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A federal court declaring any portion of the tax code unconstitutional is enough to throw the Internal Revenue Service into paroxysms of anxiety. But last August’s ruling from the U.S. Circuit Court of Appeals for the District of Columbia that taxing awards for emotional distress is unconstitutional shocked not only the agency but also the insurance industry. Now it appears the three-judge panel in Murphy v. IRS, 460 F.3d 79 (2006), has had second thoughts. In a highly unusual move, the same unanimous panel recently voted to reconsider its earlier decision and set new arguments for April 23. At stake is the structuring of future settlement deals in everything from personal injury to mass tort, environmental and civil rights cases. And going forward, insurers and corporate defendants must decide how to deal with existing settlements, structured for years as taxed payouts, that now may be tax-free. With billions of dollars annually flowing through the structured-settlement arm of the insurance industry, it is no small question. Lurking in the background is also the Internal Revenue Service (IRS) fear that a constitutional reversal in one area of the tax code will unleash broader attacks on its taxing authority. “The opinion will give substantial credence to all the nut cakes out there that taxes are unconstitutional,” said former IRS Commissioner Donald Alexander, a partner in the Washington office of Akin Gump Strauss Hauer & Feld. Meanwhile, “the whole damages industry is watching the case with great attention,” said Robert Caron, tax law professor at the University of Cincinnati College of Law. It could affect all pending settlement talks and would reopen all settlements in the last three years if people think tax consequences must be reconsidered, he said. In 1996, Congress revised Internal Revenue Code Section 104(a)(2) to render physical injury damages tax-free, but not those for emotional distress or loss of reputation. And Congress did not define what physical injury covers. “Congress did not do a good job of drawing a line between physical and nonphysical damages, and the IRS has not even tried to draw the line,” said Robert W. Wood, a lawyer with Wood & Porter in San Francisco and author of a book on taxation of damage awards. Murphy will be a wake-up call to the IRS to provide guidance to tax professionals through regulations interpreting Section 104, he said. “At its core, all the Murphy court said was nonphysical injury is not taxable,” he said. Now he says defendants may be asked not to issue 1099 tax forms, which report settlements, and plaintiffs may get more aggressive about nontaxable injury claims in other circuits as well. Whistleblower Marrita Murphy sued the Air National Guard in 1994 saying the guard blacklisted her in retaliation for complaints about environmental law violations. She was awarded $45,000 for emotional distress and $25,000 for loss of reputation. In 2001, she challenged tax on the award, arguing her emotional stress showed physical symptoms. D.C. Circuit Chief Judge Douglas Ginsburg wrote that Murphy’s damages award was supposed to make her emotionally and reputationally whole, not to compensate for lost wages or taxable earnings. Insofar as Section 104(a)(2) permits taxation of compensation for personal injury, unrelated to lost wages or earnings, that provision is unconstitutional, he wrote. The settlement industry so far is pretending the Murphy decision never happened, according to Mark Wahlstrom, attorney and president of Wahlstrom Associates, a plaintiffs’ structured-settlement firm in Scottsdale, Ariz. “They really would like it to go away” because of the potential it could pique interest in Congress to tax physical damages as well, said Wahlstrom. He praised Ginsburg’s decision. “I have always felt it was a gross inequity that a damage award to someone who is sexually molested for years is taxed but if they slip and fall while abused it is not taxed,” he said. “The industry is afraid to open up and look at it and I think it is a cowardly approach,” he added. “If you can’t speak out for someone sexually molested or falsely imprisoned, what good are you as an industry?” Michael Graetz, a Yale Law School professor, thinks the court got it flat wrong. The Justice Department’s original brief did not take the constitutional argument seriously because it was unthinkable the court would adopt it, Graetz said. But in seeking reconsideration, the IRS pointed out that the taxing power of Congress is not limited to taxes on income, he said. The IRS, the Justice Department and Murphy’s lawyer, David Colapinto of Kohn, Kohn & Colapinto, did not respond to requests for comment.

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