“‘[S]tate law creates legal interests and rights,’ while federal law ‘designates what interests or rights, so created, shall be taxed.’” (original alterations omitted) (quoting Morgan v. Comm’r, 309 U.S. 78, 80 (1940))
How later courts described this case
- “‘[S]tate law creates legal interests and rights,’ while federal law ‘designates what interests or rights, so created, shall be taxed.’” (original alterations omitted) (quoting Morgan v. Comm’r, 309 U.S. 78, 80 (1940))
- noting "prejudgment interest is more naturally associated with . . . opportunity cost"
- “[P]rejudgment interest in Louisiana is viewed as a form of reparation.”
Written by the judges who cited it.
The opinion
United States Court of Appeals
Fifth Circuit
F I L E D
In the United States Court of Appeals
February 18, 2005
For the Fifth Circuit
Charles R. Fulbruge III
_________________________ Clerk
No. 03-31136
_________________________
CHAD ANTHONY CHAMBERLAIN,
By and Through His Curator,
Wilmer Joseph Chamberlain and His Under-Curatrix,
Beverly LeBlanc Chamberlain;
WILMER JOSEPH CHAMBERLAIN;
BEVERLY LEBLANC CHAMBERLAIN,
Plaintiffs - Appellants,
versus
UNITED STATES OF AMERICA,
Defendant - Appellee.
_________________________
Appeals from the United States District Court
For the Eastern District of Louisiana
_________________________
Before KING, Chief Judge, HIGGINBOTHAM, and DAVIS, Circuit
Judges.
PATRICK E. HIGGINBOTHAM, Circuit Judge:
Chad Chamberlain, by and through his parents Wilmer and
Beverly Chamberlain,1 brought suit against the United States
seeking recovery of over one million dollars in income tax assessed
against prejudgment interest awarded in a personal injury lawsuit.
The Chamberlains argued that prejudgment interest recovered in a
personal injury suit is excluded from taxation by section 104(a)(2)
1
Wilmer Chamberlain is Chad Chamberlain’s curator, and Beverly Chamberlain
is his under-curatrix.
of the Internal Revenue Code (“section 104(a)(2)”). The district
court rejected their argument, finding that prejudgment interest
received in a personal injury suit is not received “on account of”
the personal injury. We affirm.
I
Chad Chamberlain was severely injured while swimming due to
the negligence of the State of Louisiana. A lawsuit against the
State produced total damages of $9,253,551.58, of which
$3,791,741.53 was attributable to prejudgment interest. The IRS
assessed income tax against the prejudgment interest component of
the award, and the Chamberlains paid the required amount under
protest.2 The Chamberlains sought a refund, and received a
certified letter from the IRS informing them that their claims had
been fully disallowed. They timely filed suit in the U.S. District
Court for the Eastern District of Louisiana seeking recovery of the
contested amount.
The district court granted summary judgment in favor of the
United States. The court found that federal law controls the tax
treatment of prejudgment interest awarded under Louisiana law.3
Applying federal law, the district court found that the
Chamberlains’ prejudgment interest award was taxable as gross
2
The tax was paid as part of the Chamberlains’ 1994 taxable income. The
taxable interest included $3,513,641.53 attributable to the award to Chad
Chamberlain, and $278,100.00 attributable to the award to Wilmer and Beverly
Chamberlain.
3
Chamberlain v. United States, 286 F. Supp. 2d 764, 766 (E.D. La. 2003).
2
income, and was not excluded from taxation under section 104(a)(2).
In making this determination, the court applied the two-part
test articulated by the Supreme Court for determining whether an
amount is excluded under section 104(a)(2). Under this test, the
taxpayer must 1) demonstrate that the underlying cause of action
giving rise to the recovery is based upon a tort or tort type
rights; and 2) show that the damages were received on account of
personal injuries or sickness.4 The district court found that the
Chamberlains satisfied the first part of the test, but faltered on
the second. Citing to cases decided by the First, Third and Tenth
Circuits addressing the applicability of section 104(a)(2) to
prejudgment interest, the district court found that prejudgment
interest was paid to compensate injured parties for their lost time
value of money, and not their personal injuries.5 In addition, the
district court deemed it irrelevant that, unlike some common law
jurisdictions, prejudgment interest is classified as part of a
plaintiff’s reparation damages under Louisiana Civil Law:
While the Court acknowledges the unique legal history of
Louisiana and the important contributions of the scholars
cited by the plaintiffs, it does not change the treatment
of such interest under the federal tax laws. Prejudgment
interest may be considered part of damages under
Louisiana law, but, nonetheless, it is not received “on
account of” personal injuries. Instead, it is received
on account of the time delay. Therefore, prejudgment
4
Comm’r v. Schleier, 515 U.S. 323, 336-37 (1995).
5
286 F. Supp. 2d at 767.
3
interest is taxable under the Federal Tax Code.6
The Chamberlains filed a timely notice of appeal.
II
On appeal, the Chamberlains argue that the district court
erred in finding that prejudgment interest awarded under Louisiana
law in a personal injury suit is taxable.7 We review the district
court’s decision de novo.8
The Chamberlains’ argument presents a question of first
impression for our court. Accordingly, we begin our analysis with
a review of the pertinent provisions of the Internal Revenue Code.
A
In order for a specific amount to be subject to federal income
tax, it must first come within the Internal Revenue Code’s
definition of “gross income.” Section 61(a) of the Code broadly
defines gross income as “all income from whatever source derived.”9
The Supreme Court has repeatedly emphasized the sweeping scope of
6
Id.
7
The Chamberlains also contend that, by finding their prejudgment interest
award to be taxable, the district court improperly afforded retroactive
application to a “new” rule of law. This argument was not raised before the
district court and is therefore waived. See Brown v. Ames, 201 F.3d 654, 663
(5th Cir. 2000) (“To avoid being waived, an argument ‘must be raised to such a
degree that the trial court may rule on it.’” (quoting In re Fairchild Aircraft
Corp., 6 F.3d 1119, 1128 (5th Cir. 1993))).
8
See United States v. Lowe, 118 F.3d 399, 400 (5th Cir. 1997) (noting that
a district court’s grant of summary judgment based upon its interpretation of a
federal statute is reviewed de novo (citing Estate of Bonner v. United States,
84 F.3d 196, 197 (5th Cir. 1996))).
9
I.R.C. § 61(a).
4
this definition, holding that Congress intended section 61(a), as
well as its statutory predecessors, to exert the “full measure of
its taxing power.”10 In contrast, the Court has held that
exclusions from gross income must be construed narrowly.11
The parties do not dispute, and we have no difficulty finding,
that prejudgment interest awarded under Louisiana law in a personal
injury suit constitutes gross income, and is therefore taxable
unless it comes within an exclusion.12 The Chamberlains argue that
their prejudgment interest award is excluded from tax under
section 104(a)(2) of the Code.
As in effect for the 1994 tax year, section 104(a)(2) provides
that gross income does not include “the amount of any damages
received . . . on account of personal injuries or sickness.”13 The
words “on account of” do not readily admit of a precise and
unambiguous meaning,14 and neither the Code nor the relevant
10
Helvering v. Clifford, 309 U.S. 331, 334 (1940); see also Comm’r v.
Glenshaw Glass Co., 348 U.S. 426, 429 (1955).
11
See Schleier, 515 U.S. at 328 (“We have . . . emphasized the corollary
to § 61(a)’s broad construction, namely, the default rule of statutory
interpretation that exclusions from income must be narrowly construed.” (internal
quotation marks and citation omitted)); see also United States v. Centennial Sav.
Bank FSB, 499 U.S. 573, 583 (1991) (exclusions from income are to be construed
narrowly); Comm’r v. Jacobson, 336 U.S. 28, 49 (1949) (same).
12
See Wesson v. United States, 48 F.3d 894, 898 (5th Cir. 1995)
(“Accessions to wealth are generally presumed to be gross income unless the
taxpayer can show that the accession falls within a specific exclusion.”).
13
I.R.C. § 104(a)(2) (1988 ed. and Supp. V) (amended 1996) (emphasis
added).
14
We have previously commented upon the ambiguous nature of section
104(a)(2):
5
Treasury Regulations attempt to define them.15 Thus, we must turn
to Supreme Court precedent for guidance.
The Supreme Court has decided three seminal cases interpreting
section 104(a)(2). Although these cases do not consider the
question of whether prejudgment interest is excluded from taxation,
they provide the basic legal framework within which this question
must be addressed.
In the first of these cases, United States v. Burke,16 the
Court held that a backpay award received in settlement of a claim
brought under Title VII of the Civil Rights Act of 1964 was not
excluded from gross income under section 104(a)(2). The Court
found that, in order for an award of damages to come within section
104(a)(2), it must redress a tort like personal injury.17 Noting
that “[r]emedial principles . . . figure prominently in the
As the Ninth, Federal, and Fourth Circuits have noted, section
104(a)(2) is ambiguous, susceptible of at least two conflicting
interpretations. We agree. Section 104(a)(2) could mean that all
damages recovered in a personal injury suit are excluded, or it
could mean that only those damages that purport to compensate the
plaintiff for the personal injury suffered are received on account
of personal injury . . . .”
Wesson, 48 F.3d at 897.
15
Treasury Regulation 1.104-1(c) provides that “[t]he term ‘damages
received (whether by suit or agreement)’ means an amount received . . . through
prosecution of a legal suit or action based upon tort or tort type rights, or
through a settlement agreement entered into in lieu of such prosecution.” Treas.
Reg. § 1.104-1(c) (2004). While this regulation clearly requires that damages
excluded under section 104(a)(2) be received through a legal action grounded in
tort, it does not define the words “on account of.”
16
504 U.S. 229 (1992).
17
Id. at 237.
6
definition and conceptualization of torts,” the Court construed
“damages” and “personal injury” broadly to encompass damages
awarded to compensate plaintiffs for both physical and non-physical
injuries.18 Applying these general principles to Title VII, the
Court found that an award of backpay to compensate plaintiffs for
wages properly due and taxable did not redress a tort like personal
injury within the meaning of section 104(a)(2), and failed to
compensate plaintiffs for “any of the other traditional harms
associated with personal injury, such as pain and suffering,
emotional distress, harm to reputation, or other consequential
damages (e.g., a ruined credit rating).”19
The Supreme Court extended this analysis in Commissioner v.
Schleier,20 holding that an award of backpay and liquidated damages
received in settlement of a claim brought under the Age
Discrimination in Employment Act of 1967 was not excluded under
section 104(a)(2). In reaching this conclusion, the Court
announced two independent requirements that must be met for an
amount to be excluded from taxation under section 104(a)(2):
“[f]irst, the taxpayer must demonstrate that the underlying cause
18
Id. at 234-37. Congress amended section 104(a)(2) in 1996 to limit its
application to amounts received for personal physical injuries or sickness. See
Small Business Job Protection Act of 1996, Pub L. 104-188, § 1605(a), 110 Stat.
1838; Forste v. Comm’r, T.C. Memo 2003-103 (“Before Congress amended section
104(a)(2) in 1996 to limit the exclusion to amounts received for physical
personal injuries, the U.S. Supreme Court interpreted section 104(a)(2) to
encompass harms both tangible and intangible, both physical and nonphysical.”).
19
Id. at 239.
20
515 U.S. 323 (1995).
7
of action giving rise to the recovery is based upon tort or tort
type rights; and second, the taxpayer must show that the damages
were received on account of personal injuries or sickness.”21 The
Court emphasized the independent nature of these two inquiries,
noting that “[t]he regulatory requirement that the amount be
received in a tort type action is not a substitute for the
statutory requirement that the amount be received ‘on account of
personal injuries or sickness’; it is an additional requirement.”22
In United States v. O’Gilvie,23 the Supreme Court applied this
test and held that punitive damages received in connection with a
wrongful death recovery were not excluded from taxation under
section 104(a)(2). The Court found that the punitive damages in
question satisfied the first prong of the test because they had
been received in an “ordinary suit for personal injuries.”24 Moving
to the second prong, the Court observed that punitive damages could
be excluded from taxation under section 104(a)(2) only if they were
received “on account of” the personal injuries. Noting that the
“phrase ‘on account of’ does not unambiguously define itself,” the
Court proceeded to examine it.25
21
Id. at 337 (internal quotation marks omitted) (emphasis added).
22
Id. at 333.
23
519 U.S. 79 (1996).
24
Id. at 82 (internal quotation marks omitted).
25
Id.
8
The Court began its analysis by setting forth two competing
interpretations of the phrase “on account of”:
On one linguistic interpretation of those words, that of
petitioners, they require no more than a “but-for”
connection between “any” damages and a lawsuit for
personal injuries. They would thereby bring virtually
all personal injury lawsuit damages within the scope of
the provision, since: “but for the personal injury, there
would be no lawsuit, and but for the lawsuit, there would
be no damages.” On the Government’s alternative
interpretation, however, those words impose a stronger
causal connection, making the provision applicable only
to those personal injury lawsuit damages that were
awarded by reason of, or because of, the personal
injuries. To put the matter more specifically, they
would make the section inapplicable to punitive damages,
where those damages “‘are not compensation for injury
[but] [i]nstead . . . are private fines levied by civil
juries to punish reprehensible conduct and to deter its
future occurrence.’”26
The Court then adopted the Government’s proposed interpretation,
noting that it “gives the phrase ‘on account of’ a meaning more
consistent with the dictionary definition.”27 The Court also found
this interpretation consistent with its holding in Schleier that
liquidated damages received under the ADEA are not excluded from
taxation under section 104(a)(2) because they are not “designed to
compensate ADEA victims [but instead are] punitive in nature.”28
The Court found the similarity between liquidated damages under the
ADEA and punitive damages striking, observing that punitive damages
26
Id. at 82-83 (quoting Int’l Brotherhood of Elec. Workers v. Foust, 442
U.S. 42, 48 (1979) (quoting Gertz v. Robert Welch, Inc., 418 U.S. 323, 350 (1974)
(footnote omitted))).
27
Id. at 83.
28
Id. at 84 (internal quotation marks and citations omitted).
9
constitute an element of damages designed not to compensate tort
victims, but to punish tortfeasors.29
Turning to the history of section 104(a)(2) and the “tax-
related purpose that the history reveals,” the Court identified
pronouncements made by all three branches of the federal government
indicating that amounts received as restoration or replacement of
capital should not be taxed.30 Based on this history and the policy
it reflected, the Court concluded that “there is no strong reason
for trying to interpret the statute’s language to reach beyond
those damages that, making up for a loss, seek to make a victim
whole, or, speaking very loosely, ‘return the victim’s personal or
29
Id.
30
Specifically, the Court cited to two of its cases addressing the tax
implications of capital conversions, an opinion by the Attorney General, a
Treasury Decision, and legislative materials. See Doyle v. Mitchell Bros. Co.,
247 U.S. 179, 185 (1918) (“‘Income may be defined as the gain derived from
capital, from labor, or from both combined.’ Understanding the term in this
natural and obvious sense, it cannot be said that a conversion of capital assets
invariably produces income.” (quoting Stratton’s Independence v. Howbert, 231
U.S. 399, 415 (1913))); S. Pac. Co. v. Lowe, 247 U.S. 330, 335 (1918) (“We must
reject in this case, as we have rejected in cases arising under the Corporation
Excise Tax Act of 1909, the broad contention submitted in behalf of the
government that all receipts – everything that comes in – are income within the
proper definition of the term ‘gross income,’ and that the entire proceeds of the
conversion of capital assets, in whatever form and under whatever circumstances
accomplished, should be treated as gross income.” (citations omitted)); 31 Op.
Att’y. Gen. 304, 308 (1918) (“[T]he proceeds of an accident insurance policy are
not ‘gains or profits and income’ . . . in a broad, natural sense the proceeds
of the policy do but substitute, so far as they go, capital which is the source
of future periodical income. They merely take the place of capital in human
ability which was destroyed by the accident. They are therefore ‘capital’ as
distinguished from ‘income’ receipts.” ); T.D. 2747, 20 Treas. Dec. Int. Rev. 457
(1918) (noting that “upon similar principles . . . an amount received by an
individual as the result of a suit or compromise for personal injuries sustained
by him through accident is not income [that is] taxable . . . ”); Revenue Act of
1918, ch. 18, § 213(b)(6), 40 Stat. 1066 (excluding from income “[a]mounts
received, through accident or health insurance or under workmen’s compensation
acts, as compensation for personal injuries or sickness, plus the amount of any
damages received whether by suit or agreement on account of such injuries or
sickness”).
10
financial capital.’”31
Finally, the Court queried why Congress might have wanted to
exclude punitive damages from taxation, and found no satisfactory
answer. The Court observed that punitive damages “are not a
substitute for any normally untaxed personal (or financial)
quality, good, or ‘asset[,]’ [and] do not compensate for any kind
of loss.”32 In addition, the Court found that the “statute’s
language does not require, or strongly suggest, their exclusion
from income.”33
Taken together, Burke, Schleier, and O’Gilvie provide that, to
be excluded from taxation under section 104(a)(2), an amount must
be received in an action seeking recovery for tort or tort type
rights, and must constitute damages received “on account of”
personal injury. In addition, O’Gilvie indicates that, in order to
constitute damages received “on account of” personal injury, an
amount must be awarded “by reason of” or “because of” personal
injury, and must compensate a victim for the loss of personal or
financial capital.
31
O’Gilvie, 519 U.S. at 86. The Court conceded that the exclusion for
damages that substitute for lost wages goes beyond “what one might expect a
purely tax-policy-related ‘human capital’ rationale to justify.” Id. The Court
concluded, however, that the statute’s failure to separate damages compensating
for lost wages from those compensating for lost human capital “does not change
its original focus upon damages that restore a loss, that seek to make a victim
whole, with a tax-equality objective providing an important part of, even if not
the entirety of, the statute’s rationale.” Id.
32
Id. at 86-87.
33
Id. at 87.
11
B
We now turn to the question of whether prejudgment interest is
excluded from taxation under section 104(a)(2). We begin by
applying the test articulated in Schleier. The Chamberlains
clearly meet the first prong of the Schleier test given that the
underlying cause of action giving rise to their recovery of
prejudgment interest was based upon tort type rights.
Specifically, they sought damages for personal injuries suffered by
their son due to the negligence of the State of Louisiana.
The more difficult question is whether, under the second
prong, prejudgment interest is received “on account of” personal
injury. Neither our court nor the Supreme Court has addressed this
precise issue. However, three of our sister circuits have held
that prejudgment interest is not received “on account of” personal
injury, and therefore fails to qualify for the section 104(a)(2)
exclusion. We examine the reasoning set forth in each of these
cases in turn.
1
The Tenth Circuit was the first circuit court to address the
taxability of prejudgment interest received in a personal injury
suit, holding in Brabson v. United States that section 104(a)(2)
does not exclude such interest from federal income tax.34 In
34
73 F.3d 1040 (10th Cir. 1996). Brabson was decided roughly ten months
before O’Gilvie. Thus, the Tenth Circuit’s discussion of Supreme Court precedent
was necessarily limited to consideration of Burke and Schleier.
12
reaching this conclusion, the Tenth Circuit first observed that the
United States Tax Court had held in Kovacs v. Commissioner35 that
prejudgment interest awarded in a personal injury suit was taxable.
The Tenth Circuit then noted that “[t]he Tax Court’s subsequent
decisions, relying on Kovacs, consistently have held that
prejudgment interest is taxable, regardless of how the state
characterizes its prejudgment interest statute or whether the final
disposition is judgment or settlement.”36
The Tenth Circuit next applied the test articulated in
Schleier, finding that prejudgment interest received in a personal
injury tort suit satisfies the first prong of the test. The court
then began its analysis of the second prong by looking to Colorado
law to ascertain the nature of the prejudgment interest at issue.
After examining relevant case law, the court concluded that, under
Colorado law, prejudgment interest constitutes damages which
“compensate the injured victim for the lost time value of money.”37
The court then narrowed its inquiry to whether compensation
35
100 T.C. 124 (1993), aff’d without published opinion, 25 F.3d 1048 (6th
Cir. 1994).
36
Brabson, 73 F.3d at 1042-43 (citing Burns v. Comm’r, T.C. Memo 1994-284;
Robinson v. Comm’r, 102 T.C. 116, 1994 WL 26303 (1994), aff’d in part and rev’d
in part, 70 F.3d 34 (5th Cir. 1995); Delaney v. Comm’r, T.C. Memo 1995-378,
aff’d, 99 F.3d 20 (1st Cir. 1996); Forest v. Comm’r, T.C. Memo 1995-377, aff’d,
104 F.3d 348 (1st Cir. 1996)). The Tax Court has continued this trend of
affirming its holding in Kovacs following Brabson. See, e.g., Gregg v. Comm’r,
T.C. Memo 2001-245; Quantum Co. Trust v. Comm’r, T.C. Memo 2000-149; Rozpad v.
Comm’r, T.C. Memo 1997-528, aff’d, 154 F.3d 1 (1st Cir. 1998); Bagley v. Comm’r,
105 T.C. 396, 1995 WL 730447 (1995), aff’d, 121 F.3d 393 (8th Cir. 1997).
37
Brabson, 73 F.3d at 1044.
13
for lost time value of money is excludable under § 104(a)(2).38 To
answer this query, the Tenth Circuit looked first to the language
of section 104(a)(2), its legislative history, and the relevant
Treasury Regulations all without definitive result. The court then
examined three factors that militated against the exclusion of
prejudgment interest. First, the court noted that prejudgment
interest is not a traditional remedy for personal injury, and
therefore was not a part of Congress’ original understanding of
damages awarded on account of personal injuries.39 Second, the
court found that Schleier emphasized the necessity of a “direct
link between the injury and the [excludable] remedial relief.”40
Noting that prejudgment interest is “compensation for the lost time
value of money . . . caused by the delay in attaining judgment,”
the court found that “prejudgment interest is not linked to the
injury in the same direct way as traditional tort remedies.”41
Third, the court found that the default rule requiring that
exclusions to gross income be construed narrowly mandated a finding
that prejudgment interest was taxable in the absence of clear
38
Id.
39
Id. at 1046 (“Prejudgment interest was rarely available under the common
law, and never for personal injuries. Thus prejudgment interest, when awarded
at all, generally compensated for pecuniary harms, most often easily determinable
contractual ones.” (citations omitted)).
40
Id at 1047.
41
Id.
14
guidance to the contrary.42
The taxability of prejudgment interest was next considered by
the First Circuit in Rozpad v. Commissioner.43 Building upon the
reasoning in Brabson, the First Circuit concluded that prejudgment
interest received as part of a personal injury recovery awarded
under Rhode Island law is neither “damages,” nor awarded “on
account of” personal injury. The court first found that the
prejudgment interest at issue did not constitute “damages” within
the meaning of section 104(a)(2) because, under Rhode Island law,
prejudgment interest is available in all civil cases, and therefore
constitutes an incident attached to the damage award after the fact
to compensate plaintiffs for “a delay in payment.”44 Second, the
court found that prejudgment interest is not received “on account
of personal” injury because personal injury does not cause the
delay in payment. Rather, “the injury causes damages, thus
creating the fund on which interest for delay in payment is owed.”45
Finding no direct link between a personal injury and the award of
prejudgment interest, the court concluded that “prejudgment
interest is inextricably intertwined with the very delay that
severs the connection between prejudgment interest and the
42
Id.
43
154 F.3d 1 (1st Cir. 1998).
44
Id. at 6.
45
Id.
15
underlying personal injury.”46
Finally, the taxability of “delay damages” awarded under
Pennsylvania law was addressed by the Third Circuit in Francisco v.
United States.47 The court began its analysis by observing that
“[t]he principle underlying § 104(a)(2) is known as the ‘human
capital’ rationale.”48 The court found that this rationale limited
the application of section 104(a)(2) to “those damages that, making
up for a loss, seek to make a victim whole, or, speaking very
loosely, ‘return the victim’s personal or financial capital.’”49
The court then determined that “delay damages” received under
Pennsylvania law are equivalent to prejudgment interest, awarded
“to remedy the time value of [plaintiff’s recovery] lost during the
period preceding judgment.”50
Turning to the application of section 104(a)(2) to delay
damages, the court examined in detail the reasoning in Brabson and
Rozpad. The court then applied Brabson and Rozpad, finding first
that prejudgment interest awards in personal injury lawsuits lacked
46
Id. at 7 (emphasis added). The First Circuit also recited as
justification for its decision three “indicia” set forth in Brabson: (1)
prejudgment interest is not a traditional remedy for personal injuries; (2)
prejudgment interest was not typically available at common law in personal injury
cases at the time the section 104(a)(2) exclusion was created, and (3) there is
no “direct link” between personal injury and prejudgment interest. Id. at 6-7.
47
267 F.3d 303 (2001).
48
Id. at 307.
49
Id. (quoting O’Gilvie, 519 U.S. at 86) (internal quotation marks
omitted).
50
Id. at 310.
16
“any basis in common law,” and were not intended by Congress to be
excluded from taxation under section 104(a)(2).51 The court next
found that prejudgment interest “serves to indemnify the plaintiff
for the money he would have earned on his award if he had promptly
received it[,]”52 thereby serving to “compensate the plaintiff for
the delay in payment of the principal.”53 As such, prejudgment
interest fails to fit within the “human capital” rationale
underlying section 104(a)(2). Specifically, the court found that
prejudgment interest is not awarded on account of personal injury
because it “compensate[s] for the additional economic harm – as
opposed to the injury itself – caused by the deprivation over a
period of time of the underlying remedy.”54 Finally, the court
noted that prejudgment interest, although compensatory in nature,
does not compensate plaintiffs for any of the traditional harms
associated with personal injury. Rather, it compensates plaintiffs
for an economic harm that is normally taxable, and that does not
substitute for a normally untaxed quality, good or asset.55
2
51
Id. at 315.
52
Id. (internal quotation marks and citation omitted).
53
Id. at 316.
54
Id. at 315-16.
55
Id. at 317 (“Because compensation for economic harm in the form of
interest is usually taxable and thus is not a substitute for any normally untaxed
personal (or financial) qualify, good, or asset, we see no reason why either the
statutory text of § 104(a)(2) or its rationale would support exempting delay
damages from income.” (internal quotation marks and citation omitted)).
17
The Chamberlains urge us to dismiss Brabson and its progeny as
a jurisprudential “leap in the dark.” They argue that the clear
language of section 104(a)(2) as interpreted by the Supreme Court
mandates the exclusion of a broad range of compensatory damages,
including prejudgment interest awarded to compensate parties for
loss occurring “because of” personal injury. Relatedly, they
contend that, under Louisiana law, prejudgment interest constitutes
part of the reparation or compensatory damages which serve to “make
whole” an injured party, thus bringing it squarely within the
section 104(a)(2) exclusion. These arguments fail to persuade us
to reject the considered opinions of our sister circuits. Several
reasons inform this conclusion.
First, we agree with our sister circuits that prejudgment
interest lacks the direct relationship to personal injury necessary
to meet the second prong of the Schleier test as described by
O’Gilvie. In O’Gilvie, the Supreme Court found that, in order to
be excluded under section 104(a)(2), an amount of damages must have
more than a “but-for” connection to personal injury; it must be
awarded “by reason of” or “because of” the personal injury.56 This
observation points up the fact that damages are not excluded from
taxation under section 104(a)(2) solely by virtue of having been
awarded in a personal injury lawsuit. A closer relationship to the
injury itself is required.
56
O’Gilvie, 519 U.S. at 82-83.
18
This relationship is described in O’Gilvie as compensatory and
restorative in nature. Namely, excluded damages are those that
compensate an injured party for her personal injuries by restoring
her “personal or financial capital.”57 In addition, this exclusion
is motivated in part by a “tax-equality objective” whereby damages
that substitute for otherwise untaxed personal qualities, goods or
assets are excluded.58 For example, an individual’s physical health
is, in itself, an untaxable human “asset.” When this asset is
wrongfully converted by a tortfeasor, damages paid to compensate an
individual for this harm are exempt from taxation because they
serve to replace otherwise untaxable “human capital.”
Unlike damages paid to compensate an individual for the loss
of normally untaxed human or financial capital, prejudgment
interest compensates an individual for his lost time value of
money.59 Under Louisiana law, were a tortfeasor to pay compensatory
damages immediately upon demand, prejudgment interest would not
57
Id. at 86.
58
Id. at 86-87.
59
See Virginia v. United States, 479 U.S. 305, 310 n.2 (1987)
(“Prejudgment interest serves to compensate for the loss of use of money due as
damages from the time the claim accrues until judgment is entered, thereby
achieving full compensation for the injury those damages are intended to
redress.”); Gore, Inc. v. Glickman, 137 F.3d 863, 868 (5th Cir. 1998)
(“Prejudgment interest, like any other interest, is to compensate one for the
time value of money.” (citing Brabson, 73 F.3d at 1044; Motion Picture Ass’n of
Am., Inc. v. Oman, 969 F.2d 1154, 1157 (D.C. Cir. 1992); In re Cont’l Ill. Sec.
Litigation, 962 F.2d 566, 571 (7th Cir. 1992)).
19
accrue.60 It is only when an injured party suffers a delay in
payment in addition to a personal injury that he will be entitled
to prejudgment interest. Thus, prejudgment interest is more
naturally associated with an injured party’s opportunity cost for
the lost use of funds than it is with his lost human or financial
capital. Furthermore, were an injured party who received payment
of compensatory damages immediately upon demand to invest those
funds and receive a fixed rate of return, the interest earned on
those funds would be fully taxable.61 Although not completely
analogous to interest earned through the voluntary investment of
monies within one’s possession, prejudgment interest serves the
function of giving the injured party the benefit of the time value
of a money award retained for a period of time by a tortfeasor.62
60
See LA. REV. STAT. ANN. § 13:4203 (West 1991) (“Legal interest attaches
from [the] date of judicial demand, on all judgments, sounding in damages, ‘ex
delicto’, which may be rendered by any of the courts.”).
61
See I.R.C. § 61(a)(4) (West 2002) (specifically providing that
“interest” is taxable as gross income); Comm’r v. Glenshaw Glass Co., 348 U.S.
426, 430 (1955) (characterizing taxable income as, inter alia, “gain derived from
capital, from labor, or from both combined.” (quoting Eisner v. Macomber, 252
U.S. 189, 207 (1920) (emphasis added)); United States v. Smith, 890 F.2d 711, 715
(5th Cir. 1989) (stating that monies received as a return of invested capital are
non-taxable); Cagle v. Comm’r, 539 F.2d 409, 413 (5th Cir. 1976) (“To the extent
a partner’s compensation was considered a return of his own capital, that partner
received no taxable income.”); Durkee v. Comm’r, 162 F.2d 184, 186 (6th Cir.
1947) (“It is settled that since profits from business are taxable, a sum
received in settlement of litigation based upon a loss of profits is likewise
taxable; but where the settlement represents damages for lost capital rather than
for lost profits the money received is a return of capital and not taxable.”);
see also Lukhard v. Reed, 481 U.S. 368, 387 (1987) (Powell, J., dissenting) (“In
Glenshaw Glass, the Court observed that ‘[d]amages for personal injury are by
definition compensatory only,’ and cited “[t]he long history of departmental
rulings holding personal injury recoveries nontaxable on the theory that they
roughly correspond to a return of capital . . . .” (citations omitted)).
62
See Francisco, 267 F.3d at 315-16.
20
Thus, the tax-equality objective underpinning section 104(a)(2)
counsels against excluding prejudgment interest.
Second, we note that prejudgment interest is not awarded as a
substitute for lost human or financial capital. We have explicitly
found that the “concept of a return of human capital lost through
injury continues to support the [section 104(a)(2)] exclusion.”63
The human capital rationale holds that the “recipient of personal
injury damages is in effect forced to sell some part of her
physical or emotional well-being in return for money.”64 This
rationale militates against excluding prejudgment interest, which
serves to compensate an injured party for the purely economic harm
of lost time value of money.
Third, we can find no significant difference between
prejudgment interest in Louisiana and the prejudgment interest
found taxable in Brabson, Rozpad and Francisco.65 The Chamberlains
make much of the fact that, under Louisiana law, prejudgment
interest is deemed compensatory in nature. To be sure, unlike some
common law states, which view prejudgment interest as serving a
63
Dotson v. United States, 87 F.3d 682, 685 (5th Cir. 1996).
64
Id.
65
We recognize that when dealing with questions regarding the taxability
of income under the Internal Revenue Code, it is well-established that “[s]tate
law creates legal interests and rights,” while federal law “designate[s] what
interests or rights, so created, shall be taxed.” Morgan v. Comm’r, 309 U.S. 78,
80 (1940); see also United States v. Irvine, 511 U.S. 224, 238 (1994); United
States v. Mitchell, 403 U.S. 190, 197 (1971); United States v. Bess, 357 U.S. 51,
55 (1958); Lyeth v. Hoey, 305 U.S. 188, 194 (1938). We address Louisiana law
here solely for the purpose of elucidating the nature of the Chamberlains’
prejudgment interest award, which in turn informs whether it was received “on
account of” personal injury.
21
punitive function, prejudgment interest in Louisiana is viewed as
a form of reparation. This fact was neatly summarized by the
Louisiana Supreme Court in Trans-Global Alloy, Ltd. v. First
National Bank of Jefferson Parish:
The defendant urges us to follow the practice of those
jurisdictions which allow prejudgment interest only when
the amount in controversy is either liquidated or is
readily ascertainable by simple computation. That
practice is reflective of the common law view of interest
as punitive in nature. According to that view, when
damages are reasonably ascertainable, the defendant can
determine what his liability might be, and stop the
accrual of interest by paying the claim; when the damages
are uncertain, however, the defendant cannot determine
the extent of his liability prior to trial, and it would
be unjust to penalize him for failure to pay the damages
before judgment. Under civil law doctrine, however,
damages are viewed as reparation for the loss suffered by
the creditor, and not as a penalty imposed on the
debtor.66
Because prejudgment interest is viewed as reparation under
Louisiana law, the Chamberlains contend that it should be
classified as part of the “broad range of damages” excluded under
section 104(a)(2).67 This argument assumes that prejudgment
interest must be excluded because it is awarded as part of an
injured party’s compensatory damages. Although it is true that,
under Louisiana law, prejudgment is compensatory in nature, its
taxability turns on whether it compensates an injured party for his
or her personal injury. Louisiana law provides a clear answer to
66
583 So.2d 443, 457 (La. 1991) (emphasis added).
67
See Burke, 504 U.S. at 234-35 (noting that § 104(a)(2) applies to awards
received from suits based on tort type rights; that remedial principles figure
prominently in torts; and that one of the hallmarks of tort liability is the
availability of a broad range of damages to compensate the plaintiff).
22
this query: like the interest found taxable in Brabson, Rozpad and
Francisco, prejudgment interest awarded under Louisiana law
compensates an injured party for lost time value of money.68
Accordingly, prejudgment interest awarded under Louisiana law is
not excluded from taxation under section 104(a)(2) by virtue of its
status as reparation or compensatory damages because it does not
repair or compensate for personal injury.
The Chamberlains also point out that, under Louisiana law,
prejudgment interest was recognized as part of a plaintiff’s
reparation for personal injury long before the predecessor to
section 104(a)(2) was enacted.69 While Louisiana’s long history of
recognizing prejudgment interest as reparation damages is
undisputed, it is also true that such interest has historically
been awarded on account of delay in payment.70 Because Congress
68
See, e.g., Corbello v. Iowa Prod., 850 So.2d 686, 706 (La. 2003)
(“Prejudgment interest, which stems from the damages suffered by the victorious
party, is meant to fully compensate the injured party for the use of funds to
which he is entitled but does not enjoy because the defendant has maintained
control over the funds during the pendency of the action.” (quoting Sharbono v.
Steve Land & Son Loggers, 696 So.2d 1382, 1386 (La. 1997))); Hall v. Brookshire
Brothers, Ltd., 848 So.2d 559, 574 n.7 (La. 2003) (“In tort actions generally,
legal interest attaches from the date of judicial demand. Such an award of legal
interest is designed to compensate a plaintiff for his loss of the use of money
to which he is entitled, the use of which the defendant had during the pendency
of the litigation.”); Sharbono, 696 So.2d at 1388 (“In other words, in cases ex
delicto and ex contractu, ‘prejudgment interest’ is awarded to make an injured
party whole by compensating that party for the time-value of money to which that
party was entitled from the date set by the legislature, but over which the
defendant, in retrospect, had wrongfully continued to exercise dominion and
control while the suit was pending.”).
69
See Holmes v. Barclay, 4 La. Ann. 64 (La. 1849) (interest allowed as
part of damages).
70
See Ventrilla v. Tortorice, 107 So. 390, 393 (1926) (“[L]egal interest
which attaches to a judgment for damages ex delicto ‘from date of judicial
demand’ is due for delay in the performance of an obligation to pay money; in
23
intended section 104(a)(2) to exclude amounts received on account
of personal injury, amounts received on account of delay in payment
as reparation for lost time value of money are taxable regardless
of their historical pedigree.
A fourth and final consideration compelling us to agree with
the holdings of our sister circuits is the well-established rule
that exclusions from income are to be construed narrowly.71 We have
recognized that this is a “default rule” which applies in the
absence of a showing that an amount is encompassed within a
specific exclusion.72 Here, the Chamberlains have failed to show
that prejudgment interest received under Louisiana law is excluded
under section 104(a)(2). Thus, by default such interest is not
excluded.
III
Based upon the legal arguments presented in this case, we find
no compelling reason to depart from the path carved out by our
sister circuits. Moreover, we find the reasoning of our sister
circuits to be sound and in conformity with the language and
purpose of § 104(a)(2) as interpreted and articulated by the
Supreme Court. Accordingly, we hold that prejudgment interest
other words, for delay in paying a moneyed debt.”).
71
See, e.g., Martin v. United States, 159 F.3d 932, 934 (5th Cir. 1998);
Lubart v. Comm’r, 154 F.3d 539, 542 (5th Cir. 1998) (same); Gajda v. Comm’r, 158
F.3d 802, 805 (5th Cir. 1998) (same).
72
See Martin, 159 F.3d at 934; Julius M. Israel Lodge of B’nai B’rith No.
2113 v. Comm’r, 98 F.3d 190, 191 (5th Cir. 1996).
24
awarded under Louisiana law in a personal injury suit is not
excluded from taxation under § 104(a)(2). The judgment of the
district court is AFFIRMED.
25