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Taxation of Damages
End the inequity

Special to The National Law Journal
September 17, 2007

House and Senate committees are considering the Civil Rights Tax Relief Act of 2007. The CRTRA would remedy anomalies in the treatment of damages obtained by employment discrimination victims and other civil rights plaintiffs, which disadvantage them by comparison with victims of physically injurious torts. A section of an earlier version, enacted in 2004, went part way toward rejecting this harsh approach by ending taxation of attorney fees to both the lawyer and the client. Congress should finish the job this session. Passage of the two remaining provisions — one dealing with noneconomic, the other with economic harm — would aid both workers and defendant companies while striking a blow for tax equity.

The following analysis illustrates the problem. Suppose, first, that you have been hurt in a car accident caused by another driver's negligence. After suing him, by verdict or settlement you recover damages for the earnings you lost when out of work, for pain and suffering — including your mental and emotional anguish — and for any medical expenses you had to pay. On April 15, will Uncle Sam take a slice of this loaf? The answer is no, because Internal Revenue Code § 104(a)(2) does not include in gross income "damages (other than punitive damages) received . . . on account of personal physical injuries or physical sickness."

Next, suppose that your former boss sexually harassed you — to the extent that you incurred a nervous breakdown, necessitating psychotherapy — then dismissed you, after you filed charges against him. Ultimately, you obtain an award representing the following items: back pay for the time you spent regaining your health and securing a new job; "front pay," to cover a reduction in your future earnings and a forfeited pension; and compensation for emotional pain and unreimbursed costs of treatment. You also get your attorney fees, as provided by statute in civil rights cases. Will you owe tax on any of these items?

The answer is yes: on all but the legal and medical expenses. Section 104(a)(2) states: "[E]motional distress shall not be treated as a physical injury or physical sickness." This holds true even when mental anguish generates bodily symptoms, as typically occurs, except that this proviso does not apply to "amount[s] paid for medical care . . . attributable to emotional distress." Moreover, if the award preceded Oct. 22, 2004, you would be taxed on the fee portion despite the fact that you never saw one cent of it! C.I.R. v. Banks, 543 U.S. 426 (2005). (Under the double-taxation regime, the interaction of the rules on miscellaneous itemized deductions and the alternative minimum tax has sometimes caused the "victorious" employee to pay more to the Internal Revenue Service than she realized from her case!)

One might wonder why mental suffering stemming from whiplash should be recompensed tax-free, while reparations for misery arising from months or years of job discrimination — which can produce medical problems as grave as stroke or heart attack — must be shared with Uncle Sam. The difference may reflect worry that wily plaintiffs will "con" juries into bestowing unwarranted sums for dubious harms. But that could be alleviated by less blunt instruments than the Tax Code: e.g., remittitur. The variance might also be due to devaluation of "mere" emotional disturbance, not grounded in tangible trauma, or to concerns specific to employment (or civil rights) actions. The latter explanation draws support from the fact that until 1996, Section 104(a)(2) excluded from income all "damages on account of personal injury." Significantly, only after the Civil Rights Act of 1991 did plaintiffs suing under Title VII of the Civil Rights Act of 1964 and the Americans with Disabilities Act secure the right to noneconomic compensatory damages.

Unfair disparities

This development cannot, however, account for the second major difference in the treatment of discrimination damages. As a result of U.S. Supreme Court decisions in the 1990s, followed by the 1996 Code revision, back and front pay in addition to emotional distress sums are taxable. While construing "income" to cover wages has much greater justification than extending the label to pain and suffering, the contrast with the handling of economic damages in physical torts still violates notions of fairness.

The CRTRA would wholly overturn the status quo respecting mental anguish damages by making these nontaxable again. As to recoveries for lost pay, it would grant a partial remedy: permitting awards to be averaged over the years the money would have been earned, thus lowering marginal rates. This more than "half loaf" solution goes far to correct the current injustice toward victims of discrimination. Further, by encouraging lower (because less taxable) settlements, it would benefit business as well. The CRTRA — a win-win — deserves passage.