Compensatory Damages May Not be Taxable

The tax code is an intricate and complex framework that governs the collection of taxes in the United States. While numerous provisions have been contested in courts, it is quite rare for a provision to be deemed unconstitutional, particularly for a tax code section that has already undergone substantial litigation.

In the landmark case of Murphy v. IRS, 460 F.3d 79 (D.C. Cir. 2006), the court made a groundbreaking decision by declaring Section 104(a)(2) unconstitutional. The implications of this ruling could be far-reaching, especially for taxpayers who have received compensatory damages related to emotional distress and loss of reputation, and it raises important questions about the limits of Congress’s power to tax under the Sixteenth Amendment.

Facts & Procedural History

In 1994, the taxpayer filed a complaint with the Department of Labor, alleging that her former employer, the New York Air National Guard (“NYANG”), had unlawfully discriminated and retaliated against her. She claimed that the NYANG had “blacklisted” her and provided unfavorable references to potential employers after she had complained to state authorities about environmental hazards on an NYANG airbase. This action violated various whistle-blower statutes.

The Secretary of Labor determined that the NYANG had indeed unlawfully discriminated against the taxpayer and ordered that any adverse employment references to her in the Office of Personnel Management files be withdrawn. The case was then remanded to an Administrative Law Judge (“ALJ”) for findings on compensatory damages.

On remand, the taxpayer submitted evidence that she had suffered both mental and physical injuries as a result of the NYANG’s blacklisting her. A physician testified that the taxpayer had sustained “somatic” and “emotional” injuries, such as “bruxism” (teeth grinding often associated with stress, which may cause permanent tooth damage) and other “physical manifestations of stress” like anxiety attacks, shortness of breath, and dizziness. The ALJ recommended compensatory damages totaling $70,000, with $45,000 for “emotional distress or mental anguish” and $25,000 for “injury to professional reputation” from being blacklisted. None of the award was for lost wages or diminished earning capacity.

In 1999, the Department of Labor Administrative Review Board affirmed the ALJ’s findings and recommendations. In her 2000 tax return, the taxpayer included the $70,000 award in her “gross income” under Section 61. The taxpayer paid $20,665 in taxes on the award.

The taxpayer later filed an amended return, seeking a refund of the $20,665 based on Section 104(a)(2), which states that “gross income does not include . . . damages . . . received . . . on account of personal physical injuries or physical sickness.” The IRS denied her refund request, deciding that the compensatory damages were not attributable to “physical injury” or “physical sickness.”

The taxpayer then sued the IRS and the United States in District Court, seeking a refund of the $20,665 plus applicable interest, pursuant to the Sixteenth Amendment, as well as declaratory and injunctive relief against the IRS under the Administrative Procedure Act and the Due Process Clause of the Fifth Amendment. She argued that her compensatory award was for “physical personal injuries” and should be excluded from gross income under Section 104(a)(2). Alternatively, the taxpayer asserted that Section 104(a)(2), as applied to her award, was unconstitutional because the award was not “income” within the meaning of the Sixteenth Amendment.

The district court rejected all of Murphy’s claims on the merits and granted summary judgment for the IRS. The taxpayer then appealed the judgment of the district court concerning her claims under Section 104(a)(2) and the Sixteenth Amendment.

Restoration of Human Capital

The courts typically look to Section 61 to determine whether an item is taxable income. Essentially, “everything” is taxable income unless there is a specific Code section that excludes it.

The taxpayer’s argument was that compensatory damages did not constitute income, as they merely restored her human capital rather than providing her with an accession to wealth. In a surprising turn of events, the court agreed with the taxpayer’s argument, rejecting the IRS’s creative counterarguments. The court based its decision on the Sixteenth Amendment to the U.S. Constitution.

The Sixteenth Amendment was ratified in 1913 and grants Congress the power to levy and collect income taxes without apportioning them among the states or basing them on the Census. The full text of the amendment reads: “The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.”

Human capital refers to an individual’s skills, abilities, knowledge, and other intangible assets that contribute to their earning potential. When Murphy received compensatory damages, she claimed that these damages were meant to restore her to the position she would have been in had she not suffered emotional distress and loss of reputation. In other words, the compensatory damages were not meant to provide her with additional wealth or gains but rather to compensate her for the losses she experienced.

The court concluded that the drafters of the Sixteenth Amendment would not have considered this return of human capital as income. Thus, the court concluded that Section 104 was unconstitutional as it counted this as income.

Update: The court recently reversed its opinion in this case. You can read about that decision here. You can also read about other return of capital cases that do not involve human capital, like this one and this one for restoration payments in retirement accounts.

The Takeaway

The Murphy v. IRS case is a noteworthy example of a court finding a provision of the tax code unconstitutional, which is an uncommon occurrence, especially for well-litigated tax code sections. This decision has the potential to significantly impact taxpayers who have received compensatory damages for emotional distress and loss of reputation by potentially excluding these damages from taxable income.

The ruling also raises questions about the scope and applicability of the Sixteenth Amendment, which could lead to further litigation and potential changes in tax law. Additionally, the case highlights the importance of understanding the concept of restoration of human capital and its relevance in determining what constitutes income for tax purposes.