Nonphysical injury awards after Murphy.

• Author: Winkelman, Kenneth A.

EXECUTIVE SUMMARY

* The Supreme Court denied certiorari in Murphy II, in which the DC Circuit held that a tax on an award of damages for nonphysical injuries under Sec. 104(a)(2) was constitutional.

* Prior to its decision in Murphy II, the DC Circuit held (in Murphy I) that the taxation of an award for nonphysical injuries under Sec. 104(a)(2) was a violation of the Sixteenth Amendment of the Constitution. The court later vacated this decision on its own accord.

* In Murphy II the DC Circuit held that a tax on an award of damages for nonphysical injuries was an excise tax permitted under Article I, Section 8, of the Constitution and was not a direct tax subject to the apportionment requirement of Article I, Section 9.

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On April 21, 2008, the Supreme Court (1) denied appellant Marrita Murphy s petition to have her case reviewed on the issue of whether Sec. 104(a)(2) constitutionally taxes awards for emotional distress, mental anguish, or injury to reputation (i.e., nonphysical injury awards). Sec. 104 was amended by the Small Business Job Protection Act of 1996 (2) to provide that a personal injury or sickness for which damages are received must be physical in order for the damages to be excluded from income under Sec. 61. In addition, the flush language of Sec. 104(a) adds that "emotional distress shall not be treated as a physical injury or physical sickness." Therefore, Murphy's awards for "emotional distress" and "injury to professional reputation" (nonphysical injury awards) were not excludible and were taxable income under Sec. 61.

The Supreme Court's denial of certiorari has significant consequences for taxpayers. The decision in Murphy II, (3) in which the DC Court of Appeals validated an excise tax on income under an income tax statute (See. 61), can be viewed as expanding Congress's power to tax incomes.

In addition, for taxpayers who filed protective refund claims with the IRS and awaited the outcome of the Murphy case, it is expected that the IRS will deny these claims because there is currently no outstanding contingency. Taxpayers should be mindful that they have only two years from the denial of their refund claim to seek redress in court. Those who recently received or will receive damage awards on account of emotional distress may wish to consider filing protective refund claims should a new contingency arise. Taxpayers continue to litigate claims for nonphysical injuries, and courts outside the DC Circuit are not bound by the Murphy decision. If a split in circuits arises, this issue could become appropriate for Supreme Court review.

Overview of the Case

In the first Murphy decision (Murphy 1), (4) the DC Court of Appeals held that the taxation of nonphysical injury awards was unconstitutional because it taxed the receipt of money that is not "income" under the Sixteenth Amendment. The Court of Appeals, on its own motion a mere four months later (December 22, 2006), vacated its Murphy I decision and decided to rehear the case. (5)

In the second Murphy decision (Murphy II), the court unanimously reversed itself, holding that the taxation of nonphysical injury awards was constitutional. Murphy then asked for an en banc rehearing of the full DC Circuit Court of Appeals, which was denied. An appeal to the Supreme Court for a writ of certiorari filed on December 13, 2007, was also denied. (6)

The original ruling in Murphy I was widely criticized by legal and tax practitioners, scholars, and other commentators, who asserted that the decision ignored Congress's power to tax and would subject the courts to numerous challenges under the Sixteenth Amendment as to the definition of "incomes." (7) However, others defended Murphy I as properly recognizing the limitations of incomes within the Sixteenth Amendment. (8) For these reasons, many consider Murphy I to be one of the more controversial tax decisions in recent times.

Some tax professionals believe that the decisions in Murphy I and Murphy II, coupled with the denial of certiorari by the Supreme Court, signal that the issue has been resolved. Others believe that the denial of certiorari will likely lead to a flurry of activity in the lower courts.

The Supreme Court has stated that a denial of certiorari "carries with it no implication whatever regarding the Court's views on the merits of a case which it has declined to review." (9) The Maryland v. Baltimore Radio Show decision explains that one of the reasons for a denial of certiorari is that "[i]t may be desirable to have different aspects of an issue further illumined by the lower courts." (10) As taxpayers continue to challenge the validity of Sec. 104(a)(2), it is likely that the issue will be further illuminated and could become appropriate for review by the Supreme Court.

Murphy h Issues and Analysis

Marrita 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." (11) Murphy was successful, and an administrative law judge awarded compensatory damages totaling $70,000, consisting of $45,000 for "emotional distress or mental anguish" and $25,000 for "injury to professional reputation." (12)

Since the compensatory damages were awarded for nonphysical injuries, which are taxable under Sec. 104(a), Murphy included the award on her year 2000 tax return per Sec. 61 ("gross income means all income from whatever source derived") and paid related income taxes of $20,665. Murphy subsequently filed an amended return for...