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Murphy v. IRS: IRC 104(a)(2) nonphysical damages are excludable (Overturned but interesting reasoning)

Murphy v. I.R.S. — F.3d — 2006 WL 24113372, D.C.Cir., Aug 22, 2006 (Slip Opinion No. 05-5139).

Quick summary

What the Murphy court said is if you are emotionally harmed or if your reputation is injured, you get to keep all of the damages and not pay any taxes.

[Please note that upon appeal, the United States Court of Appeals, District of Columbia Circuit, reversed this decision stating, “We reject Murphy’s argument in all aspects. We hold, first, that Murphy’s compensation was not ‘received . . . on account of personal physical injuries’ excludable from gross income under § 104(a)(2). Second, we conclude gross income as defined by § 61 includes compensatory damages for non-physical injuries. Third, we hold that a tax upon such damages is within the Congress’s power to tax.”  493 F.3d 170 (2007)]

Longer Summary

A federal appeals court ruled that the government cannot tax compensation for non-physical injuries. Citing the Sixteenth Amendment to the Constitution, it ruled that a portion of the tax law, Internal Revenue Code (IRC) § 104(a)(2), is unconstitutional as compensation for a non-physical personal injury is not income because the award is unrelated to lost wages or earnings. It only affects Washington DC, but it will broadly affect civil rights, whistleblower and employment cases.

Implications of the Murphy decision

Here are some initial thoughts:

Assumptions: Don’t assume that IRC 104(a)(2) is set in constitutional, legislative or judicial concrete.

Relevance: The Murphy ruling only affects taxpayers in the Circuit Court of Washington DC.

Structured Settlements: There is no change for cases where the origin of the claim is a personal physical injury and the action is based on tort or tort type rights. Therefore it does not directly affect Structured Settlements. Keep in mind the following:

If an action has its origin in a physical personal injury or physical sickness, then all damages (other than punitive damages) that flow therefrom are treated as payments received on account of physical injury or physical sickness whether or not the recipient of the damages is the injured party. For example, damages (other than punitive damages) received by an individual on account of a claim for loss of consortium due to the physical injury or physical sickness of such individual’s spouse are excludable from gross income. In addition, damages (other than punitive damages) received on account of a claim of wrongful death continue to be excludable from taxable income as under present law). Small Job Protection Act of 1996, H.R. 3448, Report of the Committee On Ways and Means, House of Representatives. Report 104-586, 104th Congress 2d Session. May 20, 1996.

See also 26 U.S.C.A. 104(a)(2) and 26 CFR § 1.104-1.

IRS: The IRS has several choices. Among other things, it can appeal the decision, come up with more precise regulations for IRC § 104(a)(2), adopt the ruling nationally, or do nothing.

Plaintiffs: Plaintiffs and their attorneys will rejoice at this ruling, and likely move quickly for similar decisions in other circuits.

Assignment providers for taxable damages: This may affect insurance companies who provide assignments for taxable damages. Since at least now in one Circuit court there is no tax issue to solve by deferring tax-free damages, i.e. damages for non personal physical injuries.

Structured Settlement agents: Structured Settlement agents should be aware of this case especially when considering presenting cases with tax-free damages to potential providers for assignment.

Other types of income: This ruling may also affect some insurance proceeds, and possibly potential damages for loss of reputation to a business and not just to a natural person.

Broader implications: There may some constitutional implications and it may embolden anti-tax groups even though it only covers one small portion of the tax code.

Background of Murphy case

Ms. Murphy filed a complaint that she was blacklisted by the New York Air National Guard and obtained a $70,000 award from an Administrative Law Judge (ALJ) – $45,000 for mental pain and anguish and $25,000 for injury to her professional reputation – which was affirmed by the Department of Labor Administrative Review Board. She declared her award as income and paid taxes $20,665 in 2000. She later filed an amended return and sought a refund. The IRS denied the refund and she sued the IRS.

Murphy’s arguments

Murphy made two arguments in her complaint. The first was that her compensatory damage award was for “personal physical injuries” under IRC § 104(a)(2). This argument was rejected by the court. She had claimed “somatic” and “body” injuries as a result of the blacklisting. However, the Government argued and the court concluded that she received the award on account of her mental pain and anguish and for injury to her professional reputation, not for her bruxism (grinding of teeth) or other physical symptoms.

The second argument made by Murphy was that IRC § 104(a)(2) was unconstitutional when applied to her award because her award was not “incomes” within meaning of the Sixteenth Amendment, which allows Congress to “…lay and collect taxes on incomes…”. This argument was upheld by the court. The court’s ruling hinges on the whether Murphy’s compensation is “incomes” as under the Sixteenth Amendment or “gross income” as defined by IRC § 61(a) as the Supreme Court found these two to be “coextensive” in Helvering v. Clifford, 309 U.S. 331, 334 (1940).

Court’s analysis

The court went through an historical analysis. It first stated that the taxing power of Congress extended to any “gain derived from capital, from labor, or from both combined”, citing Eisner v. Macomber, 252 U.S. 189, 207 (1920). The court then cited Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 430-31 (1955) where under the IRC and “by implication, under the Sixteenth Amendment – the Congress may “tax all gains or ‘accessions to wealth.'”

Human Capital

The court then supported Murphy’s argument that the award was not a gain or an accession to wealth but instead a return of capital — “human capital” the court argued. It cited Gary S. Becker, Human Capital (1st ed. 1964); Gary S. Beck, “The Economic Way of Looking at Life,” 43-45 (Nobel Lecture, Dec. 9, 1992). The court then discussed the concept of human capital and Murphy’s and the Government’s arguments.

Is compensation for injuries income?

The court then clarified the discussion and focused on a single issue. “The question in this case is not, however, about a return of capital – except insofar as Murphy analogizes human capital to physical or financial capital, the question is whether the compensation she received for her injuries is income”.

To determine this, the court looked at whether the award of compensatory damages is “a substitute for [a] normally untaxed personal…quality, good or ‘asset'”. The “in lieu of test” was used in the court’s analysis. The court ruled that the compensation was to make her whole in lieu of something normally untaxed, i.e. to make her emotionally and reputationally whole. Therefore, the court argued that the compensation she received in lieu of what she lost cannot be considered “income” and therefore the Sixteenth Amendment does not allow the Congress to tax the award. This conclusion was however tentative subject to further examination.

Framers’ intent

The court further examined whether the framers of the Sixteenth Amendment and Congress when they implemented it, thought that compensatory damages for a nonphysical injury would be “incomes”. The court also reviewed an Attorney General’s opinion, state legislation at the time and the view of the IRS.

The question the court asked was, “Therefore, we must inquire whether ‘the people when they adopted the Sixteenth Amendment,’ or the Congress when it implemented the Amendment, would have understood compensatory damages for a nonphysical injury to be ‘income.'”

The court concluded that the House Report on the 1918 Act was not helpful, and agreed with the Government’s argument that the Attorney General’s 1918 opinion and the Treasury’s ruling in that same year to support that the Sixteenth Amendment’s term “incomes” does not extend to compensation for non-physical injuries. The court cited that 39 of the then 48 states and the District of Columbia in 1913 treated damages recovered for “mental suffering” the same as compensatory damages for a physical injury. Also, the court found cases involving defamation and similar nonphysical injuries in 34 states and five states that allowed alienation of affections, which is also a nonphysical injury. The court concluded that the term “incomes” back in 1913 did not include physical personal injury damages, and therefore it does not include damages for a nonphysical injury unrelated to lost wages or earnings capacity.

The court also considered the conclusion of the IRS when it first looked at this issue. The IRS said that damages for a loss of personal reputation were not income because it was an attempt to make the plaintiff whole. Sol. Op. 132, I-1 C.B. 92, 93 (1922); see also Hawkins v. Commissioner, 6 B.T.A. 1023, 1024-25 (U.S. Bd. Of Tax App. 1927)

Conclusion of Murphy’s court

Therefore the court used two lines of reasoning to decide that damages solely for non-physical personal injuries are not income as defined by the Sixteenth Amendment. The first was that compensation for damages such as well-being or reputation are a personal attribute and are therefore not damages received in lieu of income. The second was that the drafters of the Sixteenth Amendment would have said that compensation for nonphysical injuries should not be seen as different from physical injuries, and therefore damages on account of nonphysical injuries should not be income, and therefore not taxable under this amendment. Therefore the court concluded it is unconstitutional for a provision of section of IRC § 104(a)(2) to tax damages that are not earnings or wages.

The case was remanded to the District Court and ordered that the taxes paid be refunded along with interest.

This information is not tax or legal advice and as tax information and laws are ever changing it is advised you obtain professional advice in these two areas.


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