|September 12, 2006|
Previously published on September 7, 2006
The United States Court of Appeals for the District of Columbia has held that compensatory damages received for emotional upset and harm to reputation, but not connected to any physical injury, are not taxable as income. See Murphy v. I.R.S. (D.C. Cir. Aug. 22, 2006). The court's decision is the first federal appeals court decision to rule on the taxability of compensatory damages not connected to physical injuries.
In this case, Murphy filed a complaint with the Department of Labor, claiming her former employer, the New York Air National Guard (NYANG), "blacklisted" her and provided unfavorable references to potential employers after she complained to state authorities about environmental hazards on a NYANG airbase. The DOL found in her favor and awarded her $70,000, of which $45,000 was for emotional distress or mental anguish and $25,000 was for "injury to professional reputation." Murphy included the $70,000 in her gross income on her tax form. She later filed an amended tax return, seeking a refund of $20,665, based on § 104(a)(2) of the Internal Revenue Code, which provides that "gross income does not include . . . damages . . . received . . . on account of personal physical injuries or physical sickness." The IRS found that Murphy had not shown that the compensatory damages were attributable to physical injury or sickness and denied her refund request. Subsequently, Murphy sued the IRS and the United States in federal court, claiming the IRS was wrong when it determined that the compensatory damage award was not for physical injury or sickness. Alternatively, she claimed that § 104(a)(2) is unconstitutional to the extent it fails to exclude compensatory damages unrelated to physical injury from the definition of gross income.
The Court of Appeals for the District of Columbia held that Murphy failed to show that she received compensatory damages "because of'" a physical illness or injury, but also held that § 104(a)(2) is unconstitutional. The court held that the compensatory damages Murphy received were awarded to make her "emotionally and reputationally 'whole,'" not to compensate her for lost wages or other kinds of taxable earnings. Since Murphy's emotional well-being and reputation were not taxable as income, the compensation she received in lieu of what she lost was not taxable as income.
Additionally, the court held that the framers of the Sixteenth Amendment would not have understood compensation for a personal injury - including a non-physical injury - to be income. Thus, the court held that § 104(a)(2) is unconstitutional to the extent it permits the taxation of an award of damages for mental distress and loss of reputation.
Employers' Bottom Line:
This decision is binding only in the District of Columbia Circuit, although other courts could follow the court's analysis. Plaintiffs may attempt to rely on Murphy to argue that settlement amounts paid to resolve claims involving purely non-physical injuries should not be treated as income and should not be reported on IRS Form 1099; however, unless and until the IRS changes its current guidance or the U.S. Supreme Court rules on the issue, employers outside the DC Circuit should continue to treat such payments as taxable and either withhold taxes or require the employee to indemnify the company for tax liability. In either case, the payment should be reported on a Form 1099.