Opinion ID: 760493
Heading Depth: 2
Heading Rank: 1

Heading: Federal Income Taxation

Text: 8 Mertens v. Hewitt Associates Interpretation of Relief Available Under § 502(a)(3) 9 The district court held that inasmuch as Mertens limits the relief available under § 502(a)(3) to traditional forms of equitable relief and does not allow for compensatory damages, Plaintiffs' settlement proceeds could not be characterized as being from a tort or tort-like remedy, and therefore were not excludable from taxation under § 104(a)(2). 6 10 In Mertens, several former employees of the Kaiser Steel Company lost a significant portion of their pensions because of the alleged breach of fiduciary duties by Hewitt Associates, an actuarial services company. 508 U.S. at 250-51, 113 S.Ct. 2063. The petitioner, William Mertens, was one of a class of former Kaiser employees who sued Hewitt for breach of fiduciary duty. Id. The class also sued Hewitt as a non-fiduciary, claiming that ERISA § 502(a)(3) allowed a plan participant to sue a non-fiduciary and also permitted the court to order whatever equitable relief the court deemed necessary. 7 Id. At the time, the Supreme Court had not interpreted the precise meaning of the phrase other appropriate equitable relief as it is found in § 502(a)(3). Id. at 253-55 113 S.Ct. 2063. 11 In a five to four opinion, Justice Scalia narrowly construed the phrase other appropriate equitable relief as found in § 502(a)(3) as only permitting the categories of relief that were typically available in equity; those forms of relief such as injunctions, mandamus, and restitution. Mertens, 508 U.S. at 256-58, 113 S.Ct. 2063. In doing so, Justice Scalia acknowledged that the Court had not interpreted the precise phrase other appropriate equitable relief in the context of ERISA's § 502(a)(3), but that the Court had construed the similar language of Title VII of the Civil Rights Act of 1964 (before its 1991 amendments)--'any other equitable relief as the court deems appropriate,' 42 U.S.C. § 2000e-5(g)--to preclude 'awards for compensatory or punitive damages.'  Id. at 255, 113 S.Ct. 2063 (citing United States v. Burke, 504 U.S. 229, 238, 112 S.Ct. 1867, 119 L.Ed.2d 34 (1992)). The Justice went on to conclude that it was appropriate to likewise limit the relief available under ERISA inasmuch as doing otherwise, would 12 require us either to give the term a different meaning these than it bears elsewhere in ERISA, or to deprive of all meaning the distinction Congress drew between equitable and remedial relief in § 409(a), and between equitable and legal relief in the very same section of ERISA, see 29 U.S.C. § 1132(g)(2)(E); in the same subchapter of ERISA, see § 1024(a)(5)(C); and in the ERISA subchapter dealing with the PBGC, see §§ 1303(e)(1), 1451(a)(1). Neither option is acceptable. The authority of courts to develop a federal common law under ERISA, is not the authority to revise the text of the statute. 13 Id. at 258-59, 113 S.Ct. 2063 (citations and footnotes omitted). 8 14 Writing for the dissent, Justice White opined that the words appropriate equitable relief as found in § 502(a)(3) [we]re no more than descriptive and simply refer[red] to all remedies available in equity under the common law of trusts, whether or not they were or are the exclusive remedies for breach of trust. Mertens, 508 U.S. at 268, 113 S.Ct. 2063 (White, J., dissenting). Justice White noted that this interpretation was consistent with the traditional equitable remedies available to trust beneficiaries, and avoid [ed] the anomaly of interpreting ERISA so as to leave those Congress set out to protect--the participants in ERISA-governed plans and their beneficiaries--with 'less protection ... than they enjoyed before ERISA was enacted.'  Id. at 266-67, 113 S.Ct. 2063 (citations omitted). 15 Split Among the Circuits as to Whether Mertens Applies to the Continental Settlement 16 The split among the circuits as to the legal issues before this Court today and the application of the Mertens decision to the various claims arising from the Continental settlement, is as sharply divided as the Mertens Court itself. For example, the Court of Appeals for the Fourth Circuit found that settlement proceeds from the Continental settlement were properly subjected to income and FICA taxation. See Hemelt v. United States, 122 F.3d 204, 208-09 (4th Cir.1997). Like the Plaintiffs in the instant case, the Hemelt plaintiffs' were seeking a refund of the federal income taxes and the FICA taxes withheld from their settlement awards from Continental. Id. In rejecting the plaintiffs' claims, the Fourth Circuit found that compensatory damages were not recoverable under ERISA, and therefore, the settlement proceeds were properly taxed as income. Id. 17 The Hemelt Court found that the fact that the settlement predated the Supreme Court's holding in Mertens was of no consequence because, in applying Mertens, the court was 18 simply giving effect to the Supreme Court's enunciation of what ERISA means and always has meant, notwithstanding the McLendon Special Master and parties. Thus, the retroactivity of Mertens is not at issue here, as [i]t is only when the law changes in some respect that an assertion of nonretroactivity may even be considered. 19 122 F.3d at 208-09 (citation omitted). Relying upon United States v. Burke, 504 U.S. 229, 238, 112 S.Ct. 1867, 119 L.Ed.2d 34 (1992) and Commissioner v. Schleier, 515 U.S. 323, 115 S.Ct. 2159, 132 L.Ed.2d 294 (1995), the Hemelt Court agreed that compensatory damages were not allowed under ERISA, inasmuch as ERISA actions are not designed to compensate for ... intangible injuries and thus do not involve 'tort or tort type rights.'  122 F.3d at 208. 20 Like the Court of Appeals for the Fourth Circuit, the Eighth Circuit has also found that the application of Mertens precluded proceeds from the Continental settlement from being exempt from taxation under § 104(a)(2). See Mayberry v. United States, 151 F.3d 855 (8th Cir.1998). The Eighth Circuit agreed with the Hemelt Court that, under Mertens, the Continental settlement did not stem from a tort or tort-like remedy. 151 F.3d at 859. 21 However, unlike the Courts of Appeals for the Fourth and Eighth Circuits, when addressing the same disputes arising out of this settlement, the Court of Appeals for the Fifth Circuit found that the proceeds were exempt from income taxation under § 104(a)(2) and were not subject to taxation under FICA. See Dotson v. United States, 87 F.3d 682, 687 (5th Cir.1996). The Dotson Court characterized the case as one of an income tax issue, as opposed to an ERISA issue, and therefore found that Mertens did not apply. Id. at 686-87. Specifically, the Dotson Court stated as follows: 22 The characterization of damages received is not affected by the shifting sands of statutory interpretation after a bona fide settlement has been reached or a damage award rendered.... The characterization of settlement depends upon the determination that the damages were received through prosecution of a legal suit or action based upon tort or tort-type rights ... Treasury Reg. 26 C.F.R. 1.104-1(c). The fact that such a remedy may no longer exist is irrelevant to the determination of the character of a settlement to be taxed. 23 Although the Supreme Court's decision in Mertens may retroactively apply to pending ERISA cases, this case is not an ERISA case. It is an income tax case involving the tax treatment of a final settlement of a claim for damages under ERISA that was concluded before the issue of first impression decided by the sharply divided Mertens court was even clearly foreshadowed. Consequently, Mertens does not change the classification of the instant settlement for tax purposes any more than it could retroactively reduce the amount of the settlement which the parties made based on their now perhaps outmoded interpretation of ERISA law. 24 Id. (footnote omitted). 25 However, the Fifth Circuit noted that, in the recent case of Commissioner v. Schleier, the Supreme Court clarified the requirements of § 104(a)(2) exclusion: the taxpayer must (1) demonstrate that the underlying cause of action is based upon tort or tort-type rights and (2) show that the damages were received on account of personal injury or sickness. Dotson, 87 F.3d at 685 (citing Schleier, 515 U.S. at 334-37, 115 S.Ct. 2159). Having found settlement proceeds were recovered for a tort-like claim, the Dotson Court stated that next inquiry was whether these damages were received on account of personal injury. 57 F.3d at 689. 26 In analyzing this inquiry, the Dotson Court focused on the Schleier holding, where it was found that settlement damages for back pay received through a discriminatory firing case brought under the Age Discrimination in Employment Act (ADEA) were taxable as income and not excludable under § 104(a)(2) because the recovery of back wages was not on account of any personal injury and because no personal injury affected the amount of back wages recovered. By way of example, the Schleier Court explained its reasoning: 27 Consideration of a typical recovery in a personal injury case illustrates the usual meaning of on account of personal injuries. Assume that a taxpayer is in an automobile accident, is injured, and as a result of that injury suffers (a) medical expenses, (b) lost wages, and (c) pain, suffering, and emotional distress that cannot be measured with precision. If the taxpayer settles a resulting lawsuit for $30,000 (and if the taxpayer has not previously deducted her medical expenses, see § 104(a)), the entire $30,000 would be excludable under § 104(a)(2). The medical expenses for injuries arising out of the accident clearly constitute damages received on account of personal injuries. Similarly, the portion of the settlement intended to compensate for pain and suffering constitutes damages on account of personal injury. Finally the recovery for lost wages is also excludable as being on account of personal injuries, as long as the lost wages resulted from time in which the taxpayer was out of work as a result of her injuries. See. e.g., Threlkeld v. Commissioner, 87 T.C. 1294, 1300, 1986 WL 22061 (1986) (hypothetical surgeon who loses finger through tortious conduct may exclude any recovery for lost wages because [t]his injury ... will also undoubtedly cause special damages including loss of future income), aff'd, 848 F.2d 81 (C.A.6 1988). The critical point this hypothetical illustrates is that each element of the settlement is recoverable not simply because the taxpayer received a tort settlement, but rather because each element of the settlement satisfies the requirement set forth in 104(a)(2) (and in all of the other subsections of § 104(a)) that the damages were received on account of personal injuries or sickness. 28 In contrast, no part of respondent's ADEA settlement is excludable under the plain language of § 104(a)(2). Respondents recovery of back wages, though at first glance comparable to our hypothetical accident victim's recovery lost wages, does not fall within § 104(a)(2)'s exclusion because it does not satisfy the critical requirement of being on account of personal injury or sickness. Whether one treats respondent's attaining the age of 60 or his being laid off on account of his age as the proximate cause of respondent's loss of income, neither the birthday nor the discharge can fairly be described as a personal injury or sickness. Moreover, though respondent's unlawful termination may have caused some psychological or personal injury comparable to the intangible pain and suffering caused by an automobile accident, it is clear that no part of respondent's recovery of back wages is attributable to the injury. Thus, in our automobile hypothetical, the accident causes a personal injury which in turn causes a loss of wages. In age discrimination, the discrimination causes both the personal injury and loss of wages, but neither is linked to the other. The amount of back wages recovered is completely independent of the existence or extent of any personal injury. 29 Schleier, 515 U.S. at 329-30, 115 S.Ct. 2159 (footnote omitted). 30 Based upon this reasoning, the Fifth Circuit found that the back wages received by Dotson under the settlement with Continental could not be excluded from taxation under § 104(a)(2). 87 F.3d at 689. The Fifth Circuit analogized the antidiscrimination provision of § 510 of ERISA to the ADEA, and noted that, similarly, the damages received by Dotson were for both a firing and for personal injuries; however, the personal injuries did not give rise to the lost wages. Id. Therefore, the court concluded that it was necessary to remand Dotson's case for a determination of the amount of back wages included in the Basic Award, which would then be subject to income taxation. The court also concluded that, because the Earnings Impairment Additur compensated to some extent for future lost wages, remand was necessary on that issue as well. Id. The court held that upon remand, 31 the district court should determine the degree to which the award represented lost wages for Mr. Dotson, since the record shows that he actually saw an increase in earnings at his next job. Once the district court distinguishes future lost wages from other potential parts of the Earnings Impairment Additur, it must also determine the nature of that award, and the degree to which the award envisioned earnings impairment as a result of the firing, and thus taxable, or instead, on account of personal injuries such as emotional damage or loss of reputation. Any part of the future lost wages attributable to causation by personal injury is excludable. 32 Id. However, the Fifth Circuit made it clear in Dotson that, on all other points, the proceeds from the settlement with Continental fell squarely within the exclusion set forth in § 104(a)(2), and therefore were excludable from income taxation. Sixth Circuit's View 33 In Mayberry, the Eighth Circuit acknowledged that the Fourth Circuit and the Fifth Circuit had reached opposing results in deciding the exact issues arising out of the Continental settlement: [A] Fifth Circuit panel decided in favor of the taxpayers after focusing on the parties' intent at the time of the settlement and the interests in finality and predictability of taxation ... [while] the Fourth Circuit focused instead on the nature of the underlying action that had been settled and on the Supreme Court's decision in Mertens [and decided in favor of the Government]. Mayberry v. United States, 151 F.3d 855, 858 (8th Cir.1998) (citations omitted). 34 We agree with the Fifth Circuit's reasoning. As noted by the Dotson Court, the Special Master in this case allowed Plaintiffs to introduce evidence of nonpecuniary losses. 9 Therefore, in arriving at a proposed remedy, the Special Master considered the testimony of former workers who talked about lost opportunities, severe financial and emotional problems, severe financial dislocation, divorces, problems with offspring, and bankruptcies. The arm's length settlement agreed to between the parties provided compensatory relief for the wrongs to which these plaintiffs testified. Accordingly, such compensatory relief clearly falls within the § 104(a)(2) exclusion, and to find otherwise would thwart the Congressional intent behind § 104(a)(2), which is to provide a tax exclusion for victims of these very types of injuries. See Dotson, 87 F.3d at 687. 35 We emphasize, as did the Fifth Circuit, that the case before us today is not an ERISA case. Dotson, 87 F.3d at 686. We are not deciding whether compensatory damages were properly allowed under the facts of this case. That question need not be answered because the parties agreed to provide such damages in an arm's length good faith settlement nearly six years ago, and the district court judge approved the settlement where the law at the time did not dictate otherwise; specifically, the Supreme Court had yet to render an affirmative decision on this issue and the dicta of Ingersoll-Rand supported a finding that compensatory damages were allowed under ERISA. See Ingersoll-Rand Co. v. McClendon, 498 U.S. 133, 145, 111 S.Ct. 478, 112 L.Ed.2d 474 (1990); supra note 9; see also, Mertens, 508 U.S. at 255, 113 S.Ct. 2063 (noting that the precise phrase other appropriate equitable relief as found in § 502(a)(3) had never been specifically interpreted by the Court); Dotson, 87 F.3d at 688 n. 3 (citing Commissioner v. Duberstein, 363 U.S. 278, 80 S.Ct. 1190, 4 L.Ed.2d 1218 (1960) (inquiry into the motives of taxpayers and those from whom they receive income is relevant when ascertaining whether taxation is appropriate)). 36 If there had been a bench trial and the district court judge had allocated the award based on dignitary loss, loss in earning capacity, and long-term loss in employment prospects, this Court would respect that allocation unless it was clearly erroneous. Because the law at the time did not dictate otherwise, we would find that the district court's decision was not clearly erroneous, although after Mertens a different result would be necessary because Mertens allows only equitable relief which would mean back-pay and not tort-type relief. Therefore, because this was a court approved settlement, the point remains that the law at the time was such that the district court's approval was proper under the law and, as found by the Fifth Circuit, [t]he characterization of damages received is not affected by the shifting sands of statutory interpretation after a bona fide settlement has been reached or a damage award rendered.... The fact that such a remedy may no longer exist is irrelevant to the determination of the character of a settlement to be taxed. Dotson, 87 F.3d at 686-87. 37 The case before us today is an income tax case in which we must determine whether the settlement proceeds, that were provided as compensatory damages for the wrongs to which the plaintiffs testified, are subject to income taxation or exempt under § 104(a)(2). Under these facts, the answer is clear--the compensatory damages provided in the arm's length agreement with Continental fit squarely within the purpose and intent of the § 104(a)(2) exclusion as proceeds from a tort or tort-type remedy. See Dotson, 87 F.3d at 687. 38 As such, we find that Harper v. Virginia Department of Taxation, 509 U.S. 86, 97, 113 S.Ct. 2510, 125 L.Ed.2d 74 (1993) should not be used to retroactively apply Mertens to this case. See supra note 6. Although Supreme Court case law as it stands today may dictate that the Special Master incorrectly found that compensatory damages were allowed in the Continental settlement, the law at the time did not specifically dictate otherwise; the parties agreed to such damages in good faith negotiations; and the district court approved the settlement based upon the testimony provided by the aggrieved plaintiffs. We are not here to question the wisdom of the agreement reached, nor recharacterize the damages to which the parties agreed and the district court approved, where the law at the time did not command a different result. Accordingly, we find that the settlement award is no longer open on direct review and the rule espoused in Harper does not apply. See, e.g., Zeneca Ltd. v. Novopharm Ltd., 923 F.Supp. 74, 76 (D.Md.1995) (finding that in patent infringement case, retroactive application of underlying patent suit that was eventually settled and vacated was not justified because the underlying case was no longer open on direct review). 10 39 Although we find that Mertens is not applicable to the instant case, we hasten to note that while Mertens and its progeny 11 are currently the law of the land, as a matter of public policy, academics and legal commentators have been extremely critical of the holding espoused in Mertens because of its narrow scope and unjust result. 12 In fact, the Sixth Circuit has expressed its displeasure with the apparent inequity Mertens provides to aggrieved parties seeking remedies under ERISA. See Allinder v. Inter-City Prods.Corp., 152 F.3d 544, 553 (6th Cir.1998) (embracing the criticism of Mertens and holding that, because it was constrained by Mertens, the plaintiffs were left without a suitable remedy under ERISA for an employer's misdeeds). However, we also note that while we are displeased with the Mertens' holding, our displeasure in no way influenced our decision today. 40 Mertens restricts plan beneficiaries to remedies such as mandamus, injunction, constructive trust, and restitution, even if those beneficiaries suffer harms that can only be properly rectified through compensatory damages. As such, the practical import of Mertens, as applied to a case such as this, is that a corporation could create a scheme to prevent employees from fully vesting in their pensions without suffering any severe liability for their actions. See Flint, supra note 12 at 618-19. We find such a result unacceptable, particularly in light of the Congressional intent behind § 104(a)(2)--to relieve a taxpayer who has suffered a personal injury, as well as the Congressional intent behind ERISA--to protect ... the interests of participants in employee benefit plans and their beneficiaries ... by providing for appropriate remedies, sanctions, and ready access to the Federal courts. 29 U.S.C. § 1001(b). Under Mertens, it is dubious whether a plan beneficiary would get appropriate remedies, as Congress intended. See H.R.REP. NO. 101-247, at 55-56 (1989), reprinted in 1989 U.S.C.C.A.N. 1906, 1948. 13 41 However, with that said, under Schleier, we must nevertheless determine what portion of Plaintiffs' settlement awards were for back wages and therefore subject to income taxation. See Schleier, 515 U.S. at 329-31, 115 S.Ct. 2159 (finding that to qualify for exclusion under § 104(a)(2), the damages received must be both on account of personal injury and stem from a tort or tort-like claim); Dotson, 87 F.3d at 689. Accordingly, those damages not received on account of personal injury must be factored out, even though they stemmed from a tort or tort-like claim. As the Fifth Circuit found necessary to do in Dotson, we must remand this case to the district court for a determination of the amount of back wages included in the Basic Award, which would then be subject to income taxation. Dotson, 87 F.3d. at 689. In addition, we must also remand the case for a determination of future lost wages included in Plaintiffs' Earnings Impairment Additur award that were attributable to the firing, which would be subject to income taxation, while carefully factoring out those future lost wages and other components attributable to causation by personal injury which would be excludable under § 104(a)(2). Id. 42 In summary, at the time the settlement was crafted by the Special Master, agreed to by the parties, and approved by the district court in this case, it was designed to compensate for non-physical personal injuries inflicted by Continental's apparent wrong-doing resulting in class members being deprived of their Magic Number pension benefits. As such, we find it unnecessary to apply Mertens retroactively to the settlement proceeds at this date, and decline to do so because the law at the time apparently allowed for such compensatory damages under ERISA and the case is therefore no longer open on direct review. Accordingly, we hold that Plaintiffs' compensatory settlement award for non-physical personal injuries fits squarely within the I.R.C. § 104(a)(2) tort or tort-type rights exemption, subject to those proceeds received for back or future wages received as a result of the firing.