Income Tax and Sanctity of Property in Our Constitutional System:

As Orin points out, the D.C. Circuit has just held that a small part of the federal tax code exceeds Congress's power to lay income taxes under the Sixteenth Amendment. The tax code, the court held, does tax as income compensatory damages for emotional distress and loss of reputation. But such damages aren't "income" for purposes of the Sixteenth Amendment ("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"), because they are not a gain but merely a compensation for loss; therefore, the court held, they can't constitutionally be subjected to the income tax.

I don't have much to say about the opinion but one thing did strike me. The court writes:

The Sixteenth Amendment simply does not authorize the Congress to tax as "incomes" every sort of revenue a taxpayer may receive.... [B]ecause the "the power to tax involves the power to destroy," 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.

Yet "the sanctity of property in our system" does not generally protect people from taxes on their capital. Not only may the federal government impose taxes on transactions involving property (such as importation, gift, or disposition on death), but state governments are free to tax property in a wide range of ways, including by imposing a percentage tax on all possessed property.

The state may, for instance, impose a percentage tax on all real estate; it may do the same for personal property, though my understanding is that administrative (and political) problems usually prevent that from happening; and I think it would be quite free to impose a tax on compensatory damage awards as well. States have long taxes real estate, to my knowledge from before the Constitution, though a property tax is often thought of as a quintessential direct non-income tax that the federal government may not impose. There's just nothing in the federal Constitution, or to my knowledge in most state constitutions, that prohibits states from laying taxes either on capital or on compensation for loss. Our system just doesn't view such taxes on property as inconsistent with "the sanctity of property."

Rather, the limits on the federal income tax are limits specific to the federal government — limits that originated in the Direct Tax Clause and were then made much looser by the Sixteenth Amendment. They stem from concerns about federal power, not about government power more generally. And they thus have to do not with "the sanctity of property" as such, but rather with what only states and not the federal government should be able to do as to that property.

Related Posts (on one page):

  1. Income Tax and Sanctity of Property in Our Constitutional System:
  2. Constitutional Limits on the Power to Tax:
David Walser:
I'm glad I read the entire post. I was about to disagree, until I read the last paragraph. Yep. The reason this tax provision was held to be unconstitutional was because it violated the Constitution's limitations on federal power, not because the Constitution prohibits such taxes by all levels of government.
8.22.2006 7:02pm
Simon (391563) (mail) (www):
I've long thought the rhetoric surrounding property rights overstates their importance in our legal system. As best as I can tell, property rights receive less protection under the Constitution than any other rights in the classically-liberal "individual rights" basket.
8.22.2006 8:21pm
Ron Hardin (mail) (www):
My own explanation to myself was that money for damage to reputation leaves you where you started, asset-wise, and therefore no income had occurred.

(Since there was an exchange of money for reputation, however, perhaps a sales tax could be applied. It's just that there was no profit to tax, with taxes that tax profit.)
8.22.2006 9:42pm
A. Zarkov (mail):
There was an IRS case concerning forgiveness of a gambling debt. As I remember someone ran up a big debt gambling in Vegas and couldn't pay it. The casino forgave all or part of debt and then the IRS decided that was income to the gambler. Eventually the gambler won in tax court, which held it, wasn't really income. Anyone know the precise details?
8.22.2006 9:57pm
AGENT (mail):
Maybe I'm being too much of an economist, but isn't every sort of income, even traditionally accepted work related income, just "compensation for a loss" -- in this case time, physical or mental exertion, etc.? The difference, in my opinion is that the former is a voluntary loss. This one word would make a much stronger ruling, in that the portion of work that is considered "involuntary," i.e. which covers the cost of staying alive and basic necessities (the poverty line) is traditionally untaxed as far as income tax is concerned. The wording, at least how it's portrayed here, seems to allow my interpretation. Now whether and to what extent the government is allowed to tax even voluntary transactions is another issue.

Any thoughts?

A.G. Reed
8.22.2006 11:01pm
Volokh Is Soooooo Wrong Here (mail):
You are ALL missing the point. Compensation for a tortious wrong is not income. If it were taxed, then you would not be made whole. Let's say someone negligently chops off your arm and then pays you a settlement that perfectly compensates you for the loss of your arm. There is no income. There is no gain. The money is just compensation for the loss of your arm. That money = your arm. Because the government cannot take a random piece of your arm, the government cannot tax your compensatory judgment. No level of American government has the right to just hack off a little piece of your arm. All of you on this thread are absolutely wrong and you should be ashamed. This decision is absolutely right.
8.23.2006 1:06am
blackdoggerel (mail):
Wow, "Volokh is Soooooo Wrong Here," that's quite a bold stand to take. But the theory you're endorsing, while superficially appealing, runs into many conceptual problems. For example:

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? (That is the answer many academics reach.) 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 do you reconcile this with the concept of basis that permeates the rest of the tax code? If you're 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? Is that what you're claiming? Because that's where the theory leads us.

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?

I don't know what the answers to these questions are. But they are questions that need to be asked and answered if one is going to accept the human-capital theory that you are so boldly espousing and that the CADC's opinion comes awfully close to endorsing. That's why this is a difficult case, and it will be interesting to see if/how the SCt handles it.
8.23.2006 1:36am
Suppose you sold your arm, would the proceeds be income?
8.23.2006 1:41am
Eugene Volokh (www):
"That money = your arm"? Not "is used to compensate you for," but actually "="? In a world where money = an arm, then I suppose taxes of all sorts = dismemberment = zombie attacks = the alligator from Peter Pan. Fortunately that's not the world our legal system envisions.
8.23.2006 1:56am
Z Jones (mail):
Zarkov: The case you are referring to was ultimately decided in the court of appeals for the third circuit, Zarin v. CIR, 916 F.2d 110. The tax court ruled 11 to 8 that the forgiveness of Zarin's debt by the casino constituted income. However, the 3rd circuit reversed, saying that the amount Zarin owed to the casino did not constitute "indebtedness" as defined in IRC Section 108(d)(1), as (1) the debt was unenforceable, and (2) the chips that Zarin acquired for the debt did not meet the definition of "property". Very interesting analysis by both the tax and appellate courts.
8.23.2006 1:59am
Volokh is still wrong (mail):
I never said "money = an arm". I said "that money = your arm". One cannot make the analytical leap from the latter to the former, if one reads my post closely. Professor Volokh, you should be above straw-men.
8.23.2006 2:42am
Volokh is still wrong (mail):
Suppose you sold your arm, would the proceeds be income?

If it is compensation for a tortious wrong, it is not income.
8.23.2006 3:02am
Eugene Volokh (www):
Hmm; I meant "money = an arm" as a reference to "that money = your arm," which seems an entirely fictional equation (precisely the way that "money = an arm" is fictional). No amount of money is ever equal to an arm, even if it is compensation for an arm; and arguments that rest on such asserted equality don't make much sense. Never fall for the trap of believing that your metaphors (or other figurative usages) are actually real.
8.23.2006 3:12am

Suppose you sold your arm, would the proceeds be income?

If it is compensation for a tortious wrong, it is not income.

So, I presume that under your rule, if a farmer harvested a field of corn and sold it at market, the proceeds would be taxible income. By contrast, if the day before the harvest, another party's tortious wrong caused the field to burn and be a total loss, and the tortfeasor paid the farmer the market value of the corn in settlement of the farmer's claim, the farmer would be liable for no income tax on the settlement proceeds. What is the reason for treating the two cases differently?
8.23.2006 4:05pm
arbitraryaardvark (mail) (www):
If you sell your arm, does that trigger a realization of accrued income? What was your basis in the arm?
Assume the seller is a US citizen, that the transaction takes place in the Tongan organ futures market.

I have no doubt when the government wants a piece of your arm, they will just take it, perhaps as part of the anti-terrorist national dna database. Currently the IRS says I owe them an arm and a leg.
8.23.2006 4:07pm
Tax Guy (mail):
The question of whether an item is income that can be taxed under the 16th amendment is not clear. Many of the cases state the test as whether there is a "net accretion to wealth," or some similar phrasing (the court here used the wording "accessions to wealth"). Under this approach, the court's holding seems reasonable: the taxpayer suffered an injury and received cash as compensation. She was made whole, presumably, but there was no "profit" or "gain" from this transaction. To put it differently, it would not make sense to give her a tax deduction when the injury occurred, so why tax her when she recovers cash for that loss?

I do have some reservations, albeit only after a quick read through.

(1) The injury in question was not a chopped off hand. The taxpayer suffered mental anguish. The court did not consider whether there was a practical rationale for Congress' decision to subject mental anguish awards to tax. Could be that Congress felt that such awards are really disguised punitive damages (which the no-accretion-to-wealth rationale would not save from taxation). Could be that Congress felt that there was little objective basis for the granting of awards for emotional distress. This litigation arises from a change in the law added by Congress in 1996 which states that "emotional distress shall not be treated as a physical injury or physical sickness," and thus cannot qualify as tax exempt. There is a slight caveat to this -- the recovery of amounts for the costs of therapy, medication, etc., are exempt. One reading of this change is that Congress simply wanted to raise the evidentiary bar -- i.e., there is no taxation of emotional distress awards where there is some indicia that the distress actually occurred, it is very easy to fake emotional distress, there are no objective tests for it, so we will use actual outlays for therapy, etc., as a proxy. Perhaps this is wrong, but the court does not consider it.

(2) I am familiar with the practice of some trial attorneys of arguing for an increase in damages on the basis that whatever the jury gives will be taxed, so to put the plaintiff right the award should be grossed up (this would typically be in connection with a wage claim). This opinion was an appeal from a summary judgment motion, and did not reach such facts. However, I assume that if such an argument was made, then various equitable doctrines would bar a taxpayer from claiming that a grossed up damage award was exempt from tax.

(3)The court's reasoning rests in part on the scope of the term "income" at the time the 16th amendment was ratified. To do this it looked at enactments to the Internal Revenue Code soon after ratification, as well as an AG opinion and Treasury ruling, all on the theory that people back then had a better idea of what the term income meant at the time of ratification. The IRC enactments cited did not differentiate between physical and emotional injuries. The court does not consider whether there was any tort theory under which a person could recover for emotional distress at that time. I'm not an expert, but it seems likely that Congress did not distinguish between physical and emotional injuries because no one could recover for the latter at that time. Even if this is wrong, the court is assuming from Congress' failure to tax an item that it was unconstitutional to tax that item. Sometimes Congess simply does not exert all the power it has. As for the AG and Treasury guidance, the excerpts appear to address only physcial injuries. This does not mean that the court's interpretation is wrong, but these authorities do not seem particularly helpful in either direction.

(4) Finally -- Whenever a court strikes down a provision of the Internal Revenue Code on a constitutional basis, the hive is alerted -- all the quacks, con artists, conspiracy buffs, and their ilk become emboldened in their belief that they do not have to pay federal income tax. I'm no fan of the IRS but I would predict a rash of tax protester activity after this case gets into the hinterland.

That said, there are few instances when tax law and constitutional law intersect (at least at the federal level). It will be fascinating to watch this case as it goes forward. Regardless of whether the taxpayer is ultimately upheld, I fear this case will live on in the filings of tax protesters for decades to come.
8.23.2006 4:13pm
Ijustwannapostasaguest (mail):
All of these arguments just serve to point out that there is no such thing as a just tax. Taxation is the coerced involuntary seizure of property from an individual by a third party. If taxation were just, it would be voluntary, therefore, if it is not voluntary, it is injust. This is true despite any arguments about social contract, the cost of civilization, who would save the children/feed the poor/help the elderly/ stop the invaders, or any other personal preference that one uses to support this type of forceful theft or delude themselves that it is anything other than just that.

Of course, I do realize that my statement goes a bit beyond the the specifics of the matter that you all are discussing.
8.23.2006 8:17pm