Miller v. Commissioner

93 T.C. No. 29, 93 T.C. 330, 1989 U.S. Tax Ct. LEXIS 125

Opinions

OPINION

WELLS, Judge:

Respondent determined a deficiency of $249,106 and an addition to tax pursuant to section 6661¹ of $62,254 against petitioner for 1983.

The instant case stems from petitioner’s receipt of $525,000 in settlement of two defamation actions. We must decide (1) whether the settlement proceeds should be excluded from gross income pursuant to section 104(a)(2), (2) whether any portion of the proceeds characterized as punitive damages should also be excluded pursuant to section 104(a)(2), and (3) whether petitioner is hable for the section 6661 addition to tax.

The facts are fully stipulated. We hereby incorporate by reference the stipulation of facts and attached exhibits.

Petitioner resided in Westminister, Maryland, when she filed her petition.

The Two Civil Actions

On or about March 28, 1979, petitioner commenced an action (the first action) by filing a declaration (the declaration) in the Superior Court of Baltimore City. The declaration named Cary Wellington, Sidney Rapkin, Publication Press, Inc. (Publication Press), and Graphic Arts Finishing Co. (Graphic Arts), as defendants. According to the declaration, Publication Press and Graphic Arts had employed petitioner as personnel manager. Mr. Wellington was chairman of the boards of both corporations, while Mr. Rapkin was the financial vice president of the corporations.

The declaration alleged a conspiracy by the defendants to accuse petitioner of embezzlement so that a bribery scheme could be concealed. Publication Press and Graphic Arts (collectively, the companies) provided printing services to various Government agencies. The companies had difficulty making timely delivery of printed material to the agencies. Sometime in 1977, the companies began paying Government employees bribes for undated or backdated receipts for printed material. Through early 1979, the companies paid approximately $38,000 in bribes. Around March 1979, the defendants decided to shield themselves from responsibility for the bribery scheme by firing petitioner and accusing her of embezzling the $38,000. The companies fired petitioner on March 23, 1979.

Count I of the declaration alleged that Mr. Wellington accused petitioner of embezzlement in the presence of Mr. Rapkin and two other employees of the companies. Mr. Wellington made the accusation the day petitioner was fired. Counts II through VIII of the declaration alleged that Mr. Wellington told various employees of the companies that petitioner had been terminated for embezzlement.

Counts IX and X of the declaration alleged that Mr. Rapkin made similar allegations respecting petitioner to various employees of the companies.

Count XI of the declaration alleged that Mr. Wellington and Mr. Rapkin told the Internal Revenue Service that petitioner had received embezzlement income from the companies.

Count XII of the declaration alleged that the companies had made a claim on petitioner’s fidelity bond, claiming a loss because of petitioner’s embezzlement. Count XIII of the declaration alleged that the defendants had engaged in “extreme and outrageous conduct” that resulted in petitioner’s emotional distress.

On or about November 30, 1982, petitioner commenced a second action (the second action). She filed a declaration (the second declaration) in the Circuit Court for Baltimore County. The second declaration named the Continental Insurance Co. (Continental), The Glen Falls Insurance Co. (Glen Falls), Underwriters Adjusting Co. (Underwriters), Barry Bach, William Butler, David Gischel, Publication Press, and Graphic Arts as defendants.

According to the second declaration, Glen Falls was the liability insurer for the companies. Continental was the corporate parent of Glen Falls, while Underwriters was another Continental subsidiary and adjusted claims against Glen Falls (collectively, Glen Falls, Continental, and Underwriters are referred to as the insurance company defendants). Mr. Bach served as an attorney for Underwriters. Mr. Butler was the deliveryman for the companies who paid the bribes for undated and backdated receipts.

Petitioner’s second declaration alleged that the insurance company defendants knew that the companies lacked a meritorious defense to the first action and that the insurance company defendants therefore conspired to defame petitioner so that her testimony at trial would be less credible. The second declaration also alleged that the insurance company defendants hired Mr. Butler to discredit petitioner.

Count I of the second declaration alleged that Mr. Butler told a group at “Shinberg’s Bar” that petitioner had “unchaste” relations with the “Cash brothers.” The Cash brothers were independent contractors who built skids and pallets for the companies. Mr. Butler also told the group that petitioner had assisted the Cash brothers in overcharging the companies. Count II of the second declaration alleged that Mr. Butler made similar allegations in the companies’ warehouse.

Count III of the second declaration alleged that Mr. Butler told another employee of the companies, Mr. Gischel, that petitioner had forged receipts for the delivery of skids and pallets from the Cash brothers. Count IV óf the second declaration alleged that Mr. Gischel repeated the statement alleged in Count III to Mr. Newcomer, whose name had allegedly been forged by petitioner.

Count V of the second declaration alleged that various defendants had been negligent in employing Mr. Butler to investigate petitioner’s first action.

Count VI of the second declaration alleged that defendants’ extreme and outrageous conduct resulted in emotional distress to petitioner.

Petitioner’s first action went to trial, and on October 6, 1983, a jury awarded petitioner $950,000, consisting of $500,000 in compensatory damages and $450,000 in punitive damages. No portion of the jury award was attributable to Count XIII of the first declaration, i.e., petitioner’s;claim for the intentional infliction of emotional distress.

After the jury award, petitioner and the defendants in both actions entered into settlement negotiations. The parties reached agreement. On or about November 22, .1983, petitioner signed a general release discharging all defendants in both actions from liability, in exchange for $900,000 (the settlement proceeds). Petitioner filed an order of satisfaction in the first action and dismissed the second action. In December 1983, petitioner received $525,000 of the settlement proceeds (the net settlement proceeds), after petitioner’s attorneys had deducted legal fees and costs of $375,000 from the settlement proceeds.

Section 104(a)(2)

We must decide whether the net settlement proceeds² received by petitioner in 1983 constitute gross income. Generally, a taxpayer must include in gross income “all income from whatever source derived.” Sec. 61(a). One exception to this rule is provided by section 104(a)(2), which excludes from gross income “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 * * * .” Regulations broadly interpret this language as encompassing damages received through the litigation of “tort or tort type rights.” Sec. 1.104-1(c), Income Tax Regs. Thus, section 104(a)(2) does not exclude only recoveries for physical injury. Church v. Commissioner, 80 T.C. 1104, 1106 (1983). Rather, the proper inquiry is whether damages have been recovered for personal injury.

Whether damages received through settlement of litigation are excluded under section 104(a)(2) depends upon the nature of the claim settled, rather than upon the validity of the claim. Rickel v. Commissioner, 92 T.C. 510 (1989); Metzger v. Commissioner, 88 T.C. 834, 847 (1987), affd. without published opinion 845 F.2d 1013 (3d Cir. 1988); Seay v. Commissioner, 58 T.C. 32, 37 (1972). When, as in the instant case, a settlement agreement fails to specify the claim or claims for which payment is made, the intent of the payor is the most important factor determining whether section 104(a)(2) applies. Rickel v. Commissioner, supra; Metzger v. Commissioner, supra at 847-848; Knuckles v. Commissioner, 349 F.2d 610, 613 (10th Cir. 1965), affg. a Memorandum Opinion of this Court.

We find that the defendants paid petitioner the settlement proceeds with the intent of satisfying petitioner’s claims for defamation. All but two of the counts in both the first and second declarations allege defamation. One count in the first declaration alleged the intentional infliction of emotional distress, but none of the jury award in the first action was attributable to that count. The second declaration also contained one count alleging the intentional infliction of emotional distress. Yet, in light of the outcome of the first action, we believe the defendants’ intent in settling both the first and second actions was to satisfy their liabilities for defamation.

Defamation is an action for personal injury in Maryland. New York, Philadelphia and Norfolk Railroad Co. v. Waldron, 116 Md. 441 (1911), 82 A. 709, 714. Because the nature of a taxpayer’s claim determines whether damages are excluded under section 104(a)(2), petitioner’s recovery is thus excluded from gross income.

In asserting that section 104(a)(2) does not exclude the net settlement proceeds from gross income because the proceeds represent compensation for damage to professional reputation, respondent relies upon our holding in Roemer v. Commissioner, 79 T.C. 398 (1982), revd. 716 F.2d 693 (9th Cir. 1983). In Roemer, an insurance agent recovered compensatory and punitive damages after successfully prosecuting a defamation action against a credit reporting agency. The agency had issued a defamatory credit report concerning the agent. After the agent failed to report any of the damages as gross income, the Commissioner determined a deficiency. We sustained the deficiency, reasoning that the damages compensated for damage to the agent’s business, or lost profits. 79 T.C. at 405-407. The Ninth Circuit Court of Appeals, however, reversed our holding and explained, “We reverse because we have concluded that the tax court’s analysis of this matter confuses a personal injury with its consequences and illogically distinguishes physical from nonphysical injuries.” 716 F.2d at 696-697.

While this Court examined the pleadings and proof before the State court to determine whether the damages awarded to the taxpayer were a substitute for lost business profits, the Ninth Circuit rejected the relevancy of this inquiry, reasoning that although personal injury may result in both personal and economic consequences, it remains personal injury for purposes of section 104(a)(2). The Ninth Circuit’s inquiry focused upon the nature of the taxpayer’s claim. 716 F.2d at 697. The Ninth Circuit concluded that defamation is an action for personal injury under California law and that therefore section 104(a)(2) excluded the taxpayer’s recovery. 716 F.2d at 700.

In Revenue Ruling 85-143, 1985-2 C.B. 55, the Commissioner rejected the Ninth Circuit’s approach. The Commissioner reasoned as follows: “The characterization of the lawsuit brought by the individual under the law of the particular state where suit was filed should not determine the characterization of the damages received for federal income tax purposes.” 1985-2 C.B. at 56. The Commissioner also stated that he would follow this Court’s approach in Roemer (rather than that of the Ninth Circuit) and determine whether section 104(a)(2) applies by inquiring whether a defamatory statement “is directed at the business and causes loss of business income.” 1985-2 C.B. at 56.

In Threlkeld v. Commissioner, 87 T.C. 1294 (1986), affd. 848 F.2d 81 (6th Cir. 1988), however, we rejected the approach we had taken in Roemer. In Threlkeld, the taxpayer had received $300,000 in settlement of a malicious prosecution action. After various concessions, the issue before the court was whether $21,500 received for injury to “professional reputation” should be excluded from gross income pursuant to section 104(a)(2). 87 T.C. at 1297. We held the amount to be excludable and stated that our holding in Roemer lacked “a firm foundation in the case law.” 87 T.C. at 1304. We expressly embraced the reasoning of the Ninth Circuit with its emphasis on “the nature of the claim,” but cautioned that if a judgment or settlement were not “clearly allocated to an identifiable claim,” an examination of pleadings, and proof would be necessary to ascertain whether or not a recovery flowed from personal injury. 87 T.C. at 1305-1306. We concluded that because malicious prosecution is an action for personal injury under Tennessee law, the recovery in that case was excludable. Our opinion offers the following test for determining whether a claim is for personal injury: “Exclusion under section 104 will be appropriate if compensatory damages are received on account of any invasion of the rights that an individual is granted by virtue of being a person in the sight of the law.” 87 T.C. at 1308. The approach adopted in Threlkeld, i.e., a focus upon the nature of an injury as opposed to its consequences, has been reaffirmed in subsequent cases. E.g., Rickel v. Commissioner, supra; Thompson v. Commissioner, 89 T.C. 632, 648 (1987), affd. 866 F.2d 709 (4th Cir. 1989); Metzger v. Commissioner, supra at 857-858.³

Respondent asks that we reconsider the rule set forth in Threlkeld and again draw a distinction between damage to personal reputation and damage to professional reputation. We decline, however, to revert to the approach we took in Roemer. Given the approach of the appellate courts⁴ and that of this Court since Threlkeld, we reject respondent’s request to reconsider Threlkeld. Section 104 does not distinguish between physical and nonphysical injuries (Church v. Commissioner, 80 T.C. at 1106), and we see no sound reason to construe the statute in such a way as to not afford the same tax treatment to recoveries for all types of “personal” injury regardless of consequence. We therefore hold that section 104(a)(2) excludes the net settlement proceeds from gross income.

Punitive Damages

Respondent next argues that section 104(a)(2) does not exclude punitive damages from gross income and that all of the net settlement proceeds are taxable because petitioner failed to establish the portion of the net settlement proceeds which represents excludable compensatory damages. We reject respondent’s argument because the statutory language excludes from gross income both compensatory and punitive damages received on account of personal injuries.

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. Cf. Browning-Ferris Industries of Vermont, Inc. v. Kelco Disposal, Inc., 492 U.S. _, _n. 20, 57 U.S.L.W. 4985, 4990 n. 20 (June 26, 1989) (Framers of the Bill of Rights, aware of punitive damages, could have subjected them to Eighth Amendment limitations if they had so intended.). 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).

In Burford v. United States, 642 F. Supp. 635 (N.D. Ala. 1986), the court held, as we do, that the statutory language is susceptible of only one reasonable interpretation. The court held that section 104(a)(2) excluded an award in a wrongful death action despite the award’s characterization as “punitive.” The court explained,

The starting place in the construction of any statute is with the language of the statute itself. The clear import of “any damages received * * * on account of personal injuries” would seem to express clearly the Congressional intent to exclude wrongful death proceeds — regardless of whether those proceeds are classified as compensatory or punitive — from gross income. * * * [642 F. Supp. at 636.]

At one time, the Commissioner also viewed the statute as free of ambiguity. Revenue Ruling 75-45, 1975-1 C.B. 47, stated the following:

Section 104(a)(2) excludes from gross income “the amount of any damages received (whether by suit or agreement) on account of personal injuries or sickness” * * * . Therefore, under section 104(a)(2) any damages, whether compensatory or punitive, received on account of personal injuries or sickness are excludable from gross income. [Emphasis in revenue ruling.]

In Revenue Ruling 84-108, 1984-2 C.B. 32, 34, the Commissioner reversed his position and stated that section 104(a)(2) does not exclude punitive damages from gross income. The Commissioner relied primarily on Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955). See also Rev. Rul. 85-98, 1985-2 C.B. 51. As pointed out by the court in Burford, however, Glenshaw Glass does not support respondent’s position. Glenshaw Glass involved two-thirds of treble damages recoveries for violations of Federal antitrust laws and a punitive damages recovery for fraud. The taxpayers had not received any recoveries on account of personal injuries, and thus the predecessor of section 104(a)(2) was not in issue. Burford v. Commissioner, 642 F. Supp. at 637.

Revenue Ruling 84-108, supra, also reasons that punitive damages are not awarded “on account of” personal injury, because they are “determined with reference to the defendant’s degree of fault.” 1984-2 C.B. at 34. The Commissioner has given the statute a strained and unnatural interpretation. Webster’s defines the phrase “on account of” as: “For the sake of,” “by reason of,” or “because of.” Webster’s Third New International Dictionary (1981). These phrases suggest causation. Punitive damages result from both personal injury and a defendant’s culpability. Without the “invasion of * * * rights” referred to in Threlkeld, punitive damages are unavailable, and most jurisdictions require some amount of actual damages before punitive damages may be awarded. Browning-Ferris Industries of Vermont, Inc. v. Kelco Disposal, Inc., 57 U.S.L.W. at 4991 n. 24; W. Prosser and W. Keeton, Torts, sec. 2, p. 14 (5th ed. 1984). Thus, punitive damages are received “on account of” personal injury, although personal injury alone may not justify an award of punitive damages.

Finally, revenue rulings represent only the Commissioner’s position on specific factual situations rather than substantive authority (Stark v. Commissioner, 86 T.C. 243, 250-251 (1986)), and we disagree with Revenue Ruling 84-108, supra.

Recently, in Rickel v. Commissioner, supra, an opinion reviewed by the Court, we stated, “Depending upon the nature of the claim, amounts awarded as punitive damages may be included in gross income.” 92 T.C. at 521. Our statement strongly implies that punitive damages are not taxable in all circumstances and that their taxability, like the taxability of compensatory damages, depends upon the nature of a taxpayer’s claim.

The regulations state: “In addition to the items enumerated in section 61(a), there are many other kinds of gross income. For example, punitive damages such as treble damages under the antitrust laws and exemplary damages for fraud are gross income.” Sec. 1.61-14(a), Income Tax Regs. By using the words “such as,” the regulation arguably implies that all punitive damages are includable in gross income. We read the regulation, however, as providing that punitive damages are included in gross income in the absence of some statutory provision for exclusion, such as section 104(a)(2). Graves v. Commissioner, 88 T.C. 28, 33 (1987), and cases cited therein (Regulations should be interpreted so as to uphold their validity.). Respondent, as well, must have read the regulation in that manner when he issued Revenue Ruling 75-45, supra. Thus, there remains the issue of whether punitive damages awarded in an action for personal injury fall within the general rule of inclusion or are, rather, shielded by section 104(a)(2)’s umbrella. As discussed above, we believe the statute’s broad language covers both components of a taxpayer’s recovery.

We are mindful that statutes excluding items from gross income are to be narrowly construed. Silverman v. Commissioner, 28 T.C. 1061, 1067-1068 (1957), affd. 253 F.2d 849 (8th Cir. 1958). Yet, we should not disregard the plain meaning of a statute except to prevent an absurd result or one that is contrary to legislative intent. United States v. American Trucking Assns., Inc., 310 U.S. 534, 543 (1940); Abeles v. Commissioner, 91 T.C. 1019, 1028 (1988); Zinniel v. Commissioner, 89 T.C. 357, 362 (1987), affd. 883 F.2d 1350 (1989).

Including punitive damages within the ambit of section 104(a)(2) does not produce an absurd result. Punitive damages have served as a means of compensating plaintiffs for intangible harm and for costs and attorneys’ fees. W. Prosser and W. Keeton, supra, sec. 2, p. 9; Note, “Exemplary Damages in the Law of Torts,” supra at 520-521. Although they may serve these purposes to a lesser extent now than in the past, the fact that punitive damages may possess a compensatory aspect renders it reasonable to afford them the protection of section 104(a)(2). It also might explain why Congress in 1918 did not expressly limit the statutory exclusion to compensatory damages.

The legislative history provides no sound basis for disregarding the plain meaning of the statute. The House Report to the Revenue Act of 1918 offered the following justification for the exclusion: “Under the present law it is doubtful whether * * * damages received on account of such injuries or sickness, are required to be included in gross income.” H. Rept. 767, 65th Cong., 2d Sess. 9-10 (1918), 1939-1 C.B. 86, 92 (Part 2). While statutes involving exclusions from income are generally narrowly construed, without a clearer indication of Congressional intent, we will not contort the statutory language. We therefore hold that any portion of the net settlement proceeds which represents punitive damages is excluded from gross income by section 104(a)(2).

Our holdings make it unnecessary to address the section 6661 addition to tax determined by respondent.

Accordingly,

Decision will be entered for the petitioner.

Reviewed by the Court.

Nims, Chabot, Parker, Kórner, Shields, Clapp, Swift, Jacobs, Gerber, Wright, Parr, Williams, RUWE, and COLVIN, JJ., agree with the majority opinion.

1 Unless otherwise indicated, all section references are to the Internal Revenue Code of 1954 and all Rule references are to the Tax Court Rules of Practice and Procedure.

2 In the notice of deficiency, respondent determined that petitioner had received $525,000 of unreported income in 1983, implying that although she had received $900,000 of income, she was entitled to deduct $375,000 of costs and attorneys’ fees. Respondent did not determine alternatively that in the event a portion of the settlement proceeds were held to be excluded from gross income, the deduction of a portion of the costs and fees should be disallowed pursuant to sec. 265 or some other provision. Our holding infra obviates any need to address the issue.

3 In Byrne v. Commissioner., 90 T.C. 1000 (1988), revd. 833 F.2d 211 (3d Cir. 1989), the taxpayer received $20,000 in settlement of various claims against her former employer, including claims stated in a complaint filed by the Equal Employment Opportunity Commission. We excluded only one half of the taxpayer’s recovery pursuant to sec. 104(a)(2), reasoning that the taxpayer’s claim under the Fair Labor Standards Act could be analogized to both tort and contract actions and that the parties’ settlement resolved “a range of issues between them —including, potentially, claims based on their employment contract.” 90 T.C. at 1009-1010. The Third Circuit Court of Appeals disagreed with our conclusion that contract-type claims were settled and excluded all of the taxpayer’s recovery. Byrne is thus consistent with Threlkeld in that it focuses upon the nature of a taxpayer’s claim. Byrne, however, does not otherwise apply to the facts of the instant case because petitioner never asserted a claim which could be characterized as contractual.

4 Although Thompson v. Commissioner, 89 T.C. 632 (1987), affd. 866 F.2d 709 (4th Cir. 1989), may not be so “squarely in point” that the rule of Golsen v. Commissioner, 54 T.C. 742, 756-757 (1970), affd. 445 F.2d 985 (10th Cir. 1971), should be brought into play, we note the Fourth Circuit’s apparent general agreement with this Court’s current approach.