Should Personal Injury Damage Awards Be Taxed?

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." Originally enacted in 1918, the provision is almost as old as the modem federal income tax system. According to the committee report on the original legislation, the exclusion was enacted because it was "doubtful ," under existing law, whether such damages were required to be included in gross income. In other words, the Committee perceived the statutory exclusion as a mere clarification of existing law. Courts have broadened the concept of gross income significantly since 1918, but the statutory exclusion for personal injury damage awards has survived. Absent the exclusion, most damage awards would constitute gross income under the modem definition. Thus, the original exclusion was based upon what now appears to be an erroneous assumption. To the extent that the original reasoning no longer supports the exclusion, a search for alternative reasons is appropriate. One might first ask whether there is any basis in "tax theory" for excluding personal injury damage awards from gross income. If no such basis can be found, the inescapable conclusion is that the exclusion is a tax subsidy - a benefit supported, if at all, by policy considerations. To the extent Sec. 104(a)(2) represents a tax subsidy, an inquiry into the reasons for and consequences of the subsidy is appropriate