Case Western Reserve Law Review
The exclusion of personal injury damage awards from gross income is inconsistent with established principles of taxation. Section 104(a)(2) of the Internal Revenue Code excludes from gross income “the amount of any damages received . . . on account of personal injury or sickness.” While the existence of Section 104(a)(2) traditionally has been justified as a humanitarian gesture, more logical explanations have been offered.
Damage awards cannot accurately be characterized as a return of capital. Nor does the involuntary nature of the transaction justify the exclusion. While so-called imputed income is not taxed, the reasons supporting its non-taxability do not extend to damage awards representing a cash substitute for such income. Excluding damage awards avoids certain administrative problems that may otherwise arise, but those problems could be resolved by less drastic means. These justifications for the exclusion cannot be rationalized as a logical application of tax theory.
To the extent that such a justification is lacking, the exclusion should be evaluated as a tax subsidy. Although Congress did not originally intend the exclusion to be a subsidy, it functions as such in the context of modern tax law. The exclusion provided by Section 104(a)(2) compensates tort victims by allowing receipts that logically should be included in gross income to escape taxation. While an expenditure of government funds for the benefit of innocent tort victims has emotional appeal, a closer inspection of the ramifications of the subsidy reveals that it is not a wise investment of public resources. The subsidy is not fairly allocated and the government subsidization of injuries is contrary to sound tort policy.
If damage awards were taxed, the policy goals of the tort system would be advanced rather than frustrated, since defendants would not be under-penalized and plaintiffs would not be overcompensated.
Mark W. Cochran, Should Personal Injury Damage Awards Be Taxed?, 38 Case W. Res. L. Rev. 43 (1987).