Last week, the D.C. Circuit Court of Appeals issued a potential bombshell taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. opinion in the case of Murphy v. I.R.S. The potential ramifications for the federal income tax system are enormous because the court ruled that the Sixteenth Amendment of the Constitution precluded the income taxation of non-economic (i.e. emotional distress) compensatory damages.
The case involved a woman employed by the New York Air National Guard. When she blew the whistle on environmental problems on an airbase, she claimed that her employer retaliated by “blacklisting” her and providing bad references to potential employers. She filed a complaint with the Department of Labor, who referred the case to an administrative law judge, who ultimately ended up rewarded her $70,000 in compensatory damages for emotional distress.
She initially paid tax on the $70,000 but later filed for a refund. She had two main claims in her refund lawsuit: first, that the Internal Revenue Code (IRC) excluded the $70,000 from gross incomeFor individuals, gross income is the total pre-tax earnings from wages, tips, investments, interest, and other forms of income and is also referred to as “gross pay.” For businesses, gross income is total revenue minus cost of goods sold and is also known as “gross profit” or “gross margin.” ; second, that the Sixteenth Amendment precluded the taxation of the $70,000 as income.
Chief Judge Douglas Ginsburg, writing for a unanimous court, rejected her first claim but accepted her second. Basically, Judge Ginsburg wrote that the IRC—specifically, §104(a)(2)—did not exclude damages for emotional distress from gross income. However, he went on to hold that the Sixteenth Amendment basically required that such damages be excluded from income, and held §104(a)(2) unconstitutional to the extent that it did not.
This case involves the thorny issue of the definition of income. We have wrestled with this definition in the past (click here for one such report). Fortunately, we don’t have to wade into that thicket in order to notice a couple of problems with this decision.
First, in finding constitutional infirmity in taxing emotional distress damages as income, the court blamed the wrong section of the tax code. §104(a)(2), the section the court held unconstitutional, is an exclusion section. The IRC is structured such that gross income is broadly defined (“from whatever source derived”) in §61, with the definition only limited by specific exclusions in other sections of the IRC.
To the extent that the IRC includes emotional distress damages in gross income, §61—not an exclusion section like §104(a)(2)—is the culprit. Thus, the court should have held §61 unconstitutional, not §104(a)(2). Professor Maule discusses this issue in a worthwhile blog post located here.
Second, the Sixteenth Amendment inquiry is not the end of the constitutional analysis in this case, because that amendment is not the sole source of congressional tax authority in the Constitution. The basic taxation power of Congress is found in Article I, §8, which says that “The Congress shall have Power To lay and collect Taxes, Duties, Imposts and Excises, to pay the Debts and provide for the common Defence and general Welfare of the United States…” This power is limited in Article I, §9, which says that “No Capitation, or other direct, Tax shall be laid, unless in Proportion to the Census of Enumeration herein before directed to be taken.”
Thus, it is likely that Congress could levy an income tax even in the absence of the Sixteenth Amendment, just as it levies taxes on gasoline, tobacco, etc. Some commentators believe it was ratified in order to reverse the Supreme Court’s Pollock opinion, which held that an income tax was a direct taxA direct tax is levied on individuals and organizations and cannot be shifted to another payer. Often with a direct tax, such as the personal income tax, tax rates increase as the taxpayer’s ability to pay increases, resulting in what’s called a progressive tax. and thus had to be apportioned based on census data. If this view of the Sixteenth Amendment is correct, then the Murphy opinion failed to wrestle with the issue of whether Article I, §8 can be cited as independent constitutional authority for the power to tax emotional distress damages as income.
In the future, we will consider the economic issues presented by the court’s ruling that emotional distress damages are not income.
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