Constitutional Limits on the Power to Tax:
This morning the D.C. Circuit decided a fascinating case holding that the Constitution does not permit the federal government to collect income taxes on compensation for a non-physical work-related injury not related to wages or earnings.

  In Murphy v. IRS, Murphy received $70,000 from the state of New York for anxiety suffered and injury to her reputation for being unlawfully "blacklisted" after becoming a whistleblower aaginst her former employer, the New York Air National Guard. The government wanted to tax the $70,000 as income, but Murphy claimed that it was not taxable either because it was excludable as compensation for "personal physical injuries" or because the Internal Revenue Code is unconstitutional for trying to tax such earnings as income.

  Murphy drew a very favorable panel for this sort of claim -- Chief Judge Douglas Ginsburg, Judge Judith Rogers, and Judge Janice Rogers Brown -- and the panel held, in an opinion by Ginsburg, that the text of the Internal Revenue Code does not exclude such compensation but is unconstitutional for not doing so. The basic argument: When the Sixteenth Amendment was passed in 1913 and permitted the federal income tax, the framers of the amendment did not have this broad an understanding of "income." Here's an excerpt:
The Sixteenth Amendment simply does not authorize the Congress to tax as "incomes" every sort of revenue a taxpayer may receive. As the Supreme Court noted long ago, the "Congress cannot make a thing income which is not so in fact." Burk-Waggoner Oil Ass’n v. Hopkins, 269 U.S. 110, 114 (1925). Indeed, because the "the power to tax involves the power to destroy," McCulloch v. Maryland, 17 U.S. (4 Wheat.) 316, 431 (1819), it would not be consistent with our constitutional government, and the sanctity of property in our system, merely to rely upon the legislature to decide what constitutes income.

* * * [T]he term "incomes," as understood in 1913, clearly did not include damages received in compensation for a physical personal injury, we infer that it likewise did not include damages received for a nonphysical injury and unrelated to lost wages or earning capacity.

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. First, as compensation for the loss of a personal attribute, such as wellbeing or a good reputation, the damages are not received in lieu of income. Second, the framers of the Sixteenth Amendment would not have understood compensation for a personal injury -- including a nonphysical injury -- to be income. Therefore, we hold § 104(a)(2) unconstitutional insofar as it permits the taxation of an award of damages for mental distress and loss of reputation.
  I know essentially nothing about the Sixteenth Amendment, but it will be interesting to see if the SG petitions for certiorari in this case (assuming it doesn't go en banc). I suspect the Supreme Court would take the case.

  Thanks to How Appealing for the link.

Related Posts (on one page):

  1. Income Tax and Sanctity of Property in Our Constitutional System:
  2. Constitutional Limits on the Power to Tax:
Fascinating decision. This raises all sorts of concerns about different areas of tax laws and if allowed to stand will severely impact the entire tax code. For example does the taxation of insurance proceeds in certain instances (e.g. fire insurance proceeds that are not reinvested) count as income? What about windfalls? (finding a hundred dollar bill on the street)

I seriously doubt that this decision stands, simply becuase there are way too many implications for the current tax system. The traditional notion of income is Haig-Simons where Income = Consumption plus savings and I suspect that either en banc or the SC will reverse and hold a broader notion of income applies.
8.22.2006 1:29pm
This has unanimous reversal written all over it.
8.22.2006 1:36pm
It would appear that those members of the DC circuit have not read Glenshaw Glass.
8.22.2006 2:20pm
Mark Field (mail):
Marty Lederman has a post about the ruling here.
8.22.2006 2:36pm
Eh Nonymous (mail) (www):
I agree with Marty; I'm not sure how failure to comply with the 16th amendment is relevant to the constitutionality of a tax.

I, too, however, know next to nothing about tax law.

I *do* know that a lot of tax protesters are delighted to hear that there's *anything* that can ever be classified as "not income" when it so clearly is money, in your possession, that wasn't before.

As a plaintiffs' lawyer, I applaud the result. Getting paid back for a harm done is not income, it's restitution. As a fan of good solid historically-based constitutional reasoning, I'm curious if there's justification for the result, as Marty asks.
8.22.2006 2:49pm
dammitboris (mail):
until you've worked on a tax protestor case, you haven't lived.
8.22.2006 2:53pm
Little Girl:
(whispers) Please, God, stop them before they tax everything away....
8.22.2006 3:09pm
Greedy Clerk (mail):
until you've worked on a tax protestor case, you haven't lived

Those of us who clerked in the federal courts know this all too well. Tax protesters are some of the most notorious vexatious litigants -- right up there with persons with paranoid delusions that the government is spying on them and poisoning their food, etc.

Re this case, it is fascinating. I agree with the result, although I am not sure of the reasoning as I do not know enoough about the issue. I do think, however, that the distinction between physical and mental injuries for purposes of taxation is not supported by a rational basis -- for on thing, it is based on the very mistaken view that real "mental" injuries are not as harmful or legitimate as physical ones -- and thus violates due process and the equal protection component of the 5th Amendment. Supreme Court precedent on the rational basis test, however, would probably disagree with me.
8.22.2006 3:42pm
This decision does not appear to raise any controversial const. issue. THe court held that, while following supreme court precedent, sixteenth amendment's definition of "incomes" did not include compensation for physical injuries--since there is no "gain." So presumably, the IRS and statutes which seeks to tax such compensation is in contradiction of the constitution.

I predict cert. denied, or 9-0 affirmance.

[OK Comments: The D.C. Circuit held a part of federal law unconstitutional under the 16th Amendment, and you don't think it's controversial? Percuriam, I wonder what you think *is* controversial. Also, I would assume this is a reverse if the court takes it.]
8.22.2006 4:05pm
Tom Holsinger (mail):
This has immense meaning for double taxation of the attorney fee portion of personal injury awards.
8.22.2006 4:09pm
TaxGuy (mail) (www):
[Deleted by OK]

[OK Comments: TaxGuy, I'm sure you can make your argument without calling people who disagree with you "stupid." If you are so much smarter than everyone else, then surely you are smart enough to figure out a way to do that.]
8.22.2006 4:25pm
Richard Riley (mail):
I strongly disagree with percuriam's prediction. I predict reversal en banc, or 9-0 reversal by the Supreme Court. The question is (kind of) interesting as a policy matter, and both the decision and its ultimate reversal will be great additions to Chapter 1 of future federal income tax casebooks, but this opinion will not stand.
8.22.2006 4:33pm
Tom Holsinger (mail):
I vaguely recall contrary holdings by other circuit courts. There was a fuss while I was in private practice about general damages for loss of reputation being taxed upon receipt by the client &counsel combined, with the attorneys' 1/3 fee being taken out of the gross such that clients would see less than 40% of their reputation general damages. 30% of general damages would go to taxes and 33% as attorney fees so clients would get only, say, 37% of the general damages.
8.22.2006 4:38pm
blackdoggerel (mail):
I don't agree that the opinion isn't "controversial," but, as a person pretty well-versed in tax law, I think it is actually quite defensible. It will get taken by SCOTUS, of course, not just because it struck down a recent amendment of federal law, but also because the questions raised go to the very heart of defining "income" under the Sixteenth Amendment, which is ultimately the province of the Supreme Court.

As for what SCOTUS will do with it, I actually have no idea. On the one hand, CADC's opinion is actually very consistent with existing SCOTUS precedent, and unless the Court dramatically veers away from how it has defined income over time, it's hard to see how it would uphold the IRC provision in question. On the other hand, finding for the plaintiff means coming perilously close to accepting the human-capital theory of taxation, which opens up a huge can of worms. So I couldn't say what the Court will do with it, although those who think it will be 9-0 one way or the other just don't know much about tax law or the difficult questions this case presents.

My prediction is that the Court will ultimately reverse the CADC, but will do so on less-than-doctrinally-pure grounds, in the name of pragmatism and practicality. Which, of course, will mean a field day for the commentators.
8.22.2006 4:44pm
So I couldn't say what the Court will do with it, although those who think it will be 9-0 one way or the other just don't know much about tax law or the difficult questions this case presents.

BlackDoggerel, are you assuming that the Supreme Court knows a lot about tax law and the difficult questions this case presents?
8.22.2006 4:55pm
Nom (mail):
I am no expert (though this will not top me from opining), but I seem to recall that, despits Marty's argument, Article I would not be enough here because the tax would not be per capita (i.e. each state's population paying the same numerical amount of the tax, per person). As Section 2 of Article I states ". . . direct Taxes shall be apportioned among the several States which may be included within this Union, according to their respective Numbers . . . ," this is a fatal problem.

This was the perceived problem with the income tax before the 16th amdmt - some states have higher-income people than others, so the tax would not fall equally on the states. The same would be true with a tax on damages. Since the 16th amdmt is the only source of a taxing power that doesn't require per capita equality, and it only permits taxation of "income," the tax would be invalid.
8.22.2006 5:08pm
Seeing as how the money received from the lawsuit is compensation, it is clearly not income. It (in a perfect world) is a zero sum game. She suffered a loss in this case physically and that was made up to her in money. I really see it no different than an insurance company paying for repairs on a vehicle. But then like most people I am no expert.
8.22.2006 5:43pm
Dustin (mail):
how could a reversal be 9-0 if ginsburg wrote what is to be reversed?

I know I'm missing something obvious and this will be embarassing for me. Go Tarheels!
8.22.2006 5:45pm
8.22.2006 6:04pm
Brian G (mail) (www):
Please keep updating this case here. I am here every day and would like to see what happens next.
8.22.2006 6:12pm
The NJ Annuitant (mail):
The 16 th Amendment gives Congress the power to lay and collect income taxes without apportionment among the States by population. The 16th Amendment was required to undo the POLLOCK cases , in which the Fuller Court had held that taxes on income from invested capital, or from rentals of real property , were direct taxes, and they therefore were unconsitutional unless apportioned among the States. On the other hand, it would seem reasonably clear that a levy on tort recoveries for personal injuries would not be a direct tax under the reasoning of HYLTON v. UNITED STATES. Accordingly, even if the recovery at issue were not inocme within the meaning of the 16th Amendment, the unapportioned tax was nevertheless valid.
8.22.2006 6:23pm
Steveo987 (mail):
The following is relatively obvious. but might not be generally known, based on some of the prior comments: a tax on income is not necessarily a direct tax. Thus, not all income taxes need be apportioned.
8.22.2006 6:26pm
Steve Brady (mail) (www):
A few more years of Republican presidents, and we'll be getting Supreme Court decisions written by these folks....
8.22.2006 6:33pm
blackdoggerel (mail):
BlackDoggerel, are you assuming that the Supreme Court knows a lot about tax law and the difficult questions this case presents?

Not sure if that was sarcasm or not. My point is that the case raises difficult questions about which reasonable minds could easily disagree, particularly since human-capital theory has, for the past 80 years, been the sole province of academics. It wasn't relevant in the real world until Congress amended this particular IRC provision in 1996. So immediately to conclude that it will go 9-0 one way or the other on the grounds of "Of course it's (not) income!" is to miss the difficult questions the case raises -- the ones that make it so "fascinating" to begin with (to quote from the original post).

In addition, while the SCt may not be experts on the intricacies of the IRC, yes, I guess I do assume the SCt knows a lot about constitutional tax law and the issues this case raises under the Sixteenth Amendment. And because the question here basically reduces to "what is income?", the entire matter may come down to policy arguments, which makes it all the more appropriate for SCt review.
8.22.2006 6:59pm
blackdoggerel (mail):
A few more years of Republican presidents, and we'll be getting Supreme Court decisions written by these folks....

I guess you don't recall a certain Republican president trying to get one of "these folks" on the Court in 1987 and not succeeding. And I don't think you're going to see a Republican president appointing Judge Rogers any time soon. And the idea of a Republican president appointing a judge who would be in favor of striking down tax relief provisions is amusing, to say the least. But other than that, your comment is spot on.
8.22.2006 7:03pm
Although this case may raise some interesting theoretical points trying to determine what the 16th amendment means it is unlikely (and would be unwise) for the SCt. to try and determine the constitutional definition of income as anything other than Haig-Simons (as opposed to the statutory definition) would invite a flood of litigation and confusing and contradictory decisions.

While certainly this constitutional issue has not really been addressed since the 20's and the SCt. precedents and history give some support to the TP's argument as a practical matter this would be a god awful mess. Just like Lochner never being overruled or the arguments (all quite plausible) against Wickard; all the ensuing decisions, legislation and practice point to incredible discretion to Congress on this issue. When was the last time a tax statute was struck down as violating the 16th amendment? (interesting research question)

I am sympathetic to the TP's argument, but this decision would make an evern greater mess out of the tax code. More incoherence and uncertainty would be good for the tax bar, but not for an efficient, coherent and stable tax system.
8.22.2006 7:56pm
What a mind boggling ruling. I say mind boggling because it both

(1) has the potential to create massive upheaval in the tax code (I don't even want to start thinking of the tax statutes you could strike down using the "it's not income" reasoning.)

(2) is logically and rationally sound (we have to be honest and admit that emotional distress damages are not income, but rather a "making whole.")

8.22.2006 9:02pm
blackdoggerel (mail):
And the idea of a Republican president appointing a judge who would be in favor of striking down tax relief provisions is amusing, to say the least.

Doh! The IRC provision in question is obviously not a "tax relief" provision. It actually increased the potential amount taxpayers might have to pay. Hoisted by my own snarky petard.
8.22.2006 11:01pm
I don't get why they had to reach the Constitutional question. If the award does not constitute "income" then the statute doesn't cover it. Shouldn't they have read the IRC narrowly to avoid the Constitutional question?
8.22.2006 11:19pm
Interesting point. IRC 104 says you are not to be taxed on compensation received for physical injury, then explicitly states that emotional distress damages (in excess of the amount actually paid for medical care) do not count as physical injury damages. It is pretty clear from the legislative history that congress included that wording to tax emotional distress damages. Because (at least in my preliminary reading) congress' intent is so crystal clear, I'm not sure how the court could have made that argument.
8.22.2006 11:39pm
Daniel S (mail):
Just a guest passing through late in the evening...

(1) I am not sure that emotional damages "make one whole". After all, one could make the argument at least in song that "can't buy me love". There seems to be a very old legal idea gong back a least many 100s of years about "blood money" and it seems to me that emotional damages are in line with that tradition. But I find the notion that money makes one whole for an injury just plain odd, though it may be standard in modern law. Like blood money, emotional damages seem more defenable on "keeping the peace" grounds than "wholeness" grounds.

(2) I do wonder about the equal protection line here. There is a huge gap that remains in many people's minds between physical injuries and mental injuries. You see this often in disability law. Somehow or another mental or emotional pain just isn't as real or important as physical harm. I don't agree but I am not sure that SC has ever ruled for certain on this matter. It may be that the court went with the 16th simply because it felt that going on equal protection grounds was more risky.
8.23.2006 1:28am
blackdoggerel (mail):
I posted these questions in the other VC post about this case, but I would be interested to hear thoughts from commenters here. They represent possible situations that need to be grappled with if one is to accept the "human capital" theory that the CADC touches upon here and that many people quick to defend the opinion seem to be endorsing. I don't know the answers to these questions, but they are what makes this a fascinating opinion and topic:

1. In the typical return-of-capital context (e.g., your house gets damaged, and you get insurance proceeds to cover the capital loss), one is taxed on anything over one's basis in, say, the house. Basis constitutes the cost plus any capital improvements minus depreciation and other capital subtractions. But what is the basis in one's body? You never paid anything for it. So isn't the basis zero? Which means that one should be taxed for anything received to "return" one's human capital, since it necessarily exceeds the basis of zero. If not, why not, and how does one reconcile this with the concept of basis that permeates the rest of the tax code? If one is going to say that there is a non-zero basis in our bodies (or mental facilities), then how to measure it?

2. If money to compensate the loss of an arm is not taxable, does that mean if one loses an arm to, say, disease, or an act of nature (ie, not recoverable from some other party), is one then entitled to a deduction, since one's capital has been reduced?

3. Suppose you're a scrawny beanpole construction worker who doesn't have the strength to do anything more than the lowest-paying jobs. You decide to spend 6 months at the gym to improve your arm muscles, which lets you take a tougher but higher-paying job. Have you increased the "basis" in your body? You've improved a capital asset so that it earns more income, have you not? And if you have increased your basis, by how much? How do we measure it?

4. Suppose that in between being awarded damages of $100,000 for mental anguish (for some company's wrongdoing) and actually receiving the money, your beloved spouse dies. You're emotionally crushed. When you eventually receive the $100,000, shouldn't you, under your approach, now have to pay tax on at least some of it -- since it necessarily exceeds by some amount the basis in your psychological well-being that decreased as a result of your spouse's death? Again, that's where the theory takes us. But, of course, how to measure how much of the award is now taxable, since we have no idea what one's exact basis was before or after the spouse's death (even if we know it's definitely lower afterward)? And to add another twist, what if, after the death but prior to receiving the award, you meet a new person who makes you just as happy as your spouse? Has your basis gone back up? If so, by how much, so that we can determine the tax consequences?
8.23.2006 1:45am

No matter how clear Congressional intent is, you can't escape the fact that the provision that has been held unconstitutional does not define income. Section 104 only excludes certain receipts from being considered income. It seems a tremendous stretch, no matter how certain one may be of intent, to conclude that Congress expanded the definition of income by enacting a provision that purports to limit the definition of that term.

Also, take a look at the holding.

"[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."

"Permits" is an odd word to use. The Court never addreses how section 104 "permits" this taxation. If you agree that section 104 only permits the taxation because it does not prohibit it, is every section of the IRC which fails to prohibit such taxation also unconstitutional?
8.23.2006 2:53am
I think the court used the words "[I]nsofar as . . . " for the reasons you state above?
I am very interested to see what becomes of this. By finding a way to over-ride congress' definition of taxable income, Ms. Murphy's $70,000 case has shaken the foundations of the federal government (In my opinion taxes are the most important tool by which the government governs.)
8.23.2006 3:26am
blackdoggerel (mail):

Some points that may clear up your conversation:

1. 61(a) of the IRC sets a very broad statutory definition of gross income: "all income from whatever source derived." Note the tautology: it doesn't resolve what "income" is -- we have to go back to the Sixteenth Amendment (and the S. Ct.) for that. But whatever income is, 61(a) sets a broad statutory base for what income can be taxed.

2. Certain provisions then statutorily exclude certain receipts from the statutory definition of gross income found in 61(a). For 80 years, one of these exclusions was damages for nonphysical injuries. So for 80 years, it didn't matter whether damages for nonphysical injuries were "income" in the constitutional sense, because Congress, through its largesse, statutorily excluded such receipts from gross income.

3. Once Congress amended 104(a)(2) in 1996 to remove the exclusion, damages for nonphysical injuries once again became included in the statutory definition of gross income, and became taxable. BUT, now, a different question arises: sure, by removing the exclusion, Congress says damages from nonphysical injuries are part of the statutory definition of gross income. But does that necessarily mean that it's part of the constitutional definition -- that is, do such receipts fall under our conception of what "income" really is? For 80 years, nobody had to think about this question because there had always been a statutory exclusion removing these damages from the statutory definition of income. Now that the exclusion's been repealed, the constitutional question in finally ripe.
8.23.2006 10:55am
Joe Kristan (www):
Villanova's Dr. Maule says that there was no need to address the constitutional issue even if the conclusion that the damages were not income is correct (I don't think the court even got that right, but that's another issue).
8.23.2006 12:57pm
Thales (mail) (www):
Question re earlier comment on Glenshaw Glass--didn't that case only count *punitive* or windfall damages as "income" w/in Am. 16? I don't think it bears directly on the issue of non-physical (emotional/reputational/hedonic etc.) compensatory damages.
8.23.2006 1:59pm
I do agree with Vipj and others that it would have been less jarring had the court exercised judicial restraint, and not reached the constitutional issue.

However, I can not think of one case where a federal appellate court read a congressional statute in a way which directly contradicted crystal clear legislative intent -- without pointing to the constitution (even if just in dicta.)

I also note that the court didn't necessarily reach the constitutional issue. They said that if 104 taxes emotional distress damages it is unconstitutional. They didn't definitively say that 104 taxes emotional distress damages.
8.23.2006 2:43pm
Carey Gage:
Regardless of what you think of the opinion, anyone who received an award which might be exempt from tax under the rationale of Murphy should be filing a protective claim for refund to toll the statute of limitations pending what is probably an inevitable appeal.
8.25.2006 6:15pm