If an employee in an age discrimination lawsuit prevails at trial (or settles before
trial) and receives money as damages, does he have to pay income tax on the amount he
receives? The courts addressing this question have reached different results. Earlier this
year the United States Supreme Court gave the final word, holding that amounts received to
settle an age discrimination case are taxable. Commissioner of Internal Revenue v.
Schleier, 115 S. Ct. 2159 (1995).
After United Airlines discharged Erich Schleier, he filed a lawsuit claiming that United violated the Age Discrimination in Employment Act (ADEA), a federal law which generally prohibits employment discrimination on the basis of age. At trial, a jury decided that United willfully violated the ADEA in terminating Schleier, a verdict that was reversed on appeal. Subsequently, United and Schleier entered into a settlement under which Schleier received $145,629, half of which was attributed to “back pay” and half to “liquidated damages.”
When Schleier filed his federal income tax return that year, he included as gross income the back pay portion of the settlement but excluded the liquidated damages portion. The Internal Revenue Service, in response, told Schleier that he owed taxes on the liquidated damages portion of the settlement. Schleier initiated a proceeding in the Tax Court, contending that he properly excluded from gross income the portion attributed to liquidated damages and, in addition, that he was entitled to a refund of the taxes he had paid on the back pay portion of the settlement. The Tax Court ruled in favor of Schleier, concluding that none of the settlement was subject to income tax because it constituted damages for “personal injuries or sickness.” After this decision was upheld on appeal, the IRS appealed to the Supreme Court.
The Supreme Court reversed, holding that the Tax Code’s exclusion from gross income of amounts received for “personal injuries or sickness” does not apply to amounts received in an ADEA action. The Court reasoned that being discharged because of one’s age cannot fairly be described as a “personal injury or sickness.” The Court also noted that while Schleier’s unlawful termination may have caused him some sort of psychological or “personal” injury, it did not fall within the Tax Code exclusion because no part of the settlement was attributable to such an injury, nor was such recovery available under the ADEA.
The Court also decided that the liquidated damages portion of the settlement must be included as gross income. The Court rejected Schleier’s argument that the liquidated damages provisions of the ADEA were designed to compensate plaintiffs for their personal injuries and, as a result, those damages are excluded from income tax. The Court reasoned that the purpose of the liquidated damages provisions was to punish an employer who violates the statute. Liquidated damages, the Court continued, are not, therefore, in the nature of compensation for personal injuries.
This decision is significant because during the course of its ruling, the Court signaled its intent to exclude from taxation certain recoveries under Title VII of the Civil Rights Act of 1964 — a federal law that generally prohibits employment discrimination on the basis of race, color, sex, national origin or religion. Prior to 1991, Title VII did not permit a prevailing employee to recover compensatory damages for pain and suffering or emotional distress. Effective November 21, 1991, however, Title VII was amended to allow prevailing plaintiffs, in certain cases, to recover these damages. In reaching its decision in Schleier, the Court indicated that if compensatory damages are intended to provide compensation for traditional harms associated with personal injury, it is likely that these amounts would be excluded from taxable income. Thus, in settling Title VII cases brought after 1991, the parties have greater latitude in fashioning the settlement to accommodate the tax preference of the employee and the employer.
After United Airlines discharged Erich Schleier, he filed a lawsuit claiming that United violated the Age Discrimination in Employment Act (ADEA), a federal law which generally prohibits employment discrimination on the basis of age. At trial, a jury decided that United willfully violated the ADEA in terminating Schleier, a verdict that was reversed on appeal. Subsequently, United and Schleier entered into a settlement under which Schleier received $145,629, half of which was attributed to “back pay” and half to “liquidated damages.”
When Schleier filed his federal income tax return that year, he included as gross income the back pay portion of the settlement but excluded the liquidated damages portion. The Internal Revenue Service, in response, told Schleier that he owed taxes on the liquidated damages portion of the settlement. Schleier initiated a proceeding in the Tax Court, contending that he properly excluded from gross income the portion attributed to liquidated damages and, in addition, that he was entitled to a refund of the taxes he had paid on the back pay portion of the settlement. The Tax Court ruled in favor of Schleier, concluding that none of the settlement was subject to income tax because it constituted damages for “personal injuries or sickness.” After this decision was upheld on appeal, the IRS appealed to the Supreme Court.
The Supreme Court reversed, holding that the Tax Code’s exclusion from gross income of amounts received for “personal injuries or sickness” does not apply to amounts received in an ADEA action. The Court reasoned that being discharged because of one’s age cannot fairly be described as a “personal injury or sickness.” The Court also noted that while Schleier’s unlawful termination may have caused him some sort of psychological or “personal” injury, it did not fall within the Tax Code exclusion because no part of the settlement was attributable to such an injury, nor was such recovery available under the ADEA.
The Court also decided that the liquidated damages portion of the settlement must be included as gross income. The Court rejected Schleier’s argument that the liquidated damages provisions of the ADEA were designed to compensate plaintiffs for their personal injuries and, as a result, those damages are excluded from income tax. The Court reasoned that the purpose of the liquidated damages provisions was to punish an employer who violates the statute. Liquidated damages, the Court continued, are not, therefore, in the nature of compensation for personal injuries.
This decision is significant because during the course of its ruling, the Court signaled its intent to exclude from taxation certain recoveries under Title VII of the Civil Rights Act of 1964 — a federal law that generally prohibits employment discrimination on the basis of race, color, sex, national origin or religion. Prior to 1991, Title VII did not permit a prevailing employee to recover compensatory damages for pain and suffering or emotional distress. Effective November 21, 1991, however, Title VII was amended to allow prevailing plaintiffs, in certain cases, to recover these damages. In reaching its decision in Schleier, the Court indicated that if compensatory damages are intended to provide compensation for traditional harms associated with personal injury, it is likely that these amounts would be excluded from taxable income. Thus, in settling Title VII cases brought after 1991, the parties have greater latitude in fashioning the settlement to accommodate the tax preference of the employee and the employer.