Opinion ID: 198101
Heading Depth: 2
Heading Rank: 2

Heading: The Taxability of Prejudgment Interest.

Text: 23 Having disposed of the petitioners' claim that no part of their settlements constituted prejudgment interest, we turn to their theory that prejudgment interest on a personal injury award is itself an award of damages received on account of personal injury, and thus excludable from federal income taxation by virtue of section 104(a)(2). 24 The petitioners accurately remark the tension between sections 61 and 104(a)(2)--a tension that we noted but did not reconcile in Delaney, 99 F.3d at 26-27. Other courts, however, have resolved this tension in a manner adverse to the petitioners' position. See, e.g., Brabson v. United States, 73 F.3d 1040 (10th Cir.1996) (Coffin, J., sitting by designation); Kovacs v. Commissioner, 100 T.C. 124, 1993 WL 46512 (1993), aff'd, 25 F.3d 1048, 1994 WL 253035 (6th Cir.1994) (table). In both instances, final judgments in personal injury cases had entered that specifically included prejudgment interest; the taxpayers sought to avoid taxation of the prejudgment interest, arguing that it was indistinguishable from the compensatory personal injury awards; and the courts held that the portions of the recoveries allocated to interest were taxable. See Brabson, 73 F.3d at 1046-47; Kovacs, 100 T.C. at 133. 25 The petitioners suggest that Kovacs, the principal Tax Court precedent on which the Commissioner relies, is a hoax, built upon an improper analogy to earlier Tax Court cases dealing with post-judgment, rather than prejudgment, interest. See, e.g., Aames v. Commissioner, 94 T.C. 189, 1990 WL 17276 (1990); Church v. Commissioner, 80 T.C. 1104, 1983 WL 13864 (1983). This claim is easily dispatched. It is true that many of the cases discussed in Kovacs deal with post-judgment interest--but the petitioners fail to persuade us that this distinction makes a meaningful difference. Interest, whether pre- or post-judgment, compensates for delay in payment, and is specifically included in the litany of income items subject to taxation under section 61. Thus, essentially the same rationale supports the includability of both species of interest for tax purposes. The Tax Court merely applied existing precedent to a new version of an old problem and reached a sensible result. See Kovacs, 100 T.C. at 129-30. 26 The petitioners also claim that the Kovacs court overlooked the legislative history of section 104(a)(2). They assert that the 1982 amendment to that section, which specifically approved exclusion from taxation of periodic payments received on account of personal injuries, demonstrates that Congress intended to exempt the interest portion of personal injury settlements from taxation. 5 This strikes us as wishful thinking. There is nothing in the text of the amendment that necessitates (or even suggests) such a conclusion. Indeed, it seems likely that Congress's decision not to tax periodic payments reflects recognition of the administrative difficulties of such a task--and nothing more. See Brabson, 73 F.3d at 1045 n. 5; Kovacs, 100 T.C. at 132-33. 27 The petitioners next turn to Schleier, 515 U.S. 323, 115 S.Ct. 2159, 132 L.Ed.2d 294, and United States v. Burke, 504 U.S. 229, 112 S.Ct. 1867, 119 L.Ed.2d 34 (1992), in their effort to persuade us that Brabson and Kovacs are wrongly decided. In both instances, the Court held that backpay awards in workplace discrimination cases were not excludable under section 104(a)(2) because they were not received on account of personal injuries. See Schleier, 515 U.S. at 336-37, 115 S.Ct. 2159; Burke, 504 U.S. at 242, 112 S.Ct. 1867. Glossing over these holdings, the petitioners focus on a passage in Schleier, 515 U.S. at 329-30, 115 S.Ct. 2159, where the Court observed in dictum that lost wages recovered in a suit for bodily injuries are excludable from taxation under section 104(a)(2). In the petitioners' view, this passage implies that all amounts received as part of a personal injury award are similarly sheltered. 28 Like the Brabson court, 73 F.3d at 1046, we think that this generous reading is unwarranted. In both Schleier and Burke, the Court recognized that there are two elements which a taxpayer must establish to qualify for an exclusion under section 104(a)(2). First, damages must be incurred through a tort or a tort-like incident causing personal injury. See Schleier, 515 U.S. at 336-37, 115 S.Ct. 2159; Burke, 504 U.S. at 237, 112 S.Ct. 1867. Second, those damages must be received on account of that personal injury. See Schleier, 515 U.S. at 333-34, 115 S.Ct. 2159; Burke, 504 U.S. at 234, 112 S.Ct. 1867; see also Delaney, 99 F.3d at 27. It follows inexorably that the decisive question here cannot be the extent to which prejudgment interest is like or unlike lost wages, but, rather, whether prejudgment interest, under the circumstances of this case, can pass the Court's two-part test. 29 Applying this test, we conclude that prejudgment interest is not damages received on account of a personal injury, and is, therefore, taxable. In reaching this conclusion, we place considerable emphasis on the nature of the funds that the Commissioner found taxable. Section 104(a)(2) excludes from taxation the amount of any damages received ... on account of personal injury or sickness. (emphasis supplied). Language is not infinitely elastic, and here, the disputed prejudgment interest simply does not comprise damages within the meaning of section 104(a)(2). We explain briefly. 30 Under the applicable Rhode Island statute, prejudgment interest is awarded in all civil cases, not just in personal injury cases. See R.I. Gen. Laws § 9-21-10. This interest is separate and distinct from damages, and is awarded mainly to compensate for delay in payment. See Foster v. Quigley, 94 R.I. 217, 179 A.2d 494, 495 (1962) (holding that prejudgment interest for damages to the person is not of the substance of the right of action but exclusively an incident attached thereto by legislative fiat after such right has been adjudicated); accord Balian v. Allstate Ins. Co., 610 A.2d 546, 549-50 (R.I.1992) (reaffirming Foster and acknowledging that the definition of damages may not always include interest); DiMeo v. Philbin, 502 A.2d 825, 826 (R.I.1986) (explaining that the legislature's intent in providing for prejudgment interest was to encourage settlement of tort cases without delay). 31 To be sure, federal law--not state law--supplies the rule of decision in determining whether a given payment is subject to federal income tax. See Helvering v. Stuart, 317 U.S. 154, 162, 63 S.Ct. 140, 87 L.Ed. 154 (1942); Lyeth, 305 U.S. at 194, 59 S.Ct. 155. Nevertheless, a state's characterization of such a payment can inform the federal determination, see Brabson, 73 F.3d at 1044, and Rhode Island's characterization of prejudgment interest comports with the idea, venerated in federal jurisprudence, that the principal purpose of prejudgment interest is to compensate for a delay in payment. See West Virginia v. United States, 479 U.S. 305, 310 n. 2, 107 S.Ct. 702, 93 L.Ed.2d 639 (1987); Kovacs, 100 T.C. at 128. To that extent, then, federal and state law converge. 32 We also conclude that prejudgment interest fails the second prong of the Court's two-part test as it is not received on account of a personal injury. As the Schleier Court explained, a recovery attributable to lost wages is not taxable because the accident causes a personal injury which in turn causes a loss of wages. 515 U.S. at 330, 115 S.Ct. 2159. Conversely, the personal injury that a victim experiences in, say, a medical malpractice case, does not cause a delay in payment. Rather, the injury causes damages, thus creating the fund on which interest for delay in payment is owed. See Kovacs, 100 T.C. at 128-29. So viewed, the second half of the Court's test strongly suggests that, unlike lost wages, prejudgment interest should not be excluded from federal income taxation by operation of section 104(a)(2). 6 33 Other indicia point persuasively in the same direction. These signposts are neatly synthesized in Judge Coffin's thoughtful opinion in Brabson, 73 F.3d 1040. We rehearse three such indicia. First, prejudgment interest is not a traditional remedy for personal injuries. See id. at 1046.. The Supreme Court has accorded considerable significance to this factor, see, e.g., Schleier, 515 U.S. at 329, 115 S.Ct. 2159 (focusing on typical recovery in a personal injury case in applying the two-part test), and so do we. 34 Second, and relatedly, the Brabson court attached great weight to the fact that prejudgment interest was not available at common law in personal injury cases. Indeed, such a boon was unheard-of in 1919 when Congress enacted the direct lineal ancestor of section 104(a)(2), section 213(b)(6) of the Revenue Act of 1918, ch. 18, 40 Stat. 1057, 1066 (1919). Since the exclusion for personal injury awards has been handed down almost verbatim from 1919 forward, Congress could not conceivably have intended the exclusion to apply to prejudgment interest. Cf. Monessen S.W. Ry. Co. v. Morgan, 486 U.S. 330, 338-39, 108 S.Ct. 1837, 100 L.Ed.2d 349 (1988) (disallowing recovery of prejudgment interest in FELA cases because, when Congress enacted the FELA in 1908, the common law did not allow prejudgment interest in personal injury suits). 35 Third, the Brabson court read Schleier as requiring a direct link between the injury and the remedial relief for the exclusion to apply, Brabson 73 F.3d at 1047, and found no such link between personal injuries and prejudgment interest. Time becomes the relevant factor, not the injury itself--the longer the procedural delay, the higher the amount. Id. Thus, prejudgment interest is inextricably intertwined with the very delay that severs the connection between prejudgment interest and the underlying personal injury. 36 To say more would be supererogatory. Mindful of the panoply of factors favoring taxability, and mindful, too, of the default rule that all exclusions from income must be construed parsimoniously, see Schleier, 515 U.S. at 328, 115 S.Ct. 2159, we rule that prejudgment interest on compensatory damage awards in personal injury actions falls within the broad mandate of section 61, and that section 104(a)(2) provides no safe haven for taxpayers. Because the Commissioner's (and the Tax Court's) determination that such prejudgment interest is subject to federal income tax jibes with the weight of authority and rests upon a sound construction of the Tax Code, we uphold it. 37