D.C. Circuit Switches Position in Murphy

The Court of Appeals for the D.C. Circuit recently reissued its opinion in Murphy, Marrita v. IRS (see “ Tax Matters,” JofA, Feb. 07, page 70). The original opinion was released in August 2006, and vacated in December 2006, after the IRS requested a rehearing en banc. The request was denied; however, the same panel agreed to rehear the case, this time reaching a different decision.

The case arose after the taxpayer sued her former employer when she was blacklisted for being a whistleblower. The administrative law judge awarded her damages for emotional distress and injury to professional reputation. Although the taxpayer suffered physical ailments as a result of her emotional distress, none of the damages were specifically labeled as being for such physical injuries. The taxpayer attempted to exclude the damages under IRC § 104(a)(2), and the IRS disallowed the exclusion because the damages were not paid on account of physical injuries. The taxpayer argued that because physical injuries resulted from her emotional distress, the damages were excludable.

Consistent with its original opinion, the D.C. Circuit held that the damages could not be excluded under section 104(a) because they were not paid “on account of” physical injury. This time the court elaborated on its position. Citing the Supreme Court in O’Gilvie v. U.S. , the court stated that there must be a strong causal connection between the physical injury and the damages. Since the taxpayer could not demonstrate that the damages were a direct result of the physical injuries, she was not entitled to the exclusion.

Exclusion aside, the taxpayer alternatively argued that the damages did not constitute income within the 16th Amendment, and taxation of such damages was therefore unconstitutional. The taxpayer likened damages for nonphysical injuries to a return of human capital, and under this view the damages do not fit within the Supreme Court’s often-cited definition of income in Glenshaw Glass, as an accession to wealth. Contrary to its original opinion, the D.C. Circuit now disagrees with this position.

In its latest opinion, the court noted that IRC § 61 defines income broadly, and accordingly the Glenshaw Glass definition is not the only way an item can be considered income. The court focused on the 1996 amendment to section 104, which narrowed the exclusion by adding the specific language “emotional distress shall not be treated as a physical injury or physical sickness.” The court reasoned that the amendment to section 104 would have no effect unless damages for emotional distress are income within section 61. The amendment is therefore evidence that Congress considers such damages to be income.

The court did not attempt to discern whether such damages would have been considered income by the framers of the 16th Amendment, as it had in its August 2006 opinion. The court’s constitutional analysis instead focused on a new argument raised by the government in the rehearing—that the tax is constitutional because it is not a direct tax but rather an excise tax. The court agreed, finding the tax was more like a tax on a transaction than a capitation tax, and since the tax is imposed uniformly, Congress has the power to tax such damages under Article 1 of the Constitution.

Murphy, Marrita v. IRS , 100 AFTR2d 2007-5075 .

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