In a potentially extraordinary decision, a federal appeals court has held that it is unconstitutional for the government to tax damages for personal injuries such as emotional distress or loss of reputation. Although the government is sure to appeal, this case (Murphy v. Internal Revenue Service, 2006 U.S. App. LEXIS 21401 (D.C. Cir. 2006)) has the potential to change completely the taxation of many employment judgments and settlements.
In 1994, Marrita Murphy filed a complaint alleging that her former employer, the New York Air National Guard, had, in violation of various whistle-blower statutes, “blacklisted” her and provided unfavorable references to potential employers after she had complained to state authorities of environmental hazards on an airbase. Ms. Murphy submitted evidence that she had suffered both mental and physical injuries as a result of the blacklisting. One such injury was “bruxism,” or teeth-grinding, often associated with stress, which may cause permanent tooth damage. After a finding that Ms. Murphy had also suffered other “physical manifestations of stress,” including “anxiety attacks, shortness of breath, and dizziness,” she was awarded compensatory damages totaling $70,000, of which $45,000 was for “emotional distress or mental anguish,” and $25,000 was for “injury to professional reputation” from having been blacklisted. No part of the award was for lost wages or diminished earning capacity.
On her tax return for 2000, Ms. Murphy included the $70,000 award in her income pursuant to the tax rule that payments for damages are includible in taxable income unless they qualify for an exclusion under Section 104(a)(2) of the Internal Revenue Code for damages received “on account of personal physical injuries or physical sickness.” Under this rule, damages for emotional distress and reputational injuries have, since an amendment to the statute in 1996, been held subject to tax.
But Ms. Murphy took issue with this longstanding rule and filed an action against the Internal Revenue Service, seeking a refund of the $20,665 she had paid in taxes on her award. Her fight with the IRS wound up in the federal appellate court for the District of Columbia, which reached a remarkable decision.
The first of the court’s two holdings was not the bombshell. In that holding, the court simply held that the plaintiff’s damages did not qualify for the exclusion under Section 104 because they were awarded for emotional distress and reputational injuries, and not “on account of” her physical injuries or sickness. No surprise there. But, after concluding that the tax code did not permit Ms. Murphy to exclude her award from her taxable income, the court immediately posed the question, “Is that constitutional?”
The Sixteenth Amendment to the Constitution, ratified in 1913, provides that the government may tax income “from whatever source derived….” But, citing an 1819 Supreme Court statement that “the power to tax involves the power to destroy,” the court held that a recovery of damages received solely in compensation for personal injury is not “income” within the meaning of the Sixteenth Amendment. The court first reasoned that compensation for the loss of a personal attribute, such as well-being or a good reputation, is not damage received in lieu of income. Second, the court reviewed legislative history and court decisions from the early twentieth century to conclude that the framers of the Sixteenth Amendment would not have understood compensation for a personal injury, including a nonphysical injury, to be income. Therefore, the court held, Section 104(a)(2) of the Internal Revenue Code is unconstitutional where it permits the taxation of an award of damages for mental distress and loss of reputation.
Lawyers for plaintiffs may try to rely on this decision to argue that employers settling employment cases should not report any emotional distress or reputational damages as taxable income. But this case reflects the judgment of only one court of appeals, and is not binding everywhere in the country. Before this decision, such attacks on constitutional grounds ran the risk of being labeled frivolous. Moreover, plaintiffs always can, like Ms. Murphy, file for a refund from the IRS, regardless of how the employer has reported the payment for tax purposes. Finally, given the implications of the case, the government is sure to appeal the outcome. As a result, employers that rely on this surprising decision to treat emotional distress payments as not taxable do so at their peril. However, employers should stay in close communication with their counsel and tax advisers to monitor the progress of this unprecedented case when settling any matters involving alleged emotional distress damages or loss of reputation.