DC Circuit Rules Compensatory Damages for Personal Injuries in an Employment Case Not Taxable

In a recent case, a three judge panel of the U.S. Court of Appeals for the District of Columbia Circuit surprisingly ruled that compensatory damages for personal injuries resulting from mental distress and loss of reputation are not taxable to plaintiffs in employment cases. Murphy v. IRS, 2006 WL 2411372 (D.C. Cir. Aug 22, 2006).

In 1994, Marrita Leveille (now Murphy) filed a complaint with the Department of Labor alleging that her former employer, the New York Air National Guard (NYANG), in violation of various whistle-blower statutes, had “blacklisted” her and provided unfavorable references to potential employers after she had complained to state authorities of environmental hazards on a NYANG airbase. The Secretary of Labor determined the NYANG had unlawfully discriminated and retaliated against Murphy, ordered that any adverse employment references to the taxpayer in Office of Personnel Management files be withdrawn, and remanded her case to an Administrative Law Judge “for findings on compensatory damages.”

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

On her tax return for 2000, Murphy included the $70,000 award in her “gross income” pursuant to § 61 of the Internal Revenue Code (the “IRC”), which states that “[g]ross income means all income from whatever source derived”. As a result, she paid $20,665 in taxes on the award. Murphy later filed an amended return in which she sought a refund of the $20,665 based upon § 104(a)(2) of the IRC, which provides that “gross income does not include ··· damages ··· received ··· on account of personal physical injuries or physical sickness.” In support of her amended return, Murphy submitted copies of her dental and medical records. Upon deciding Murphy had failed to demonstrate the compensatory damages were attributable to “physical injury” or “physical sickness,” the Internal Revenue Service denied her request for a refund. Murphy thereafter sued the IRS and the United States in federal district court.

In her complaint, Murphy sought a refund of the $20,665, plus applicable interest, pursuant to the 16 th Amendment, along with declaratory and injunctive relief against the IRS pursuant to the Administrative Procedure Act and the Due Process Clause of the Fifth Amendment to the Constitution. She argued her compensatory award was in fact for “physical personal injuries” and therefore excluded from gross income under § 104(a)(2). In the alternative Murphy asserted § 104(a)(2) as applied to her award was unconstitutional because the award was not “income” within the meaning of the 16 th Amendment. The Government moved for summary judgment on all claims. The district court rejected all Murphy's claims on the merits and granted summary judgment for the Government and the IRS. Murphy then appealed the judgment to the D.C. Circuit.

Section 104(a) (“Compensation for injuries or sickness”) provides that “gross income [under § 61 of the IRC ] does not include the amount of any damages (other than punitive damages) received ··· on account of personal physical injuries or physical sickness.” Since 1996 it has further provided that, for purposes of this exclusion, “emotional distress shall not be treated as a physical injury or physical sickness.” The version of § 104(a)(2) in effect prior to 1996 had excluded from gross income monies received in compensation for “personal injuries or sickness,” which included both physical and nonphysical injuries such as emotional distress.

Murphy contended that § 104(a)(2), even as amended, excludes her particular award from gross income. First, she asserted her award was “based upon ··· tort type rights” in the whistle-blower statutes the NYANG violated-a position the Government did not challenge. Second, Murphy claimed she was compensated for “physical” injuries, which claim the Government did dispute.

Murphy pointed both to her physician's testimony that she had experienced “somatic” and “body” injuries “as a result of NYANG's blacklisting [her],” and to the American Heritage Dictionary, which defines “somatic” as “relating to, or affecting the body, especially as distinguished from a body part, the mind, or the environment.” Murphy further argued that the dental records she submitted to the IRS proved she had suffered permanent damage to her teeth. Murphy further contended that neither § 104 of the IRC nor the regulation issued thereunder “limits the physical disability exclusion to a physical stimulus.”

The Government argued that Murphy's exclusive focus upon the word “physical” in § 104(a)(2) was misplaced; more important is the phrase “on account of.” Citing prior Supreme Court cases, the Government concluded that Murphy had to demonstrate she was awarded damages “because of” her physical injuries, which the Government claimed she had failed to do.
Indeed, as the Government pointed out, the ALJ expressly recommended, and the Board expressly awarded, compensatory damages “because of” Murphy's nonphysical injuries.

The Court conceded that Murphy no doubt suffered from certain physical manifestations of emotional distress, but it claimed that “the record clearly indicates the Board awarded her compensation only ‘for mental pain and anguish’ and ‘for injury to professional reputation.’” Because the Board left no room for doubt about the grounds for Murphy’s award, the Court concluded that Murphy's damages were not “awarded by reason of, or because of, ··· [physical] personal injuries,” Thus, § 104(a)(2) did not permit Murphy to exclude her award from gross income. The Court then turned to Murphy’s constitutional argument.

The constitutional power of the Congress to tax income is provided in the 16 th Amendment, ratified in 1913: “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.” The Supreme Court has held the word “incomes” in the Amendment and the phrase “gross income” in § 61(a) of the IRC are coextensive.

Murphy argued that, being neither a gain nor an accession to wealth, her award was not income and § 104(a)(2)was therefore unconstitutional insofar as it would make the award taxable as income. Murphy pointed out that the Supreme Court has long recognized “the principle that a restoration of capital [i]s not income; hence it [falls] outside the definition of ‘income’ upon which the law impose[s] a tax.” By analogy, Murphy contended a damage award for personal injuries-including nonphysical injuries-is not income but simply a return of capital-“human capital”.

The Government attacked Murphy's constitutional argument on all fronts. First, invoking the presumption that the Congress enacts laws within its constitutional limits, the Government asserted at the outset that § 104(a)(2) is constitutional even if, as amended in 1996, it does permit the taxation of compensatory damages. Indeed, the Government went further, contending the Congress could, consistent with the 16 th Amendment, repeal § 104(a)(2) altogether and tax compensation even for physical injuries.

The Government next maintained that compensatory damages “plainly constitute economic gain, for the taxpayer unquestionably has more money after receiving the damages than she had prior to receipt of the award.”

At the outset, the Court rejected the Government's “breathtakingly expansive claim of congressional power under the 16 th Amendment.” According to the Court, “[t]he 16 th Amendment simply does not authorize the Congress to tax as ‘incomes’ every sort of revenue a taxpayer may receive.”

To determine whether Murphy's compensation was income under the 16 th Amendment, the Court first considered whether the taxpayer's award of compensatory damages is “a substitute for [a] normally untaxed personal ··· quality, good, or ‘asset.’ ” The Court observed that “it 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. Under this analysis, therefore, the compensation she received in lieu of what she lost cannot be considered income and, hence, it would appear the 16 th Amendment does not empower the Congress to tax her award.”

The Court concluded that “[i]n sum, every indication is that damages received solely in compensation for a personal injury are not income within the meaning of that term in the 16 th Amendment.” First, as compensation for the loss of a personal attribute, such as well-being or a good reputation, the damages were not received in lieu of income. Second, the framers of the 16 th Amendment would not have understood compensation for a personal injury-including a nonphysical injury-to be income. Therefore, the Court held § 104(a)(2) unconstitutional insofar as it permits the taxation of an award of damages for mental distress and loss of reputation. The Court thus remanded the case to the district court to enter an order and judgment instructing the Government to refund the taxes Murphy paid on her award plus applicable interest.

Many commentators have been critical of the Murphy case, and have expressed the view that it will be overturned. As it stands now, however, the decision is governing law in the District of Columbia, and may make it easier for employment cases to settle at least in that jurisdiction, because settlement payments may not be subject to taxation for the employee or the employer. It is unclear how many, if any, other courts will follow Murphy. What is certain is that when structuring settlements, employers must continue to consider the tax consequences of settlement payments very carefully.

Michael L. Stevens
202.857.6382
[email protected]