- The Supreme Court denied certiorari in Murphy II, in which the DC Circuit held that a tax on an award of damages for nonphysical injuries under Sec. 104(a)(2) was constitutional.
- Prior to its decision in Murphy II, the DC Circuit held (in Murphy I) that the taxation of an award for nonphysical injuries under Sec. 104(a)(2) was a violation of the Sixteenth Amendment of the Constitution. The court later vacated this decision on its own accord.
- In Murphy II, the DC Circuit held that a tax on an award of damages for nonphysical injuries was an excise tax permitted under Article I, Section 8, of the Constitution and was not a direct tax subject to the apportionment requirement of Article I, Section 9.
On April 21, 2008, the Supreme Court1 denied appellant Marrita Murphy's petition to have her case reviewed on the issue of whether Sec. 104(a)(2) constitutionally taxes awards for emotional distress, mental anguish, or injury to reputation (i.e., nonphysical injury awards). Sec. 104 was amended by the Small Business Job Protection Act of 19962 to provide that a personal injury or sickness for which damages are received must be physical in order for the damages to be excluded from income under Sec. 61. In addition, the flush language of Sec. 104(a) adds that "emotional distress shall not be treated as a physical injury or physical sickness." Therefore, Murphy's awards for "emotional distress" and "injury to professional reputation" (nonphysical injury awards) were not excludible and were taxable income under Sec. 61.
The Supreme Court's denial of certiorari has significant consequences for taxpayers. The decision in Murphy II,3 in which the DC Court of Appeals validated an excise tax on income under an income tax statute (Sec. 61), can be viewed as expanding Congress's power to tax incomes.
In addition, for taxpayers who filed protective refund claims with the IRS and awaited the outcome of the Murphy case, it is expected that the IRS will deny these claims because there is currently no outstanding contingency. Taxpayers should be mindful that they have only two years from the denial of their refund claim to seek redress in court. Those who recently received or will receive damage awards on account of emotional distress may wish to consider filing protective refund claims should a new contingency arise. Taxpayers continue to litigate claims for nonphysical injuries, and courts outside the DC Circuit are not bound by the Murphy decision. If a split in circuits arises, this issue could become appropriate for Supreme Court review.
Overview of the CaseIn the first Murphy decision (Murphy I),4 the DC Court of Appeals held that the taxation of nonphysical injury awards was unconstitutional because it taxed the receipt of money that is not "income" under the Sixteenth Amendment. The Court of Appeals, on its own motion a mere four months later (December 22, 2006), vacated its Murphy I decision and decided to rehear the case. 5
In the second Murphy decision (Murphy II), the court unanimously reversed itself, holding that the taxation of nonphysical injury awards was constitutional. Murphy then asked for an en banc rehearing of the full DC Circuit Court of Appeals, which was denied. An appeal to the Supreme Court for a writ of certiorari filed on December 13, 2007, was also denied. 6
The original ruling in Murphy I was widely criticized by legal and tax practitioners, scholars, and other commentators, who asserted that the decision ignored Congress's power to tax and would subject the courts to numerous challenges under the Sixteenth Amendment as to the definition of "incomes." 7 However, others defended Murphy I as properly recognizing the limitations of incomes within the Sixteenth Amendment. 8 For these reasons, many consider Murphy I to be one of the more controversial tax decisions in recent times.
Some tax professionals believe that the decisions in Murphy I and Murphy II, coupled with the denial of certiorari by the Supreme Court, signal that the issue has been resolved. Others believe that the denial of certiorari will likely lead to a flurry of activity in the lower courts.
The Supreme Court has stated that a denial of certiorari "carries with it no implication whatever regarding the Court's views on the merits of a case which it has declined to review." 9 The Maryland v. Baltimore Radio Show decision explains that one of the reasons for a denial of certiorari is that "[i]t may be desirable to have different aspects of an issue further illumined by the lower courts." 10 As taxpayers continue to challenge the validity of Sec. 104(a)(2), it is likely that the issue will be further illuminated and could become appropriate for review by the Supreme Court.
Murphy I: Issues and Analysis
Marrita Murphy filed a complaint with the Department of Labor in 1994 alleging that her former employer "had ‘blacklisted' her and provided unfavorable references to potential employers." 11 Murphy was successful, and an administrative law judge awarded compensatory damages totaling $70,000, consisting of $45,000 for "emotional distress or mental anguish" and $25,000 for "injury to professional reputation." 12
Since the compensatory damages were awarded for nonphysical injuries, which are taxable under Sec. 104(a), Murphy included the award on her year 2000 tax return per Sec. 61 ("gross income means all income from whatever source derived") and paid related income taxes of $20,665. Murphy subsequently filed an amended return for that year seeking a refund for the taxes paid. The IRS denied the claim, and Murphy filed a complaint in the DC District Court, which also ruled against her. 13
Murphy then sought redress in the DC Court of Appeals on two legal grounds. First, she claimed that the award was for "personal physical injuries" and was therefore excludible under Sec. 104(a)(2). Second, she asserted that the award was not income under the Sixteenth Amendment, so taxing it was unconstitutional. The Murphy I court found that the awards (emotional distress and injury to professional reputation) were clearly for nonphysical injuries and were not the result of a physical injury, and it ruled against Murphy on her first legal ground.
The court then considered whether a compensatory award for a nonphysical injury was income under the Sixteenth Amendment. The court began its constitutional analysis by stating that "[t]he Government of the United States is a government of limited powers: ‘Every law enacted by Congress must be based on one or more of its powers enumerated in the Constitution'"14 and that "[t]he constitutional power of the Congress to tax income is provided in the Sixteenth Amendment, ratified in 1913: ‘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.'" 15
Guided by past Supreme Court decisions, the Murphy I court then examined the definition of income using
- The O'Gilvie "in lieu of" test, 16
- The Glenshaw Glass "gain or accession to wealth" test, 17 and
- The Merchants' Loan and Trust Co. 18 analysis: "[I]n defining ‘incomes,' we should rely upon ‘the commonly understood meaning of the term which must have been in the minds of the people when they adopted the Sixteenth Amendment.'"19
Applying O'Gilvie, the court examined whether "the taxpayer's award of compensatory damages is ‘a substitute for [a] normally untaxed . . . quality, good, or "asset."'"20 Using this "in lieu of" test, the court determined that the award of compensatory damages was to "make Murphy emotionally and reputationally ‘whole' and not to compensate her for lost wages or taxable earnings of any kind." 21 Accordingly, the $70,000 award was in lieu of something normally not taxed, and therefore it was not income under the Sixteenth Amendment.
Guided by Glenshaw Glass, the Murphy I court then examined whether the taxpayer had a "gain or accession to wealth." Having already determined that the damages were not to compensate her for lost wages or taxable earnings, the court ruled that damages received (1) solely as compensation for a personal injury (physical or nonphysical) and (2) not in lieu of something that is normally taxed are not an accession to wealth and therefore are not income under the Sixteenth Amendment.
Finally, the court attempted to discern the meaning of "income" during the time period when the Sixteenth Amendment was ratified. The court found that the Revenue Act of 191822 was the first act to "address the tax treatment of compensatory damages for personal injuries, and it did so without distinguishing between physical and nonphysical injuries." 23 The court further examined a 1918 attorney general's opinion24 and a revenue ruling25 of the same year and determined that these documents "strongly suggest that the term ‘incomes' as used in the Sixteenth Amendment does not extend to monies received solely in compensation for a personal injury and unrelated to lost wages or earnings." 26
In applying these three analyses, the court held that damages received to compensate an individual for a physical or nonphysical injury are not income within the meaning of the Sixteenth Amendment and held Sec. 104(a)(2) "unconstitutional insofar as it permits the taxation of an award of damages for mental distress or loss of reputation." 27
Murphy I Court Vacates Its DecisionShortly after the Murphy I decision, the government petitioned for a rehearing en banc, raising the argument for the first time that "even if Murphy's award is not income, there is no constitutional impediment to taxing it because a tax on the award is not a direct tax and is imposed uniformly." 28 While the DC Court of Appeals did not grant the en banc rehearing, in a highly unusual move, the court vacated its decision on its own accord on December 22, 2006. 29 Due to the importance of the issue raised, the three-judge panel decided to rehear the case.
Murphy II: New Constitutional ReasoningIn Murphy II, the court analyzed the government's new argument that a tax on the award was not a direct tax and was imposed uniformly. As a starting point, the court looked at Congress's power to tax under Article I, Sections 8 and 9, of the U.S. Constitution and whether the constraints imposed under these articles were violated in taxing Murphy's compensatory awards.
Article I, Section 8, of the Constitution in relevant part states:
The Congress shall have power to lay and collect taxes, duties, imposts and excises, to pay the debts and provide for the common defense and general welfare of the United States; but all duties, imposts and excises shall be uniform throughout the United States.Article I, Section 9, of the Constitution in relevant part states:
No capitation, or other direct, tax shall be laid, unless in proportion to the census or enumeration herein before directed to be taken.
In resolving the limitations of a direct tax imposed by Article I, Section 9, the Murphy IIcourt found that the tax imposed on Murphy was not a direct tax. The court reasoned that there were three definitely known direct taxes: (1) a capitation tax (per person, per capita), (2) a tax on real property, and (3) a tax on personal property. According to the court, "[s]uch direct taxes are laid upon one's ‘general ownership of property.'"30
The court noted this should be "contrasted with excise taxes laid ‘upon a particular use or enjoyment of property,'" 31 "duties imposed on importation, consumption, . . . a sale of certain commodities, . . . privileges," 32 or income from employment. 33 In Murphy's case, "[t]he tax may be laid upon the proceeds received when one vindicates a statutory right . . . as a ‘privilege' taxable by excise." 34 In essence, the court was saying that Murphy had the privilege to go to court and enforce her rights and that her award is taxable by excise, with the only restriction being that it be enforced uniformly throughout the United States, which the court found it was. Thus, the court found that Murphy's award was taxable under Congress's power to tax under Article I, Section 8, of the Constitution.
The implication of the government's new legal argument and the Murphy II court's acceptance of it led the court to state that "if § 61(a) were amended specifically to include in gross income ‘$100,000 in addition to all other gross income,' then that additional sum would be a part of gross income under § 61 even though no actual gain was associated with it." 35 The Murphy II court felt that under Article I, Sections 8 and 9, Congress has the authority to "label a thing income and tax it, so long as it acts within its constitutional authority [to tax], which includes not only the Sixteenth Amendment but also Article I, Sections 8 and 9." 36
Based on this analysis, the court concluded that the award fell within the purview of Sec. 61 and did not violate the U.S. Constitution. The Murphy II decision can be interpreted as an expansion of Congress's power to tax income if it is no longer constrained by the Sixteenth Amendment's definition of "incomes."
Disconnect in the Constitutional Analyses of Murphy I and Murphy IIThe judicial analysis in the Murphy I decision was mainly based on whether taxing income under Sec. 104(a)(2) violated the Sixteenth Amendment. The court made the following statements:
- "The constitutional power of the Congress to tax income is provided in the Sixteenth Amendment";37
- "In sum, every indication is that damages received solely in compensation for a personal injury are not income within the meaning of that term in the Sixteenth Amendment"; 38 and
- "Therefore, we hold § 104(a)(2) unconstitutional insofar as it permits the taxation of an award of damages for mental distress or loss of reputation." 39
The court in Murphy II reached the opposite result, ruling that taxing awards for mental distress or loss of reputation was constitutional. However, this decision was based on Congress's power to tax under Article I, Section 8, of the Constitution, and the court did not address (or repudiate) its prior holding that the taxation of awards for mental distress or loss of reputation violated the Sixteenth Amendment.
The court in Murphy II disregarded its analysis in Murphy I that Sec. 104(a)(2) taxes something that is not income within the meaning of the Sixteenth Amendment. The court reasoned that under Article I, Section 8, an excise tax could be imposed on Murphy's monetary award received through the "privilege" of using the legal system. As long as this excise tax is uniform throughout the United States (which the court found it was), it is constitutional. In its conclusion, the court went on to state that "the award is part of her ‘gross income,' as defined by § 61 of the IRC; and . . . the tax upon the award is an excise and not a direct tax subject to the apportion requirement of Article I, Section 9 of the Constitution." 40
The reasoning of the Murphy II court in validating an excise tax under Article I, Section 8, on "income" under Sec. 61, an income tax statute, is problematic. As the court stated in Murphy I, "[t]he constitutional power of the Congress to tax income is provided in the Sixteenth Amendment." 41 Therefore, at the very least any tax on incomes should be evaluated under the Sixteenth Amendment in conjunction with Article I, Sections 8 and 9.
By not addressing the Sixteenth Amendment issue at all, the Murphy II court left some unanswered questions that require further scrutiny:
- Can an income tax under Sec. 61 still be constitutionally valid if it violates the Sixteenth Amendment's constraints on income?
- If a tax on income passes scrutiny under Article I, Section 8 or 9, must it also meet the definition of income under the Sixteenth Amendment in order for it to be constitutional?
Even though this uncertainty will persist, there are immediate ramifications for taxpayers.
Statute of Limitation and Protective Refund ClaimsIn August 2006 when the Murphy I decision came out, it was recommended that all taxpayers who received an award for a nonphysical injury should file a protective refund claim, a formal claim to the IRS that is contingent on a future event and is filed because the future event in question may not be settled until after the statute of limitations expires. 42 Generally, the IRS will not act on a protective refund claim until the contingency has been settled. 43
The importance of timely filing a refund claim is that while the eventual outcome of a case is uncertain, the statute of limitation under Sec. 6511 continues to run. Sec. 6511(a) provides that a claim for refund of an overpayment of tax "shall be filed by the taxpayer within 3 years from the time the return was filed or 2 years from the time the tax was paid, whichever of such periods expires the later, or if no return was filed by the taxpayer, within 2 years from the time the tax was paid."
Filing the refund claim within the time prescribed by Sec. 6511 is of utmost importance in protecting the taxpayer's right to seek a civil action for a refund in court. Sec. 7422(a) prohibits filing a suit for refund "until a claim for refund or credit has been duly filed with the Secretary, according to the provisions of law." The U.S. Supreme Court has affirmed that Sec. 7422 limits a taxpayer's right to seek a remedy in court, stating that "unless a claim for refund of a tax has been filed within the time limits imposed by Section 6511(a), a suit for refund . . . may not be maintained in any court." 44
Taxpayers Seeking Redress in CourtThe Supreme Court's recent denial of certiorari removes outstanding contingencies; thus, the IRS likely will deny the protective refund claims filed by taxpayers who received awards for nonphysical injuries. Under Sec. 6532(a)(1), taxpayers have "2 years from the date of mailing by certified mail or registered mail by the Secretary to the taxpayer of a notice of the disallowance of the part of the claim to which the suit or proceeding relates" to file suit for a refund.
Given the far-reaching and seemingly contradictory rulings in the Murphy cases, future litigation in other appellate circuits appears likely. Practitioners should therefore advise taxpayers to diligently follow future events and take appropriate action should a new contingency arise. In such cases, the taxpayer has two options in seeking a refund of taxes paid.
First, taxpayers can petition the IRS to reconsider its denial of their claim. It is very important that taxpayers be aware that they have two years to initiate a suit for refund under Sec. 6532(a)(1) and that any reconsideration by the IRS "shall not operate to extend the period within which suit may be begun." 45 Second, if there is a significant amount involved and taxpayers have the resources to go to court themselves, they can initiate a suit for a refund.
ConclusionThe Supreme Court's denial of the appellant's petition for certiorari does not affirm the Murphy II decision; however, it does allow the DC Court of Appeals' decision to stand, and the lower courts within the DC Circuit must follow the decision. 46 However, other jurisdictions are not bound by the decision.
Recent Tax Court cases decided subsequent to Murphy II, while all affirming the validity of Sec. 104(a)(2), suggest that litigation about Sec. 104 will continue.47 Ballmer and Hawkins acknowledge the Murphy decisions, but none of the recent cases explored Murphy's arguments regarding the definition of income under the Sixteenth Amendment or the government's argument upheld in Murphy II as to the power to tax under Article I. As taxpayers challenge the validity of Sec. 104(a)(2) under Murphy's legal theories, courts in jurisdictions outside the DC Circuit will be forced to evaluate them. Should a split in circuits arise, the case could become ripe for the Supreme Court to grant certiorari and rule on this important constitutional issue. The taxation of nonphysical injury awards is far from settled, and taxpayers and practitioners should be diligent in monitoring future developments.
Kenneth Winkelman is an assistant professor of accounting, James Fornaro is an associate professor of accounting, and Peter Lucido is an assistant professor of accounting in the School of Business at SUNY College at Old Westbury, NY. For more information about this article, contact Prof. Winkelman at firstname.lastname@example.org.
1 Murphy, S. Ct. Dkt. 07-802 (U.S. 4/21/08).
2 Small Business Job Protection Act of 1996, P.L. 104-188, §1605.
3 Murphy, 493 F.3d 170 (D.C. Cir. 2007) ( Murphy II), aff'g 362 F. Supp. 2d 206 (D.D.C. 2005).
4 Murphy, 460 F.3d 79 (D.C. Cir. 2006) (Murphy I), remanding 362 F. Supp. 2d 206 (D.D.C. 2005).
5 Murph, No. 05-5139 (D.C. Cir. 12/22/06), vact'g 460 F.3d 79 (D.C. Cir. 2006).
6 Murphy, S. Ct. Dkt. 07-802 (U.S. 4/21/08).
7 See, e.g., Kenney, "Murphy a Boon for Protesters, Critics Say," 112 Tax Notes 832 (September 4, 2006); Prusiecki, "Murphy: The 16th Amendment May Be Irrelevant," 113 Tax Notes 926 (December 4, 2006); Sheppard, "Murphy's Law: Tax Provision Declared Unconstitutional," 112 Tax Notes 825 (September 4, 2006); Stratton, "Experts Ponder Murphy Decision's Many Flaws," 112 Tax Notes 822 (September 4, 2006).
8 See, e.g., Reardon, "Marrita Murphy: The Flip Side of the Economic Substance Doctrine," 112 Tax Notes 1167 (September 25, 2006).
9 Maryland v. Baltimore Radio Show, 338 U.S. 912 (1950).
10 Id. at 918.
11 Murphy I, 460 F.3d at 81.
12 Leveille v. New York Air Nat'l Guard, No. 94-TSC-00003 (DOL Off. Adm. App. 2/9/98).
13 Murphy, 362 F. Supp. 2d 206 (D.D.C. 2005).
14 Murphy I, 460 F.3d at 84, quoting Morrison, 529 U.S. 598, 607 (2000).
15 Id. at 84–85, quoting the Sixteenth Amendment to the U.S. Constitution.
16 O'Gilvie, 519 U.S. 79 (1996).
17 Glenshaw Glass Co., 348 U.S. 426 (1955).
18 Merchants' Loan & Trust Co. v. Smietanka, 255 U.S. 509 (1921).
19 Murphy I, 460 F.3d at 88-89, quoting Merchants' Loan & Trust Co., 255 U.S. at 519.
20 Id. at 88, quoting O'Gilvie, 519 U.S. at 86.
21 Id. at 88.
22 Revenue Act of 1918, ch. 18, 40 Stat. 1057 (1919).
23 Murphy I, 460 F.3d at 89.
24 31 Op. Att'y Gen. 304 (1918).
25 T.D. 2747, 20 Treas. Dec. Int. Rev. 457 (1918).
26 Murphy I, 460 F.3d at 89.
27 Id. at 92.
28 Murphy II, 493 F.3d at 173.
29 Murphy, No. 05-5139 (D.C. Cir. 12/22/06), vact'g 460 F.3d 79 (D.C. Cir. 2006).
30 Murphy II, 493 F.3d at 181, quoting Bromley v. McCaughn, 280 U.S. 124, 136 (1929).
31 Id. at 181, quoting Fernandez v. Wiener, 326 U.S. 340, 352 (1945).
32 Id. at 181, quoting Thomas, 192 U.S. 363, 370 (1904).
33 Id. at 181, citing Pollock v. Farmers' Loan & Trust Co. , 157 U.S. 429 (1895).
34 Id. at 186.
35 Id. at 179.
37 Murphy I, 460 F.3d at 84.
38 Id. at 92.
40 Murphy II, 493 F.3d at 186.
41 Murphy I, 460 F.3d at 84.
42 See, e.g., Winkelman and Fornaro, "Tax on Emotional Damages Held Unconstitutional: How to Protect Clients in the Short Term," Tax Clinic, 37 The Tax Adviser 700 (December 2006); Vincent, "Taxation of Emotional Damages Held Unconstitutional," 62 J. Mo. Bar (September–October 2006).
43 IRS Publication 17, Your Federal Income Tax, Ch. 1 (2007).
44 Dalm, 494 U.S. 596 (1990).
45 Sec. 6532(a)(4).
46 The DC Court of Appeals hears appeals from the District Court for the District of Columbia and the Tax Court.
47 See, e.g., Pettit, T.C. Memo. 2008-87; Sanford, T.C. Memo. 2008-158; Ballmer, T.C. Memo. 2007-295; and Hawkins, T.C. Memo. 2007-286.