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Abstract

Shortly after the income tax became a permanent part of the federal tax landscape in 1913, Congress added a provision to the Internal Revenue Code allowing taxpayers to exclude from income “any damages” received “on account of personal injury or sickness.” Since its enactment, § 104(a)(2) has been the subject of intense scrutiny and constant litigation. Part II of this article reviews the history of the personal injury exclusion. It finds that, at its inception, the exclusion actually constituted two separate exclusions: a statutory exclusion for physical injuries and a nonstatutory exclusion for nonphysical injuries. It examines the policy rationale for both exclusions and determines that each resulted from a questionable use of precedent by early tax policymakers. Eventually, the two exclusions were merged, first by the courts and then by Congress, as a result of the 1989 amendment. This historical review leads to two conclusions. First, if Congress, by amending § 104(a)(2), is stating that the exclusion never was intended to apply to nonphysical injuries, despite the 1989 amendment, then Congress’s position is correct and both the Service and the courts should reject the extension of § 104(a)(2) to nonphysical injuries in all preenactment cases. Second, and more importantly, history reveals that the original justification for the physical injury exclusion was seriously flawed and should have been rejected by both Congress and the courts. Part III then examines amended § 104(a)(2) and questions whether Congress’s decision to draw a line between physical and nonphysical injuries and sickness can be applied sensibly. Congress’s attempt to provide a limited exclusion for the nonphysical injury of emotional distress creates serious interpretive difficulties that courts are likely to wrestle with in the near future. Part IV asks the question Did Congress go far enough? It reviews human capital theory and its recent metamorphosis and suggests that this theory remains a suspect foundation for the personal injury exclusion. Consequently, Part IV concludes that Congress was wrong; the only appropriate congressional action with respect to § 104(a)(2) was repeal.

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