Vanderbilt Law Review


Robert C. Illig

First Page



The Internal Revenue Code (the "Code") defines income broadly to include wealth from almost every source, while at the same time exempting a number of items for various tax and public policy reasons. One such policy-based exemption is section 104(a)(2)-the Personal Injuries Exemption-which exempts from tax "any damages ... received on account of personal injuries or sickness." The Personal Injuries Exemption, however, exists in a state of disarray and needs amending. Since its inception, this exemption has lacked both clear definitions of its key terms and a sound theoretical foundation. Moreover, although courts traditionally read exemptions narrowly, they have interpreted section 104(a)(2) broadly and have applied it in a number of situations where it was not meant to be applied. As a result, the exemption now serves largely as an incentive to sue and as a windfall for those taxpayers fortunate enough to fall within its scope. So great is the disagreement over how to deal with these problems that between 1992 and 1994 the federal circuit courts of appeals split over at least three separate issues regarding the application of the exemption. The Personal Injuries Exemption should be narrowed significantly by giving it a clear definition tied to a sound theoretical foundation These changes would alleviate many of the current problems and give courts and the Internal Revenue Service (the "Service") guidance in dealing with future problems. It would also raise revenue and eliminate a major incentive to sue.

It is a rare occurrence when the political will for change arises at the precise moment when an often-overlooked area of law most needs amending. Such is the case today as a result of the confluence between America's desire for tort reform and the need for congressional action regarding the Personal Injuries Exemption. America currently needs and wants tort reform. Indeed, such reform was one of the major provisions of the Contract with America that helped catapult the Republicans to electoral victory in 1994. Because section 104(a)(2) serves as a significant incentive to litigate, Congress currently has an opportunity to use the political will for tort reform to simultaneously limit one of the largest and least justified tax expenditures in the Code-the tax-exempt status of damage awards received on account of personal injuries.

Parts II and III of this Note discuss the legal background of and recent developments in the Personal Injuries Exemption. Part IV analyzes the problems arising from the exemption's current application in more detail and proposes a statutory amendment to section 104(a)(2) which narrows the exclusion by giving it a clear definition which is closely tied to a sound theoretical foundation.

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Torts Commons