D.C. Circuit Strikes Down as Unconstitutional the Taxation of Nonphysical Injury Awards...

A U. S. Department of Labor Administrative Law Judge awarded Marrita Murphy $45,000 for "emotional distress or mental anguish" and $25,000 for "injury to professional reputation," because the New York Air National Guard unlawfully discriminated and retaliated against Murphy. She invoked certain whistleblower statutes after complaining to state agencies about environmental hazards at the airbase where she was employed. Evidence was presented that Murphy had been "blacklisted" and suffered injuries associate with the stress she encountered such as teeth grinding, "anxiety attacks, shortness of breath, and dizziness."

Murphy included the total award in gross income on her tax return for 2000. She later amended the return and asked for refund of $20,665. She claimed that ?104(a)(2) of the Code excludes from gross income "damages ... received ... on account of personal physical injuries or physical sickness." Because her award was associated with personal physical injury, e.g., the teeth grinding, the award should not have been included in her gross income. The IRS denied the refund request and Murphy filed her complaint in federal district court. She reasserted her original argument and alternatively argued that ?104(a)(2) was unconstitutional as applied to her award because the award was not "income" under the Sixteenth Amendment. The district court rejected her claims and granted summary judgment in favor of the IRS. Murphy appealed.

The DC Circuit in Murphy v. IRS and United States, D.C. Cir. No. 05-5139 (8/22/2006), reviewed the history of ?104 (a)(2) which, since 1996, provides that "gross income [under ?61] does not include the amount of the damages (other than punitive damages) received ... on account of personal physical injuries or physical sickness." The 1996 amendment to ?104(a)(2) also provides that "emotional distress shall not be treated as a physical injury or physical sickness." Prior to 1996, ?104 excluded from gross income monies received for "personal injuries or sickness'" which included both physical and nonphysical injuries, such as emotional distress. See United States v. Burke, 504 U.S. 229, 235 n.6 (1992)

Schleier, 515 U.S. 323 (1995) found that exclusion of compensatory damages from gross income required a showing by the taxpayer that the "underlying cause of action ... [was] 'based on tort or tort type rights.'" Id. at 337. The same burden applied to a taxpayer after the 1996 amendment. The Government did not challenge Murphy's assertion that the award was "based upon...tort type rights."

As to Murphy's first argument, the Court of Appeals found that the award was compensation for "her mental distress and reputational loss," not her teeth grinding or "other physical symptoms." Thus, the award was not because of her physical personal injuries. Accordingly, ?104 (a)(2) did "not permit Murphy to exclude her award from gross income." Murphy fared much better with her constitutional argument.

Murphy's argument and the Government's counter-argument start with the Sixteenth Amendment as ratified in 1913 ("The Congress shall have power to lay and collect taxes on incomes, from whatever source derived...") and the Code as adopted shortly thereafter as well as the 1916, 1917 and 1919 amendments thereto. Their arguments rely, in part, on the legislative history (H.R. Rep. No. 65-767 at 9-10 (1918)) associated with the amendments in the Revenue Act of 1918 (40 Stat. 1057, 1057 (1919)), an Opinion of the Attorney General (31 Op. Att'y Gen. 304, 308 (1918)), and a Treasury Department Decision T.D. 2747, 20 Treas. Dec. Int. Rev. 457 (1918).

The question addressed by the Court of Appeals was, "Is compensation for emotional distress and loss of reputation within the breadth of the term "incomes" as used in the Sixteenth Amendment?" The Court answered, "No." Congress was not accorded the power "to tax as 'incomes' every sort of revenue a taxpayer may receive," citing Burk-Waggoner Oil Ass'n v. Hopkins, 269 U.S. 110, 114 (1925).

To determine whether Murphy's award was income, the Court used the Supreme Court's instructions to first consider whether the award was "a substitute for [a] normally untaxed personal...quality, good, or 'asset.'" O'Gilvie v. United States, 519 U.S. 79, 86 (1996). If so, then the award was not income under the Sixteenth Amendment since it was neither a "gain" nor an "accession to wealth." Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 430-31 (1955). The Supreme Court has long recognized "the principle that a restoration of capital i[s] not income; hence it [falls] outside the definition of "income.'" O'Gilvie, 519 U.S. at 84. The Court applied the "in lieu of test used in other circuits - "In lieu of what were the damages awarded?" The Court found that:

The emotional well-being and good reputation [Murphy] enjoyed before they were diminished by her former employer were not taxable as income. Under this analysis, 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.

The Court, based on guidance from the Supreme Court, looked for legislation contemporaneous to the 1913 ratification of the Sixteenth Amendment for insight into whether the Amendment's adopters or Congress as it implemented the Amendment viewed "compensatory damages for a nonphysical injury to be 'income.'" The Court found the then existing understanding in the Attorney General's 1918 opinion and the 1918 Treasury Department ruling. Each "strongly suggested that the term 'incomes' as used in the Sixteenth Amendment does not extend to monies received solely in compensation for a personal injury and unrelated to lost wages or earnings." Given that emotional distress and loss of reputation were actionable in tort in 1913, the Court determined that "compensation for these nonphysical injuries [like compensation for physical injuries] was not considered income by the framers of the Amendment and the state legislatures that ratified it." (All of which is supported by a three and one-half page footnote of citations of various state court holdings reaching as far back as 1837.)

The Court ultimately held "insofar as ?104(a)(2) permits the taxation of compensation for a personal injury, which compensation is unrelated to lost wages or earnings, that provision is unconstitutional." Murphy will get her refund and applicable interest.

Will the IRS appeal? Will the IRS leave the ruling stand because it currently only applies in the District of Columbia? Are there similar cases pending in other circuits? We shall see.