New England Biz Law Update
The federal government can’t tax the money a plaintiff received as compensation for emotional distress and other intangible injuries, the D.C. Circuit recently ruled, holding that §104(a)(2) of the Internal Revenue Code is unconstitutional as applied.
The decision has reignited a controversy that could end up before the U.S. Supreme Court.
The plaintiff was a whistleblower who received damages for emotional distress and the damage to her professional reputation. She argued she shouldn’t be taxed on a return of her “human capital” – that the damages weren’t income because she was being compensated for something that wasn’t taxable to begin with.
The D.C. Circuit in Murphy v. IRS (No. 05-5139) agreed.
This “momentous” result is “one of the most devastating and potentially far-reaching of losses for the IRS, according to Robert W. Wood, a tax practitioner at Wood & Porter in San Francisco.
“The D.C. Circuit wiped away volumes of tax case law and decades of jurisprudence,” he said.
What the tax community found particularly surprising about the decision was the broad language the court used, according to Paul Caron, a tax professor at the University of Cincinnati Law School and author of the TaxProf blog (http://taxprof.typepad.com).
“The interpretation of the opinion is unlimited, depending on how seriously you take the court’s approach,” Caron said. “If you tie income to the mindset of 1913 [as the court does], a host of tax rules that have been created to deal with more sophisticated transactions than were commonplace way back then are all up for grabs.”
While the decision is binding only in the District of Columbia, plaintiffs across the country will be citing to it, Caron noted. “It’s unclear whether any other courts will follow this case, but there will be a lot of uncertainty.”
Cheaper and easier settlements?
The decision will affect a wide variety of cases, including whistleblower suits, defamation, false imprisonment, malicious prosecution, invasion of privacy and intentional and negligent infliction of emotional distress.
Wood predicted employment litigation would be impacted the most.
According to Janet Hill, past president of the National Employment Lawyers Association and a partner at Hill & Beasley in Athens, Ga., the decision could lead to cheaper and easier settlements.
“Courts have said that parties can add in more money to a settlement [because of] the tax implications, but employers generally don’t want to do that,” she said. “In the long run, if this decision stands, settlements and judgments will be less expensive for employers and other defendants.”
But Hill won’t start counseling her clients to avoid paying taxes.
“The safe thing to do is to pay, but challenge whether it was properly taxed, citing this decision as support,” she said.
Another issue is the decision could apply retroactively to taxpayers who settled their cases earlier in 2006 – as well as those who still have open tax returns from 2005, 2004 or 2003, according to Wood, author of “Taxation of Damage Awards and Settlement Payments.”
The widespread expectation is that the IRS will appeal, either by seeking rehearing en banc or by filing a petition for certiorari with U.S. Supreme Court.
“The decision comes out of left field,” said Tyler A. Brown, managing partner of Jackson Lewis’ Washington, D.C. office. “There is no way the IRS will let it stand.”
The IRS earlier this month filed a petition for rehearing en banc before the D.C. Circuit.
Blacklisted whistleblower
Marrita Leveille (now Murphy) filed a complaint with the Department of Labor in 1994, alleging her former employer, the New York Air National Guard, had “blacklisted” her and provided unfavorable references after she complained to state authorities about environmental hazards on a Guard airbase.
The Secretary of Labor determined the Guard had unlawfully discriminated and retaliated against Murphy. She submitted evidence she suffered both physical and mental injuries as a result of the blacklisting, includng “bruxism” – teeth grinding often associated with stress. A physician also testified Murphy suffered from other physical manifestations of stress such as anxiety attacks, shortness of breath and dizziness.
An ALJ awarded Murphy a total of $70,000 in compensatory damages: $45,000 for “emotional distress or mental anguish” and $25,000 for the injury to her professional reputation. On her 2000 tax return, Murphy included the $70,000 award as gross income and paid $20,665 in taxes.
She then filed an amended return, seeking a refund of the $20,665. When the IRS denied her request she filed suit, arguing §104(a)(2) of the tax code, which provides that only damages for physical injuries are not subject to tax, was unconstitutional as applied.
A unanimous panel of the D.C. Circuit agreed.
The court said in determining whether Murphy’s award was “income under the Sixteenth Amendment, we are instructed by the Supreme Court first to consider whether the taxpayer’s award of compensatory damages is ‘a substitute for [a] normally untaxed personal … quality, good, or ‘asset.’ … Here, if the $70,000 [the plaintiff] received was ‘in lieu of’ something ‘normally untaxed,’ then her compensation is not income under the Sixteenth Amendment; it is neither a ‘gain’ nor an ‘accession[] to wealth. …
“[I]t is clear from the record that the damages were awarded to make [Murphy] emotionally and reputationally ‘whole’ and not to compensate her for lost wages or taxable earnings of any kind. The emotional well-being and good reputation she enjoyed before they were diminished by her former employer were not taxable as income,” wrote Chief Judge Douglas H. Ginsburg wrote for the court.
Looking at the state of the law in 1913, when the Sixteenth Amendment was adopted, the court said 34 states reported cases involving defamation and other reputational injuries where the damages were not considered “income” and therefore were not taxed.
“[E]very indication is that damages received solely in compensation for a personal injury are not income within the meaning of the Sixteenth Amendment. First, as compensation for the loss of a personal attribute, such as well-being or a good reputation, the damages are not received in lieu of income,” wrote Ginsburg.
The court remanded the case with an order to reimburse the plaintiff’s $20,665, plus interest.
