Federal Tax
october 1, 2006
Atlanta
Charlotte
New York
Research Triangle
Washington, DC
Advisory
Insights Into Recent Regulatory, Judicial and Legislative Developments
Constitutional Limits on Income Taxation
Murphy v. Internal Revenue Service, 98 AFTR 2d 2006-6088 (D.C. Cir. Aug. 22, 2006).
In an opinion that caught tax advisors by surprise, the influential United States Court of Appeals for the
District of Columbia Circuit recently struck down, on constitutional grounds, the application of an Internal
Revenue Code provision. In the court’s view, the provision – Section 104(a)(2) – was unconstitutional
insofar as it permitted the taxation of compensation for nonphysical personal injury, when the compensation
was not related to lost wages or earnings.
Although Murphy is not the first court decision to invalidate a particular exercise of Congress’ taxing
power, it doesn’t happen every day, or even every decade. But what makes the decision not merely
unusual but unique is the reasoning by which the court reached its conclusion.
Taxation of Personal Injury Recoveries
Before Congress amended Section 104(a)(2) in 1996, this provision excluded from income “the amount
of any damages received (whether by suit or agreement and whether as lump sums or as periodic
payments) on account of personal injuries or sickness…” Punitive damages, however, were not excluded
from income in connection with a case not involving physical injury or physical sickness.
The 1996 amendment purported to limit the exclusion. Instead of excluding certain amounts received
“on account of personal injuries or sickness,” the amended statute – as enacted – excluded only certain
amounts received “on account of personal physical injuries or physical sickness.” Thus, compensation
for nonphysical personal injuries (for example, in an employment discrimination case) would be included
in income, even if unrelated to lost wages or lost earning capacity. After the amendment, punitive
damages could not be excluded, even in cases of physical injury or physical sickness.
The Court’s Decision
The court did not invalidate the 1996 amendment to Section 104(a)(2) in its entirety. As applied to
Murphy’s recovery, however, the provision was held unconstitutional.
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Murphy had alleged that her former employer, in violation of several whistle-blower statutes, had
blacklisted her and provided unfavorable references in retaliation for her complaints of environmental
hazards. Murphy eventually received $45,000 for “emotional distress or mental anguish,” and $25,000
for “injury to professional reputation.” The court’s opinion states that no portion of the award was for lost
wages or diminished earning capacity. Murphy suffered various physical manifestations of stress. The
court, unsurprisingly, agreed with the IRS that these were not “physical injuries” within the meaning of
Section 104(a)(2) as amended, and that Section 104(a)(2) therefore did not permit Murphy to exclude
any of her award. The shocker for the tax world: according to the court, Section 104(a)(2)’s failure to
exclude the award was unconstitutional.
What Is Congress Permitted to Tax?
The court arguably implied that the Sixteenth Amendment (1913) to the Constitution prohibits Congress
from imposing any tax that is not on “income.” The conventional view is that the Sixteenth Amendment
merely expanded the power of Congress to impose tax. For example, both before and after the
Sixteenth Amendment, Congress has imposed many excise taxes. Before the Sixteenth Amendment,
however, Congress lacked the power to impose a “direct tax” that was not apportioned among the
states. Afterwards, Congress may impose any income tax without apportionment. Although the court
says nothing about the constitutional limits on direct taxes, perhaps the court assumed, without stating,
that the tax at issue was a direct tax. It is puzzling, however, why the court would have made that
assumption, especially given the fuzziness of the concept of “direct tax.”
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Federal Tax
Group
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What is “Income”?
The court derived its view of income from two sources: an economic analysis of “income,” and the
understanding of “income” at the time of the Sixteenth Amendment.
The court’s economic analysis implies – contrary to what we were taught in Tax 101 – that a taxpayer
cannot realize any income if the taxpayer is simply made whole. The award Murphy received merely
made her whole for her injury, and so is beyond Congress’ taxing power. Nothing in the court’s
analysis suggests that voluntary transactions should be treated any differently from involuntary ones.
The court seems to indicate that the taxpayer has no income even if the payment is in excess of the
taxpayer’s basis. Taking this reasoning to an unintended extreme, capital gains would not be income
(the taxpayer is made whole by selling property for its value), and neither would wages (the taxpayer
is made whole for the loss of time and energy expended in performing services). Although the court
does refer to the concept of tax basis, it is unclear what relevance this concept has for the court. While
the court of course did not intend to invalidate taxes on wages and capital gains, the court’s arguments
may embolden some taxpayers to advocate such extreme positions.
The court’s analysis of the common understanding of income at the time of the Sixteenth Amendment
also conflicts with conventional views. In the view of many, the contours of the term “income” had
not yet been clearly delineated in 1913. Some histories of Section 104(a)(2) point out that, before
1918, there were conflicting views about whether compensation for nonphysical personal injuries
constituted “income.” Many observers would also question whether the understanding of “income” in
1913 has much relevance today.
In addition, most tax experts would have said that Section 104(a)(2), as an exclusion rule, does not
require anything to be included in income. If Murphy’s award is simply not income, then there would
be no need for Section 104(a)(2) to exclude it. The court, however, clearly implies that Section
104(a)(2) itself is constitutionally infirm.
Sam K. Kaywood, Jr.
Cochair
404-881-7481
Edward Tanenbaum
Cochair
212-210-9425
Pinney L. Allen
404-881-7485
Gideon T. J. Alpert
212-210-9403
J. Bradford Anwyll
202-756-3432
Saba Ashraf
404-881-7648
John F. Baron
704-444-1434
Henry J. Birnkrant
202-756-3319
Robert T. Cole
202-756-3306
Philip C. Cook
404-881-7491
James E. Croker, Jr.
202-756-3309
Jasper L. Cummings, Jr.
202-756-3386
Eva Farkas-DiNardo
212-210-9592
Jennifer L. Dowell
404-881-4491
Implications
Plaintiffs and defendants alike are welcoming Murphy because of the rare win/win opportunity it
presents to private litigants in their dealings with each other. Under Murphy, the plaintiff winds up with
more money, but the defendant doesn’t have to pay anything extra. In drafting settlements for claims
of employment discrimination, or of other nonphysical personal injury claims in or out of employment
settings, the parties will try to allocate as little as reasonably possible to lost wages or diminished
earning capacity.
Even for taxpayers whose situations are on all fours with Murphy’s, however, chances of success may
be questionable unless the taxpayer happens to live in the District of Columbia. The court’s reasoning
is so far from the mainstream that other courts may be reluctant to follow it.
Tim L. Fallaw
404-881-7836
Terence J. Greene
404-881-7493
Michelle M. Henkel
404-881-7633
L. Andrew Immerman
404-881-7532
Andrea Lane
202-756-3354
For taxpayers whose situations are not exactly like Murphy’s, and who take positions based on an
expansive interpretation of the decision, the odds of success are even lower. Courts – probably
including even the D.C. Court of Appeals – will be concerned about the consequences of extending
Murphy’s reasoning. That reasoning has the potential to undermine countless Code provisions whose
constitutionality has never been questioned by any reputable source. After Murphy, many challenges
to the constitutionality of Code provisions may look less frivolous than they appeared to be before.
Few, however, are likely to succeed.
Brian E. Lebowitz
202-756-3394
For additional information call Andy Immerman (404) 881-7532.
Timothy J. Peaden
404-881-7475
Clay Littlefield
704-444-1440
Edgar McClellan
202-756-3462
Nicki N. Nelson
404-881-4288
Kevin M. Rowe
212-210-9505
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© Alston & Bird llp 2006
Gerald V. Thomas II
404-881-4716
Diana Wessells
202-756-3389
Charles W. Wheeler
202-756-3308