New England Biz Law Update
Reversing an opinion it issued just 11 months ago, the D.C. Circuit recently ruled the federal government can tax the money damages a plaintiff for emotional distress and other intangible injuries.
The plaintiff, a whistleblower, argued she shouldn’t be taxed on a return of her “human capital” – that her damages award wasn’t income because she was being made whole for her losses.
Last August, the same three-judge panel ruled that such damages weren’t taxable and that §104(a)(2) of the Internal Revenue Code was unconstitutional.
Plaintiffs’ employment attorneys hailed the original decision, but after another round of briefs and oral argument, the judges determined that the plaintiff’s award fell within the definition of gross income under §61 of the Code and imposing a tax was lawful.
The decision is a significant victory for the IRS and will affect a large number of plaintiffs, said David K. Colapinto, a partner at Kohn, Kohn & Colapinto in Washington, D.C. who represented the plaintiff.
“This will affect every employment law plaintiff suing under federal civil rights statutes or state laws regarding wrongful discharge, all whistleblower plaintiffs and any personal injury plaintiff that recovers non-physical damages,” he said. “And it is very troubling that the court makes little mention in the decision about the traditional ‘make-whole’ principle that is incorporated into every federal civil rights and whistleblower statute and collides with the tax law they have come up with.”
Taxable damages
Marrita Leveille (now Murphy) filed a complaint with the Department of Labor in 1994, alleging that 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 that the Guard had unlawfully discriminated and retaliated against Murphy. She submitted evidence that she suffered both physical and mental injuries as a result of the blacklisting, including ‘bruxism’ – teeth grinding often associated with stress. A physician also testified that she 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, she included the $70,000 award in her 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 that §104(a)(2) of the Code, which provides that only damages for physical injuries are not subject to tax, was unconstitutional as applied.
A panel of the D.C. Circuit agreed last August. But the judges vacated their decision sua sponte in December, reheard the case and reversed. (Murphy v. IRS, Docket No. 05-5139.)
“We hold, first, that [the plaintiff’s] compensation was not ‘received … on account of personal physical injuries’ excludable from gross income under §104(a)(2). Second, we conclude gross income as defined by §61 includes compensatory damages for non-physical injuries. Third, we hold that a tax upon such damages is within the Congress’s power to tax,” the court said.
The plaintiff “no doubt suffered from certain physical manifestations of emotional distress, but the record clearly indicates the [ALJ review] Board awarded her compensation only ‘for mental pain and anguish’ and ‘for injury to professional reputation.’ …
Further, the court said that under §61, the plaintiff’s award constituted gross income and it was not a return of “human capital.” Rather, the plaintiff’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.”
Tax advice essential
Colapinto’s client is still considering whether to appeal the decision, but he predicted the topic will arise in other jurisdictions.
“Regardless of the final outcome in this case, the same issues are going to be raised by employment lawyers … around the country,” he said.
Colapinto also expressed concern about the court’s decision to read Sect. §104(a)(2) as making non-physical damages taxable.
“In essence, what the court is saying is that Congress can call anything it wants ‘income,’ and tax it,” he said.
Robert W. Wood, a tax practitioner at Wood & Porter in San Francisco, Calif., said he was disappointed in the ruling’s lack of discussion about what constitutes an award for physical damages, especially since the plaintiff suffered physical manifestations of her emotional distress.
Further, given the court’s adherence to the ALJ’s description of the award, Wood predicted that employment plaintiffs will have great incentive to pay more attention to the tax consequences of the language in their settlements agreements.
“The exact wording of what damages are being awarded for is really important,” he stressed. Plaintiffs “are … well-advised to get tax advice before they agree to anything.”
