Case Name: Ernest and Mary C. Horton, Petitioners v. Commissioner of Internal Revenue, Respondent
Court: United States Tax Court
Jurisdiction: United States
Decision Date: 1993-02-09
Citations: 100 T.C. 93
Docket Number: Docket No. 3386-91
Parties: Ernest and Mary C. Horton, Petitioners v. Commissioner of Internal Revenue, Respondent
Judges: Hamblen, Chabot, Parker, Shields, Cohen, Clapp, Swift, Gerber, Wright, Parr, Wells, Colvin, Beghe, Chiechi, and Laro, JJ., agree with the majority opinion.
Reporter: Reports of the Tax Court of the United States
Volume: 100
Pages: 93–114

Head Matter:
Ernest and Mary C. Horton, Petitioners v. Commissioner of Internal Revenue, Respondent
Docket No. 3386-91.
Filed February 9, 1993.
Thomas J. TJtaski and Ljubomir Nacev, for petitioners.
Roderick H. Fillinger, for respondent.

Opinion:
OPINION
Ruwe, Judge:
Respondent determined a deficiency of $130,850 in petitioners' 1985 Federal income tax. After concessions, the only issue for decision is whether section 104(a)(2) allows petitioners to exclude an award of punitive damages from taxable income.
This case was submitted fully stipulated pursuant to Rule 122(a). The stipulation of facts and attached exhibits are incorporated heroin by this reference.
Petitioners resided in Florence, Kentucky, when they filed their petition in this case.
On December 1, 1981, a Boone County circuit court jury found Union Light, Heat & Power Co. (Union) liable for failing to detect a gas leak in petitioners' residence. This leak resulted in an explosion and fire that destroyed petitioners' residence, causing them personal injury.
The jury found that petitioner Ernest Horton was entitled to compensatory damages in the amount of $62,265 and also awarded punitive damages in the amount of $100,000. The jury found that petitioner Mary C. Horton was entitled to compensatory damages in the amount of $41,287 and also awarded punitive damages in the amount of $400,000. The punitive damage awards were based on a finding of gross negligence on the part of Union.
Upon entry of the judgment, Union paid the compensatory damages and appealed the issue, of punitive damages to the Kentucky Court of Appeals, which reversed the circuit court on that issue. Petitioners appealed the reversal to the Kentucky Supreme Court. On April 11, 1985, that court reversed the court of appeals and reinstated the punitive damage awards. See Horton v. Union Light, Heat & Power Co., 690 S.W.2d 382 (Ky. 1985). During 1985, Union paid $100,000 in punitive damages to petitioner Ernest Horton, and $400,000 in punitive damages to petitioner Mary C. Horton.
Petitioners excluded the punitive damage amounts from income on their 1985 Federal income tax return. Respondent determined that petitioners should have included those amounts in income, and therefore determined a deficiency. Petitioners timely filed a petition with this Court seeking a redetermination of that deficiency.
Section 104(a)(2) provides that gross income does not include:
the amount of any damages received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal injuries or sickness; [Emphasis added. ]
The phrase "damages received" is defined in the regulations as "an amount received through prosecution of a legal suit or action based upon tort or tort type rights, or through a settlement agreement entered into in lieu of such prosecution." Sec. 1.104-l(c), Income Tax Regs.
Respondent does not dispute that petitioners had an underlying claim against Union for personal injuries. The sole issue presented by the parties is whether the punitive damages, which petitioners received in addition to compen satory damages, are excludable from income pursuant to section 104(a)(2).
We recently considered whether punitive damages received in a personal injury suit were excludable under section 104(a)(2) and held that they were. Miller v. Commissioner, 93 T.C. 330 (1989). We reasoned that:
Section 104(a)(2) excludes from gross income "any damages received on account of personal injuries." Congress enacted the predecessor of section 104(a)(2) as section 213(b)(6) of the Revenue Act of 1918. Pub. L. 65-254, 40 Stat. 1057, 1066. By that time, the availability of punitive or exemplary damages had long been established. Note, "Exemplary Damages in the Law of Torts," 70 Harv. L. Rev. 517, 518-520 (1957). Congress, aware of that fact, could have excluded only "compensatory damages" or provided that only damages received "as compensation for" personal injuries be excluded. It did neither, and the plain meaning of the broad statutory language simply does not permit a distinction between punitive and compensatory damages. See Crane v. Commissioner, 331 U.S. 1, 6 (1947) ("the words of statutes — including revenue acts — -should be interpreted where possible in their ordinary, everyday senses."). Thus, we read "any damages" to mean "all" damages, including punitive damages. Webster's Third New International Dictionary (1981). [Id. at 338.]
The Court of Appeals for the Fourth Circuit reversed our holding in Miller, 914 F.2d 586 (4th Cir. 1990). The Court of Appeals agreed that the underlying cause of action in Miller (defamation) was an action for personal injury but, nevertheless, held that the portion of the award attributable to punitive damages was not excludable under section 104(a)(2). The court first found the language of section 104(a)(2) excluding "any damages received on account of personal injuries" to be ambiguous. The court then interpreted this statutory language narrowly so as to apply only to damages intended to make the taxpayer whole, as opposed to awards that generate a gain or profit. Looking to the applicable State law (Maryland) pursuant to which the damages were awarded, the court concluded that the punitive damages in Miller were awarded for "purely punitive" purposes and not to compensate for loss caused by the personal injury.
We have previously rejected the concept that section 104(a)(2) excludes only amounts that restore lost capital as opposed to amounts that would otherwise constitute gains or accessions to wealth. Downey v. Commissioner, 97 T.C. 150, 161 (1991); Miller v. Commissioner, 93 T.C. at 338. After careful consideration of the views of the Fourth Circuit, we reaffirm our holding in Miller that punitive damages received as a result of a personal injury claim are excludable under section 104(a)(2). The beginning and end of the inquiry should be whether the damages were paid on account of "personal injuries". This inquiry is answered by determining the nature of the underlying claim. Once the nature of the underlying claim is established as one for personal injury, any damages received on account of that claim, including punitive damages, are excludable.
The Supreme Court's recent opinion in United States v. Burke, 504 U.S. _, 112 S. Ct. 1867 (1992), supports the analysis that we have adopted. In that case, the taxpayers contended that backpay awarded in a sex discrimination suit under title VII of the Civil Rights Act of 1964 was excludable from income under section 104(a)(2). In Burke v. United States, 929 F.2d 1119, 1121 (6th Cir. 1991), the Sixth Circuit applied a section 104(a)(2) analysis that is identical to this Court's, stating:
determining whether the § 104(a)(2) exclusion applies requires an examination of the nature of the injury to determine whether the injury and claim are personal and tort-like in nature, and not whether the consequences of the injury resulted in an award of compensatory damages or damages for back pay.
Relying on our analysis in Threlkeld v. Commissioner, 87 T.C. 1294 (1986), affd. 848 F.2d 81 (6th Cir. 1988), the Sixth Circuit held:
In sum, Threlkeld and its progeny require that for the purposes of §104(a)(2), this court determine whether the injury is personal and the claim resulting in the damages is tort-like in nature. If the answer is in the affirmative, then that is "the beginning and end of the inquiry." Threlkeld, 87 T.C. at 1299. The damages resulting from such a claim are fully excludable under §104(a)(2). [Burke v. United States, 929 F.2d at 1123.]
Although the Supreme Court reversed the Court of Appeals' holding that the underlying title VII claim was tortlike in nature, the Supreme Court expressly adopted the Sixth Circuit's section 104(a)(2) analysis, which focused on the nature of the underlying claim, rather than on the type of damages received.
We thus agree with the Court of Appeals' analysis insofar as it focused, for purposes of § 104(a)(2), on the nature of the claim underlying [the taxpayers'] damages award. See 929 F.2d, at 1121; Threlkeld v. Commissioner, 87 T.C,, at 1305, [United States v. Burke, 504 U.S. at_, 112 S. Ct. at 1872.]
Relying on section 1.104-l(c), Income Tax Regs., the Supreme Court interpreted the words "damages received" as "an amount received through prosecution of a legal suit or action based upon tort or tort type rights". Id. at_, 112 S. Ct. at 1870. Therefore, if the taxpayer's underlying claim was based upon a tort type personal injury and the damages in question were received through prosecution of that claim, they are excludable. Downey v. Commissioner, supra at 161; Miller v. Commissioner, 93 T.C. at 337; Threlkeld v. Commissioner, supra at 1308. As the Supreme Court stated:
("The essential element of an exclusion under section 104(a)(2) is that the income involved must derive from some sort of tort claim against the payor [United States v. Burke, 504 U.S. at_, 112 S. Ct. at 1870 (quoting Threlkeld v. Commissioner, supra at 1305).]
While Justice O'Connor, joined by Justice Thomas, dissented from the majority's holding that the title VII claim was not a tort type action, the dissenting opinion was in full agreement with the majority that the essential determination for excludability under section 104(a)(2) was the nature of the underlying claim.
Section 104(a)(2) allows taxpayers to exclude from gross income "damages received . on account of personal injuries or sickness." The Court properly defers to an Internal Revenue Service (IRS) regulation that reasonably interprets the words "damages received" to mean "an amount received . . . through prosecution of a legal suit or action based upon tort or tort type rights, or through a settlement agreement entered into in lieu of such prosecution." 26 CFR §1.104-1(c) (1991). See ante, at 1870; United States v. Correll, 389 U.S. 299 (1967). Therefore, respondents may exclude from gross income any amount they received as a result of asserting a "tort type" right to recover for personal injury. [Id. at_, 112 S. Ct. at 1878 (O'Connor, J., dissenting).]
Our interpretation of the impact of United States v. Burke, supra, on the excludability of punitive damages is supported by the recent decision in O'Gilvie v. United States, 92-2 USTC par. 50,567 (D. Kan. 1992). The District Court, relying on the Fourth Circuit's opinion in Miller, had originally held that punitive damages received in a wrongful death suit were not excludable under section 104(a)(2). 70 AFTR 2d 92-5069, 92-2 USTC par. 50,344 (D. Kan. 1992). After the Supreme Court's decision in Burke, the taxpayer filed a motion for reconsideration in which he contended that the Supreme Court's focus on the underlying nature of a claim supported excludability. The District Court agreed, stating:
In our previous order, this court focused on the nature of the punitive damage award itself, rather than the nature of the underlying claim. In light of Burke, we believe our focus was misplaced. The Supreme Court's opinion makes clear that the proper inquiry for purposes of § 104(a)(2) is on the nature of the claim underlying the taxpayers' damages award. As we recognized in our previous order, the underlying suit giving rise to O'Gilvie's recovery of punitive damages is indisputedly tort-like in nature. Accordingly, the court believes its previous order is contrary to Burke and must be reversed. [O'Gilvie v. United States, 92-2 USTC par. 50,567, at 85,974-85,975 (D. Kan. 1992); citations omitted.]
In Burke, the Supreme Court focused extensively on the remedies available under title VII in order to distinguish it from claims lying in tort. In describing the nature of a tort claim, the Supreme, Court stated:
Indeed, one of the hallmarks of traditional tort liability is the availability of a broad range of damages to compensate the plaintiff . Although these damages often are described in compensatory terms, in many cases they are larger than the amount necessary to reimburse actual monetary loss sustained or even anticipated by the plaintiff, and thus redress intangible elements of injury that are "deemed important, even though not pecuniary in [their] immediate consequence[s]." [United States v. Burke, 504 U.S. at _, 112 S. Ct. at 1871; citations omitted.]
The Court held that "consideration of the remedies available is critical in determining the 'nature of the statute' and the 'type of claim'", 504 U.S. at _n.7, 112 S. Ct. at 1872 n.7, and observed that in tort actions "punitive or exemplary damages are generally available in those instances where the defendant's misconduct was intentional or reckless." Id. at _, 112 S. Ct. at 1872 (citing Molzof v. United States, 502 U.S. _, 112 S. Ct. 711 (1992)). The Supreme Court's analysis establishes that punitive damages are not merely an incidental result of a personal injury claim as suggested by the Fourth Circuit. Rather, they are "inextricably bound up" with the concept of tort type rights, id. at _n.7, 112 S. Ct. at 1872 n.7, and therefore one of the prime determinants of whether a claim is for personal injury. As one of the hallmarks of traditional tort claims, it is logical to conclude that punitive damages are received "on account of" such claims.
The underlying facts in the instant case illustrate the difficulty of attempting to apply the Fourth Circuit's test for excludability, which distinguishes between damages that serve a compensatory purpose and those that serve a retributive function. In Horton v. Union Light, Heat & Power Co., 690 S.W.2d 382, 390 (Ky. 1985), the Kentucky Supreme Court provided the following rationale for awarding punitive damages to petitioners:
There is a reason for paying the punitive damages awarded to the injured party. It is because "the injury has been increased by the manner [in which] it was inflicted." Chiles v. Drake, supra. (Emphasis added.) In Louisville & N.R. Co. v. Roth, 130 Ky. 759, 114 S.W. 264, 266 (1908), we explained that although "punitive damages are awarded as a civil punishment upon the wrongdoer, rather than as indemnity to the injured party . it might with much propriety be said that they are allowed by way of remuneration for the aggravated wrong done." Thus there are sound legal reasons of longstanding supporting both the award of punitive damages and their payment to the injured party in addition to compensatory damages.
The concept of punitive damages represents more than mere blind adherence to ancient precedent. It is as just a principle and as fair to the litigants today as it ever was. Improperly applied, it may indeed be nothing more than a windfall or a double recovery. But there are few if any principles of law which could not be criticized as sometimes misapplied.
"It would be simplistic to characterize this virtual unanimity [among the states in adhering to the concept of punitive damages] as mere blind adherence to an outmoded principle. Rather, the doctrine of punitive damages survives because it continues to serve the useful purposes of expressing society's disapproval of intolerable conduct and deterring such conduct where no other remedy would suffice." Mallor and Roberts, Punitive Damages Toward a Principled Approach, 31 Hastings L.J. 639, 641 (1980).
It appears that in Kentucky, punitive damages serve both to compensate the injured party and punish the wrongdoer.
Where punitive damages appear to serve both a retributive and compensatory purpose, there is some indication that the Fourth Circuit would hold that all or part of such damages are excludable from income, although this is not entirely clear. The Fourth Circuit apparently agreed with the holding in Burford v. United States, 642 F. Supp. 635 (N.D. Ala. 1986), in which the District Court held that all the punitive damages received under the Alabama wrongful death statute were received "on account of" personal injury and were thus excludable from gross income. Commissioner v. Miller, 914 F.2d at 591. On the other hand, the Fourth Circuit concluded that the punitive damages in Miller, which were awarded under Maryland law, were not excludable because they were "purely punitive and do not compensate." Id. We do not know how the Fourth Circuit's test would be applied to the punitive damages awarded to petitioners as a result of the Kentucky Supreme Court's decision in Horton v. Union Light, Heat & Power Co., supra. Because of our adherence to our prior opinion in Miller, we need not provide an answer.
We hold that petitioners are entitled to exclude their punitive damages from gross income under section 104(a)(2).
Decision will be entered under Rule 155.
Reviewed by the Court.
Hamblen, Chabot, Parker, Shields, Cohen, Clapp, Swift, Gerber, Wright, Parr, Wells, Colvin, Beghe, Chiechi, and Laro, JJ., agree with the majority opinion.
Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for the year in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.
In 1989, sec. 104(a) was amended, making sec. 104(a)(2) inapplicable to punitive damages received in a case not involving physical injury or sickness. Omnibus Budget Reconciliation Act of 1989, Pub. L. 101-239, sec. 7641(a), 103 Stat. 2106, 2379. The amendment generally applies to amounts received after July 10, 1989. The legislative history reveals that the amendment was meant to limit the scope of sec. 104(a)(2). See Jaeger, "Taxation of Punitive Damage Awards: The Continuing Controversy", Tax Notes 109, 113-114 (Oct. 5, 1992) (amendment serves as rejection of argument that punitive damages are taxable because they are "additions to wealth").
On brief, respondent states:
Petitioners received compensatory damages which were excluded from income. At issue is the taxability of punitive damages which were paid on account of the outrageousness of the defendant's conduct to deter similar conduct in the future. The damages were not paid on account of petitioners' personal injury.
Respondent makes no argument that any portion of the punitive damages was attributable to property damage as opposed to personal injury, and we express no view on that point.
In Downey v. Commissioner, 97 T.C. 150, 163-164 (1991), we stated:
Whether the damages paid to the tort victim reflect a substitute for amounts or items otherwise taxable or a substitute for amounts or items to be enjoyed without a tax consequence is irrelevant. Thus, section 104(a)(2) permits the exclusion of damages that are a substitute for the enjoyment of a whole body or of freedom from distress . Likewise, the section allows the exclusion of damages that are a substitute for amounts or items that otherwise would be taxable or would potentially produce taxable benefit, such as income lost as a result of a personal injury or amounts reflecting injury to a person's business or professional reputation. Burke v. United States, 929 F.2d 1119, 1123 (6th Cir. 1991) (lost wages); Threlkeld v. Commissioner, 87 T.C. 1294 (1986), affd. 848 F.2d 81 (6th Cir. 1988) (business or professional reputation). In sum, under section 104(a)(2), we will focus on whether the injury is personal and on whether the claim resulting in payment of damages is tort or tort-like, not on the consequences of the personal injury or the actual damages suffered.
Commentators have questioned the return of capital theory as a justification for exclusion under sec. 104(a)(2). See Brooks, "Developing a Theory of Damage Recovery Taxation", 14 William Mitchell L. Rev. 759, 785 (1988); Cochran, "1989 Tax Act Compounds Confusion Over Tax Status of Personal Injury Damages", Tax Notes 1565, 1573 (Dec. 31, 1990); Dodge, "Taxes and Torts", 77 Cornell L. Rev. 143, 152-153 (1992); Henning, "Recent Developments in the Tax Treatment of Personal Injury and Punitive Damage Recoveries", 45 Tax Law. 783, 796 (1992); see also Jaeger, "Taxation of Punitive Damage Awards: The Continuing Controversy", Tax Notes 109, 114 (Oct. 5, 1992).
This case is not appealable to the Fourth Circuit; therefore, we are not required to follow its holding. Golsen v. Commissioner, 54 T.C. 742 (1970), affd. 445 F.2d 985 (10th Cir. 1971).
Backpay was described as the differential between the appropriate pay and actual pay for services performed. United States v. Burke, 504 U.S. _, 112 S. Ct. 1867, 1873 (1992).
Despite other tortlike aspects of title VII, the Court rejected characterization of that statute as tortlike because the damages available thereunder were limited to backpay. The unavailability of punitive damages was one of the reasons for that rejection. Justice O'Connor, joined by Justice Thomas, dissented from the majority on the grounds that "the remedies available to Title VII plaintiffs do not fix the character of the right they seek to enforce." United States v. Burke, 504 U.S. at _, 112 S. Ct. at 1878 (O'Connor, J., dissenting). The majority opinion's response was that "the concept of a 'tort' is inextricably bound up with remedies — specifically damages actions. Thus, we believe that consideration of the remedies available under title VII is critical in determining the 'nature of the statute' and the 'type of claim' brought by respondents for purposes of §104(a)(2)." Id. at n.7, 112 S. Ct. at 1872 n.7.
In Commissioner v. Miller, 914 F.2d 586, 591 (4th Cir. 1990), revg. 93 T.C. 330 (1989), the Fourth Circuit distinguished its decision in Thompson v. Commissioner, 866 F.2d 709 (4th Cir. 1989), affg. 89 T.C. 632 (1987), in which it had held that liquidated damages serving "both a deterrent and compensatory purpose" were excludable under sec. 104(a)(2).
Compare Pacific Mut. Life Ins. Co. v. Haslip, 499 U.S. 1, _, 111 S. Ct. 1032, 1042 (1991) (citing Wilkes v. Wood, 98 Eng.Rep. 489 (C.P. 1763), in which "The Lord Chief Justice [validated] exemplary damages as compensation, punishment, and deterrence") with id. at _, 111 S. Ct. at 1044 (punitive damages under Alabama law imposed for purposes of retribution and deterrence) and Embrey v. Holly, 442 A.2d 966, 973 (Md. 1982) (punitive damages serve to deter and punish) with Shell Oil Co. v. Parker, 291 A.2d 64 (Md. 1972) (injury required for imposition of punitive damages); see also Prosser & Keeton, Torts, sec. 2, at 9 (5th ed. 1984) (punitive damages as means of compensating intangible harm and costs and attorney's fees).