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. Jack Cummings Editor The Atlantic Building 950 F Street, NW Washington, DC 20004-1404 202-756-3300 Fax: 202-756-3333 www.alston.com One of the “FORTUNE 100 Best Companies to Work For®” 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.” continued on back page... Federal Tax Group continued from front page... 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 All regular monthly and “Special Alert” issues of the Federal Tax Advisory can be viewed on our Website at http://www.alston.com/index.cfm?fuseaction=ArtsAndAds or contact us at taxgroup@alston.com. This Federal Tax Advisory is published by Alston & Bird to provide a summary of significant developments to our clients and friends. It is intended to be informational and does not constitute legal advice regarding any specific situation. This material may also be considered advertising under the applicable court rules. © Alston & Bird llp 2006 Gerald V. Thomas II 404-881-4716 Diana Wessells 202-756-3389 Charles W. Wheeler 202-756-3308