Murphy v. Internal Revenue Service, the meaning of "income," and sky-is-falling tax commentary.

Author:Jensen, Erik M.

I. INTRODUCTION A. Murphy I and the Hyperventilating Blogosphere B. The Plan of Attack II. MURPHY I: THE BASICS III. THE HOWLERS IN MURPHY! IV. DIRECT TAXES AND THE SIXTEENTH AMENDMENT A. The Constitutional Structure B. Does Any of This Matter Anymore? C. What Is a Direct Tax? 1. Direct Taxes Are (Would You Believe It?) Not Indirect Taxes 2. Pollock and a Tax on Earned Income Only D. The Constitution Matters in Murphy--and in Taxation Generally V. SECTION 104(A)(2) AND NONPHYSICAL PERSONAL INJURIES A. The 1996 Amendment to Section 104(a)(2) B. Why Automatic Taxability Makes No Sense 1. Basis-Recovery Cases 2. Cash Recoveries Outside the Clear Recovery-of-Basis Context a. Alienation of Affections and Similar (Silly?) Torts b. More Tax-Free Recoveries for Losses of "Personal Rights". i. Recoveries by Victims of Persecution ii. Revocation of Acquiescences in Old Cases 3. How Common Is Recovery of Basis? 4. Gotcher: "Gross Income" Is Not All-Encompassing C. Analyzing a Recovery for a Personal Injury: The "In Lieu of" Test D. The Bottom Line: Not All "Nonphysical" Recoveries Are Taxable VI. WHY THE RESULT IN MURPHY I WAS NOT CRAZY A. The "In Lieu of" Test Applied to Murphy B. Return of Capital Ideas C. What Did "Income" Mean in 1913? D. Involuntariness and "Personal" Rights E. Wages and Recoveries for Emotional Distress 1. The Limits of Logic 2. Evolving Conceptions of "Income". VII. MURPHY II: THE DO-OVER A. Was the Tax Direct? B. Was Murphy's Recovery Includable in Gross Income? C. Can "Gross Income" Be Broader Than "Incomes"?. VIII. CONCLUSION I. INTRODUCTION

Politics constrains the federal taxing power, of course: a candidate's promise to raise taxes across the board is generally thought to be political suicide, as is breaching a promise not to raise taxes. The conventional wisdom, however, is that the Constitution imposes no significant legal limitations on the taxing power. (1) If Congress is willing to take the political rack, it can do what it wants, or so it is assumed. Similarly, in construing what Congress has done on a tax issue, a court can usually proceed without meaningful references to the Constitution.

In the widely noted case of Murphy v. Internal Revenue Service, (2) a panel of the United States Court of Appeals for the District of Columbia Circuit ultimately reached a result consistent with conventional wisdom, concluding that a whistleblower's recovery for emotional distress was properly includable in the income-tax base. (3) But the court followed a torturous path to get there, and Murphy provides an opportunity to revisit some basics of taxation. At bottom one of the questions in Murphy was "What is income?" and you cannot get more basic than that.

A. Murphy I and the Hyperventilating Blogosphere

Chief Judge Douglas Ginsburg's opinion on Murphy's first go-round in August 2006 (Murphy I), which unanimously concluded that the emotional-distress recovery was not income within the meaning of the Sixteenth Amendment and, as a result, could not be reached by the federal income tax, (4) characterized the government's arguments as resting on a "breathtakingly expansive claim of congressional power." (5) Although the panel must have known that striking down an exercise of the taxing power would be noteworthy, it apparently did not realize how controversial its conclusion would be.

Murphy I did not have a long shelf life; the negative reaction was immediate--the decision "shocked the tax community" (6)--and effective. Tax professors generally were appalled (some refusing to read the opinion, or so they said, because the result was so bizarre), and cries were heard that the decision was not only dumb but also catastrophic/ If an emotional-distress recovery were not income, then logically, it was argued, wages were not either. Remove compensation for services from the income-tax base, and the base would be gutted.

Obviously embarrassed by the reaction--according to Professor Paul Caron, the court was "prodded by the tax blogosphere" (8)--the panel on its own motion vacated its judgment in December 2006. (9) New briefs were filed, the case was reargued, and in June 2007 the same panel unanimously held, on the basis of an issue "belatedly raised" and "newly argued"--the court was covering its backside--that the recovery had been properly taxed. (10)

The panel's abrupt turnaround left rubber on the road. With the decision in Murphy II, most of the tax professoriate and the tax bar gave a sigh of relief. And when the Supreme Court denied certiorari in April 2008, (11) the Republic appeared safe.

Or maybe not. Not all critics were mollified. For example, Professor Caron has written that "the panel could not unring the bell and undo much of the damage caused by its original decision." (12) By ignoring the Supreme Court's good sense in Commissioner v. Glenshaw Glass Co. (13)--which, half a century earlier, had "appeared to establish the term 'gross income' as a catch-all phrase reaching all accessions to wealth, regardless of source" (14)--the panel "turned what should have been a run of the mill tax dispute ... into a threat to the very survival of the income tax." (15) Strong stuff. Murphy I might have no legal effect, but Caron and others worried that it encouraged tax protesters. (16) Moreover, since the opinion had been printed in the Federal Reporter, it can cause mischief for eternity. (17)

Phooey. I agree with James Reardon that "[t]he scholars and commentators should lighten up a bit." (18) Although Murphy I contained an amazing number of howlers, and deserved criticism, the result was defensible. It was not clearly right, but it was not clearly wrong either, particularly if the purposes behind the Sixteenth Amendment matter. It is hard to prove what was in peoples' minds in the early twentieth century, but I have no doubt that Amendment proponents would have been horrified to think an emotional-distress recovery might be "income." (19) Most people outside the academy would be horrified at that idea today. (20) Indeed, I will go further than the panel did: all or part of the recovery, which was assumed to have no replacement-of-earnings component, (21) might not even have been "gross income" within the meaning of section 61 of the Internal Revenue Code.

Most important, I shall argue that, if Murphy I had survived, it would not have done irreparable damage to the income tax or the tax system as a whole. The narrow issue--taxation of emotional-distress recoveries--has no significant revenue effects. (22) The decision would have stood only for the proposition that ratifiers of the Sixteenth Amendment did not think Congress can characterize anything as income (and maybe also that Congress, in defining "gross income," did not intend to pick up all receipts of value). Concluding that "income" is not an empty vessel into which any content can be poured is not revolutionary; it takes language seriously. (23)

The idea that tax protesters gained traction from Murphy I was especially overdone in the commentary. Protesters need no encouragement to see systemic flaws. And, if encouragement to frivolousness developed, it came more from critics than from the Murphy I opinion. (24) It was the critics who said Murphy I might mean that wages (and other clearly taxable items) are not income. (25) Wages and emotional-distress recoveries are not the same, (26) and, in any event, no one can seriously argue that wages are off-limits in the income tax. (27) Murphy I might have been problematic, but hyperbole seems to overwhelm common sense in discussions like this. (28)

Finally, I shall argue, Murphy II contained its own complement of questionable propositions--questionable partly because they are inconsistent with prior authority. For one thing, the D.C. Circuit advanced a conception of the relationship between the meaning of "incomes" in the Sixteenth Amendment and the meaning of "income" in the Internal Revenue Code that was contrary to decades of Supreme Court authority.

As a matter of first principle, it is not absurd to think that the statutory definition of "income" can include items that are not income under the Amendment as long as other constitutional authority supports taxation. (29) But the Court has many times said the two documents should be interpreted consistently. (30) (Indeed, Judge Ginsburg in Murphy I noted that "[t]he Supreme Court has held that the word 'incomes' in the Amendment and the phrase 'gross income' in [section] 61(a) of the IRC are coextensive." (31)) In Murphy II, however, the D.C. Circuit concluded that the whistleblower's recovery could constitutionally be reached by section 61 regardless of whether it was "income" under the Amendment. (32) In addition, the panel concluded the recovery could be taxed even though it might not have been considered "gross income" historically and even though Congress had not explicitly amended section 61 to expand its scope. (33)

Taxation is hard enough to understand without the meaning of "income" shifting from one setting to another, and, if the cash received by Ms. Murphy was not "income" under the Sixteenth Amendment--Murphy II did not repudiate that part of Murphy I--what was the effect of imposing a tax on the recovery? The Murphy II panel said the levy was an "excise," (34) but it looks a lot like a tax on wealth. If so, to be constitutional, it should have been subject to the onerous direct-tax apportionment rule. (35) Never before had a court hinted that an unapportioned national tax on wealth, if packaged in the right way, might meet constitutional requirements. In its haste to correct mistakes in Murphy I--and to be applauded by the legal academy--the panel in Murphy II took positions that are harder to defend than Murphy I.

B. The Plan of Attack

The Murphy litigation is done, but the issues should not go away. They are important, interesting, and even fun. In making the case for their significance, I shall proceed as follows. Part II sets out the...

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