Wednesday, August 23, 2006


Murphy's Law?

Much of what passes for conservative political thought these days is nothing more than rationalizations attempting to justify policies that favor the rich and economically entrenched. It is therefore refreshing to find a judicial opinion that actually applies conservative principles.

Yesterday, in the case of Murphy v. IRS, the U.S. District Court for the District of Columbia (per Ginsburg, C.J.) determined that, as a matter of Constitutional law, "compensation for a non-physical personal injury is not income under the Sixteenth Amendment if . . . it is unrelated to lost wages or earnings."

The taxpayer had "filed a complaint with the Department of Labor alleging that her former employer . . . in violation of various whistle-blower statues, had 'blacklisted' her and provided unfavorable references to potential employers after she had complained to state authorities of environmental hazards . . . ." The Secretary of Labor found in favor of the taxpayer and the case was remanded to an administrative law judge for a determination of the amount of compensatory damages to which she was entitled.

The taxpayer:
submitted evidence that she had suffered both mental and physical injuries as a result of the . . . .blacklisting . . . . A physician testified [that the taxpayer] had sustained "somatic" and "emotional" injuries. One such injury was "bruxism," or teeth grinding often associated with stress, which may cause permanent tooth damage. Upon finding [that the taxpayer] had also suffered from other "physical manifestations of stress" including "anxiety attacks, shortness of breath, and dizziness," the ALJ recommended compensatory damages totaling $70,000, of which $45,000 was for "emotional distress or mental anguish," and $25,000 was for "injury to professional reputation" from having been blacklisted. None of the award was for lost wages or diminished earning capacity.
IRC Section 104(a) provides that "gross income [under IRC Section 61] does not include the amount of any damages (other than punitive damages) received ... on account of personal physical injuries or physical sickness." Since 1996 it has further provided that, for purposes of this exclusion, "emotional distress shall not be treated as a physical injury or physical sickness." The taxpayer had contended that the award was not taxable because she had suffered physical injury (e.g., the bruxism). However, that argument was rejected by the Court which stated that:
[The taxpayer] no doubt suffered from certain physical manifestations of emotional distress, but the record clearly indicates [that she was] awarded . . . compensation only "for mental pain and anguish" and "for injury to professional reputation."
The Court then turned to the argument that makes this case remarkable. Specifically, is IRC Section 104(a)(2), which does not permit the award to be excluded from income, constitutional? The Court held that it was not.

In its analysis, the Court extensively reviewed the history of the Sixteenth Amendment. Ultimately, it agreed with the taxpayer's contention that:
a damage award for personal injuries-- including nonphysical injuries -- is not income but simply a return of capital -- "human capital," as it were. See Gary S. Becker, Human Capital (1st ed. 1964); Gary S. Becker, "The Economic Way of Looking at Life," 43-45 (Nobel Lecture, Dec. 9, 1992).
In a footnote, the Court remarked:
[The taxpayer's point] is that as with compensation for a harm to one's financial or physical capital, the payment of compensation for the diminution of a personal attribute, such as reputation, is but a restoration of the status quo ante, analogous to a "restoration of capital," [Commissioner v.] Glenshaw Glass, 348 U.S. [426 (1955)] at 432 n.8; in neither context does the payment result in a "gain" or "accession[] to wealth," id. at 430-31.
In Commissioner v. Banks, the Supreme Court determined that when a litigant's recovery constitutes income, the litigant's income includes the portion of the recovery paid to the attorney as a contingent fee. As a practical matter, any legal fee paid in the course of a lawsuit except one for personal injury will, under IRC Section 104, generally get added back into income when computing the claimant's liability for alternative minimum tax. Since such fees are not deductible for alternative minimum tax purposes, they are, in essence, not deductible at all. See my comments here made before Banks was handed down.

The decision in Murphy re-establishes balance to the equation, at least in those situations where the award sought is for "personal injury." (This would not include, however, awards for economic injuries such as lost wages, etc. In my previous comments on Banks, I pointed out some of the practical problems that employees face in attempting to use attorneys or other paid agents in negotiating contracts or other compensation awards.)

Murphy is a conservative opinion in the traditional sense of the word "conservative." It is doubtful whether a "conservative court" in the post-20th Century meaning of the term (the Fourth Circuit, for instance) would have reached the same conclusion as did the D.C. Circuit.

3 comments:

Daryl J. Sidle said...

Stuart:

I respectfully disagree. I read the decision quickly this morning and found it to be very troubling.

Let's put aside for the moment the fact that it will give aid and comfort to every tax dodging wacko out there who claims that the entire income tax is unconsitutional.

The court's attempt to limit the interpretation of the 16th amendment to to its understanding by those who adopted it is very disturbing. Does this mean that anything not orignally considered income in 1916 cannot be income, without another amendment of the Constitution?

In addition, even if we grant the odd "human capital" concept, which is the fulcrum of the whole opinon, I don't understand how a payment that compensates one for the loss of human capital is tax-free if one has no basis in that intangible asset. The gov't raised this argument and it seems to me that the court just brushed it aside without any convincing response.

To put things in context, take any other type of self-created intangible asset in which I have no basis. If its value is tortiously reduced by a third party, and I receive payment to compensate me for the impairment of that asset, my recovery has income tax consequences, notwithstanding the fact that I am just being made whole. If I have no basis with which to offset the recovery, I am taxed. Why is this any different?

From a policy perspective, I like the opinion. The nonsense that Sec. 104 has wrought in terms of dressing up claims and catching the unaware is a real shame. Nonetheless, I am not persuaded by the court's argument.

What do think the Supremes will do?

Mark Finley said...

Stuart:IagreewithMr.Sidle.IfyouYoucross the center line,total my car and your insurance company pays me $10,000,and my basis in my car,due to deprec.deduct.is $3,000 do I not have a gain of $7,000? Has not the law already estab. that a blood donor has 0 basis in his blood and therefore payment received for the "donation" is taxable? ( I can't give you the site,but I remember reading such a case).

Stuart Levine said...

I actually also agree with much of what Daryl says.

My initial reaction when reading the opinion was that it will give renewed energy and hope to those who simply don't want to pay taxes of any kind and drape their argument on the alleged "unconstitutionality" of the Sixteenth Amendment. However, I think that the opinion is actually far more limited.

This ties back to the question of how the Sixteenth Amendment should be interpreted. I don't believe in the "original intent" approach to Constitutional interpretation. However, however, we are not so distant in time from the date of adoption of the Sixteenth Amendment. At the least, we should try to comprehend the concept of what was meant by income at the time of the Amendment's passage.

Like both Daryl and Mark, however, I believe that income was recognized. I think that the case Mark alludes to, Green v. Commissioner, 74 T.C. 1229 (1980) does address this point well. ("The rarity of petitioner's blood made the processing and packaging of her blood plasma a profitable undertaking, just as it is profitable for other entrepreneurs to purchase hen's eggs, bee's honey, cow's milk, or sheep's wool for processing and distribution. Although we recognize the traditional sanctity of the human body, we can find no reason to legally distinguish the sale of these raw products of nature from the sale of petitioner's blood plasma. Even human hair, if of sufficient length and quality, may be sold for the production of hairpieces. The main thrust of the relationship between petitioner and the lab was the sale of a tangible raw material to be processed and eventually resold by the lab.")

Finally, I don't think that the case will get to the Supremes. I'm betting on an en banc reversal.