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It’s not that often that federal tax laws are ruled unconstitutional. When it happens, people take notice, even if the ruling is quickly vacated and set for rehearing, and especially if the court rendering the opinion is the U.S. Court of Appeals for the District of Columbia. So while the facts of Murphy v. United States (2006) were hardly unusual, the court’s opinion — ruling Internal Revenue Code Section 104(a)(2) unconstitutional — was very unusual. As a result, there are real-world issues that practitioners must understand, at least until, and if, the court issues an opinion in line with the current state of the law. The facts of the case are straightforward. Marrita Murphy brought a complaint with the Labor Department against the New York Air National Guard. She alleged that the National Guard blacklisted her and gave potential employers unfavorable references after she reported environmental hazards at a National Guard air base. At a hearing, Murphy presented evidence showing that the National Guard’s activities caused her to suffer mental and physical injuries. Ultimately, the Labor Department determined that Murphy suffered from physical manifestations of stress and awarded her $70,000 in damages: $45,000 for “emotional distress or mental anguish” and $25,000 for “injury to reputation.” None of the damages were for lost wages or diminished earning capacity. Murphy included the entire $70,000 as income on her federal tax return and paid more than $20,000 in related federal taxes. Murphy later filed an amended federal tax return claiming a refund of the taxes paid. When the Internal Revenue Service denied the refund, she filed suit in the U.S. District Court for the District of Columbia. Murphy ultimately made two arguments: First, she claimed that her medical records showed that she suffered physical injuries, and under Section 104(a)(2) gross income does not include damages received on account of “personal physical injuries or physical sickness.” In the alternative, Murphy claimed that, even if her injuries were not physical, Section 104(a)(2) was unconstitutional in her case because the damages she received were not “income” within the meaning of the 16th Amendment. The IRS, and then the district court, rejected her arguments. On appeal, however, a panel of the D.C. Circuit took a more favorable view of her constitutional claim. The court held that “[f]irst, as compensation for the loss of a personal attribute, such as well-being or a good reputation, the damages are not recovered in lieu of income. Second, the framers of the 16th Amendment would not have understood compensation for a personal injury — including a nonpersonal injury — to be income.” As a result, the court concluded: “[w]e hold section 104(a)(2) unconstitutional insofar as it permits the taxation of an award for damages for mental distress and loss of reputation.” Essentially, the court determined that the damage award Murphy received did nothing but make her whole from the loss she had suffered and therefore did not provide her with any compensation which could be taxed as income. Instead, she received her damage award “in lieu” of what she lost. Therefore, the damage award could not be considered income and could not be taxed. Criticism of the court’s opinion was swift. Many critics focused on theoretical issues addressing the definition of the term “income” and constitutional issues addressing the scope of Congress’ authority to impose taxes. For practitioners, however, the most relevant criticism may be that the court simply misread and misunderstood the basic application of Section 104(a)(2). GROSS INCOME To understand this practical criticism, some technical tax background may be useful. Section 61(a) of the Internal Revenue Code defines “gross income” subject to taxation broadly, and damage awards are included within its ambit. At the same time, it is a long-standing tenet of tax law that exclusions from tax are a matter of legislative grace. Reading these two concepts together results in the conclusion that anytime a taxpayer receives a damage award the taxpayer is subject to taxation on the recovery unless a specific provision of law allows otherwise. Section 104(a)(2) provides a limited exception to the broad rule of Section 61(a). It provides that damage awards for personal physical injuries are not required to be included in income or taxed. But it says nothing about damage awards for personal nonphysical injuries. Thus, contrary to the court’s analysis, Section 104(a)(2) does not permit the taxation of damage awards for nonphysical injuries. Instead, it only excludes from taxation damage awards for physical — and only physical — injuries. As a result, damage awards for nonphysical injuries are subject to taxation because of Section 61(a), not Section 104(a)(2). Section 104(a)(2) simply looks at one type of damage recovery — the recovery for personal physical injuries — and excludes those damage awards from income and from taxation. REAL IMPLICATIONS Although the case seems to turn on fairly technical provisions of law and legal theory, the court’s decision has very real and very prominent implications. Some of these implications merely force us to make different value and policy judgments — for instance, whether we really want to tax damage awards in the first place; if so, whether all damage awards should be taxed; if not, which types of damage awards should be taxed. Other results raise more complicated practical considerations. For instance, the court’s opinion potentially undermines years of work by the IRS and the courts to discourage the “tax-protester” movement — groups of people who have spent decades shouting at windmills that the tax code is unconstitutional, that it taxes income only from foreign sources, that Congress has no authority to impose taxes outside the District of Columbia, and other similar theories. Courts routinely dismiss these arguments without much, if any, analysis. Now, however, these “tax protesters” are likely to be encouraged to continue making frivolous arguments because a prominent U.S. Court of Appeals has actually agreed a provision in the Internal Revenue Code is unconstitutional. In addition, the decision has the potential to wreck havoc on the IRS’s refund bureaucracy and the related court system. Taxpayers who have received damage awards for nonphysical injuries during the last three years who included the awards in income and paid tax on them may now argue that they are entitled to refunds. Regardless of the ultimate outcome of their claim, these taxpayers can point to a case that says they are right, they can file refund claims, and if the Internal Revenue Service does not grant their claims within six months, they can file suit in district court. The decision may also affect your clients directly. For instance, plaintiffs in personal injury cases may demand that defendants not issue Forms 1099 reporting settlement awards on the theory that all damage awards in personal injury cases are not subject to tax. Defendants, however, may be penalized by the Internal Revenue Service if they do not properly issue Forms 1099. In addition, if the D.C. Circuit’s decision stands, defendants in personal injury cases may want to spend more time on the settlement arbitrage potentially available to them. Defendants could theoretically make lower settlement offers to plaintiffs knowing that the plaintiffs would still end up with more money in their pockets because they don’t have to pay taxes on their recovery. Furthermore, structured settlement payouts, both those existing and those under negotiation, may need to be amended to take into account the fact that the payouts may not be subject to tax. Recent events, however, have suggested that the ruling may not be long lived. On Dec. 22, 2006, the panel of the D.C. Circuit that issued the original opinion in Murphy vacated its earlier decision and, on its own motion, scheduled the case for additional briefing and oral arguments. The court’s order ignored the government’s request for an en banc rehearing, indicating that it may have already decided its original decision was not correct. On the other hand, it is still possible that the court has simply decided to make sure its original position is correct or to provide additional support for its conclusion in light of the criticism it has faced from within the tax community. Oral arguments are scheduled for April 23 in Washington. Regardless of the ultimate outcome, Murphy v. United States will long be remembered as one of the leading cases of 2006 and 2007, and, with appeals, maybe even 2008 or 2009.
Brian C. Bernhardt is a partner in the Richmond, Va., office of McGuireWoods, where he practices in the area of federal civil tax controversies and litigation. He previously served as a trial attorney with the IRS Office of Chief Counsel.

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