Taxing Damages for Emotional Distress

he Court of Appeals for the District of Columbia on Dec. 22, 2006, vacated its judgment from four months earlier in Murphy, Marrita v. IRS in which the court held that a lawsuit award for emotional distress was not taxable. The government had petitioned for an en banc hearing. Instead, a panel indicated it will rehear the case, with oral arguments set for April 23.

The Internal Revenue Code imposes tax on all income regardless of its source, unless the income is specifically excluded. One such exclusion provided by IRC section 104(a)(2) is for damages received on account of physical injuries. Since not specifically excluded by section 104, damages that do not relate to physical injuries, such as those paid for emotional distress, typically are included in a taxpayer’s income and are subject to tax.

Marrita Murphy challenged the constitutionality of taxing damages for nonphysical injuries. Murphy worked for the New York Air National Guard (NYANG). When she complained to state authorities that a NYANG airbase contained environmental hazards, NYANG retaliated by blacklisting her and giving poor recommendations to potential new employers. Because these acts were violations of the whistle-blower statutes, NYANG was ordered to pay the taxpayer damages in the amount of $70,000: $45,000 on account of her emotional distress or mental anguish and $25,000 for the injury to her professional reputation.

Murphy originally included the full amount of the damages in her gross income and paid the appropriate taxes, but she later filed an amended return claiming a refund based on the exclusion in section 104(a)(2) regarding damages received “on account of personal physical injuries or physical sickness.” After the IRS denied the claim, she filed a lawsuit in district court.

The taxpayer first argued that the damages she received should be excluded under section 104 because she suffered from physical manifestations of her emotional injury. In the alternative, Murphy argued that damages paid with regard to nonphysical injuries are not “income” as the term has been defined by the U.S. Supreme Court. The district court ruled for the IRS, and Murphy appealed to the Court of Appeals for the District of Columbia.

Result. For the taxpayer initially, although the D.C. Circuit vacated the judgment and will rehear the case. The Internal Revenue Code was amended in 1996 to provide that emotional distress is not treated as a physical injury or physical sickness for purposes of section 104; as a result all damages other than those for physical injury fall within the general inclusion rule of section 61.

Murphy submitted evidence that as a result of NYANG’s conduct she suffered from bruxism, a stress-related condition that caused her to grind her teeth, resulting in permanent damage to her teeth. However, the D.C. Circuit found that although she suffered from physical injuries, the damages she received were not awarded on account of such injuries, and therefore section 104 was not applicable.

Murphy alternatively argued that the damages were not income within the 16th Amendment, and therefore could not be subject to tax. The Supreme Court defined income in 1955 in Glenshaw Glass as gains and “accessions to wealth,” and it has long been recognized that a return of capital falls outside this definition of income. Murphy argued that the damages she received, which compensated her for the loss of her emotional well-being and reputation, were a return of human capital and therefore not income. She contended that the Supreme Court alluded to the notion of human capital in Glenshaw Glass, where it distinguished taxable punitive damages from damages for personal injury; the latter, it held, are compensatory in nature and therefore not taxable income. Since Glenshaw Glass did not differentiate between physical and nonphysical damages, Murphy argued, the Supreme Court intended that all damages for personal injury be excluded from income.

The IRS’s rebuttal to this argument distinguished human capital from financial capital. Financial capital has a basis, such that when it is sold there is income to the extent that the amount realized exceeds the taxpayer’s basis. The IRS argued that since people don’t pay for their reputation or emotional well-being, there is no basis and therefore the entire amount received constitutes income.

The D.C. Circuit used an “in lieu of” analysis and held that the damages were not income. If a taxpayer receives damages in lieu of something that is normally subject to tax, such as wages, then the damages would be taxed. However, the taxpayer’s emotional well-being and reputation were not taxable, and therefore neither are the damages she received as a result of her losses. In addition, based on a review of the legislation that implemented Congress’ taxing power provided in the 16th Amendment, particularly the original exclusion for personal injury damages, the court found that the framers of the 16th Amendment would not have construed compensatory damages for nonphysical injuries to be income. Accordingly, the court held that the taxpayer’s damages for emotional distress and loss of reputation did not constitute income within the Constitution and the IRC, and any application of section 104(a)(2) that subjects such payments to taxation is unconstitutional.

Murphy, Marrita v. Internal Revenue Service, D.C. Circuit 05-5139 (8/22/06).

Prepared by Laura Lee Mannino, CPA, LLM, assistant professor of accounting and taxation, St. John’s University, Jamaica, N.Y.