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On Aug. 22, the U.S. Circuit Court of Appeals for the District of Columbia issued a curveball of a decision that stunned tax practitioners and plaintiffs’ lawyers alike. In Murphy v. Internal Revenue Service (IRS), No. 05-5139, 2006 WL 2411372 (Aug. 22,, 2006), the court stated that � 104(a)(2) of the Internal Revenue Code unconstitutionally taxed Marrita Murphy’s award of compensation for a nonphysical personal injury because it is unrelated to lost wages or earnings in violation of the 16th Amendment. The 16th Amendment grants Congress the broad power to lay and collect taxes on incomes “from whatever source derived.” Rarely does a court invalidate a substantive tax provision on constitutional grounds. Damages award arose in a whistleblower suit Murphy won a whistleblower suit against her former employer, the New York Air National Guard. She was awarded $70,000 in total damages: $45,000 for emotional distress or mental anguish and $25,000 for injury to her professional reputation. Murphy initially reported the award as gross income on her tax return and paid $20,665 in income taxes. She later filed an amended return, claiming she was entitled to a refund because her award was on account of “personal injuries or physical sickness,” and therefore excluded from income under � 104(a)(2) of the code. The IRS denied the refund, and she brought suit for refund in federal district court. Section 61 of the code lays the foundation for taxing all income “from whatever source derived” except “as otherwise provided” in the code. Section 104(a)(2) is such an exclusionary provision of the code, and it excludes from gross income any damages awards received “on account of personal physical injuries or physical sickness.” However, an additional clause of � 104(a) added as part of the Small Business Job Protection Act of 1996 (and applying only to damages received after the date of enactment, Aug. 20, 1996) specifically states that emotional distress damages will not be considered damages from a “physical injury or sickness” and will not qualify for the exclusion from gross income. The federal district court granted summary judgment against Murphy, and she appealed. On appeal, Murphy reiterated her argument that � 104(a)(2) was unconstitutional as applied to her because she neither gained nor received an accession of wealth from her award. She described her award for nonphysical injuries as analogous to a “return of capital,” a type of compensation that has enjoyed a long history of being excluded from taxable income. Judge Douglas H. Ginsburg, writing for the D.C. Circuit, stated that Murphy’s compensatory award was effectively for a loss of a personal attribute, and not to compensate her in lieu of lost wages or any other kind of 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 that the Sixteenth Amendment does not empower the Congress to tax her award.” 2006 WL 2411372, at 8. The court also discussed the legislative history underlying the 16th Amendment and determined that the drafters of the legislation that became the 16th Amendment would not have intended an award of damages for nonphysical injuries to be included in income subject to taxation. It remanded the case to the district court with instructions to enter judgment for Murphy. Murphy provides a stark contrast to other recent appellate court decisions. The 8th and 9th circuits have recently ruled that compensation for a nonphysical personal injury (mental distress) is taxable as “income.” Lindsey v. Comm’r, 422 F.3d 684 (8th Cir. 2005); Rivera v. Baker W. Inc., 430 F.3d 1253 (9th Cir. 2005). These cases held that damages for mental distress are not excluded from income by code � 104(a)(2) and therefore are included in gross income by default under the general rule of � 61. However, neither Lindsey nor Rivera discussed the constitutionality of �104(a)(2) under the 16th Amendment. Though rare, decisions holding a provision of the Internal Revenue Code unconstitutional are not unheard of. In the venerable and well-known case of Eisner v. Macomber, 252 U.S. 189 (1920), the U.S. Supreme Court considered the taxability of stock dividends. A provision of the Internal Revenue Code of 1913, enacted immediately on the heels of the 16th Amendment, explicitly provided that “a stock dividend shall be considered income, to the extent of its cash value.” The Supreme Court held that this provision was unconstitutional because a stock dividend did not fall within the common understanding of the word “income” under the 16th Amendment, which the court defined as ” ‘the gain derived from capital, from labor, or from both combined,’ provided it be understood to include profit gained through a sale or conversion of capital assets.” Id. at 207. Under the definition of income employed in Eisner, Murphy’s settlement might not be subject to tax if the reviewing court were to go back to the “common understanding” of income as intended by the framers of the 16th Amendment (the concept of damages for emotional distress probably never even crossed their minds). But her settlement might well be taxable if the court were to adopt Murphy’s analysis of her mental health and reputation as “human capital assets” (now converted to cash and to taxable “profit,” given the zero cost basis associated with such assets). But that is not certain. In Garber v. U.S., 607 F.2d 92 (5th Cir 1979), the 5th Circuit considered a taxpayer’s appeal from a conviction for failure to report money received from sales of her very rare type blood. The taxpayer based her appeal, in part, on the theory that such sales proceeds were “amounts received on account of personal injuries or sickness,” nontaxable under � 104(a). The 5th Circuit specifically declined to rule on this contention, but held that the law in this area was so unsettled that, as a matter of law, the taxpayer could not have the requisite “willfulness” to be prosecuted for failure to report such income. It explained the background of � 104(a) as follows: “[T]he Attorney General in a 1918 opinion considered the human body a kind of capital asset [and] held that the proceeds of an accident insurance policy were not subject to tax because [they] represented a conversion of the capital loss which the . . . taxpayer had suffered . . . .Eventually the Code was amended to include a . . . provision covering the tax consequences of compensation for injuries or sickness.” Id. at 95. Who and what is affected by the ‘Murphy’ ruling? For the time being at least, Murphy will only affect individuals within the D.C. Circuit. People residing in the District of Columbia expecting to receive such awards either by settlement or by trial should give attention to drafting jury instructions or settlement documents to carefully separate dollar amounts received for mental distress and loss of reputation from those attributable to lost wages or injuries of a clearly physical nature. The IRS will not follow Murphy, unless and until it is affirmed by the Supreme Court. The Supreme Court, speaking in Commissioner v. Glenshaw Glass, 348 U.S. 426 (1995), broadly declared that gain from any source was taxable income because it was an “accession to wealth.” The Murphy decision purports to duck the broad sweep of Glenshaw Glass and the 16th Amendment by pointing out that the restoration of Murphy to her status quo through the payment of compensation for the diminution of a personal attribute (and not received in lieu of income) does not result in “accession to wealth” and therefore is not income. It has only been 10 years since the IRS successfully lobbied Congress to amend the Internal Revenue Code to exclude awards for nonphysical emotional and mental damages from the scope of nontaxable income under � 104(a)(2). The “can’t see them, can’t touch them” nature of emotional and mental injuries makes it easy for taxpayers to allege such injuries, and there is no incentive for those who agree to pay damages in settlement of lawsuits to oppose settlement agreements that unfairly allocate damages to allegations of “emotional distress” and away from allegations of “lost wages.” (In fact, defendants can probably get away with paying smaller awards if the plaintiff can be sure that the payments are not subject to income taxes.) Murphy‘s challenge to a recently won amendment to the code and the resulting administrative challenge of separating out the legitimate claims of emotional distress from the bogus ones are more than sufficient incentive for the government to bring out its big guns. It is virtually certain that the IRS and the U.S. Department of Justice will not allow Murphy to stand unopposed. Look for the government to ask for Murphy to be re-heard en banc; and if that is not successful, you can bet the government will seek to take the case to the Supreme Court. Given the conservative drift of the court and the rarity of decisions holding tax laws unconstitutional, don’t bet the ranch on Murphy surviving a challenge. G. Tomas Rhodus is the managing member of Looper, Reed and McGraw’s Dallas office. He practices primarily in the areas of criminal and civil tax controversy, health care and corporate transactions. Michelle Sandner is an associate at the firm.

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