Hemelt v. United States ( 1997 )

PUBLISHED
UNITED STATES COURT OF APPEALS
FOR THE FOURTH CIRCUIT
GEORGE J. HEMELT; THERESA G.
HEMELT,
Plaintiffs-Appellants,
No. 96-2827
v.
UNITED STATES OF AMERICA,
Defendant-Appellee.
WILLIAM W. SCHELL; LAVERNE C.
SCHELL,
Plaintiffs-Appellants,
No. 96-2828
v.
UNITED STATES OF AMERICA,
Defendant-Appellee.
Appeals from the United States District Court
for the District of Maryland, at Baltimore.
Andre M. Davis, District Judge.
(CA-94-2490-AMD, CA-95-3978-AMD)
Argued: July 9, 1997
Decided: August 7, 1997
Before WILKINSON, Chief Judge, LUTTIG, Circuit Judge,
and BOYLE, United States District Judge for the
Eastern District of North Carolina, sitting by designation.
_________________________________________________________________
Affirmed by published opinion. Chief Judge Wilkinson wrote the
opinion, in which Judge Luttig and Judge Boyle joined.
COUNSEL
ARGUED: Stephen Liddon Hester, Washington, D.C., for Appel-
lants. Kenneth W. Rosenberg, Tax Division, UNITED STATES
DEPARTMENT OF JUSTICE, Washington, D.C., for Appellee. ON
BRIEF: K. Peter Schmidt, ARNOLD & PORTER, Washington,
D.C., for Appellants. Loretta C. Argrett, Assistant Attorney General,
Kenneth L. Greene, Lynne A. Battaglia, United States Attorney, Tax
Division, UNITED STATES DEPARTMENT OF JUSTICE, Wash-
ington, D.C., for Appellee.
_________________________________________________________________
OPINION
WILKINSON, Chief Judge:
George Hemelt, William Schell and their spouses brought actions
seeking to recover federal income and FICA taxes withheld from their
portions of a settlement in a class-action ERISA lawsuit. The district
court denied both claims, ruling that the settlement proceeds did not
fall within the Internal Revenue Code's exception for "damages
received . . . on account of personal injuries or sickness," I.R.C.
§ 104(a)(2), and that they were "wages" subject to FICA taxation.
Taxpayers' challenges to these rulings are without merit. In
Mertens v. Hewitt Associates, 508 U.S. 248 (1993), the Supreme
Court held that ERISA section 502(a)(3) cannot be the source of the
sort of compensatory damages excluded from income by section
104(a)(2). As a result, and in light of FICA's broad definition of
"wages" and the close relationship between the settlement awards and
taxpayers' employment with Continental, the claims for FICA refunds
must also fail. Accordingly, we affirm the judgment of the district
court.
I.
In 1983, a class of employees laid off by Continental Can Com-
pany filed suit against their former employer under section 502 of the
Employee Retirement Income Security Act of 1974 (ERISA), 29
2
U.S.C. § 1132. Plaintiffs alleged that Continental fired them to avoid
incurring liability for their pensions in violation of section 510 of
ERISA, 29 U.S.C. § 1140. McLendon v. Continental Group, Inc., 660
F. Supp. 1553, 1556 (D.N.J. 1987), aff'd, 908 F.2d 1171 (3d Cir.
1990). The district court in McLendon granted partial summary judg-
ment to the plaintiffs on the issue of Continental's liability for violat-
ing ERISA. 660 F. Supp. at 1564-65. To facilitate settlement of the
outstanding damages issues, the court appointed a Special Master.
McLendon, 749 F. Supp. 582, 612 (D.N.J. 1989), aff'd, 908 F.2d 1171
(3d Cir. 1990).
With the assistance of the Special Master, the parties to the class
action negotiated a Settlement and Plan of Distribution that required
Continental to pay a total of $415 million to approximately five thou-
sand former employees. McLendon, 802 F. Supp. 1216, 1220-21
(D.N.J. 1992). The Special Master concluded that individualized
determinations of the losses suffered by each class member would be
too difficult and time-consuming. Thus, to allocate the $415 million,
the Master devised formulas for two categories of recovery: the Basic
Award and the Earnings Impairment Additur. The Basic Award was
determined by factoring together each class member's age and years
of service as of the time he was laid off. The Earnings Impairment
Additur sought to approximate lost earnings capacity by comparing
each class member's earnings after leaving Continental to the amount
that class member would have earned at Continental had he not been
laid off. Every member of the class received some amount as a Basic
Award, and most members also received an Earnings Impairment
Additur.
Applying the two formulas, Mr. Hemelt received a total award of
$31,480, the combination of a $24,500 Basic Award and a $6,980
Earnings Impairment Additur. Continental withheld a portion of this
award to cover its share of FICA and FUTA taxes. Continental also
withheld federal and state income taxes and the employee's share of
FICA taxes totaling $8,083.62, making the Hemelts' net proceeds
from the settlement $20,613.09. Mr. Schell received a $58,124 Basic
Award and a $16,744 Earnings Impairment Additur for a total award
of $74,868. This amount was reduced by Continental's share of FICA
and FUTA taxes, a contribution to a qualified pension plan, and a
$15,502.20 deduction for federal and state income taxes and the
3
employee's share of FICA taxes, resulting in a net award of
$42,068.03.
In December 1993, the Hemelts and the Schells both sought
refunds of the federal income taxes and FICA taxes they had paid on
the settlement award in the 1992 tax year. They argued that since the
settlement payments aimed to compensate them for personal injuries,
including the anxiety and stress caused by their illegal layoff, the
amounts should be excluded from income for tax purposes and should
not be considered wages under FICA. The IRS disallowed the claims.
Taxpayers then sued for refunds, maintaining that the settlement
awards should be excluded from their gross income under section
104(a)(2) of the I.R.C. because they were received as settlement of
claims for personal injury damages. As such, taxpayers further con-
tended, the awards were not "wages" for the purpose of FICA taxa-
tion.
The district court determined that the settlement awards did not fit
within the section 104(a)(2) exclusion of "the amount of any damages
received (whether by suit or agreement and whether as lump sums or
as periodic payments) on account of personal injuries or sickness."
See Hemelt v. United States, 951 F. Supp. 562, 568 (D. Md. 1996).
The court found that the Supreme Court's decision in Mertens fore-
closed a ruling that the McLendon suit was an "action based upon tort
or tort type rights," which is a necessary element of the test for
excluding the awards from income under I.R.C. section 104(a)(2). 26
C.F.R. § 1.104-1(c); see also Commissioner v. Schleier, 115 S. Ct.
2159, 2167 (1995). Granting the United States' motion for summary
judgment in full, the district court also held, without discussion, that
FICA wage taxes were properly withheld from the awards. Taxpayers
now appeal.
II.
In order to claim the exemption from federal income taxation pro-
vided in I.R.C. section 104(a)(2), taxpayers seek to characterize the
awards they received as satisfaction of tort-like claims for personal
injury. The Supreme Court has squarely rejected this characterization
by interpreting section 502(a) of ERISA to provide only for equitable
relief, not for tort-like compensatory damages. Mertens, 508 U.S. at
4
258-59. Taxpayers deny that Mertens controls this case. They further
argue that the parties' and the Special Master's belief that the
McLendon settlement would provide damages for personal injuries
controls the characterization of the awards.* We reject these attempts
to avoid the Mertens decision.
A.
Taxpayers are right to insist that the tax treatment of the settlement
payments at issue in these cases turns on the nature of the claims at
issue in McLendon. What they fail to recognize is that Mertens is dis-
positive of that question.
The McLendon plaintiffs alleged that Continental's layoff practices
violated section 510 of ERISA, which makes it "unlawful for any per-
son to discharge . . . a participant . . . for the purpose of interfering
with the attainment of any right to which such participant may
become entitled under the plan." 29 U.S.C. § 1140. Thus, they sued
under section 502(a), the civil enforcement provision of ERISA. Sec-
tion 502(a) provides, in relevant part:
A civil action may be brought --
...
(3) by a participant, beneficiary, or fiduciary (A)
to enjoin any act or practice which violates any
provision of this subchapter or the terms of the
plan, or (B) to obtain other appropriate equitable
relief (i) to redress such violations or (ii) to
enforce any provisions of this subchapter or the
terms of the plan. . . .
_________________________________________________________________
*This argument swayed the Fifth Circuit to award an income tax
refund to another member of the McLendon class based on the section
104(a)(2) exclusion. Dotson v. United States , 87 F.3d 682 (5th Cir.
1996). However, like the district court, we agree with the dissenting
judge in Dotson that Supreme Court precedent dictates a contrary result.
See id. at 690 (Smith, J., dissenting).
5
29 U.S.C. § 1132(a)(3).
In Mertens the Supreme Court plainly held that personal injury
damages are not contemplated by section 502(a)(3) of ERISA, which
authorizes suits only for injunctive relief and"other appropriate
equitable relief" (emphasis added). The Court noted that compensa-
tory damages are "the classic form of legal relief," and are not tradi-
tionally denominated "equitable." 508 U.S. at 255 (citations omitted).
The Court also relied on the interpretation of virtually identical lan-
guage in Title VII of the Civil Rights Act of 1964 in United States
v. Burke, where the phrase "any other equitable relief as the court
deems appropriate" was held to limit recovery to back pay, injunc-
tions and other equitable remedies and not to allow"awards for com-
pensatory or punitive damages." Id. (citing Burke, 504 U.S. 229, 238
(1992)). The Mertens Court further concluded that an expansive inter-
pretation of section 502(a)(3) to include money damages would dis-
tort the statute by giving the term "equitable relief" "a different
meaning [in section 502(a)(3)] than it bears elsewhere in ERISA."
Mertens, 508 U.S. at 258.
By foreclosing the award of compensatory damages under ERISA
section 502(a)(3), the holding in Mertens also foreclosed any asser-
tion that the McLendon settlement falls within the 104(a)(2) exclu-
sion. The class action award fails the basic test enunciated in Schleier
for determining whether an award may fairly be characterized as per-
sonal injury damages:
First, the taxpayer must demonstrate that the underlying
cause 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."
115 S. Ct. at 2167.
The touchstone for whether a cause of action is tort-like is the
availability of compensation for the "traditional harms associated with
personal injury, such as pain and suffering, emotional distress, harm
to reputation, or other consequential damages." Id. (quoting Burke,
504 U.S. at 239). As with the ADEA claim at issue in Schleier and
6
the Title VII cause of action at issue in Burke , ERISA actions are not
designed to compensate for these intangible injuries and thus do not
involve "tort or tort type rights." Perforce the taxpayers after Mertens
are unable to satisfy "[t]he essential element of an exclusion under
section 104(a)(2) . . . that the income involved must derive from some
sort of tort claim against the payor." Threlkeld v. Commissioner, 87
T.C. 1294, 1305 (1986) (internal quotation marks omitted), aff'd, 848
F.2d 81 (6th Cir. 1988).
B.
Taxpayers assert that the Special Master and the parties in
McLendon believed all along that the Settlement Plan would award
personal injury damages to compensate for the plaintiffs' anxiety and
emotional distress, unaware that such damages were not provided for
in section 502 of ERISA. However, "the characterization of a settle-
ment cannot depend entirely on the intent of the parties." Dotson, 87
F.3d at 687. Thus the possibility that the parties and the Special Mas-
ter misapprehended the limited nature of ERISA remedies does not
alter our characterization of the awards as taxpayers assert it should.
The error of the settling parties and the Special Master was just that
-- an error that was highlighted by the Supreme Court's ruling in
Mertens.
The fact that the McLendon settlement predates the Supreme
Court's ruling in Mertens does not change our conclusion: As an
interpretation of the ERISA provision at issue in McLendon, Mertens
must direct our disposition of taxpayers' claims. When the Supreme
Court "applies a rule of federal law to the parties before it, that rule
is the controlling interpretation of federal law and must be given full
retroactive effect in all cases still open on direct review and as to all
events, regardless of whether such events predate or postdate our
announcement of the rule." Harper v. Virginia Dept. of Taxation, 509
U.S. 86, 97 (1993) (emphasis added). See also Rivers v. Roadway
Express, 511 U.S. 298, 312-13 (1994). Of course we cannot go back
in time and correct the parties' and the Special Master's misapprehen-
sion about the nature of the McLendon settlement. But today's appli-
cation of Mertens is no attempt at hindsight. We are simply giving
effect to the Supreme Court's enunciation of what ERISA means and
always has meant, notwithstanding the contrary expectations of the
7
McLendon Special Master and parties. Thus the"retroactivity" of
Mertens is not at issue here, as "[i]t is only when the law changes in
some respect that an assertion of nonretroactivity" may even be con-
sidered. James B. Beam Distilling Co. v. Georgia , 501 U.S. 529, 534
(1991).
Mertens cannot be said to have changed the law. Nor, as the district
court observed, can it be said that Mertens' interpretation of ERISA
was unforeseeable. Mertens simply confirmed the plain meaning of
the statutory reference to "other appropriate equitable relief" in sec-
tion 502(a)(3) of ERISA. And the result in Mertens was foreshad-
owed by Massachusetts Mutual Life Ins. Co. v. Russell, 473 U.S. 134
(1985). Russell focused on ERISA section 502(a)(2), which refers
generally to "appropriate relief." Even though section 502(a)(2) is not
explicitly limited to equitable relief, the Supreme Court read this sec-
tion not to authorize "extracontractual" compensatory or punitive
damages. Id. at 144. Although at the time the McLendon settlement
was finalized, in July 1992, one federal appeals court had found "ex-
tracontractual" damages (i.e., compensation for personal injury)
recoverable under section 502(a)(3), Warren v. Society Nat'l Bank,
905 F.2d 975, 982 (6th Cir. 1990), most courts of appeals, including
this one, had followed Russell and held that such claims were not
authorized by ERISA. E.g., Powell v. Chesapeake & Potomac Tel.
Co., 780 F.2d 419, 424 (4th Cir. 1985); Reinking v. Philadelphia
American Life Ins. Co., 910 F.2d 1210, 1219-20 (4th Cir. 1990);
Drinkwater v. Metropolitan Life Ins. Co., 846 F.2d 821, 825 (1st Cir.
1988); Sommers Drug Stores Co. v. Corrigan Enterprises, 793 F.2d
1456, 1462-65 (5th Cir. 1986); Davis v. Kentucky Finance Cos.
Retirement Plan, 887 F.2d 689, 696 (6th Cir. 1989); Kleinhans v.
Lisle Sav. Profit Sharing Trust, 810 F.2d 618, 626-27 (7th Cir. 1987);
Sokol v. Bernstein, 803 F.2d 532, 534-38 (9th Cir. 1986); United
Steelworkers of America v. Connors Steel Co., 855 F.2d 1499, 1509
(11th Cir. 1988). Thus the Special Master and parties in McLendon
should have known that their characterization of the settlement
awards as extracontractual compensatory damages was legally dubi-
ous.
Even without Mertens to guide our disposition of these refund
claims, we would be drawn to the same result by"the default rule of
statutory interpretation that exclusions from income must be narrowly
8
construed." Burke, 504 U.S. at 248 (Souter, J., concurring). See
United States v. Centennial Savings Bank FSB, 499 U.S. 573, 583
(1991); Commissioner v. Jacobson, 336 U.S. 28, 49 (1949). That
canon would have special force in cases like these. Taxpayers have
already received one substantial benefit to which they were not enti-
tled under law, namely the award of large sums of money for emo-
tional and intangible injuries that ERISA section 502 does not
compensate. Thus, the decision to deny them a double windfall by
denying a refund of the income taxes paid is a sound one.
III.
Taxpayers also seek a refund of their FICA taxes. They argue that,
however the ERISA settlement awards might be characterized, they
are not "wages" under FICA.
We disagree. The language in the Internal Revenue Code and the
Treasury Regulations relevant to taxpayers' FICA refund claims is
expansive, and the settlement payments fit easily within FICA's broad
definition of "wages" as "all remuneration for employment unless
specifically excepted," 26 C.F.R. § 31.3121(a)-1(b); see I.R.C.
§ 3121(a). The I.R.C. broadly defines "employment" to include "any
service, of whatever nature, performed (A) by an employee for the
person employing him," I.R.C. § 3121(b). The Supreme Court has
emphasized the inclusive nature of this definition:
The very words "any service . . . performed . . . for his
employer," . . . import breadth of coverage. They admonish
us against holding that "service" can be only productive
activity. We think that "service" as used by Congress in this
definitive phrase means not only work actually done but the
entire employer-employee relationship for which compensa-
tion is paid to the employee by the employer.
Social Security Board v. Nierotko, 327 U.S. 358, 365-66 (1946). The
ERISA claims at issue in McLendon related directly to taxpayers'
employment relationship with Continental, and thus the awards con-
stitute "remuneration for employment" within the meaning of FICA.
9
Further, we have already seen that employees suing their employer
under section 502(a)(3) of ERISA cannot recover"extracontractual"
or tort-like damages. See Mertens, supra . Instead, payments based on
section 502(a)(3) claims, like claims under Title VII and the ADEA,
are analogous to, and were designed to approximate, recovery for lost
wages and other economic harms. By holding that ERISA section
502(a)(3) only permits equitable relief, of which lost wages and other
economic harms are a major component, Mertens reinforces our con-
clusion that the settlement payments at issue here are wages.
The method used to calculate the awards here further supports the
view that the settlement payments are properly characterized as
wages. The two components of the settlement awards were based
directly on taxpayers' employment relationship with Continental; key
factors in determining the amounts of each award were the length of
each employee's tenure with Continental and the salary he received
from Continental. Thus, because the payments from Continental to
taxpayers and other class members arose out of their employment
relationship, they fit within the statutory and regulatory definition of
wages, and FICA taxes were properly withheld from the awards.
Notwithstanding the above factors, taxpayers contend that the set-
tlement payments are damages for emotional distress and thus cannot
constitute wages. The answer to this question, however, is the same
answer that we gave to taxpayers' contention that the settlement pay-
ments were emotional distress payments and thus were not taxable
income. Mertens forbids recovery under section 502 of ERISA for
emotional and intangible injuries and thus forbids the characterization
of the settlement payments that taxpayers seek. If it forbids that char-
acterization for income tax purposes, Mertens must forbid that same
characterization for FICA purposes as well.
Either the settlement payments are tort-based awards, or they are
wage-based equitable relief. It is clear that the payments must be both
income and wages, or they must be neither. They cannot be six of
one, half-dozen of the other. The Fifth Circuit majority, for example,
believed the payments were not wages because they were not income.
Dotson, 87 F.3d at 689-90; see also Rowan Cos. v. United States, 452
U.S. 247, 254-58 (1981) (tax statutes favor a consistent definition of
wages for both FICA purposes and for purposes of income tax with-
10
holding). We agree, however, with the district court that the Commis-
sioner's characterization of these payments as income was correct and
that Mertens would perforce require treatment of the payments as
wages.
Taxpayers next argue that part of the payments they received repre-
sented interest on which FICA taxes are not due and that thus they
should receive a refund of that portion of the FICA taxes they paid
on this putative interest component. Taxpayers are correct to insist
that interest payments are not generally wages for FICA purposes,
see, e.g., Rev. Rul. 80-364, 1980-2 C.B. 294 (interest awarded by
court in connection with claim for back pay is not"wages" under
FICA). But the interest component of a settlement can only be
excluded from wages for FICA purposes if it has been separately
identified. Id. (where employer paid back wages pursuant to court
order that "did not indicate that a portion of the award was attorney's
fees or interest," "the full amount of the award is . . . wages for federal
employment tax purposes") (emphasis added). See also Melani v.
Board of Higher Education, 652 F. Supp. 43, 48 (S.D.N.Y. 1986),
aff'd, 814 F.2d 653 (2d Cir. 1987). While the amount paid by Conti-
nental might have included (and earned) interest, no amount was seg-
regated from or within the settlement fund or separately identified
either in the lump sum or in the payments made to each class member.
As a result, there is no way taxpayers can identify what amount of the
awards at issue here represents interest. Thus, the attempt to shield
this component from wage taxes fails.
Taxpayers' final claim, that the payments they received should be
allocated to the years to which they are attributable and taxed at the
rate prevailing in each of those years, is also meritless. It is clear
under the Treasury Regulations that "wages" are to be taxed for FICA
purposes in the year in which they are received. See 26 C.F.R.
§ 31.3121(a)-2(a) ("In general, wages are received by an employee at
the time that they are paid by the employer to the employee."). Fur-
thermore, taxpayers have provided no evidence of how they would
have us allocate their awards among the years to which they are sup-
posedly attributable (not to mention the awards of the other five thou-
sand class members). Thus, we could not undertake such allocation
even if we were allowed to do so, and FICA taxes were properly with-
11
held from the settlement awards at the time they were paid to the tax-
payers.
IV.
For the foregoing reasons, we affirm the judgment of the district
court.
AFFIRMED
12