Did the Sixth Circuit Get It Right in Stadnyk?: What to Do About the § 104(a)(2) Personal Injury Damages Exclusion

I. INTRODUCTION Each year, millions of dollars are awarded to victims of physical and non-physical personal injury. These damages include amounts for lost wages, actual medical expenses, pain and suffering, emotional distress, and punitive damages, among others. Taxes are a lurking factor affecting the amount that ultimately ends up in the pocket of the injured party. The courts and Congress have changed the relevant income tax standards multiple times in the past ninety years, making planning difficult for die injured parties and their attorneys. Courts provide remedies for wrongs; specifically, tort law attempts to restore the victim to his or her previous position. Although most scholars and empatiiizers agree that no amount of money can truly restore personal injury victims to who and what they were before the injury, federal income tax law still considers the amount of money received by tort victims as "accessions to wealth," which are taxable sums except to the extent that Congress has provided a statutory exclusion.2 Legislators have grappled with the extent to which die injured party's compensation should be taxed, and particularly with the implications of § 104(a)(2) of the Internal Revenue Code, which excludes compensation received for personal physical injuries but not for non-physical injuries. The relevant language is as follows: "gross income does not include . . . die amount of any damages (other than punitive damages) received ... on account of personal physical injuries or physical sickness."4 From 1918 to 1996, however, if a judgment or settlement was granted "on account of personal injuries or sickness," the statutory exclusion allowed the entire amount of damages to be exempt from federal income taxes, regardless of whether the personal injury was physical or non-physical.5 Both Congress and the courts have made various changes since that time, first denying tax-free status for non-compensatory punitive damages6 and then, in 1996, reducing the exclusion to only "personal physical injuries or physical sickness."7 Since 1996, as long as a recovery amount has its origin in personal physical injury or sickness, all resulting damages (except punitive damages) are excluded under § 104(a). So, if a physical injury leads to emotional-distress damages, those damages would be excluded. However, Congress specifically decreed that "emotional distress" is not itself a physical injury or sickness and therefore cannot be the independent origin of an excluded recovery, although reimbursement for specific medical care costs may be excluded.9 There has been significant uncertainty in determining whether a personal injury award qualifies for an exclusion. In order to promote predictability and consistency, the exclusion should be eliminated. Removing the exclusion would also result in increased clarity and uniformity in the law, sympathy for the victim, and revenue for the federal government. Moreover, it would comply with tax laws and constitutional principles. This Note considers the current treatment and application of the § 104(a)(2) exclusion in the context of a recent case, Stadnyk v. Commissioner.10 In Stadnyk, the Sixth Circuit ruled that the exclusion did not apply to a settlement amount based on a claim of false imprisonment.11 In Part II, this Note will oudine the history of the § 104(a)(2) exclusion and then describe the Stadnyk decisions by the Tax Court and the Sixth Circuit. Part III will provide analysis of these decisions as well as the actions of the legislature, the Internal Revenue Service (IRS), and other courts with respect to die § 104(a)(2) exclusion, and will then consider options for improvement. In Part IV, this Note will conclude. II. TAX HISTORY AND STADNYK In terms of what was considered "income," tax law used to be much more taxpayer-friendly than it is now. In the monumental 1955 Glenshaw Glass case, the Supreme Court ruled that any accession to wealth must be included in gross income unless a clearly defined exclusion applies. …