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On a rehearing by the same three-judge panel that originally issued a contrary decision, the D.C. Circuit Court of Appeals recently reversed itself in Murphy v. Internal Revenue Service and held that awards for emotional distress are subject to tax and the taxation of such awards is within the taxing authority granted Congress under Article I, Section 8 of the U.S. Constitution.

Section 104(a)(2) of the Internal Revenue Code provides an exclusion from gross income for the amount of any damages received (whether by suit or agreement) on account of personal physical injuries or physical sickness. Section 104(a) also specifically provides that emotional distress shall not be treated as a physical injury or physical sickness. The limitation of this exclusion to only “physical” injuries and sickness and the specific reference to emotional distress was incorporated into Section 104(a)(2) or part of the Small Business Job Protection Act of 1996 (SBJPA).

In August 2006, most tax professionals were shocked and perplexed when the D.C. Circuit held that Section 104(a)(2), as it applies to damages awarded on account of personal injuries and personal sickness that are not “physical,” such as emotional distress, is unconstitutional.

The taxpayer in this dispute, Marrita Murphy, originally filed a complaint with the U.S. Department of Labor alleging that her former employer, the New York Air National Guard, violated a variety of whistleblower statutes and had “blacklisted” her and provided unfavorable references to potential new employers after she had complained about environmental hazards at an Air National Guard facility. An administrative law judge sustained Murphy’s complaint and awarded her compensatory damages totaling $70,000, of which $45,000 was for emotional distress and $25,000 was for injury to Murphy’s reputation. The record at the administrative hearing did show that Murphy suffered adverse physical manifestations as a result of her emotional distress.

Murphy originally included the $70,000 award in her gross income and paid approximately $21,000 in taxes on the award, but she subsequently filed an amended return seeking a refund of the taxes paid. The IRS denied Murphy’s request for a refund on the basis that the award was not on account of a “physical injury” or “physical sickness” and were therefore not eligible for the exclusion from income under Section 104(a)(2). Murphy subsequently filed a refund claim in district court and argued that her award was in fact for “physical personal injuries” and therefore excluded from gross income under Section 104(a)(2).

In the alternative, Murphy asserted that taxing her award was unconstitutional because the award was not “income” within the meaning of the 16th Amendment (which authorized the creation of the income tax in 1916). The district court rejected all of Murphy’s arguments and granted summary judgment for the IRS.

In its original decision, the court of appeals held that under the language of Section 104(a)(2), Murphy’s award would not be exempt from taxation. Specifically, the court cited established precedent that although emotional distress may have physical manifestations, for an award to be excluded from income under Section 104(a)(2), the award must be “on account of” an underlying physical tort.

However, the court did hold that the 16th Amendment only empowered Congress to impose a tax on “income” and that compensatory damages awarded to make a plaintiff “whole” as a result of emotional harm or lost reputation does not constitute taxable income of any kind.

In reaching this conclusion, the court of appeals cited the precursor to Section 104(a)(2), adopted shortly after the ratification of the 16th Amendment, and which excluded from gross income all amounts received as compensation on account of personal injuries or sickness, without any limitation that such injuries or sickness must be “physical” and without the specific carve-out for damages related to emotional distress. The court also noted that the original version of Section 104(a)(2), prior to its amendment by the SBJPA, was consistent with case law that equated compensatory damages for any tort-like injury as the equivalent of a tax-free return of capital.

In its successful petition for a rehearing on banc, the IRS argued for the first time that even if damage awards for emotional distress do not constitute income under the 16th Amendment, Congress still has the power to impose a tax on such awards pursuant to Article I, Section 8 of the Constitution, provided that such tax is not a direct tax and is imposed uniformly.

Writing on behalf of the same three-judge panel that rendered the first Murphy decision, Chief Judge Douglas Ginsburg again concluded that Section 104(a)(2), by its terms, would not permit an award on account of emotional distress to be excluded from gross income. However, unlike his original opinion in Murphy, Ginsburg upon rehearing concluded that damages awarded as compensation for emotional distress do constitute “income” under code Section 61(a) and that Congress has the right to impose a tax on such income under Article I, Section 8 of the Constitution.

The court’s conclusion that damages on account of emotional distress constitute income is the product of classic reverse engineering. Although Section 61(a) defines gross income to include “all income from whatever source derived,” the court concedes that damages received for emotional distress are not listed among the examples of income contained in Section 61 or the regulations promulgated thereunder.

However, the court noted that if Congress did not believe that damages on account of emotional distress should be included in gross income, there would have been no need for Congress to amend Section 104(a) to narrow the exclusion from income provided by this section to amounts received on account of “personal physical injuries or physical sickness” and to explicitly provide that emotional distress shall not be treated as a physical injury or physical sickness. In essence, the court concluded that the amendment of Section 104(a) as part of the SBJPA constituted an “implicit” amendment of Section 61 to cover awards of damages on account of emotional distress.

Having established the congressional intent to tax awards on account of emotional distress, the court of appeals next had to address the constitutionality of such a tax. Rather than analyze the application of the 16th Amendment as it did in its original decision, the court of appeals in its second decision relied exclusively on the taxing power of Congress established by Article I, Section 8 of the Constitution, which provides that “Congress shall have power to lay and collect taxes, duties, imposts and excises.”

The court did note two limitations on this power. First, Article I, Section 8 requires that all “duties, imposts and excises shall be uniform throughout the United States.” Second, as provided in Section 9 of Article I, “No capitation, or other direct tax shall be laid, unless in proportion to the census or enumeration herein before directed to be taken.” After a lengthy analysis of these limitations, the court concluded that the imposition of a tax on damage awards on account of emotional distress did not constitute a prohibited “direct” tax (which the court concludes is either a per capita tax or a property tax).

The court also concluded that imposing a tax on damage awards satisfies the uniformity requirement since it operates with “the same force and effect” on all similarly situated individuals throughout the country.

It is interesting to note that in the second Murphy decision, the court of appeals relied extensively on the definition of income contained in Section 61 and on the congressional power to tax found in Article I, Section 8 of the Constitution. However, in its original decision in Murphy, the court of appeals made a passing reference to Section 61 and did not cite the taxing authority contained in Article I, Section 8 of the Constitution.

Most tax practitioners believe that in its rehearing and second opinion, the court of appeals finally reached the correct conclusion with respect to the taxation of damage awards on account of emotional distress. This most recent decision reaffirms the clear intent of Congress in amending Section 104(a)(2) to exclude from gross income only damage awards received on account of a direct physical injury or illness and to tax awards received on account of emotional distress, even if such distress leads to adverse physical manifestations.

MARK L. SILOW is the administrative partner and chief operating officer of Fox Rothschild. Silow formerly was chairman of the firm’s tax and estates department. Silow’s work involves a broad range of commercial and tax matters including business and tax planning, corporate acquisitions and dispositions, real estate transactions, estate planning and employee benefits.

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