a conceptual standpoint, the amount of the award is to compensate for a certain period of time. In addition, averaging is necessary to give an accurate account of what the injured party's tax would have been. The capital gains approach would not be sufficient. It gives preferential treatment to those with higher incomes. Structured settlements would have their income averaging plan contained within the settlement.
1 Unless otherwise stated, all references to I.R.C. are to the
Internal Revenue Code of 1986, as amended.
3 See Ralph S. Rice, Federal Income Taxation 2 (1967). The federal
income tax system dates back to 1913 when the Sixteenth Amendment was
4 See Note, Taxation of Damage Recoveries from Litigation, 40
CORNELL L.Q. 345, 346 (1945-1955)(stating that the notion behind this
justification is the desire to relieve an injured person, who has
suffered enough, from both tax and the burden of allocating a recovery
between taxable and tax exempt components); Harnett, Torts and Taxes,
27 N.Y.L.U. REV. 614, 626-627 (1954) (noting that a tax treatment of
personal injury recoveries is more likely based on humanitarian aid and
less legalistic notions concerning good policy).
5 Comment, Tax Treatment of Post-Termination Personal Injury
Settlements, 61 CAL.L. REV. 1237, 1237 (1937).
6 5 Ill.2d 135, 125 N.E.2d 654 (1953).
7 199 F.2d 508 (7th Cir. 1952).
8 I.R.C. 101(a)
9 Lynch v. Hornby, 247 U.S. 339 (1918); Southern Pac. Co. v. Lowe,
247 U.S. 330 (1918); Lynch v. Turrish, 247 U.S. 221 (1918); Doyle v.
Mitchell Bros. Co., 247 U.S. 179 (1918)
10 247 U.S. 179, 184 (1918).
11 31 Op. Att'y 304, 308 (1918).
12 T.D. 2747, 20 Treas. Dec. Int. Rev. 457 (1918).
13 I-1 C.B 92 (1922).
15 I.R.C. 1001(a) Basis is determined by costs derived from
nondeductible capital expenditures or income inclusions with respect to
the asset itself.
16 See Paul B. Stephen, III, Federal Income Taxation and Human
Capital, 70 VA. L. REV. 1357 (1984).
17 40 B.T.A. 1023 (1927)
18 348 U.S. 426, 432 (1955).
19 Id. at 432, n.8; See 2 Cum. Bull. 71;I--1 Cum. Bull. 92,93; VII--
2 Cum. Bull. 123; 1954--1 Cum. Bull. 179,180. Damages for personal
injury are by definition compensation only. Punitive damages, on the
other hand, cannot be considered a restoration of capital for taxation
20 252 U.S. 189 (1920).
21 Id. at 190.
22 H.R. REP. NO. 767, 65 Cong., 2d Sess.9-10 (1918), reprinted in 94
INTERNAL REVENUE ACTS OF THE UNITED STATES 1909-1950 LEGISLATIVE
HISTORIES, LAWS AND ADMINISTRATIVE DOCUMENTS 9-10 (B. Reams, Jr. ed.
23 Treas. Reg. 1.262-1(b) (1958).
24 See John K. McNulty, Tax Policy and Tuition Credit Legislation:
Federal Income Tax Allowance for Personal Costs of Higher Education, 61
CAL. L. REV. 1, 26-27 (1973).
25 Cf. Inaja Land Co. c. Commissioner, 9 T.C. 727 (1947), acq.,
1948-1 C.B. 2.
26 See Philadelphia Park Amusement Co. v. United States, 126 F.
Supp. 184 (1954).
27 Joseph W. Blackburn, Taxation of Personal Injury Damages:
Recommendation for Reform, 56 TENN. L. REV. 661, 663-668 (1989)
28 This in itself might be difficult since a basis to depreciate
must be determined. However, more Government tables could be produced.
But if so, where do we get basis from? age? education? race? domicile?
sex? Do all these factor a person's inherent worth or their ability to
29 Here again an arbitrary amount must be determined using possibly
the same factors as stated in 28 and adding others. To determine the
amount of deduction, the pain and suffering factor must be added to the
above factors, time of impairment and maybe lost opportunities.
30 See RESTATEMENT (SECOND) OF TORTS, 901-932 (1977).
31 348 U.S. 426 (1955).
32 247 U.S. 179 (1918).
33 I.R.C. 104(a)(2).
34 Bolla, Contort: New Protector of Emotional Well-Being in
Contract, 19 WAKE FOREST L. REV. 561 (1983).
35 Seay v. Commissioner, 58 T.C. 32,37 (1972).
36 This is actually what the "lost-profit" approach is suggesting is
37 Verdicts do not require an itemization of amounts awarded under
FED. R. CIV. P. 46(b): see also Kalevity v. United States, 548 F.2d
809, 811 (6th Cir. 1978) (court rejected argument that any award over
and above actual loss is 'punitive' on grounds that traditional tort
law mixes theories of compensation and deterrence together when
awarding ordinary damages).
38 See Note, Roemer v. Commissioner: The excludability of
Nonphysical Tort Damages from Gross Income Under Internal Revenue Code
104(a)(2), 1985 UTAH L. REV. 477, 478 n.7 (citing L. ELRIDGE, THE LAW
OF DEFAMATION 2 (1978)).
39 Lawrence A. Frolik, The Convergence of I.R.C. 104(a)(2), Norfolk
and Western Railway Co. v. Liepelt and Structured Tort Settlements: Tax
Policy 'Derailed', 51 FORDHAM L. REV. 565, 591 (1983).
40 This issue was addressed in Norfolk & Western Railway Co. V.
Liepelt, 444 U.S. 490 (1980).
41 While taking part in a settlement agreement or filing a lawsuit
is a voluntary act, the reference to an involuntary act relates to the
42 I.R.C.451(a) provides that "[t]he amount of any item of gross
income shall be included in the gross income for the taxable year in
which received by the taxpayer, unless, under the method of accounting
used in computing taxable income, such amount is to be properly
accounted for as of a different period."
43 I.R.C. 213
44 See Phoenix Coal Co. v. Commissioner, 231 F.2d 240 (2d Cir. 1956)
45 See, e.g. I.R.C. 61,167 and 168.
46 Rev. Rul. 85-98, 1895-2 C.B. 51
47 I.R.C. 104(a) does include, at a minimum, the punitive damages
portion in a nonphysical personal injury suit.
48 See Roemer v. Commissioner, 716 F.2d 693 (9th Cir. 1983); Church
v. Commissioner, 80 T.C. 1104 (1983); Woodward v. Commissioner, 397
U.S. 572 (1970)
49 I.R.C.85 and 122(b).
50 I.R.C. 1
51 Structured settlements allow a portion of the total award plus
accrued interest to be paid the injured party over a certain number of
53 304 F.2d 574 (9th Cir. 1962), aff'g 35 T.C. 646 (1961).
54 I.R.C. 101-135
55 I.R.C. 1221 defines what assets will be treated as capital
assets. However, its definition does not tell what a capital asset is,
only what a capital asset is not.
56 I.R.C. 1(h) provides a limit on the amount of tax that can be
levied on capital gains of 28%. However, this limit is restrictive in
the fact that capital gains is taxed at the same rate as ordinary
income until the tax rate goes over 28%.
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