Murphy’s new law: Emotional distress at no tax cost

Albert Einstein once said that the hardest thing in the world to understand is the income tax.

Now some tax scholars say a ruling on what is — or more precisely,
isn’t — taxable as income in legal awards is equally incomprehensible.

On Aug. 22, a Washington, D.C., federal appeals court judge ruled that
the U.S. government cannot tax money individuals receive as
compensation for emotional distress and other intangible injuries.

Some brief background: In 1994, Marrita Murphy filed a complaint with
the Department of Labor claiming that her former employer, New York Air
National Guard, had blacklisted her because she blew the whistle on
environmental hazards on a National Guard base.

She alleged both
physical and emotional injuries and was subsequently awarded $70,000 in
compensatory damages; $45,000 of that was for "emotional distress or
mental anguish" and the remainder for "injury to professional
reputation." None of the money was for any lost wages or diminished
earning capacity.

When the award became final in 1999, Murphy reported the income on her
tax return for that year as "other income." But she later amended the
filing in an effort to get a refund of the $20,665 in taxes (plus
interest) she paid. Her argument was that gross income does not include
damages paid in connection with physical injuries.

She, i.e., her attorneys, also added an alternate reason Murphy should
get the tax payment back: Section 1040(a)(2) of the Internal Revenue
Code as applied to her complaint award was unconstitutional because the
money was not "income" within the meaning of the 16th
Amendment.

Thus, the legal wheels started turning.

And now, in the wake of the Murphy ruling, so too do the gears grind in the heads of every tax protester.

A legal opening for tax protestors? While the case doesn’t deal with
wage income, the core of those loony arguments against the most basic
of IRS collections, "unconstitutional taxation" fruitcakes have got to
be salivating at what they no doubt will see as a chink in the 16th
Amendment armor.

Those who contend that the IRS has no legal standing to tax us at all
have been creating frivolous arguments for ages with no shred of
official documentation to back them up. I’m sure they’ll go even
crazier now that they can point to this ruling.

ProfessorBainbridge.com
takes a
look at what the tax nuts will find comforting in the ruling, while
Taxable Talk examines the short-term (since he
thinks it will eventually be overturned) implications of the ruling.

Technically, the case applies only to the District of Columbia, unless
the IRS and/or Congress decide to make the ruling applicable to similar awards in other types of court cases. Given the tax gap, don’t expect the feds to give up an avenue of tax collections so easily. The ruling also
could be more widely applied if the appellate process goes all the way to the Supreme Court, a much more likely route.

Meanwhile, there are other side affects as this continues to play out.
Will recipients of previous emotional distress awards now be stampeding
to their lawyers’ offices? Will the courts, depending on what finally
shakes out in Murphy, become clogged with similar filings? What advice
does a tax pro give a client now in a similar situation?

These, along with more esoteric discussions of tax and tort case law,
have been filling up tax and law blogs and discussion forums since the
minute the ruling was released earlier this week.

Kaye Thomas at Fairmark.com offers a very good
backgrounder on the case and the apparently idiosyncratic judge, Douglas H. Ginsburg, who
issued the ruling. Dan Shaviro at Start Making Sense pulls no punches
in telling us why he believes Ginsburg makes absolutely no sense in this
case.

TaxProf, the blog keeper of all things tax, both academic and practical,
has been tracking these and other key writings and comments on
Murphy, with compilations here and here.

Or, if you prefer, you can read the ruling itself and come to your own conclusions.

Please, just don’t let it upset you too much.