Compensatory Damages May Not be Taxable: Let the Tax Refunds Begin

This is one of those fascinating cases. Despite the long line of case law, the US Court of Appeals for the District Circuit, in Murphy v. Internal Revenue Service, has held that IRC Section 104(a)(2) is unconstitutional.

Murphy was awarded compensatory damages for emotional distress and loss of reputation. Murphy made the traditional argument that has failed in the past, i.e., that her compensatory damages were excludable pursuant to Section 104(a)(2) as they were received “on account of personal physical injuries or physical sickness.” Murphy also made an alternative argument that Section 104 was unconstitutional as if fails to exclude from income revenue that is not “income” within the meaning of the Sixteenth Amendment.

The traditional analysis starts with Section 61, the section that says everything is taxable income unless there is a Code Section that specifically excludes a particular item. The courts have held that “everything” is basically any accession to wealth. So Murphy’s argument was that compensatory damages were not income, as they were a restoration of human capital. In other words the damages did not put her in a better position; they merely put her in the same position. And since she was in the same position as before, she had no accession to wealth and no gain. Despite the IRS’s creative arguments, the court agreed with Murphy.

The IRS will no doubt appeal this decision. In most cases similar to this the Treasury Department has been successful in convincing Congress to take action to reform the statute. The problem here is that it is the income tax itself, based on the Sixteenth Amendment that is in question. As such, Congress could probably not simply amend Section 61 so that compensatory damages are specifically added to that section. There would have to be a change to the Sixteenth Amendment, which is highly unlikely.

So what does this mean for the average taxpayer? Presumably nothing yet. Once the appeal time passes and the case is not appealed or the IRS appeal is unsuccessful, taxpayers who have been awarded compensatory damages in the past few years - either outright or via a settlement agreement - and who paid taxes on those amounts will need to put some serious thought into whether to file an amended tax return asking for a tax refund.

Given the thousands if not millions of trials, arbitration awards, and settlement agreements that award compensatory damages in any one year, this could produce a flood tax refund requests. Attorneys are in the best position to notify their clients of this new tax law change, so lawyers and law firms may need to start going through their client records to see which clients should be notified that they may be entitled to a tax refund.