Scott E. Vincent
Vincent & Fontg LLC
Kansas City

In a decision of note for plaintiffs, the District Court for the DC Circuit recently held § 104 unconstitutional to the extent it taxes damages awarded for emotional distress or mental anguish and loss of reputation. Murphy v. IRS, No. 05-5139 (D.C. Cir. 8/22/06). This decision places in question the tax collected on many awards and settlements since a key law change in 1996 began taxing all damages unless they related to specific physical injuries or sickness.

Factual Background

The plaintiff in Murphy filed a complaint against her former employer, the state National Guard, alleging discrimination involving whistleblower environmental statutes. The whistle-blower statutes provided for compensatory damages. Witnesses during the trial testified that the plaintiff’s injuries were the result of her former employer’s conduct, and she demonstrated emotional injuries, including a condition causing tooth grinding damages and pain. The plaintiff also demonstrated other physical manifestations of stress, including anxiety attacks, shortness of breath, and dizziness. She was eventually awarded $70,000 in damages in the case, including $45,000 for mental pain and anguish and $25,000 for injury to her professional reputation.

The plaintiff reported the damage recoveries as taxable income on her tax return for the year of the recovery. She later requested a refund of the tax paid on the damages, arguing that § 104(a)(2) exempted the damages from tax. The IRS denied the refund claim stating that the plaintiff did not demonstrate that the damages in question were attributable to physical injury or sickness as required by changes to § 104(a)(2) adopted by Congress in 1996.

Following the IRS denial of her refund claim, the plaintiff filed a refund suit. The district court rejected the plaintiff’s refund claim, granting summary judgment to the IRS and holding that the injuries to professional reputation and for pain and mental anguish resulting from her former employer’s discriminatory action did not qualify for exclusion under revised § 104(a)(2). The plaintiff appealed the district court decision pursuing her claims under both § 104(a)(2) and the Sixteenth Amendment.

Analysis and Holding

The D.C. Circuit held that § 104(a)(2) is unconstitutional to the extent it permits the taxation of an award of damages for mental distress and loss of reputation. The circuit court concluded that the term “incomes” in § 104 was not intended to include damages received in compensation for a physical personal injury, and the court also reasoned “incomes” should not include damages received for a non-physical injury and unrelated to lost wages or earning capacity. The court noted that the phrase “gross income” in the code and the related use of the word “incomes” in the Sixteenth Amendment has been broadly construed by the Supreme Court, but the court in Murphy also emphasized that the power to tax income has been extended only to gains or accessions to wealth, citing Commissioner. v. Glenshaw Glass, 348 U.S. 426 (1955).

Finally, the court reasoned that relying on the legislature to determine what constitutes “income” would undermine our constitution and the sanctity of property in our system, stating that the power to tax involves the power to destroy and citing McCulloch v. Md., 17 U.S. 316, 431 (1819).

Based on these key points, the court held that compensation for emotional distress and loss of reputation was not considered income by the framers of the Sixteenth Amendment and that § 104(a)(2) as amended in 1996 is unconstitutional to the extent it is inconsistent with this constitutional intent.

Conclusions and Recommendations

Many plaintiffs have paid taxes on recoveries for emotional distress or other damages unrelated to lost earnings since the 1996 change in law, and the IRS will continue treating these recoveries that do not involve physical injuries as taxable pending an appeal of the Murphy decision. While the issue remains open, these taxpayers should consider filing protective refund claims to preserve their rights to recover taxes that may ultimately be determined to be unconstitutional (before the statute of limitations runs on these possible refund claims).

Similarly, current litigation recoveries in cases that do not involve physical injuries should be reported with the Murphy decision in mind, and either treated as non-taxable or also be the subject of protective refund claims to preserve the taxpayers’ rights.