Murphy v. United States (D.C. Cir., Aug. 22, 2006 ) has created a furor of discussion among tax and constitutional scholars. This case has led to a long series of discussions on the TaxProf listserve that have undoubtedly influenced my views on this matter, and there are a number of excellent articles in Tax Notes, available (free) at this link. Murphy applied an originalist interpretative approach to find that emotional distress damage awards that do not compensate for lost wages probably weren't considered income in 1918 and therefore any tax on such damages is unconstitutional.
The Murphy case is a refund suit for federal income taxes paid on emotional distress and loss of reputation damages awarded in Murphy's suit against her former employer. For readers not conversant with the specifics of the rules, what follows is a very brief overview. Code Section 61 is the general rule that requires taxpayers to include in gross income "income from whatever source derived." Various types of income are excluded through specific statutory provisions. Accordingly, gifts and bequests are excluded under Section 102, even though they are clearly accessions to wealth under the Glenshaw Glass interpretation of income. Similarly, Congress chose to exclude certain scholarship funding under Section 117. Section 104 provides an exclusion for various kinds of amounts received because of personal injuries or sickness, such as workmen's compensation, compensatory damages, accident or health insurance payments, and pension payments. That exclusion, however, applies only to compensatory damages received "on account of personal physical injuries or physical sickness": the flush language explicitly states that "for purposes of paragraph (2) [covering compensatory damages], emotional distress shall not be treated as a physical injury or physical sickness." Murphy's suit claimed that her compensatory damages for emotional distress and loss of reputation should have been excluded either (i) because they were suffered "on account of personal physical injuries or physical sickness" or (ii) because those damages simply are not income within the Sixteenth Amendment, with the result that, she claimed, Section 104(a)(2) is unconstitutional because it reaches items not within the meaning of the Sixteenth Amendment's income tax provision.
The Murphy court dispensed with her first claim easily. Because of the discrimination, Murphy ground her teeth together, causing permanent damage to the teeth as substantiated by her dental records. But that is insufficient to satisfy the "on account of personal physical injuries" language of the statute, which the Supreme Court in O'Gilvie v. United States, 519 U.S. 79 (1996), interpreted to require a strong causal connection. The physical injuries were a result of the emotional distress rather than vice versa, and the damages were clearly stated to be awarded for the nonphysical injuries. Accordingly, the court held that Murphy's damage award was not excluded under the language of the statute.
But, the court asked, "is that constitutional?" The Murphy court acknowledged that I.R.C. Section 61 reaches Congress's full taxing power under the constitution. The court then looked at two early cases dealing directly with the breadth of the taxing power under the Sixteenth Amendment. Eisner v. Macomber, a 1920 case, had a rather narrow view of income due to the short time that the Congress and the courts had to develop a theory. It looked to gains from capital or labor. That would apparently not include other types of income, such as prizes and windfalls--winning a lottery worth a million or discovering a briefcase with a million dollars inside an old trunk bought for $50 at auction. (For an in-depth look at Eisner, see Marjorie Kornhauser's analysis in Tax Stories, abstracted here.)
Glenshaw Glass, a case from the 1950s, recognized that a 1920s understanding of income could not be expected to be sufficient for issues arising decades later: the opinion even stated (as quoted in Murphy) that "Eisner was not 'meant to provide a touchstone to all future gross income questions'." The Court concluded that Congress could tax "all gains" or "accessions to wealth." Glenshaw Glass thus appears to invite us to have a dynamic view of the Constitution as a document that evolves with the country that it governs and with our understanding of concepts over time.
In Murphy, the appellant urged the court to view a compensatory damage award for emotional distress as analogous to a restoration of capital (substituting an amorphous concept of "human capital" for financial capital) that should require exclusion of compensatory damages. (For an exposition of the human capital theory, see Frank Doti, Personal Injury Income Tax Exclusion: An Analysis and Update.) Murphy also urged an originalist interpretation of the Sixteenth Amendment, looking at an Opinion of the Attorney General, a Treasury Decision, and a House Ways and Means Commitee Report. The 1918 A.G. opinion argued that life insurance proceeds "merely take the place of capital in human ability which was destroyed by the accident" and are "'capital' as distinguished from 'income' receipts." The Treasury Decision merely applied the same principle to find that compensatory damages for accidental injuries were not taxable. The House Report doubted whether health insurance or workmen's compensation were required to be included in gross income. Congress then enacted a statutory provision (the precursor of Section 104(a)) that excluded various types of compensatory damages from income.
The government argued that historical exclusion of types of economic income based on a human capital theory does not demonstrate that exclusion is required under the Sixteenth Amendment. The income tax looks to economic income: gains are taxed to the extent that they exceed basis, which is the financial capital invested. There is no parallel economic amount invested for tax purposes in one's body: a person does not have a basis in their well-being.
The Murphy court does not adequately respond to the economic capital argument. Instead, it claims to avoid the need to decide whether compensatory damages are a return of human capital by resting on two arguments: the 'in-lieu-of" test and originalist interpretation of the Constitutional concept of income. Concluding that the damages are not in lieu of wages but rather make a person whole, the court concludes they must not be taxable. Finding that the Attorney General opinion and Treausry ruling "strongly suggest" that income didn't extend to compensatory damages unrelated to lost wages and that most states treated nonphysical injuries as remediable through tort compensation, the Murphy court "infer[red]" that the constitutional concept of income in 1913 did not include compensatory damages for nonphysical injuries. (These tentative conclusions metamorphose into certainty towards the end of the opinion, where the court states that the framers "would not" have treated compensatory damages for personal injuries as income.)
The Supreme Court's "in lieu of" test ultimately seems unhelpful. Asking whether an award is a substitute for normally untaxed personal qualities or assets merely shifts the decision back to another element --what constitutes a "substitute for a normally untaxed personal quality or asset." And that question must be decided in the same way as the original question. Let's accept that damages may be in lieu of wages that the recipient would have been paid or they may be to make the recipient whole for lost well-being. If one accepts some sort of human capital theory, then the make-whole type of damages will appear to be totally different from wage-restoration damages, not normally taxable, and therefore not income. But those make-whole damages can also be analogized to possible contractual exchanges which are normally taxable commercial transactions--i.e., in lieu of profits in a voluntary agreement with a masochist who offered to pay you $1 million to endure various kinds of humiliation, so compensation income or in lieu of gains in a voluntary agreement with a sick person who offered to pay you $1 million for a kidney. If you conclude that the million dollars is clearly "compensation received in lieu of what [the humiliated person] lost" (quoting Murphy), then it cannot be taxed. If you conclude that any service arrangement or exchange that results in new wealth must be income, then you will decide the in-lieu-of argument as holding that such damages are within the concept of taxable income. That the Murphy court finds it obvious that the damages at issue were "to make Murphy emotionally whole" and hence "not to compensate her for lost wages or taxable earnings of any kind" shows that it did not consider such analogies in making its determinations.
And although the O'Gilvie opinion does seem to set forth some kind of a theory of human capital recovery, it is at best inchoate and at worst unworkable. Our tax concept of capital, as the government argued, is one based on economic outlays--an investment made sinks capital into an enterprise, for which we have tax basis. An investment sold wrests capital from an enterprise, which provides an opportunity for gain to the extent that the amount received exceeds the amount invested. We cannot track a similar investment in our own bodies. Any human capital theory must therefore account for the fact that individuals are born without investing in themselves and they (and their parents, municipalities, and states) invest varying amounts in their own care and livelihood over the course of their lives, with different circumstances that can lead to radically different views of the individual's "worth." Should we award a base human capital account to each person at birth and then track all personal and nondeductible expenses as our individual investment in human capital, requiring all damage awards to reflect that "actual" figure? That seems administratively unworkable. Look at the problems with tracking comparatively simple basis amounts, described by Joe Dodge and Jay Soled in Debunking the Basis Myth under the Income Tax. Does a body's "birthright capital" increase automatically to a "fair market value" that is determined by the damages award itself, or does it depend on a "reasonable" valuation? Take the case of two plaintiffs, A and B, with otherwise identical cases. Plaintiff A received compensatory damages for emotional distress of $500,000 because she represented a sympathetic figure to the jury whereas plaintiff B received only $50,000 in compensatory damages for emotional distress. Should the excess received by A be treated as a gain in excess of the standard human capital amount or should A be allowed to receive the higher award tax free, even though it puts her in a substantially better "ability to pay" position than B? Should our human capital account be treated as zero in the case of voluntary sales of body parts, so that we would be taxed on a voluntary sale (say, a sale of a kidney for $1 million) in the same way we would be taxed on the sale of an alienable item of property, but treated as fair market value for compensatory damages awards? If our human capital account is simply valued at fair market value and fair market value can only be quantified in the context of an arbitrary award, then are we not really pretending to have a theory (human capital theory) when we are simply making a categorical distinction about taxability (damages for emotional distress are not taxable)?
As disturbing as is the human capital theory, the Murphy court's originalist interpretative approach is worse. To justify its originalist approach, the Murphy court quotes the Supreme Court in Merchants' Loan & Trust Co, 255 U.S. 509, 519 (1921), a case decided only a few years after adoption of the Sixteenth Amendment that looked to the "commonly understood meaning of the term" at the time of adoption. As a linguist by training, I find originalism generally incomprehensible, since language evolves over time and our understanding of words and phrases is appropriately framed by the context in which we use those phrases today. To attempt to freeze the Constitution in the framers' timeframe (in the case of the Sixteenth Amendment, at 1913) is to argue for its irrelevance to contemporary issues in a way that I cannot believe the framers intended. Our concept of income is understandably quite different from the 1920s or even the 1940s. For example, as others have pointed out, time value of money concepts are now integral to the income tax but were not embodied in the first tax statutes. It was not until 1965 that the Supreme Court ruled, in United States v. Midland-Ross Corp, 381 U.S. 54 (1965), that original issue discount is simply a form of interest (though the rules require taxpayers to take the accrued discount into income before it is paid). Realization, at first thought to be a constitutional requirement, has now been relegated to a rule of administrative convenience. There is no indication that the Murphy court considered these issues at all in its application of originalism to the Sixteenth Amendment.
Two other noteworthy items in the Murphy case, each pointed out by others before me. First, Murphy and the Murphy court were lax in their articulation of the constitutional issue, in a way that brings into question the ability of lay judges to deal with complex tax issues in a coherent way. The Murphy court concludes by stating that "insofar as Section 104(a)(2) permits the taxation of compensation for a personal injury, which compensation is unrelated to lost wages or earnings, that provision is unconstitutional." But Section 104(a)(2) surely isn't unconstitutional under the Murphy court's analysis. It excludes from income certain compensatory damages. The Murphy court does not hold that those exclusions are problematic. The problem is that the exclusion as stated doesn't reach some other types of compensatory damages, which the Murphy court holds must be excluded on constitutional grounds. As an exclusion provision, Section 104 does not cause those damages to be taxed. They are taxable, if at all, under the general inclusion provision, Section 61(a), that includes all items of income from whatever source derived. So the Murphy court showed its failure to understand the critically important statutory schema shaped by the the various provisions acting together, when it held that Section 104(a)(2) is unconstitutional. See Tax Foundation, The Murphy Case: interpretive and Constitutional Issues, and James Maule's blog, Mauled Again, Why Hold Section 104(a)(2) Unoconstitutional When There is No Need to Do So?.
Second, the government and the Murphy court shortchanged the constitutional analysis. Calvin Johnson has written extensively about the federal taxing power as a fundamental reason for the Constitution in Righteous Anger at the Wicked States: The Meaning of the Founders' Constitution. The Sixteenth Amendment is not the sole source of that taxing power: in fact, it overturns the "direct taxes must be proportional" Article I, Section 9 limitation to the general Article I, Section 8 taxing power. See, e.g., Tax Foundation, The Murphy Case: interpretive and Constitutional Issues (discussing the direct tax issue). As the Tax Foundation commentary notes, "the Murphy opinion failed to wrestle with the issue of whether Article I, Section 8 can be cited as independent constitutional authority for the power to tax emotional distress damages as income."
Very good commentary. I have a special intererst in the second line of attack: the direct taxation issue. The DC Circuit did not even mention it on the way to holding the tax in question invalid. The Federal tax on foreign insurance policies has nothing to do with measuring income, nor should it. Would a Federal excise on tort recoveries be a direct tax? Under the reasoning of HYLTON v. UNITED STATES the answer would clearly be , "no." The DC Circuit has done the legal fraternity a great service by reminding all of us of the direct taxation issue.
Now, I fully believe that recoveries for emotional distress are income within the meaning of Amendment 16, and that the Supreme Court will so rule ( unless the DC Circuit does so , en banc.)
Posted by: The NJ Annuitant | September 06, 2006 at 05:16 AM
I am not a proponent of originalism, and cannot offer any learned explanation of it, but i do think it's worth clarifying that an originalist argument doesn't necessarily mean that whatever items of gain the public deemed "income" in 1913 are the only items that may be reached by taxation.
for example, consider the prohibition on cruel and unusual punishment. i think all would agree today that injecting someone with the bird flu and then watching him die would constitute "cruel and unusual." however, in 17XX (i'm bad with history), when the 8th amendment was ratified, no one even knew what the bird flu was, so the framers could not possibly have intended to prevent the state from killing someone by injecting him with bird flu.
an originalist (or at least a Scalian originalist) would not thus say that the 8th amendment doesn't protect an individual from death by bird flu. Rather, the *original* meaning of the constitution was to prevent cruel and unusual things generally, and that fixed definition may refer to things that change over time. what must be unyielding and unchanging is that the prohibited punishments be "cruel and unusual"-- it cannot be the case, to the originalist, that that definition changes to include "friendly and ordinary" punishments.
Scalia recently emphasized this principle in his dissent in Georgia v. Randolph: “There is nothing new or surprising in the proposition that our unchanging Constitution refers to other bodies of law that might themselves change. The Fifth Amendment provides, for instance, that "private property" shall not "be taken for public use, without just compensation"; but it does not purport to define property rights.” 126 S.Ct. 1515.
Similarly, I do not think that the 16th amendment purports to define “income”—the body of law defining income has undoubtedly changed, but that does NOT mean, under an originalist view, that only those items constituting “income” in 1913 are subject to taxation. Rather, the 16th amendment authorizes taxation of income generally. Under an originalist view, the 16th amendment cannot broadly authorize taxes on both items of income and non-income—that much is correct (although as others have noted, congress’s general power to tax may reach to items of “non-income.”).
Whether originalism is a good theory or not, I don’t know. But I think before we instinctively bash its merits (due to its affiliation with Justice Scalia, who some would think eats little children with his morning coffee), it’s worth analyzing just exactly what it is we’re bashing.
Posted by: andy | September 07, 2006 at 08:23 AM
Professor Beale:
How about applying the tax law theories that you espoused in analyzing MURPHY to IRS instructions that provided for the exclusion from Alternative Minimum Taxable Income of refunds of tax overpayments that provided a tax benefit in a prior year when the regular tax was paid?
What section of the IRC provides for the exclusion of tax refunds from Alternative Minimum Taxable Income when the refunds are the result of overpayments when deducted under paragraph (1), (2), or (3) of secttion 164(a)in a year that the regular tax was paid? It sure is not section 56(b)(1)(D)!
And, how would you argue for the correctness of IRS instructions that requires a refund of a tax overpayment made in a year that the AMT was paid be FULLY INCLUDED in gross income for regular tax purposes. A state income tax overpayment, for example, can produce a limited long term capital gains rate based tax benefit in a year the regular tax is paid by reducing the portion of capital gains taxed at 15 percent and increasing the portion taxed at 5 percent by an equal amount. It seems to me that under section 111(a) the refund should only be included in the calculation of capital gains.
And, oh yes, how is it that section 111(a) of the IRC permits IRS to issue instructions that result in the gross income attributable to an itemized deduction recovery exceeding the amount of the recovery as happens when the refund recipient's taxable Social Security benefits are increased by the itemized deduction recovery? The tax overpayment did nothing to reduce taxable Social Security benefits!
Now to MURPHY:
I believe that this where the govenment went wrong.
The government argued that historical exclusion of types of economic income based on a human capital theory does not demonstrate that exclusion is required under the Sixteenth Amendment. The income tax looks to economic income: gains are taxed to the extent that they exceed basis, which is the financial capital invested. There is no parallel economic amount invested for tax purposes in one's body: a person does not have a basis in their well-being. REALLY?
WD Kebschull
Posted by: WD Kebschull | September 07, 2006 at 03:46 PM
An excellent comment on Murphy, Prof. Beale, hard to improve on.
Posted by: Jake | September 07, 2006 at 06:08 PM