Nina Joan Kimball is a partner at Kimball Brousseau LLP in Boston, where she concentrates in employment law. She is a past chair of the MBA Labor & Employment Section Council.
Editor's Note: After the publication deadline had passed for this issue of the Section Review, the D.C. Circuit vacated its decision on this case and scheduled an en banc hearing. Watch the D.C. Circuit for further developments in the upcoming months.
Perhaps it is not true that the only things you can count on are death and taxes.
The U.S. Court of Appeals for the District of Columbia Circuit has just declared that taxing emotional distress damages is unconstitutional. In Murphy v. IRS, 2006 U.S. App.
LEXIS 21401 (D.C. Cir. Aug. 22, 2006), the D.C. Circuit held that damages received in compensation for mental distress and harm to reputation are akin to compensation for personal injuries, which have long been understood not to be “income” within the meaning of the Sixteenth Amendment to the Constitution, and therefore not taxable.
This decision could have far-reaching consequences. Although Murphy involved a claim brought by a federal employee suing her employer for retaliation under various whistle blower statutes, the reasoning of the decision would apply to awards of emotional distress damages under any statute or common law claim. Coming out of the D.C. Circuit, one of the most respected appellate courts in the country, in an opinion authored by a Reagan appointee, Chief Judge Douglas Ginsberg, this decision will likely be followed in other jurisdictions.
The case arose when Marrita Murphy claimed that her employer, the Air National Guard, had blacklisted her and provided unfavorable references after she complained to state authorities about environmental hazards. She filed a claim with the Department of Labor.
An Administrative Law Judge awarded her $45,000 for “emotional distress or mental anguish” and $25,000 for “injury to professional reputation” on her discrimination and retaliation claims. After paying taxes of $20,665 on the $70,000 award, Ms. Murphy sought a refund of the $20,665 tax, claiming the money was not taxable “income” based on two theories: (1) it was not “income” as defined by the Internal Revenue Code (IRC)
Section 104(a)(2) because it was damages received for a “personal injury or sickness” which are not included within the statutory definition of income; and (2) it was not “income” within the meaning of the Sixteenth Amendment to the Constitution.
The D.C. Circuit rejected her first theory, finding that she was not compensated for a physical injury. Even though she had evidence that she suffered physical symptoms, such as teeth grinding, anxiety attacks, shortness of breath and dizziness – the court concluded that the damages she was awarded were not to compensate her for the physical symptoms, but rather compensated her for the underlying emotional harm. Consequently, the money on which she paid a tax was compensation for an emotional injury, not a physical injury. Hence it did not fall within the statutory exception.
Murphy, at **9-13.
However, the court agreed with Murphy’s second argument, that taxing the emotional distress damages was unconstitutional because the award did not constitute taxable “income” within the meaning of the Sixteenth Amendment. The issue before the court was whether the compensation Murphy received for her injuries was income. Congress derived its power to tax income from the Sixteenth Amendment, ratified in 1913, which provides: “The Congress shall have the power to lay and collect taxes on income from whatever source derived.” However, as the court recognized, Congress’s power to tax is limited to the power to tax “income,” and not all money persons receive is income.
To determine whether Murphy’s emotional distress award was “income” as defined in the Sixteenth Amendment, the court looked to Congressional accounts and early
Supreme Court decisions interpreting the Internal Revenue Code’s income tax provisions, enacted within a few years of the Sixteenth Amendment. The court pointed out that the
Supreme Court interpreted “gross income” in the statute to extend only to “gains” or “accessions to wealth,” but not to a “restoration of capital” since that is simply restoring something lost. Murphy argued, and the court agreed, that “a damage award for personal injuries—including non-physical injuries—is not income but simply a return of capital—human capital,” and therefore was not income. Id. at **16, 30.
The court also looked at the issue by asking the question “in lieu of what were the damages awarded?” Id. at *25 (quoting Raytheon v. Prod Corp. v. Commissioner, 144
F.2d 110, 113 (1stCir. 1944)). As the court explained, “the taxpayer’s award of compensatory damages is a ‘substitute for a normally untaxed personal . . . quality, good, or ‘asset.’ . . . Accordingly, we join our sister circuits by asking: ‘In lieu of what were the damages awarded’? Here, if the $70,000 Murphy 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.’” Murphy, at *25 (internal quotations omitted). The court answered the question thus: “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.” Id. at *30. Hence the damages are not income, and taxing them violated the Sixteenth Amendment.
The reasoning of Murphy can apply here in Massachusetts to any claims that provide emotional distress damages. The decision will benefit employees and employers alike as the net effect is that in settling cases and paying judgments, the employee will get more money in her pocket at no greater cost to the employer. The decision returns taxation of emotional distress damages to what it was a decade ago, prior to Congress’s 1996 amendment to Section 104(a), which exempted damages for physical injuries from taxation, but specifically allowed taxation of damage for emotional injuries. As a practical matter, what the attorney should do when settling claims, is to carve out the emotional distress damages from damages for back pay and attorneys’ fees. Each of these elements of damages has a different tax consequence. The employer must issue a W-2 on the back pay (the only damages subject to FICA), and should issue 1099s on the emotional distress damages and on the attorneys’ fees (which, since 2004, can be deducted from income on the employee’s tax return). Then it will be up to the employee-taxpayer to decide whether to pay the tax. The prudent approach is to do what Ms. Murphy did here: pay the tax and seek a refund of the tax relying upon the Murphy decision.