Court Reverses Itself in
Personal Injury Decision
The federal court
that had previously ruled IRC Sec. 104(a)(2) unconstitutional as to the
taxation of nonphysical personal injury damages unrelated to lost wages or
earnings reconsidered and has decided -- in “the broad public interest” --
to vacate its own judgment. Thus, the compensatory damages for emotional
distress and loss of reputation at issue are includable in gross income for
income tax purposes.
The Court of Appeals for the District of Columbia Circuit en banc rejected
the decision of a three-judge panel that held the taxation of emotional
distress awards to be unconstitutional (Murphy v. IRS, DC-Cir., 7/3/07).
This averted potential challenges to the tax code’s definition of taxable
income, as well as Congress’s broad constitutional taxing powers.
Background
The tax law (IRC Sec. 61(a)) states that, except as otherwise provided,
gross income includes all income from whatever source derived. IRC Sec.
104(a)(2), however, creates an exception for damages received as
compensation for personal physical injury or sickness.
Marrita Murphy was awarded $70,000 in an administrative proceeding -- $45,000
for “emotional distress and mental anguish” and $25,000 for “injury to
professional reputation.” There was no recovery for physical injuries.
Initially, she included the $70,000 in gross income and paid tax of $20,655
on that amount. She thereafter sought a refund of the tax paid, which the
IRS denied.
Ms. Murphy then brought suit in district court seeking a refund, but the
court decided against her, finding that the exclusion under IRC Sec.
104(a)(2) applied only to physical personal injury damages awarded as a
result of physical injuries. The compensatory damages awarded to her, the
court reasoned, were clearly due to her nonphysical injuries.
First Round
On appeal (460 F.3d 79, 2006), the three-judge panel held IRC Sec. 104(a)(2)
to be unconstitutional. It relied on Commissioner v. Glenshaw Glass Co. (348
U.S. 426) on Sixteenth Amendment grounds, concluding that Murphy’s award was
neither a “gain” nor an “accession to wealth” -- which Congress could tax --
because it compensated her for nonphysical injuries and was thus a
restoration of “human capital.”
On Second Thought . . .
Upon reconsideration, however, the entire court ruled that Murphy’s damages
were not excludable from income. The court held that Murphy’s recovery was
based on nonphysical injuries and that IRC Sec. 61(a) includes these damages
in income, regardless of whether the recovery is deemed an “accession to
wealth.” Accordingly, the recovery is not excludable under IRC Sec.
104(a)(2). The court distanced itself from the panel’s prior rationale,
indicating that, even if Murphy’s recovery isn’t “income” within the meaning
of the Sixteenth Amendment, Congress nonetheless retains taxing authority
under Article I, Section 8 of the Constitution. The court also held that the
tax here is an “indirect tax” so, regardless of whether Murphy’s recovery
was a restoration of “human capital,” no violation of Article I, Section 9
of the Constitution occurred as it relates to direct taxes that must be laid
among the states in proportion to the population.
This newsletter is provided by
Somerset for our clients and other interested persons upon request.
Since technical information is presented in generalized fashion, no
final conclusion on these topics should be made without further review.
For additional information on the issues discussed, please contact
Steve Riddle,
Tom Thieme,
Rex Collins or
Doug Ayres
of our
Litigation & Valuation Team.
This document is not intended or written to be used, and cannot be used,
for the purpose of avoiding tax penalties that may be imposed on the
taxpayer.
Somerset CPAs,
P.C.
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Indianapolis, Indiana 46240
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