WASHINGTON-A federal appeals court is weighing whether to review a controversial tax decision in which a unanimous three-judge panel struck down as unconstitutional the federal income tax on nonphysical, compensatory damages awards.
Claiming the case is one of “exceptional importance” to the execution of the nation’s tax laws, the Bush administration recently asked the full U.S. Circuit Court of Appeals for the District of Columbia to rehear Murphy v. U.S., No. 05-5139. Two weeks ago, the court, on its own motion, ordered lawyers for Marrita Murphy to respond to the government’s rehearing petition, a signal that the court is interested, according to some circuit watchers.
The Murphy decision, stemming from a whistleblower lawsuit, ignited debate and criticism among tax, employment and constitutional scholars and litigators whose descriptions of the decision ranged from “silly” and “reckless” to “momentous” and “epochal.”
The panel decision was written by Chief Judge Douglas H. Ginsburg, who was joined in full by judges Judith W. Rogers and Janice Rogers Brown-an unusual union of a moderately conservative judge, a liberal judge and a very conservative judge, respectively.
In making its ruling, the panel found that compensation for loss of a personal attribute, such as reputation, is not received in lieu of income. And, it said, the framers of the 16th Amendment, which in 1913 authorized the federal income tax, would not have regarded compensation for a personal injury, including a nonphysical injury, as income.
“Albert Einstein may have been correct that ‘[t]he hardest thing in the world to understand is the income tax,’ but it is not hard to understand that not all receipts of money are income,” wrote the chief judge.
Whether silly or momentous, the government, in its petition for rehearing, is taking the ruling very seriously. It notes the panel’s decision is the first time in more than 85 years that an exercise of congressional income-taxing power has been declared unconstitutional, and it predicts dire consequences if the decision is allowed to stand.
“Left undisturbed, the decision is likely to generate substantial litigation touching the most basic of tax concepts that were thought to have been long since settled and could provide succor to taxpayers seeking to avoid penalties,” warns the government.
But it is the government that is pushing a “radical” position, counters Stephen M. Kohn, president of the National Whistleblower Center in Washington and Murphy’s counsel, along with the center’s David Colapinto.
“ Murphy stands for the noncontroversial position that you can’t tax a loss,” said Kohn. “It is well-accepted as a matter of constitutional interpretation by every judge. The authority to tax losses has never been given to the [Internal Revenue Service] and they don’t have it.”
And the parade of horribles predicted by the government and critics if the decision should stand, he added, is “overblown” and “hyperbole.”
“We are not tax protesters and we have nothing to do with them,” said Kohn. “We’re flattered by all of the attention but I think it’s misplaced.”
Acting on a 1994 complaint filed by Murphy, the U.S. Department of Labor found that her former employer, the New York Air National Guard, violated various whistleblower laws, had blacklisted her and had given bad references to potential employers after she reported environmental hazards at a National Guard airbase to state authorities.
A department administrative law judge subsequently found that Murphy had suffered physical manifestations of stress, including anxiety attacks, teeth grinding, dizziness and shortness of breath, and recommended damages totaling $70,000. Of this, $45,000 was for “emotional distress or mental anguish,” and $25,000 was for “injury to professional reputation” from having been blacklisted. None of the award was for lost wages or diminished earning capacity.
Murphy reported the award as gross income on her tax return, according to Section 61 of the Internal Revenue Code, which states that gross income “means all income from whatever source derived.” She later unsuccessfully sought a refund of $20,665-the taxes paid on the award.
Until 1996, damages for personal injuries-physical and nonphysical-were not taxable, but in that year, Congress enacted a rider to a bill that excluded from taxation only compensation for physical injuries. It was that provision, Section 104(a)(2) of the code, that the panel found unconstitutional to the extent that it permits taxation of a nonphysical personal injury award unrelated to lost wages or earnings.
Some critics, such as tax scholar Allan Samansky of Ohio State University Michael E. Moritz College of Law, contend that the panel got the law wrong: It should have analyzed Section 61, not Section 104, an exclusion provision. And, Samansky argues, the panel should never have resorted to an originalist interpretation of the 16th Amendment.
“I would say it’s an outrageous opinion,” said Samansky. “There’s an old case- Eisner v. Macomber, 252 U.S. 189 (1920)-where the Supreme Court used the 16th Amendment to say a tax was unconstitutional because what was being taxed was not income.
“But since then, no court has decided it’s up to the courts to use the 16th Amendment to make judgments about what is income. Those are the type of issues that Congress decides. This second-guessing of Congress will undoubtedly make the law more complicated, uncertain and just messy with no benefit.”
If the decision stands, it will encourage more constitutional attacks in tax litigation, he said. The full D.C. Circuit, he added, should hear the case and reverse.
Saying he is within a “distinct minority” of tax professors, Erik Jensen of Case Western Reserve University School of Law, a 16th Amendment scholar, said the panel’s decision is defensible “if you think original intention should matter” in interpreting that amendment. The ratifiers would think you were “crazy” if asked whether this type of recovery could be included in the income tax base, he said.
“Having said that, the D.C. Circuit did get a lot of things wrong in the opinion,” he said, blaming the government for a weak brief and argument. “I think the government had no idea this result was a possibility, but it has raised all the points it should have raised in its petition for rehearing.”
Review by the full circuit court or the Supreme Court, but not a reversal, “probably would be good for the state of the law,” said Jensen.