In a decision described as a "blockbuster" and a "bombshell", the U.S. Court of Appeals for the District of Columbia has ruled the IRS may not tax emotional distress or professional reputation damage awards unrelated to lost wages or earnings.
The case began when Marrita Murphy sued the Department of Labor alleging that her former employer, the New York Air National Guard, had blacklisted her and provided unfavorable job references because she blew the whistle on environmental hazards at an airbase. Murphy received $70,000 in compensatory damages–$45,000 for emotional distress and $25,000 for injury to her professional reputation.
Murphy included the $70,000 award on her 2000 federal income tax return, then filed an amended return seeking a refund of more than $20,000, the amount of taxes paid on the $70,000 award. The Internal Revenue Service denied her request. Murphy then sued the IRS and the United States in federal district court. The federal district court rejected her claims and granted summary judgment to the government defendants.
On appeal, the D.C. Circuit reversed the lower court’s decision. The panel agreed Murphy could not prevail based on federal law 26 U.S.C. section 104(a)(2), which was amended in 1996 to prohibit the exclusion of emotional distress damages (as opposed to physical injuries) from gross income calculations. Federal law provides that damages for personal injuries and sickness are not taxable; physical injuries are based in tort and not subject to calculation as gross income.
However, the D.C. Circuit delared section 104(a)(2) unconstitutional under the 16th Amendment.
The court agreed with Murphy that her $70,000 award for emotional injury and loss of reputation was not income within the meaning of the 16th Amendment. "As we have seen, 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," Chief Judge Douglas H. Ginsburg wrote for the court. "Under this analysis, therefore, the compensation she received in lieu of what she lost cannot be considered income and, hence, it would appear the 16th Amendment does not empower the Congress to tax her award."
This decision could have a favorable impact on employees and employers alike. Employees will obviously benefit because they will pay less taxes on their settlement or judgment. Employers benefit because plaintiffs may accept less in settlement.
If the case is appealed to the U.S. Supreme Court, plaintiffs nationwide could avoid the tax if the Court rules favorably. However, many tax experts think the Supreme Court will reverse in the event the IRS appeals.
See the D. C. Circuit Court ruling.