Fabry v. Comm'r Internal Revenue

• Decision Date: 21 August 2000
• Docket Number: No. 99-12407,99-12407
• Citation: 223 F.3d 1261
• Parties: (11th Cir. 2000) CARL J. FABRY, PATRICIA P. FABRY, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: U.S. Court of Appeals — Eleventh Circuit

Page 1261

223 F.3d 1261 (11th Cir. 2000)

CARL J. FABRY, PATRICIA P. FABRY, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 99-12407.

IN THE UNITED STATES COURT OF APPEALS FOR THE ELEVENTH CIRCUIT.

August 21, 2000.

Appeal from a Decision of the United States Tax Court

Before DUBINA, BLACK and HILL, Circuit Judges.

HILL, Circuit Judge:

This tax case presents a single issue: are damages to business reputation received in the amount of $500,000 by taxpayers in 1992¹ in settlement of their tort action for strict liability and negligence against the manufacturer of an allegedly defective product properly excludable from gross income under Internal Revenue Code (IRC) § 104(a)(2) as "damages received . . . on account of personal injuries"? Under a de novo review, based upon the following, the answer to this question is yes. The decision of the tax court is reversed.

I. FACTUAL BACKGROUND

The relevant facts are straightforward and undisputed. From 1976 to 1988, taxpayers Patsy and Carl Fabry were the successful operators of an unincorporated sole proprietorship known as Patsy's Nursery in Orange County, Florida near Orlando. They specialized in raising ornamental plants² and citrus trees. During this period of time, the nursery and the Fabry's reputation in the agricultural industry prospered. Their business grew to become that of a large-scale commercial supplier.

Good times and the Fabrys' good name suffered change in 1988 when the Fabrys began to use a chemical fungicide manufactured by E. I. du Pont de Nemours and Co. (du Pont) on their plants.³ Upon using this fungicide, their plants began to yellow, leaves were distorted, growth was stunted. Many plants died. Over the next three years, the Fabrys suffered extensive damage to their nursery stock, eventually causing them to default on contracts under which they were obligated to deliver healthy plants. Then, when previously sold plants developed defects, alleged to be fungicide-related, the death knell struck. The Fabrys' reputation as respected business persons with expertise in the production and supply of quality plants was gone.⁴ They closed the nursery in 1991.

II. PROCEDURAL BACKGROUND

A. State Court Action

The Fabrys sued du Pont in state court seeking monetary damages under tort theories of negligence and strict liability. Their complaint averred that the fungicide they had used in the nursery was contaminated and that the contamination caused damage to their plants. They sought damages for lost profits, lost going concern value and damage to their business reputation.⁵

Settlement discussions commenced almost immediately. Part of the Fabry's initial settlement demand included in part a claim for $500,000 for damages to their business reputation. The lawsuit was resolved through mediation in 1992. Du Pont paid taxpayers $3.8 million in exchange for a full release of the claims asserted in the suit. In their general release, the taxpayers released du Pont from all claims relating to their use of its fungicide in their nursery between 1988 and 1991, except, among other things, for claims for damages to crops planted in the future. Thereafter, the Fabrys filed a notice of voluntary dismissal with prejudice.

B. The Federal Court Action

On their 1992 joint federal income tax return, the Fabrys did not include in gross income the $500,000 received in settlement of their tort action against du Pont attributable to damage to their business reputation. Their rationale was that, acting in good faith, they had substantial authority and reasonable grounds for their position that the $500,000 was not taxable income under IRC § 104(a)(2). The Commissioner of the Internal Revenue Service (Commissioner) disagreed, asserting against the taxpayers a tax deficiency of $201,054, plus an accuracy penalty of $40,211. The Fabrys petitioned the tax court for a redetermination of both the deficiency and the penalty.

Following trial, the tax court, using a facts and circumstance approach, found in favor of the Commissioner.⁶ A final 1992 income tax deficiency against the taxpayers was computed to be $200,192, with a penalty of $7,088. This appeal follows.

III. STANDARD OF REVIEW

The interpretation and application by the tax court of a statutory section of the Internal Revenue Code is a question of law which we review de novo. Atlanta Athletic Club v. Commissioner, 980 F.2d 1409, 1412 (11th Cir. 1993); Gold Kist v. Commissioner, 110 F.3d 769, 771 (11th Cir. 1997).

IV. ANALYSIS

A. The Statute - Damages Received for Personal Injuries or Sickness Prior to August 21, 1996⁷

The definition of gross income under the IRC sweeps broadly. Commissioner v. Glenshaw Glass Co., 75 S. Ct. 473, 475 (1955). Section 61(a) provides that "gross income means all income from whatever source derived," subject only to the exclusions specifically enumerated elsewhere in the Code. IRC § 61(a). The settlement award in this case constitutes gross income unless it is expressly excepted by another provision. Exclusions from income are narrowly construed. See United States v. Centennial Sav. Bank FSB, 111 S. Ct. 1512, 1519 (1991).

For our purposes here, section 104(a)(2) provides that damages received pursuant to a judgment or settlement (whether as lump sums or as periodic payments) on account of personal injuries or sickness were excludable from gross income. IRC § 104(a)(2). However, neither the statute nor its legislative history offer any explanation of the term "personal injuries."⁸ See United States v. Burke, 112 S. Ct. 1867 (1992). The regulations, however, in defining the term "damages" equate the term "personal injury" to a violation of tort or tort type rights.⁹ Regs. § 1.104-1(c).

B. Inconsistent Case Law Prior to 1992¹⁰

During this period of time, yet prior to the first of three Supreme Court decisions beginning in 1992¹¹, neither the courts nor the Internal Revenue Service (IRS) appear to have been able to reach a firm consensus as to what constituted a personal injury. Significant to this case, during the 1980's, there was considerable disagreement and controversy as to whether the term "personal injuries or sickness" encompassed injury to reputation, and if it did, whether that included injury to business reputation.¹²

In Roemer v. Commissioner, 79 T.C. 398 (1982), rev'd 716 F.2d 693 (9th Cir. 1983), the taxpayer was a licensed insurance broker who filed a libel suit against a credit bureau for publishing a false credit report.¹³ The tax court found that there was a distinction between an injury to personal reputation and an injury to business reputation. Only the former was excludable under IRC § 104(a)(2). The Ninth Circuit reversed. It looked to the nature of the tort of defamation under California law and concluded that the Roemer defamation resulted in a personal injury. The court noted that injury to personal reputation by a defamatory attack should not be confused with its derivatory consequences, i.e., loss of income or loss of standing in the community. As all harm flowed from the same personal attack, all compensatory damages were held excludable, whether personal or professional. Id. at 700-01; see Rev Rul 85-143, 1985-2 C.B. 55 (I.R.S. 1985) (where the IRS stated that it would not follow the Ninth Circuit's opinion in Roemer).

Then, in 1988, case law came full circle when the tax court and the Sixth Circuit appeared to put the issue of distinction between an injury to personal reputation and an injury to business reputation to rest. In Threlkeld v. Commissioner, 87 T.C. 1294 (1986), aff'd 848 F.2d 81 (6th Cir. 1988), taxpayer settled a tort action for malicious prosecution, arising out an earlier real estate contract rescission action. The tax court recognized, and the Sixth Circuit agreed, that unreasonable distinctions between an injury to personal reputation and an injury to professional reputation had been made in the past. Id. at 83. Following the Ninth Circuit's reasoning in Roemer, the Sixth Circuit stated:

We agree with the Ninth . . . Circuit[] that the nonpersonal consequences of a personal injury, such as a loss of future income are often the most persuasive means of proving the extent of the injury that was suffered, and that the personal nature of an injury should not be defined by its effect. Injury to a person's hand or arm is a personal injury. This is so even though it may affect a person's professional pursuits.

Id. at 84. The Sixth Circuit held that because the injury to the taxpayer's reputation was a personal injury, although it affected his professional pursuits, all income in compensation of the injury was excludable under IRC § 104(a)(2). Id.

C. The Supreme Court Decisions, Beginning in 1992

Finally, in three decisions, two of which are pertinent here, the Supreme Court provided some definitive guidance as to how IRC § 104(a)(2) should be interpreted.¹⁴ In 1992, the Court would essentially define what constituted a "personal injury" under the statute by examining the concept of tort in United States v. Burke, 112 S. Ct. 1867(1992). In Commissioner v. Schleier, 115 S. Ct. 2159 (1995), the Court would set forth a two-prong test for excludability, discussed below: (1) that the wrong complained of must constitute a personal injury, and, (2) that damages received must have been received on account of such personal injury.

1. The Burke Decision

The Burke case involved whether back pay received by the taxpayer in settlement of her sex discrimination claim against the Tennessee Valley Authority (TVA) under Title VII was excludable under IRC § 104(a)(2) as "damages received . . . on account of personal injuries." Burke, 112 S. Ct. at 1868. In order to qualify for the exclusion, the Court found that the taxpayer must show that Title VII, the legal basis of her recovery for back pay, redressed a tort-like personal injury, stating further that:

For example, the victim of a physical injury may be permitted, under the...