The DC Circuit Court's <i>Murphy</i> Ruling

A&FP has for several years followed the problematic interaction of:

• Laws and regulations relating to the federal taxability as income of compensatory damages in 'nonphysical' personal injury cases;
• The classification of contingent at-torney fees in those cases as income for the client (as well as for the attorney);
• The operation of federal fee-shifting statutes; and
• The alternative minimum tax (AMT).

This article discusses a subset of these legal authorities (see the sidebar) and a recent DC Circuit Court constitutional ruling that affects them.

For early background coverage of this topic, see the November 2003 and November 2004 editions of A&FP.

The first step in rectifying the rule-interaction problem was taken by Congress. As summarized by Ron Seigneur in A&FP's December 2004 edition:

A little publicized provision of the 2004 American Jobs Creation Act (AJCA) greatly assists law firm clients who seek damages for 'nonphysical' injuries ' notably in wrongful termination and other employment cases, breach of contract cases and civil rights discrimination cases. The AJCA overrides prior IRS rules that required the contingent fee component of nonphysical damage awards to be included in plaintiffs' taxable income, notwithstanding the fact that such contingent fee payments ordinarily go directly to the attorneys, who then pay income taxes on them. U.S. appellate courts had been divided on suits seeking to block that IRS rule, which caused great hardship to some plaintiffs through its congressionally unintended interaction with other rules. (Actual damage awards to plaintiffs in these cases are often small or even nominal, with attorney fees being substantial ' and the cases therefore being feasible ' only thanks to federal fee-shifting statutes. While the IRS technically allowed plaintiffs a Schedule A miscellaneous deduction to cancel out their contingent fee 'income,' the size of the contingent fee often threw the plaintiff into AMT territory for the year, rendering the miscellaneous deduction inapplicable.) As a result, some plaintiffs prior to the AJCA could not proceed with their cases because their income taxes on the contingent fee would far exceed the value of their actual award… .

By making contingent fees in these cases nontaxable to the client, the AJCA considerably alleviated the tax burden on plaintiffs. What continued to irk nonphysical PI plaintiffs with larger damage claims, however, was that the IRS still treated the compensatory damages themselves as taxable income.

Note: Rather than making complex tax determinations on their own, plaintiffs and their litigators would do well to seek the advice of a tax law attorney (or CPA) with qualifying experience in this area.

The Murphy Case

Now the Circuit Court of Appeals for the DC Circuit has cut the Gordian knot of the whole problem in a surprising way. Murphy v. Internal Revenue Service, No. 03cv02414 (D.C. Cir. 8/22/06). That decision restored to whistleblower Marrita Murphy the $20,665 she paid in taxes on a $70,000 judgment against the NY Air National Guard for emotional distress and injury to her reputation.

In retaliation for her whistleblowing about environmental misdeeds, the Guard had blacklisted Murphy and given her bad references. Nevertheless, the damages awarded to Murphy were explicitly characterized by the administrative law judge as being 'on account of' (compensatory for) emotional pain and loss of reputation ' not for lost income or for associated 'physical' (medical-dental) injuries. The IRS therefore ruled that the damages she received were taxable.

A DC district court agreed with the IRS. On appeal, however, the DC Circuit Court declared unconstitutional the use of Internal Revenue Code '104(a)(2) to support taxation of nonphysical damages. The holding of the DC Circuit Court was somewhat ambiguous, but (pending any appeal) it has solved Ms. Murphy's tax problem.

Comments By, and Upon,
The Bloggers

While the policy outcome of the Circuit Court's opinion will no doubt be popular, the initial reaction of some tax law scholars seems to range from skeptical to scathing. Paul L. Caron (U. of Cincinnati College of Law) has collected a number of such comments on his TaxProf Blog (http://taxprof.typepad.com/taxprof_blog/2006/08/tax_prof_commen.html).

Following is a synopsis of representative commentaries from Caron's collection, with some exclusions: We've omitted speculative comments asking why the Constitution didn't provide differently; comments on whether the decision provides aid and comfort to fringe protestors who reject income taxation altogether; and an obnoxious ad hominem argument against the Murphy opinion's author (Chief Judge Douglas Ginsburg), who just completed his 20^th year of service on the DC Circuit Court.

Steve Bank of UCLA and Allan Samansky (Ohio State) both argue that the court oversimplified the current definition of 'income,' which has evolved considerably since the Six-teenth Amendment's original imposition of a federal income tax. Ted Soto (Loyola-L.A.) takes a nuanced intermediate stance: 'I'm not an originalist, and therefore part ways with the DC circuit in its mode of Constitutional interpretation. But one does not have to be an originalist to conclude that purely compensatory damages not in lieu of income are not themselves 'income.”

If it accepts an appeal, the U.S. Supreme Court certainly could decide to back the IRS position that all damages for personal injury were always taxable as income under the Sixteenth Amendment, and that it was just a policy decision by Congress and the IRS that for many decades blocked such taxation.

Soto also takes a middle position on an ancillary issue: 'If [federal taxation as income is] not authorized under the Sixteenth Amendment, we're stuck with the original Constitution's limitations on direct taxation. Granted, those limitations haven't been invoked successfully for almost a century. But that doesn't mean they can't be invoked.' Roth CPA blogger Joe Kristan considers the same point, but suggests that the opposite result is likely: 'Even if it's not income, compensatory damages are still subject to Congress's power to tax unless they are a 'direct' tax, which they probably aren't.'

With regard to these views of Soto and Kristan, note that the Murphy case addresses taxation specifically under the IRC. Whether Congress could constitutionally tax such damages on some basis other than income is currently only a hypothetical question.

Bryan Camp of Texas Tech says the problem with the Murphy decision is that all three circuit judges 'missed' their first-year tax lesson on the fundamental concept of the taxable basis of a capital asset. Treating the plaintiff's emotional well-being as human capital contradicts other accepted tax conceptions such as the nondeductibility of services donated to charitable organizations.

While the Supreme Court could agree with Camp's criticism, it should be noted that the Murphy opinion does not simply ignore this issue. It briefly addresses the question of basis, and concludes that it's irrelevant. Moreover, in a footnote, the Opinion elaborates as follows:

In any event, the Government's quarrel with Murphy's analogy, based upon Glenshaw Glass, of 'human capital' to financial or physical capital is not persuasive. To be sure, the analogy is incomplete; personal injuries do not entail an adjustment to any basis, nor are human resources, such as reputation, depreciable for tax purposes. But nothing in Murphy's argument implies a need to account for the basis in or to depreciate anything. Her point, rather, is that as with compensation for a harm to one's financial or physical capital, the payment of compensation for the diminution of a personal attribute, such as reputation, is but a restoration of the status quo ante, analogous to a 'restoration of capital,' Glenshaw Glass, 348 U.S. at 432 n.8; in neither context does the payment result in a 'gain' or 'accession[] to wealth.' Id. at 430-31.

Marty McMahon (Florida) argues that, strictly speaking, the court should not have pointed to the exclusionary provision in '104(a)(2) as the site of the constitutional defect. The court should instead have held that IRC section 61 was unconstitutional as applied to the damages in question, due to the 1996 amendments to section 104(a)(2).

McMahon's suggestion seems off point to me. The Opinion rules that the damages Murphy received weren't income to begin with. Given that determination, one would not think to even invoke '61, except for the fact that the problematic wording of 104(a)(2) makes it seem applicable. It's like having a rule that says IRS regulations shouldn't be used as pleasure reading on holiday weekends.

Prognosis for Plaintiffs

Early commentators have differed in their views of whether the IRS will appeal the Murphy case (it has not, as of this writing), whether the U.S. Supreme Court would grant certiorari, and whether the ruling would be overturned. Oddly, none of these commentators mention that the logical place for fixing the policy problem should still be Congress, which all along could have legislatively directed the IRS to revise the IRC to yield more acceptable results.

Meanwhile, how should legal practitioners respond to the Murphy decision, given that decisions by the DC court are considered especially influential precedents for other circuit courts in regard to federal matters?

Bloggers Robert Loblaw (Decision of the Day) and Chris Mckinney (The HR Lawyers' Blog) assert, respectively, that the Murphy decision has two kinds of implications for employment law. One is that plaintiffs can stop 'claiming all kinds of strange physical injuries' to escape from the IRC's exclusion of nonphysical injuries. Another is that different structures of settlements may now be feasible from a tax standpoint; moreover, the possibility of amended returns should be considered.

How about civil rights plaintiffs and other beneficiaries of federal fee-shifting statutes? Does the Murphy decision provide an opportunity for some clients to gain the full benefit of those statutes, by making compensatory damages more broadly nontaxable?

The Murphy opinion slightly muddied that water by restating its holding in the Conclusion of the Opinion. Alluding to the facts of the case, the Opinion's clearly labeled holding states narrowly: '[W]e hold '104(a)(2) unconstitutional insofar as it permits the taxation of an award of damages for mental distress and loss of reputation.' (Emphasis added.) But then, in the immediately following Conclusion, the wording is broader: '[I]nsofar as '104(a)(2) permits the taxation of compensation for a personal injury, which compensation is unrelated to lost wages or earnings, that provision is unconstitutional.' (Emphasis added.)

Note: The phrase 'unrelated to lost wages or earnings' has been used since 1918 as a standard qualification whenever nontaxability of damages for personal injuries is discussed; it can, I think, be assumed to have been meant as well in the narrower first version of the holding.

If the broader statement in the Conclusion is read as part of the case holding, then the Murphy decision applies to nonphysical-PI plaintiffs even if they have not suffered 'mental distress and loss of reputation,' as may be the case for some employment law and civil rights plaintiffs. If the Conclusion is read as merely obiter dicta, however, then Murphy may apply only specifically to 'damages for mental distress and loss of reputation.' Further, while it's reasonable to assume that the latter phrase would be interpreted to mean damages for mental distress 'and/or' loss of reputation, it'd be helpful if judges were more careful to avoid that kind of ambiguity.

Source Documents for Murphy Case

The Murphy decision deals with the following federal laws:

Amendment XVI of U.S. Constitution

The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.

IRC '61. Gross Income Defined

(a) General definition

Except as otherwise provided in this subtitle, gross income means all income from whatever source derived …

IRC '104. Compensation for Injuries or Sickness

(a) In general

Except in the case of amounts attributable to (and not in excess of) deductions allowed under section 213 (relating to medical, etc., expenses) for any prior taxable year, gross income does not include ' …

(2) the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness; …

A&FP has for several years followed the problematic interaction of:

• Laws and regulations relating to the federal taxability as income of compensatory damages in 'nonphysical' personal injury cases;
• The classification of contingent at-torney fees in those cases as income for the client (as well as for the attorney);
• The operation of federal fee-shifting statutes; and
• The alternative minimum tax (AMT).

This article discusses a subset of these legal authorities (see the sidebar) and a recent DC Circuit Court constitutional ruling that affects them.

For early background coverage of this topic, see the November 2003 and November 2004 editions of A&FP.

The first step in rectifying the rule-interaction problem was taken by Congress. As summarized by Ron Seigneur in A&FP's December 2004 edition:

A little publicized provision of the 2004 American Jobs Creation Act (AJCA) greatly assists law firm clients who seek damages for 'nonphysical' injuries ' notably in wrongful termination and other employment cases, breach of contract cases and civil rights discrimination cases. The AJCA overrides prior IRS rules that required the contingent fee component of nonphysical damage awards to be included in plaintiffs' taxable income, notwithstanding the fact that such contingent fee payments ordinarily go directly to the attorneys, who then pay income taxes on them. U.S. appellate courts had been divided on suits seeking to block that IRS rule, which caused great hardship to some plaintiffs through its congressionally unintended interaction with other rules. (Actual damage awards to plaintiffs in these cases are often small or even nominal, with attorney fees being substantial ' and the cases therefore being feasible ' only thanks to federal fee-shifting statutes. While the IRS technically allowed plaintiffs a Schedule A miscellaneous deduction to cancel out their contingent fee 'income,' the size of the contingent fee often threw the plaintiff into AMT territory for the year, rendering the miscellaneous deduction inapplicable.) As a result, some plaintiffs prior to the AJCA could not proceed with their cases because their income taxes on the contingent fee would far exceed the value of their actual award… .

By making contingent fees in these cases nontaxable to the client, the AJCA considerably alleviated the tax burden on plaintiffs. What continued to irk nonphysical PI plaintiffs with larger damage claims, however, was that the IRS still treated the compensatory damages themselves as taxable income.

Note: Rather than making complex tax determinations on their own, plaintiffs and their litigators would do well to seek the advice of a tax law attorney (or CPA) with qualifying experience in this area.

The Murphy Case

Now the Circuit Court of Appeals for the DC Circuit has cut the Gordian knot of the whole problem in a surprising way. Murphy v. Internal Revenue Service, No. 03cv02414 (D.C. Cir. 8/22/06). That decision restored to whistleblower Marrita Murphy the $20,665 she paid in taxes on a $70,000 judgment against the NY Air National Guard for emotional distress and injury to her reputation.

In retaliation for her whistleblowing about environmental misdeeds, the Guard had blacklisted Murphy and given her bad references. Nevertheless, the damages awarded to Murphy were explicitly characterized by the administrative law judge as being 'on account of' (compensatory for) emotional pain and loss of reputation ' not for lost income or for associated 'physical' (medical-dental) injuries. The IRS therefore ruled that the damages she received were taxable.

A DC district court agreed with the IRS. On appeal, however, the DC Circuit Court declared unconstitutional the use of Internal Revenue Code '104(a)(2) to support taxation of nonphysical damages. The holding of the DC Circuit Court was somewhat ambiguous, but (pending any appeal) it has solved Ms. Murphy's tax problem.

Comments By, and Upon,
The Bloggers

While the policy outcome of the Circuit Court's opinion will no doubt be popular, the initial reaction of some tax law scholars seems to range from skeptical to scathing. Paul L. Caron (U. of Cincinnati College of Law) has collected a number of such comments on his TaxProf Blog (http://taxprof.typepad.com/taxprof_blog/2006/08/tax_prof_commen.html).

Following is a synopsis of representative commentaries from Caron's collection, with some exclusions: We've omitted speculative comments asking why the Constitution didn't provide differently; comments on whether the decision provides aid and comfort to fringe protestors who reject income taxation altogether; and an obnoxious ad hominem argument against the Murphy opinion's author (Chief Judge Douglas Ginsburg), who just completed his 20^th year of service on the DC Circuit Court.

Steve Bank of UCLA and Allan Samansky (Ohio State) both argue that the court oversimplified the current definition of 'income,' which has evolved considerably since the Six-teenth Amendment's original imposition of a federal income tax. Ted Soto (Loyola-L.A.) takes a nuanced intermediate stance: 'I'm not an originalist, and therefore part ways with the DC circuit in its mode of Constitutional interpretation. But one does not have to be an originalist to conclude that purely compensatory damages not in lieu of income are not themselves 'income.”

If it accepts an appeal, the U.S. Supreme Court certainly could decide to back the IRS position that all damages for personal injury were always taxable as income under the Sixteenth Amendment, and that it was just a policy decision by Congress and the IRS that for many decades blocked such taxation.

Soto also takes a middle position on an ancillary issue: 'If [federal taxation as income is] not authorized under the Sixteenth Amendment, we're stuck with the original Constitution's limitations on direct taxation. Granted, those limitations haven't been invoked successfully for almost a century. But that doesn't mean they can't be invoked.' Roth CPA blogger Joe Kristan considers the same point, but suggests that the opposite result is likely: 'Even if it's not income, compensatory damages are still subject to Congress's power to tax unless they are a 'direct' tax, which they probably aren't.'

With regard to these views of Soto and Kristan, note that the Murphy case addresses taxation specifically under the IRC. Whether Congress could constitutionally tax such damages on some basis other than income is currently only a hypothetical question.

Bryan Camp of Texas Tech says the problem with the Murphy decision is that all three circuit judges 'missed' their first-year tax lesson on the fundamental concept of the taxable basis of a capital asset. Treating the plaintiff's emotional well-being as human capital contradicts other accepted tax conceptions such as the nondeductibility of services donated to charitable organizations.

While the Supreme Court could agree with Camp's criticism, it should be noted that the Murphy opinion does not simply ignore this issue. It briefly addresses the question of basis, and concludes that it's irrelevant. Moreover, in a footnote, the Opinion elaborates as follows:

In any event, the Government's quarrel with Murphy's analogy, based upon Glenshaw Glass, of 'human capital' to financial or physical capital is not persuasive. To be sure, the analogy is incomplete; personal injuries do not entail an adjustment to any basis, nor are human resources, such as reputation, depreciable for tax purposes. But nothing in Murphy's argument implies a need to account for the basis in or to depreciate anything. Her point, rather, is that as with compensation for a harm to one's financial or physical capital, the payment of compensation for the diminution of a personal attribute, such as reputation, is but a restoration of the status quo ante, analogous to a 'restoration of capital,' Glenshaw Glass, 348 U.S. at 432 n.8; in neither context does the payment result in a 'gain' or 'accession[] to wealth.' Id. at 430-31.

Marty McMahon (Florida) argues that, strictly speaking, the court should not have pointed to the exclusionary provision in '104(a)(2) as the site of the constitutional defect. The court should instead have held that IRC section 61 was unconstitutional as applied to the damages in question, due to the 1996 amendments to section 104(a)(2).

McMahon's suggestion seems off point to me. The Opinion rules that the damages Murphy received weren't income to begin with. Given that determination, one would not think to even invoke '61, except for the fact that the problematic wording of 104(a)(2) makes it seem applicable. It's like having a rule that says IRS regulations shouldn't be used as pleasure reading on holiday weekends.

Prognosis for Plaintiffs

Early commentators have differed in their views of whether the IRS will appeal the Murphy case (it has not, as of this writing), whether the U.S. Supreme Court would grant certiorari, and whether the ruling would be overturned. Oddly, none of these commentators mention that the logical place for fixing the policy problem should still be Congress, which all along could have legislatively directed the IRS to revise the IRC to yield more acceptable results.

Meanwhile, how should legal practitioners respond to the Murphy decision, given that decisions by the DC court are considered especially influential precedents for other circuit courts in regard to federal matters?

Bloggers Robert Loblaw (Decision of the Day) and Chris Mckinney (The HR Lawyers' Blog) assert, respectively, that the Murphy decision has two kinds of implications for employment law. One is that plaintiffs can stop 'claiming all kinds of strange physical injuries' to escape from the IRC's exclusion of nonphysical injuries. Another is that different structures of settlements may now be feasible from a tax standpoint; moreover, the possibility of amended returns should be considered.

How about civil rights plaintiffs and other beneficiaries of federal fee-shifting statutes? Does the Murphy decision provide an opportunity for some clients to gain the full benefit of those statutes, by making compensatory damages more broadly nontaxable?

The Murphy opinion slightly muddied that water by restating its holding in the Conclusion of the Opinion. Alluding to the facts of the case, the Opinion's clearly labeled holding states narrowly: '[W]e hold '104(a)(2) unconstitutional insofar as it permits the taxation of an award of damages for mental distress and loss of reputation.' (Emphasis added.) But then, in the immediately following Conclusion, the wording is broader: '[I]nsofar as '104(a)(2) permits the taxation of compensation for a personal injury, which compensation is unrelated to lost wages or earnings, that provision is unconstitutional.' (Emphasis added.)

Note: The phrase 'unrelated to lost wages or earnings' has been used since 1918 as a standard qualification whenever nontaxability of damages for personal injuries is discussed; it can, I think, be assumed to have been meant as well in the narrower first version of the holding.

If the broader statement in the Conclusion is read as part of the case holding, then the Murphy decision applies to nonphysical-PI plaintiffs even if they have not suffered 'mental distress and loss of reputation,' as may be the case for some employment law and civil rights plaintiffs. If the Conclusion is read as merely obiter dicta, however, then Murphy may apply only specifically to 'damages for mental distress and loss of reputation.' Further, while it's reasonable to assume that the latter phrase would be interpreted to mean damages for mental distress 'and/or' loss of reputation, it'd be helpful if judges were more careful to avoid that kind of ambiguity.

Source Documents for Murphy Case

The Murphy decision deals with the following federal laws:

Amendment XVI of U.S. Constitution

The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.

IRC '61. Gross Income Defined

(a) General definition

Except as otherwise provided in this subtitle, gross income means all income from whatever source derived …

IRC '104. Compensation for Injuries or Sickness

(a) In general

Except in the case of amounts attributable to (and not in excess of) deductions allowed under section 213 (relating to medical, etc., expenses) for any prior taxable year, gross income does not include ' …

(2) the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness; …