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No tax on emotional distress and reputation loss damages
August 22, 2006 by Ross Runkel at LawMemo
A blockbuster case. It's unconstitutional for the IRS to tax an employee's award for "emotional distress" or "mental anguish" or "injury to professional reputation."
Murphy v. Internal Revenue Service (DC Cir 08/22/2006).
Marrita Murphy recovered damages from her employer on her claim that the employer violated various whistleblower statutes and retaliated against her. The damages were awarded in a Department of Labor administrative action.
The administrative law judge specified that part of the award was for "emotional distress or mental anguish," and part was for "injury to professional reputation."
Murphy paid taxes on the award, and then sued IRS seeking a tax refund. The trial court granted summary judgment for the government; the DC Circuit reversed.
Murphy had two theories: (1) the award was excluded from taxation by virtue of the language of the Internal Revenue Code, and (2) taxing the award would violate the 16th amendment which gives Congress the power to tax "income."
- The DC Circuit agreed with the IRS that the Tax Code did not exclude the award from income.
The compensation was not "received on account of personal physical injuries," [Section 104(a)(2)] and therefore Section 104 does not permit Murphy to exclude her award from income.
- The DC Circuit held that Section 104, as applied to Murphy, is unconstitutional.
This is for two reasons:
- Under the 16th amendment, Congress has the power to tax only "gain[s]" or "accessions to wealth." Commissioner v. Glenshaw Glass, 348 US 426 (1955). "[T]he 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 ...."
- The "original understanding" of the framers of the 16th amendment was that they "would not have understood compensation for a personal injury - including a nonphysical injury - to be income."
We're going to hear a lot about this case. For now, check what TaxProf Blog says: D.C. Circuit Holds § 104(a)(2) Unconstitutional Under 16th Amendment; Not All Receipts Constitute "Income" Under Glenshaw Glass.
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Editor: Ross Runkel, Professor of Law Emeritus. email Ross@LawMemo.Com, Phone 503-399-8028. Copyright LawMemo, Inc.
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