Yesterday, the DC Circuit court handed down what is being called a "bombshell" decision in Murphy v. IRS
. And indeed it is. For on August 22, 2006, the Circuit court declared Section 104(a)(2) of the Internal Revenue Code unconstitutional as applied to compensation for emotional damages. The relevent text of 104 is:
"(a) Except in the case of amounts attributable to (and not in excess of) deductions allowed under section 213 (relating to medical, etc., expenses) for any prior taxable year, gross income does not include -
(2) the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness;"
A brief summary of the facts: Taxpayer was fired from her job and sued for damages. The parties settled for $70k. $30k was identified as compensation for emotional distress and psychological damages and $40k was for reputational damages. Neither is excludable from income under 104.
To put this in perspective, and maybe to offer a prediction on whether this holding will stand on its inevitable review either en banc or by the Supreme Court, the Supreme Court itself has only once, since the ratification of the 16th amendment declared a tax unconstitutional. The case was Eisner v. Macomber, and is fairly long and a bit boring, but has to do with stock dividends. The DC Circuit holding will not stand on review.
An interesting note about 104(a), in 1996 it was modified to include the line "For purposes of paragraph (2), emotional distress shall not be treated as a physical injury or physical sickness." Congress was reacting in a regressive way and putting there foot down, saying, in effect, "Non-physical injuries are too difficult to verify and so will not be recognized for federal tax purposes, unless there are physical manifestations." It's hard to fault Congress for taking this stance in an era of quack doctors and over-zealous trial lawyers. Regardless, this determination is well within Congress's broad legislative and taxing powers.
This case is worth a read, as it cites some really fantastic tax and non-tax cases that most of us are familiar with: US v. Morrison, Eisner v. Macomber, Glenshaw Glass, Rust v. Sullivan, McCulloch v. Maryland, and Raytheon to name a few.
Before I really talk about the tax part of the case, there is something that confuses me about the opinion. The first section of the opinion deals with whether the taxpayer sued the right party. In other words, can the IRS be sued in this venue. On page 6 of the opinion, the court concludes: "Therefore, we hold the IRS, unlike the United States, may not be sued eo nomine in this case." In other words, TP sued the wrong party. There is a procedural flaw in the case. At this point, the court moves on to the analysis of the substantive issues and declares a tax statute unconstitutional. I don't get it. Isn't the case over when the court holds that your opposing party can't be sued. My limited understanding is that this case should have been brought in the tax court, not the district court. If I'm right on this, and there's no indication I am, the en banc or supreme court review should dispose of the case on this issue without addressing the constitutionality.
But apart from the procedural stuff, it's a pretty interesting decision which seems to rest on an unsupportable analogy. The taxpayer argues that when one sustains an mental injury, it is the same as, say, a section of an office building catching fire. When you recieve compensation for the injury, that compensation is merely making you whole, restoring your tax-paid capital investment in yourself. As such, you are not enriched. There is no net increase in your wealth, and so there is nothing for Conress to tax.
It is a persuasive argument, but one which has never been supported by Congress and which was explicitly rejected in the 1996 amendment. But this is a constitutional argument, so what Congress says is not very relevent. To support her position, taxpayer cites three sources from the period Congress first enacted section 104’s predecessor: an Opinion of the Attorney General, a Decision of the Department of the Treasury, and a Report issued by the Ways and Means Committee of the House of Representatives. The court justifies relying on these sources because “in defining “incomes,” we should rely upon the commonly understood meaning of the term which must have been in the minds of the people when they adopted the Sixteenth Amendment.”
Read the opinion and chew on it for a while. I’ve got to get some other work done now, but I will no doubt return to this case. Some topics: Is the “human capital” theory right? Does it argue too much? Should college expenses be treated as an investment in capital and depreciable over an income-producing career? Does the court rely too heavily on three somewhat obscure sources for a rather broad proposition? Why didn’t the court even mention in passing the Haig-Simmons definition of income? This case raises a lot of questions, and I’m willing to discuss any of them.