Federal Court Says Damages for Emotional Distress Not Includable in Income Under Code Section 104

Federal Court Says Damages for Emotional Distress Not Includable in Income Under Code Section 104
From the December 2006 Riker Danzig <I>Tax and Trusts & Estates UPDATE</i>.

In a federal income tax case decided last summer that surprised both tax and employment lawyers (Murphy v. IRS (No. 05-5139), slip opinion (D.C. Cir. 8/22/06)), the United States Court of Appeals for the District of Columbia Circuit - widely regarded as among the most influential of the federal appeals courts - held Section 104(a)(2) of the Internal Revenue Code unconstitutional, insofar as it requires taxation of non-wage damage awards for injuries resulting from loss of reputation and emotional distress. The gist of the decision (and its most flamboyant feature) is in its finding - contrary to the legislative history underlying a 1996 amendment to the statute - that damage awards for certain physical manifestations of emotional distress such as anxiety attacks, dizzy spells and bruxism (physical problems produced by teeth-grinding) are not taxable under Section 104 because such awards are not "income" under the constitutionally recognized meaning of that term. Rather (the court held) such awards are more appropriately treated as a return of the plaintiff to a position of status quo ante, i.e., to the state in which she found herself prior to the defendant's wrongful conduct. In other words, such damage awards really represent a return of "capital," and are therefore not properly taxable under the Sixteenth Amendment to the U.S. Constitution.

Aside from the fact that this case represents the first time in many decades in which a court has found occasion to overturn a federal tax statue on constitutional grounds (which of course makes the case particularly likely to end up before the U.S. Supreme Court), the principal upshot of Murphy is that it throws the practical aspects of litigating and negotiating settlements of employment-based lawsuits into a state of some disarray. While in a strict sense this case is only applicable to litigants in the District of Columbia, it will certainly affect judicial decisions and settlements nationwide until it is dealt with by the U.S. Supreme Court.