This weblog is not often concerned with tax law, and this is assuredly not the place to come for tax advice, but the U.S. Court of Appeals for the D.C. Circuit has issued a remarkable new decision concerning taxation of tort judgments of the sort often covered by liability insurance policies, so I will take that as an excuse to give it some attention here.
The TaxProf Blog [pointed out via Instapundit ] reports the decision in Murphy v. United States [PDF] in which, in a surprising move, the D.C. Circuit has declared unconstitutional the taxation of tort damage recoveries representing compensation for non-physical injuries unrelated to lost wages or earnings -- in this case, damages for loss of reputation and for emotional distress sustained by a "whistle blower." The court concludes that such damages are not "income" within the meaning of the 16th Amendment, so that Congress has no power to tax those damages as "income."
Although tax law is not my field, I did take a single-semester course in Federal Taxation in law school. One of the most striking things the student encounters at the outset of that subject is the Internal Revenue Code's definition of "income." You have to be able to define "income" in order to tax it, and Congress early on adopted an extra-broad definition, one that paraphrases roughly as "'income' means income . . . every imaginable kind of income and anything whatever we might characterize as income." It is the sort of definition that ought to be pronounced from out of a burning bush. (Cf. "I am that I am.") "Income" is most frequently some sort of money payment received by the taxpayer but it also includes the taxpayer's receipt of other things of value, as the celebrity community in Southern California was reminded last week when the IRS declared "income" to include award show swag.
Congress has also declared certain kinds of money flows not to be "income," and one significant exception is compensatory damages in personal injury cases. Specifically IRC section 104(a)(2) excludes from income "damages (other than punitive damages) received . . . on account of personal physical injuries or physical sickness." [Prior to 1996, the statute excluded a broader range of damages from income, because it did not include any express requirement that the injury or sickness be "physical."]
In Murphy, the plaintiff Marita Murphy was a former employee of the New York Air National Guard who successfully pursued a claim before the Department of Labor for unlawful discrimination and retaliation. That administrative proceeding resulted in an award of damages of $70,000, comprising compensation for emotional distress ($45,000) and injury to plaintiff's reputation ($25,000). Ms. Murphy duly reported the entire award as part of her "gross income" on her income tax return and paid over $20,000 in taxes on that income. She later filed suit seeking a refund of that payment, contending that her damage award should not be treated as "income."
Ms. Murphy made two contentions: First, she asserted that her damage award should fall within the exception from income for personal injury damages under section 104(a)(2); second, she argued that her damages simply were not characterizable as "income" at all under any proper definition of that term. When the case reached the D.C. Circuit, it rejected the first contention -- noting that section 104(a)(2) applies only to compensation for "physical" injuries and that while there might have been physiological consequences to her emotional distress, Ms. Murphy did not receive her damages "on account of" that physical injury -- but remarkably accepted the second.
The 16th Amendment empowered Congress only to tax "incomes." If a payment does not fall within the meaning of "incomes" in the Amendment, Congress has no power to tax it. Contrary to what it called a "breathtakingly expansive claim of congressional power," the Court emphasized that "incomes" does not include "every sort of revenue a taxpayer may receive." Murphy urged that she was not "better off" from the receipt of these damages -- they did not represent a profit or betterment of any kind, and were not a substitute for wages or other cash flows commonly viewed as "income" -- and that they should instead be viewed as a "return of capital" -- in her case "human capital." The Court essentially agreed. In the linchpin paragraph of the decision, the Court offers this reasoning:
As we have seen, it is clear from the record that the damages were awarded to make Murphy emotionally and reputationally 'whole' and not to compensate her for lost wages or taxable earnings of any kind. The emotional well-being and good reputation she enjoyed before they were diminished by her former employer were not taxable as income. Under this analysis, therefore, the compensation she received in lieu of what she lost cannot be considered income and, hence, it would appear the Sixteenth Amendment does not empower the Congress to tax her award.
Q.E.D., emotional distress and reputation damages are non-taxable.
ELSEWHERE: Unsurprisingly, there is at least some skepticism among knowledgeable tax law specialists concerning the soundness of the Court's logic here. Orin Kerr suggests that the invocation of constitutional limits on Congressional power in the ruling makes it a likely candidate for en banc review in the D.C. Circuit, or for consideration by the U.S. Supreme Court. Professor Bainbridge, meanwhile, sees the decision as fresh fodder for the denizens of the Tax Protester demimonde.
Attentive readers will note a California connection to this case: although the opinion is authored by Chief Judge (and one-time Supreme Court nominee) Douglas H. Ginsburg, the panel also includes former California Supreme Court Justice Janice Rogers Brown.