SECTION 104 VIABILITY: STILL ALIVE AND KICKING
by Robert W. Wood
Section 104 of the Internal Revenue Code provides an exclusion from
income for certain damage awards and settlement payments. Before 1996,
this exclusion covered “personal” injuries or illnesses. Since 1996, though,
it is necessary to have “physical” injury or illness in order to result
in an exclusion. No regulations, no rulings, and no cases explain what
“physical” means, and whether there must be a physical touching. The legislative
history is less than enlightening. Cases decided under the pre-1996 Act
version of Section 104 can provide helpful guidance.
The Eleventh Circuit Court of Appeals recently decided Carl J. Fabry
v. Commissioner, 11th Cir. Dkt. No. 99-12407 (August 23, 2000, 11th Cir.),
ruling that injury to reputation could result in an excludable award. Plus,
the court gave a helpful analysis of this shrouded law. It should be useful
for pre-August 20, 1996 recoveries, and for those planning settlements
and judgments in 2000 and beyond.
The Fabrys operated a nursery and business was booming until they
began using fungicides purchased from DuPont. Plants dying, customer complaints,
and the closing of their business ensued. The lawsuit alleged the fungicide
contaminated their plants. The Fabrys sought damages for lost profits,
lost going concern value, and damage to business reputation. Part of their
initial settlement demand was $500,000 in damages to business reputation.
After mediation, DuPont paid $3.8 million for a general release.
On their 1992 tax return, the Fabrys included most of their recovery,
but excluded the $500,000 for damage to business reputation. The IRS disagreed,
assessed a deficiency, penalties and interest. The Tax Court agreed with
the IRS. Then the Fabrys appealed. The Eleventh Circuit makes an exhaustive
analysis of Burke, 504 U.S. 229 (1992), and its tort-like personal injury
formula. Schleier, 515 U.S. 323 (1995), gave its own formulation of a payment
made “on account of a personal injury or sickness.” The court synthesizes
the Burke and Schleier cases (no simple task) and provides guidance about
this mish mash of Supreme Court authority. The Eleventh Circuit in Fabry
succinctly noted:
“Burke holds that payment received because of a Title VII violation
is not excludable because violation of Title VII does not provide for personal
injury losses. Schleier holds that the consequences of reaching sixty years
of age are not consequences of personal injury. We must look elsewhere
for guidance.” (Fabry slip opinion at p. 8.)
Few courts since Schleier have examined the second prong of its approach.
In Greer v. U.S., 207 F.3d 322 (6th Cir. 2000), a recovery for wrongful
termination and injury to reputation, stress, humiliation, and mental anguish
was held excludable. The Sixth Circuit in Greer held that under Schleier
the taxpayer must show that: (1) there was an underlying claim sounding
in tort; (2) the claim existed at the time of settlement; (3) the claim
encompassed personal injuries; and (4) the agreement was executed in lieu
of the prosecution of the tort claim on account of the personal injury.
The Sixth Circuit in Greer took the two-part test of Schleier and made
it into a four-part test. The Eleventh Circuit in Fabry agrees.
The Tax Court has weighted in, to. In Noel v. Commissioner, 73 T.C.M.
2178 (1997), the Tax Court found that two-thirds of the settlement proceeds
were allocable to the release of contract claims. One-third was allocable
to tortious interference, causing emotional distress and damage to business
reputation. The Tax Court found this third was excludable under Section
104. Knevelbaard v. Commissioner, 74 T.C.M. 161 (1997), involved the settlement
of a thousand dairy farmers who sued for fiduciary duty breaches and emotional
distress, achieving an excludable settlement award out of what was clearly
a commercial dispute.
In Fabry, there was a cause and effect relationship between the tort,
the resulting personal injury, and the settlement amount. The causal link
is what convinced the court Schleier’s standards were met. The Fabry court
questioned:
“Is damage to one’s business reputation a personal injury? Did the
negligent or wrongful conduct of Du Pont amount to a tort resulting in
personal injury to the Fabrys, culminating in an injury to their business
reputation, which injury in turn caused them to suffer damages, personal
to them?” (Fabry slip opinion, p. 12, footnotes omitted.)
The court just said yes.
Conclusion
While Fabry may not revolutionize Section 104 authority, every professional
who practices in this area should read it, and read it carefully. It indicates
a fundamental attempt (a valiant attempt at that) to get the Burke and
Schleier opinions to jibe, and to apply them in a practical real world
way. This is not the only case to take a more expansive view of Section
104. See Knevelbaard v. Commissioner, 74 T.C.M. 161 (1997). Despite this
favorable development, this area will be murky for some years to come.
In the meantime, the Fabry case should materially help taxpayers.
Section 104 Viability: Still Alive and Kicking, Vol. 89, No.
4, Tax Notes (October 23, 2000), p. 524.