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:
Thanks to How Appealing for the link.
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.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.
* * * [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.
Thanks to How Appealing for the link.
Related Posts (on one page):
- Income Tax and Sanctity of Property in Our Constitutional System:
- Constitutional Limits on the Power to Tax:
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.
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.
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.
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.]
[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.]
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.
BlackDoggerel, are you assuming that the Supreme Court knows a lot about tax law and the difficult questions this case presents?
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.
I know I'm missing something obvious and this will be embarassing for me. Go Tarheels!
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.
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.
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.
(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.")
Sigh.
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.
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.
AMG
(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.
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?
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?
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.)
AMG
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.
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.