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The principal issue is whether the IRS can tax as “income” plaintiffs' court awards for non-physical compensatory damages, such as “make whole” awards for emotional distress and loss of reputation. The case was brought by Marrita Murphy, an environmental whistleblowerwho won before the Department of Labor, and was awarded only compensatory damages to vindicate her rights under six federal environmental whistleblower statutes, and none of her damages were for lost wages. Murphy filed a tax refund suit when the IRS demanded that she pay taxes on the "make-whole" award.
The ruling in Murphy v. IRS will affect thousands of past and future victims of civil rights violations and whistleblower retaliation who are awarded compensatory damages for personal injuries. The following summarizes the arguments made on behalf of Ms. Murphy in the reply brief.
In her reply brief, Murphy argues that the D.C. Circuit’s final decision in Murphy v. IRS violates the “accession to wealth” test, which specifies that in order for damages to be within the scope of the “gross income” statute, 26 U.S.C. § 61(a), there must be some “accession” to the taxpayer’s wealth. Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 430 (1955). The D.C. Circuit’s final decision conflicts with this controlling precedent and a long line of authorities holding that damages awarded to make a person “whole” or to restore a personal loss are not “income” or an “accession to wealth.”
Since the enactment of the modern tax code between 1913 and 1918, numerous court and administrative rulings held that personal injury damages, including compensatory damages for non-physical personal injury losses, are not “income.” The scope of the “gross income” statute (codified at 26 U.S.C. § 61(a)) and the subsequent versions of the personal injury statutory exclusions were expressly based on the limitations set forth in the Sixteenth Amendment. Any tax on damages that are not income is not a tax within the scope of those statutes and the Sixteenth Amendment.
Notably, the D.C. Circuit never held that the compensatory damages awarded to Murphy for emotional distress and loss of reputation are “income” under the controlling “accession to wealth” test under Glenshaw Glass. Instead, the court of appeals initially held in Murphy I that Murphy’s damages did not meet this test and were not “income,” but after vacating that decision, the D.C. Circuit decided that 26 U.S.C. § 61(a) was amended “by implication” to include this type of non-physical personal injury damages as “gross income” without deciding the “accession to wealth” test required by Glenshaw Glass. Simply put, gross income under Section 61(a) cannot include damages for non-physical injuries without satisfying the “accession to wealth” test.
The court of appeals in Murphy II, invented the fiction of an excise tax in this case, in an attempt to avoid the required “accession to wealth” test. After holding that Congress amended Section 61(a) “by implication” when it amended Section 104(a)(2) in 1996, the Murphy II court went on to uphold this imagined tax under Article I of the U.S. Constitution. In continuing its fiction of a judicially created excise tax, the court of appeals held that the excise was imposed on the “privilege” of using the “legal system” to “vindicate a statutory right.” To be sure, this is the first case in which any court has judicially created an excise tax on the right to use the legal system to vindicate a federal statutory right. However, the very troubling implications of such a tax on civil rights plaintiffs, whistleblowers and tort victims are so enormous as to warrant review by the Supreme Court.
A straightforward application of Glenshaw Glass shows that Murphy’s damages are not income because they were awarded to make her “whole” and to restore a personal injury or human capital loss. Murphy was not enriched by receiving “make whole” compensatory damages.
Murphy also argues that Supreme Court review is warranted to address important questions of federal law resulting from the 1996 amendments to the personal injury exclusion, 26 U.S.C. § 104(a)(2). The type of compensatory personal injury damages at issue here are commonly awarded under numerous federal anti-discrimination and anti-retaliation statutes, as well as in state tort actions. If these damages are taxed the government not only deprives the plaintiff of a “make whole” remedy to compensate for personal injury losses, such as emotional distress and damage to reputation, but there exists confusion about the applicability of the personal injury exemption in cases where the plaintiff also suffers a physical injury of physical sickness as well as emotional distress.
Unquestionably, the D.C. Circuit decided an important question of federal law in a manner that calls for this Court’s review. The taxing of personal injury damages in light of the 1996 amendments to Section 104(a)(2) affects not only the tax bar, but impacts employment law, torts, whistleblower law, and civil rights. Review by the Supreme Court is needed to resolve whether “make whole” personal injury damages are not income and not taxable.