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Code Section Taxing Award of Damages For Emotional Distress Held Unconstitutional

By Roger Royse

Under §104(a)(2) of the Internal Revenue Code of 1986, as amended (the “Code”), damages for physical personal injury or sickness have long been excludable from income. Personal physical injuries include observable bodily harm such as bruises, cuts, swelling, and bleeding.  Nonphysical personal injuries, such as, wrongful termination, age, race, or sex-based discrimination, constitutional torts, or loss of reputation, do not qualify for the exclusion under §104 and, as a general rule, emotional distress also does not qualify as a physical injury.

In a surprising decision, on August 22, 2006, the D.C. Circuit Court of Appeals held that damages for emotional distress or mental anguish and loss of reputation were not taxable because compensation for nonphysical personal injury was not “income” under the 16th Amendment to the US Constitution.  Murphy v. IRS, No. 05-5139 (D.C. Cir.8/22/06).  The D.C. Circuit held that §104(a)(2) is unconstitutional where §104(a)(2) permits the taxation of an award of damages for mental distress and loss of reputation.

In Murphy, the plaintiff alleged that her former employer discriminated against her by engaging in conduct that violated whistleblower environmental statutes, which provided for compensatory damages. The plaintiff sustained somatic and emotional injuries, including a condition known as bruxism, or teeth grinding, as well as other physical manifestations of stress, including anxiety attacks, shortness of breath, and dizziness.

The plaintiff was awarded $70,000 in damages--$45,000 for mental pain and anguish, and $25,000 for injury to her professional reputation, and she sought exclusion of these compensatory damages from her gross income under Code §104(a)(2). The IRS denied her claim for a refund, stating that she did not demonstrate that the compensatory damages were attributable to physical injury or physical sickness. She then filed a refund suit.

The district court granted summary judgment to the government, and held that damages for injury to professional reputation and for pain and mental anguish resulting from an employer's discriminatory action did not qualify for exclusion under §104(a)(2). Murphy then appealed.

Significantly, the Court of Appeals found, first, that Murphy’s damages were not attributable to physical injuries. The Court then went on to consider whether compensation for emotional distress and loss of reputation are income or a return of capital. The court concluded that the compensation was 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.

The Murphy decision is surprising both because it is contrary to what was considered settled law, and also due to the breadth of the holding. It remains to be seen whether the opinion will withstand appeal or be followed by other courts outside the DC Circuit, but the opinion raises some significant implications for both plaintiff and defense attorneys.

First, plaintiffs will likely assert the position that damages allocable to non-physical personal injuries are not reportable by a defendant on IRS Form 1099 (or W-2).  Given that plaintiffs’ bar will now have Court of Appeals authority for this position, it is likely that defendants may be more inclined to agree to that treatment. Furthermore, plaintiffs may attempt to rely on Murphy to characterize damages arising from non-employment cases (such as defamation) as non-taxable.  Defense counsels will therefore be required to decide whether they will agree to draft defense documents consistently.

Plaintiffs will also have to decide how to report recoveries for non-physical injuries on their income tax returns. Generally, a tax return position must either be adequately disclosed (“flagged”) on the return or supported by “substantial authority.”  The Murphy decision now raises the “substantial authority” issue in situations in which it previously did not exist.

The Murphy decision is sure to generate substantial commentary in the legal community even before its ultimate legal impact is determined. In the meantime, it is important for both litigators and tax practitioners to be aware that Murphy exists, and to consider its implications in settlement documents and tax reporting.

Roger Royse has practiced tax and corporate law for 22 years. He provides services to a wide spectrum of clients, from newly formed startups to publicly traded multinationals. He is widely published in technical tax topics, is a regular speaker for the California CPA Education Foundation, and has been an adjunct Professor of Taxation for Golden Gate University.

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