Controversial Ruling Says Emotional Distress And Similar Non-Injury Damages Are Not Taxed

September 2006

Congress legislated that only damages for "physical" injuries would be tax-exempt, while damages for emotional injuries and the like would be taxable. The District of Columbia Circuit made a remarkable tax ruling that strikes this down on constitutional grounds.  Those with open tax returns that reported income from emotional distress, loss of reputation, or similar tort-based claims that are not personal injuries should consider filing an amended tax return to keep open the possibility of a refund.  Taxpayers who extended their 2002 return until October 2003 can keep their rights to a refund alive by filing a claim by October 15, 2006.

The background facts are relatively simple.  Murphy vs. IRS (No. 03cv02414, D.C. Circuit, 8/22/06) is an employment case in which a former employee received $45,000 for "emotional distress or mental anguish," and $25,000 for "injury to professional reputation".  The damages were not for lost wages or physical injuries.

Internal Revenue Code (IRC) §104 provides that "gross income does not include the amount of any damages (other than punitive damages) received ... on account of personal physical injuries or physical sickness." Since 1996, it further defined that "emotional distress shall not be treated as a physical injury or physical sickness.

The Murphy Court struck this down on constitutional grounds, stating that receipts for the "return of human capital" (such as emotional distress, and loss of reputation) are not taxable.  According to the ruling:  

"The Sixteenth Amendment simply does not authorize the Congress to tax as "incomes" every sort of revenue a taxpayer may receive. … Indeed, because the "the power to tax involves the power to destroy,… it would not be consistent with our constitutional government, and the sanctity of property in our system, merely to rely upon the legislature to decide what constitutes income." 

"… As we have seen, it is clear from the record that the 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 and, hence, it would appear the Sixteenth Amendment does not empower the Congress to tax her award."

If upheld, the effect of the Murphy ruling is huge.  The Murphy Court based its decision on a "common understanding" of what was thought of as income in 1913 when the Sixteenth Amendment was passed.  Potentially, this subjects every item now subject to the income tax to an unclear 1913 definition. Under this logic, Congress may not have the ability to tax numerous items that were not even thought of in 1913.  Consequently, the ruling encourages a whole host of challenges to other parts of the tax law.   Quoting language directly from the Murphy ruling, tax protestors will no doubt attack other types of cash receipts beyond those directly addressed in this case.

Why the Murphy Ruling will be Overturned

Before you get too excited about your refund claim, and before you stop negotiating the characterization of your settlement amounts, recognize that there are other cases expressly holding that emotional distress damages are not free of tax.  In the Ninth Circuit, see  Rivera v. Baker W., Inc., 430 F.3d 1253 (9th Cir. 2005).

The IRS would appear to have little choice but to appeal the Murphy ruling, or at least not acquiesce to Murphy's findings in other circuits.  A Supreme Court appeal appears to be almost inevitable.

The Sixteenth Amendment to the U.S. Constitution deals with the issue of whether the federal government could collect income taxes without apportioning such money back to the states.  It reads: 

"The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration." 

Although the Sixteenth Amendment authorizes the federal income tax, nothing in the Sixteenth Amendment defines the details of how the income tax is to be calculated or administered.  Such details are contained in the IRC, which Congress writes and changes.

Within the IRC, §61 defines income subject to tax, which generally provides that all income is generally subject to tax unless specifically excluded. IRC §104 (the provision that is the subject of the Murphy case) is an exclusion from tax for personal injuries.  IRC §104(a)(2) states that nonphysical injuries are outside this exception.

The basic failing of the Murphy Court is that IRC §61 is what allows imposition of tax (not IRC §104(a)(2)).  The Murphy Court focused its attention solely on §104, and did not state that Code §61 was unconstitutional.  It is likely that other courts will look to §61 for the federal government's authority to tax.

Fulcrum Inquiry is a forensic accounting and economics firm that regularly provides damages analysis and other assistance to attorneys.