Tax on emotional damages held unconstitutional: how to protect clients in the short term.

• Author: Winkelman, Kenneth A.

Since 1996, Sec. 104(a)(2) has specifically excluded awards for personal physical injuries or physical sickness from taxation. Sec. 104(a) adds that "emotional distress shall not be treated as a physical injury or physical sickness." Accordingly, awards for emotional distress, mental anguish or loss of reputation (i.e., nonphysical injury awards) have been firmly recognized as taxable income. In Murphy, DC Cir., 8/22/06, the court held that the taxation of nonphysical injury awards is unconstitutional, as it taxes receipt of money that is not "income" under the 16th Amendment. Practitioners should advise taxpayers immediately to file refund claims or protective refund claims to protect their rights under Sec. 6511.

Murphy

Marita Murphy filed a complaint with the Department of Labor in 1994, alleging that her former employer "had 'blacklisted' her and provided unfavorable references to potential employers." Ms. Murphy was successful; an administrative law judge awarded compensatory damages totaling $70,000, $45,000 for "emotional distress or mental anguish" and $25,000 for "injury to professional reputation." No portion of the award was "for lost wages or taxable earnings of any kind" (i.e., items normally taxed). The court cited the Supreme Court test first enunciated in O'Gilvie, 519 US 79 (1996), which held that damages received "in lieu of" something ordinarily not subject to tax shall not be taxed as well. The Murphy court concluded that the award was to make her "emotionally and reputationally 'whole,'" and not to compensate her for lost income. This conclusion was a major factor in declaring that Murphy's awards for emotional distress were exempt from taxation.

The $70,000 was awarded for nonphysical injuries and, thus, was taxable under Sec. 104(a). Murphy included the award on her 2000 return and paid related income taxes of $20,665. Subsequently, she filed an amended return for that year, seeking a refund of the taxes paid. After the IRS denied the claim, Murphy then filed a complaint in district court, which also ruled against her.

Murphy appealed on two legal grounds. First, she claimed that the award was for "physical personal injuries" and, thus, was excludible under Sec. 104(a)(2). Second, she asserted that the award was not "income" under the "16th Amendment and that taxation of it was unconstitutional. The court found that the awards (emotional distress and injury to professional reputation) were clearly for nonphysical...