Taxation of Damages After Schleier - Where are We and Where Do We Go from Here?

Abstract:     
Since 1919, statutory tax law has excluded from gross income damages received on account of a personal injury or sickness. The exclusion currently is set forth in section 104(a)(2) of the Internal Revenue Code. The construction of that statutory exclusion, both by the courts and by the Commissioner, has undergone a number of changes and flip-flops over its 76-year history.

The Supreme Court dealt with the meaning and application of section 104(a)(2) in its 1995 decision in Commissioner v. Schleier. While the Schleier decision arrived at a second-best solution, it was an improvement over the previous state of the law on the issue.

Schleier removes most, albeit not all, of the potential for manipulation that previously existed and provides a considerable degree of certainty in what had been a chaotic corner of the tax law. In addition, Schleier's construction of the statute comports more closely with the policies that underlie section 104(a)(2) than did prior judicial constructions. In any event, Schleier has significantly altered the construction of section 104(a)(2), and the subsequent tax treatment of damages will be controlled by that decision, even perhaps certain aspects of damages for which taxation is determined by the 1996 amendment of section 104.

This article will examine the reasoning of the Schleier decision.

Number of Pages in PDF File: 38

Keywords: Taxation, Damages, Schleier, 104

JEL Classification: H20

Accepted Paper Series