Taxpayer hits a home run, but the game is probably not over…

It came to only $20,665 in taxes for Marrita Murphy, but the decision of the Court of Appeals for the DC Circuit awarding her a full refund could cost the IRS millions.

Murphy sued the New York Air National Guard for whistleblowing and received an award of $70,000 for emotional distress and injury to her professional reputation. After paying taxes on the award, she applied for a tax refund based on IRC §104(2)(A), which provides an exclusion from gross income for damages received on account of physical injuries. Damages for emotional distress, humiliation, and other non-wage related injuries are not ordinarily within the scope of the exclusion under §104. When the IRS rejected her request, she sued. See Murphy v. Internal Revenue Service.

The case turned on the definition of the word “income.” The Sixteenth Amendment grants Congress the power to tax “incomes, from whatever source derived.” Murphy argued that as used in the Sixteenth Amendment, the term “income” is limited to accessions to wealth, and does not include compensatory damage awards received to restore the status quo. While §104 presumably provides an exclusion for damages received on account of personal injuries for this reason, the IRS nevertheless countered that Congress could elect to tax personal injury awards if it so desired, consistent with the Sixteenth Amendment. The Court didn’t buy that argument for one second:

We reject the Government’s breathtakingly expansive claim of congressional power under the Sixteenth Amendment -- upon which it founds the more far-reaching arguments it advances here. The Sixteenth Amendment simply does not authorize the Congress to tax as “incomes” every sort of revenue a taxpayer may receive. As the Supreme Court noted long ago, the “Congress cannot make a thing income which is not so in fact.” *** Indeed, because the “the power to tax involves the power to destroy,” *** it would not be consistent with our constitutional government, and the sanctity of property in our system, merely to rely upon the legislature to decide what constitutes income. Fortunately, we need not rely solely upon the wisdom and beneficence of the Congress for, when the Sixteenth Amendment was drafted, the word “incomes” had well understood limits. To be sure, the Supreme Court has broadly construed the phrase “gross income” in the IRC and, by implication, the word “incomes” in the Sixteenth Amendment, but it also has made plain that the power to tax income extends only to “gain[s]” or “accessions to wealth.”

The Court concluded that the damages had been awarded to make Murphy emotionally and reputationally “whole” after these attributes were diminished by her former employer. Consequently, “the compensation she received in lieu of what she lost cannot be considered income.”

While the Court’s opinion only affects Washington, D.C. and the IRS may appeal to the US Supreme Court, the case will likely have a significant and immediate impact on settlements and awards in employment cases nationwide.