Over the course of almost a year, I have discussed the progress of the claims by Marrita Murphy and Daniel Leveille that a non-physical injury emotional distress damages award is not taxable. See these ataxingmatter postings(in reverse chronological order): here, here, here, here, here and here.
Briefly, Murphy claimed a refund of taxes paid on her damage award on the grounds that they were excluded under section 104(a)(2) or alternatively that they were not taxable because the damages were not income under the Sixteenth Amendment. The district court rejected Murphy's claims, but on appeal the D.C. Circuit initially upheld them, ruling that the damages were not "income" within the meaning of the Constitution. There was a flurry of academic commentary, generally criticizing the court's logic and the court's conclusion. When the Government petitioned for a rehearing en banc, the original panel surprisingly vacated its judgement and agreed to rehear the case itself. Most academics assumed that the rehearing would result in a reversal of the original opinion. The uncertainty was how the opinion would deal with the vacated opinion and the constitutional issue it had raised. The court's opinion on rehearing was released July 3, 2007 and is available here: Download murphy. DC Circuit Opinion on Rehearing. 05-5139b.pdf
A key to the opinion is the face-saving language in the section in which the court explains its decision to vacate its judgement and rehear the case. The Government argued for the first time in its petition for rehearing that there is no constitutional impediment to Congress's ability to tax an emotional distress award "even if Murphy's award is not income" because the tax would not be a direct tax and is imposed uniformly, thereby satisfying the constitutional requirements for exercise of the taxing power. The court grabs that as a lifeline to rationalize its reversal, noting "the importance of the issue thus belatedly raised." Id. at 5.
The court then considers section 104(a)(2)'s exception to the section 61 inclusion rule provided for compensation for injuries or sickness in the context of the historical development of the section. The provision was amended in 1996 to make clear that the exception to inclusion applied only for damages awarded on account of physical injuries. Therefore, the court rightly concludes that Murphy cannot exclude her award under that section. The court then proceeds to note that, to be taxable, the award must be part of "gross income" as defined in section 61 and interpreted broadly to mean "all accessions to wealth". Here the court reiterates Murphy's argument that damage awards for personal injuries are a return of human capital and therefore are not taxable, and then summarizes the government's responses, including its statement of the role of basis in determining whether there is a return of non-taxable capital for federal income tax purposes. But instead of concluding that the damage award is a clear accession to wealth because the recipient has no basis in the award, the court decides to jump to the question whether section 61 can encompass non-income items under its label of "income" and still be constitutional. The answer is clearly affirmative.
Although the Congress cannot make a thing income which is not so in fact, ... it can label a thing income and tax it, so long as it acts within its constitutional authority, which includes not only the Sixteenth Amendment but also Article I, Sections 8 and 9. ... Accordingly, rather than ask whether Murphy's award was an accession to her wealth, we go to the heart of the matter, which is whether her award is properly included within the definition of gross income in section 61(a), to wit, "all income from whatever source derive." Id. at 16-17 (citations omitted).
The court then considers section 61's broad definition of income and non-exclusive examples of items that are included in income and its place within the income tax statute as a whole, noting that "reading section 61 in combination with section 104(a)(2) ... presents a very different picture--a picture so clear that we have no occasion to apply the canon favoring the interpretation of ambiguous revenue-raising statutes in favor of the taxpayer." The court concludes that Congress clearly intended for its 1996 amendment to result in emotional distress awards' being taxable to recipients. That could only result if such damages were included within the ambit of seciton 61--either already within the meaning of "income" prior to the amendment of section 104(a)(2) or within the meaning of "income" after the amendment of section 104(a)(2) by virtue of an implicit amendment to section 61 to cover such an award within the term "income". Id. at 18.
For the 1996 amendment of section 104(a) to "make sense," gross income in section 61(a)must, and we therefore hold it does, include an award for nonphysical damages such as Murphy received, regardless whether the award is an accession to wealth. Id. at 19.
Note that if the court had concluded (as I think it should have) that such damage awards are indeed accessions to wealth, it would not need to go any further. The award would be included in the broad "catch-all" language of section 61 once it was no longer excluded by section 104(a). See Joseph Dodge's succinct discussion of the problems of finding an "implicit" amendment of section 61, in the TaxProf link, below.
Instead, the court "jumps" that decision to get to the question of the ability of Congress to tax the award under the Constitution even if it is not "income" in the constitutional sense of the Sixteenth Amendment. As another tax professor noted in an online discussion of Murphy (see Bryan Camp at the TaxProf link below), this is a face-saving leap of the court--this new part of the opinion justifies the court's revised conclusion through an analysis of the taxing power of Article I, Section 8.
That taxing power has two limitations--a uniformity requirement for duties, imposts and excises (the same in Montana as in Mississippi), and an apportionment requirement for direct taxes ( head taxes and real and personal property taxes must be allocated among the states according to their representation). The court has trouble with the question of whether taxation of a damages award is a direct tax or not, and its analysis skirts very close to concluding that the damage award is in fact income under the Sixteenth Amendment in spite of the court's desire not to tread that territory.
Even if we assume one's human capital should be treated as personal property, it does not appear that this tax is upon ownership; rather, as the Government points out, Murphy is taxed only after she receives a compensatory award, which makes the tax seem to be laid upon a transaction. ... Murphy's situation seems akin to an involuntary conversion of assets; she was forced to surrender some part of her mental health and reputation in return for monetary damages. Id. at 27 (citations omitted).
After its labored excursion into the murky historical record on direct taxes, the court concludes that this is not a direct tax (and is uniform), thereby concluding that Congress could reach it with its taxing power. Murphy loses.
For a range of views about the significance of this opinion, see the Tax Prof July 6 entry, with comments by a number of tax professors. Bryan Camp
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