Source: https://www.thetaxadviser.com/issues/2008/dec/nonphysicalinjuryawardsaftermurphy.html
Timestamp: 2019-04-18 12:19:23+00:00

Document:
The Supreme Court denied certiorari in Murphy II, in which the DC Circuit held that a tax on an award of damages for nonphysical injuries under Sec. 104(a)(2) was constitutional.
Prior to its decision in Murphy II, the DC Circuit held (in Murphy I) that the taxation of an award for nonphysical injuries under Sec. 104(a)(2) was a violation of the Sixteenth Amendment of the Constitution. The court later vacated this decision on its own accord.
In Murphy II, the DC Circuit held that a tax on an award of damages for nonphysical injuries was an excise tax permitted under Article I, Section 8, of the Constitution and was not a direct tax subject to the apportionment requirement of Article I, Section 9.
On April 21, 2008, the Supreme Court1 denied appellant Marrita Murphy's petition to have her case reviewed on the issue of whether Sec. 104(a)(2) constitutionally taxes awards for emotional distress, mental anguish, or injury to reputation (i.e., nonphysical injury awards). Sec. 104 was amended by the Small Business Job Protection Act of 19962 to provide that a personal injury or sickness for which damages are received must be physical in order for the damages to be excluded from income under Sec. 61. In addition, the flush language of Sec. 104(a) adds that "emotional distress shall not be treated as a physical injury or physical sickness." Therefore, Murphy's awards for "emotional distress" and "injury to professional reputation" (nonphysical injury awards) were not excludible and were taxable income under Sec. 61.
The Supreme Court's denial of certiorari has significant consequences for taxpayers. The decision in Murphy II,3 in which the DC Court of Appeals validated an excise tax on income under an income tax statute (Sec. 61), can be viewed as expanding Congress's power to tax incomes.
In addition, for taxpayers who filed protective refund claims with the IRS and awaited the outcome of the Murphy case, it is expected that the IRS will deny these claims because there is currently no outstanding contingency. Taxpayers should be mindful that they have only two years from the denial of their refund claim to seek redress in court. Those who recently received or will receive damage awards on account of emotional distress may wish to consider filing protective refund claims should a new contingency arise. Taxpayers continue to litigate claims for nonphysical injuries, and courts outside the DC Circuit are not bound by the Murphy decision. If a split in circuits arises, this issue could become appropriate for Supreme Court review.
The original ruling in Murphy I was widely criticized by legal and tax practitioners, scholars, and other commentators, who asserted that the decision ignored Congress's power to tax and would subject the courts to numerous challenges under the Sixteenth Amendment as to the definition of "incomes." 7 However, others defended Murphy I as properly recognizing the limitations of incomes within the Sixteenth Amendment. 8 For these reasons, many consider Murphy I to be one of the more controversial tax decisions in recent times.
Some tax professionals believe that the decisions in Murphy I and Murphy II, coupled with the denial of certiorari by the Supreme Court, signal that the issue has been resolved. Others believe that the denial of certiorari will likely lead to a flurry of activity in the lower courts.
The Supreme Court has stated that a denial of certiorari "carries with it no implication whatever regarding the Court's views on the merits of a case which it has declined to review." 9 The Maryland v. Baltimore Radio Show decision explains that one of the reasons for a denial of certiorari is that "[i]t may be desirable to have different aspects of an issue further illumined by the lower courts." 10 As taxpayers continue to challenge the validity of Sec. 104(a)(2), it is likely that the issue will be further illuminated and could become appropriate for review by the Supreme Court.
Murphy then sought redress in the DC Court of Appeals on two legal grounds. First, she claimed that the award was for "personal physical injuries" and was therefore excludible under Sec. 104(a)(2). Second, she asserted that the award was not income under the Sixteenth Amendment, so taxing it was unconstitutional. The Murphy I court found that the awards (emotional distress and injury to professional reputation) were clearly for nonphysical injuries and were not the result of a physical injury, and it ruled against Murphy on her first legal ground.
Applying O'Gilvie, the court examined whether "the taxpayer's award of compensatory damages is ‘a substitute for [a] normally untaxed . . . quality, good, or "asset."'"20 Using this "in lieu of" test, the court determined that the award of compensatory damages was to "make Murphy emotionally and reputationally ‘whole' and not to compensate her for lost wages or taxable earnings of any kind." 21 Accordingly, the $70,000 award was in lieu of something normally not taxed, and therefore it was not income under the Sixteenth Amendment.
Guided by Glenshaw Glass, the Murphy I court then examined whether the taxpayer had a "gain or accession to wealth." Having already determined that the damages were not to compensate her for lost wages or taxable earnings, the court ruled that damages received (1) solely as compensation for a personal injury (physical or nonphysical) and (2) not in lieu of something that is normally taxed are not an accession to wealth and therefore are not income under the Sixteenth Amendment.
Shortly after the Murphy I decision, the government petitioned for a rehearing en banc, raising the argument for the first time that "even if Murphy's award is not income, there is no constitutional impediment to taxing it because a tax on the award is not a direct tax and is imposed uniformly." 28 While the DC Court of Appeals did not grant the en banc rehearing, in a highly unusual move, the court vacated its decision on its own accord on December 22, 2006. 29 Due to the importance of the issue raised, the three-judge panel decided to rehear the case.
In Murphy II, the court analyzed the government's new argument that a tax on the award was not a direct tax and was imposed uniformly. As a starting point, the court looked at Congress's power to tax under Article I, Sections 8 and 9, of the U.S. Constitution and whether the constraints imposed under these articles were violated in taxing Murphy's compensatory awards.
The Congress shall have power to lay and collect taxes, duties, imposts and excises, to pay the debts and provide for the common defense and general welfare of the United States; but all duties, imposts and excises shall be uniform throughout the United States.
The court noted this should be "contrasted with excise taxes laid ‘upon a particular use or enjoyment of property,'" 31 "duties imposed on importation, consumption, . . . a sale of certain commodities, . . . privileges," 32 or income from employment. 33 In Murphy's case, "[t]he tax may be laid upon the proceeds received when one vindicates a statutory right . . . as a ‘privilege' taxable by excise." 34 In essence, the court was saying that Murphy had the privilege to go to court and enforce her rights and that her award is taxable by excise, with the only restriction being that it be enforced uniformly throughout the United States, which the court found it was. Thus, the court found that Murphy's award was taxable under Congress's power to tax under Article I, Section 8, of the Constitution.
Based on this analysis, the court concluded that the award fell within the purview of Sec. 61 and did not violate the U.S. Constitution. The Murphy II decision can be interpreted as an expansion of Congress's power to tax income if it is no longer constrained by the Sixteenth Amendment's definition of "incomes."
The court in Murphy II reached the opposite result, ruling that taxing awards for mental distress or loss of reputation was constitutional. However, this decision was based on Congress's power to tax under Article I, Section 8, of the Constitution, and the court did not address (or repudiate) its prior holding that the taxation of awards for mental distress or loss of reputation violated the Sixteenth Amendment.
The reasoning of the Murphy II court in validating an excise tax under Article I, Section 8, on "income" under Sec. 61, an income tax statute, is problematic. As the court stated in Murphy I, "[t]he constitutional power of the Congress to tax income is provided in the Sixteenth Amendment." 41 Therefore, at the very least any tax on incomes should be evaluated under the Sixteenth Amendment in conjunction with Article I, Sections 8 and 9.
Can an income tax under Sec. 61 still be constitutionally valid if it violates the Sixteenth Amendment's constraints on income?
If a tax on income passes scrutiny under Article I, Section 8 or 9, must it also meet the definition of income under the Sixteenth Amendment in order for it to be constitutional?
Even though this uncertainty will persist, there are immediate ramifications for taxpayers.
The importance of timely filing a refund claim is that while the eventual outcome of a case is uncertain, the statute of limitation under Sec. 6511 continues to run. Sec. 6511(a) provides that a claim for refund of an overpayment of tax "shall be filed by the taxpayer within 3 years from the time the return was filed or 2 years from the time the tax was paid, whichever of such periods expires the later, or if no return was filed by the taxpayer, within 2 years from the time the tax was paid."
The Supreme Court's recent denial of certiorari removes outstanding contingencies; thus, the IRS likely will deny the protective refund claims filed by taxpayers who received awards for nonphysical injuries. Under Sec. 6532(a)(1), taxpayers have "2 years from the date of mailing by certified mail or registered mail by the Secretary to the taxpayer of a notice of the disallowance of the part of the claim to which the suit or proceeding relates" to file suit for a refund.
Given the far-reaching and seemingly contradictory rulings in the Murphy cases, future litigation in other appellate circuits appears likely. Practitioners should therefore advise taxpayers to diligently follow future events and take appropriate action should a new contingency arise. In such cases, the taxpayer has two options in seeking a refund of taxes paid.
First, taxpayers can petition the IRS to reconsider its denial of their claim. It is very important that taxpayers be aware that they have two years to initiate a suit for refund under Sec. 6532(a)(1) and that any reconsideration by the IRS "shall not operate to extend the period within which suit may be begun." 45 Second, if there is a significant amount involved and taxpayers have the resources to go to court themselves, they can initiate a suit for a refund.
The Supreme Court's denial of the appellant's petition for certiorari does not affirm the Murphy II decision; however, it does allow the DC Court of Appeals' decision to stand, and the lower courts within the DC Circuit must follow the decision. 46 However, other jurisdictions are not bound by the decision.
Recent Tax Court cases decided subsequent to Murphy II, while all affirming the validity of Sec. 104(a)(2), suggest that litigation about Sec. 104 will continue.47 Ballmer and Hawkins acknowledge the Murphy decisions, but none of the recent cases explored Murphy's arguments regarding the definition of income under the Sixteenth Amendment or the government's argument upheld in Murphy II as to the power to tax under Article I. As taxpayers challenge the validity of Sec. 104(a)(2) under Murphy's legal theories, courts in jurisdictions outside the DC Circuit will be forced to evaluate them. Should a split in circuits arise, the case could become ripe for the Supreme Court to grant certiorari and rule on this important constitutional issue. The taxation of nonphysical injury awards is far from settled, and taxpayers and practitioners should be diligent in monitoring future developments.
Kenneth Winkelman is an assistant professor of accounting, James Fornaro is an associate professor of accounting, and Peter Lucido is an assistant professor of accounting in the School of Business at SUNY College at Old Westbury, NY. For more information about this article, contact Prof. Winkelman at winkelmank@oldwestbury.edu.
1 Murphy, S. Ct. Dkt. 07-802 (U.S. 4/21/08).
2 Small Business Job Protection Act of 1996, P.L. 104-188, §1605.
3 Murphy, 493 F.3d 170 (D.C. Cir. 2007) ( Murphy II), aff'g 362 F. Supp. 2d 206 (D.D.C. 2005).
4 Murphy, 460 F.3d 79 (D.C. Cir. 2006) (Murphy I), remanding 362 F. Supp. 2d 206 (D.D.C. 2005).
5 Murph, No. 05-5139 (D.C. Cir. 12/22/06), vact'g 460 F.3d 79 (D.C. Cir. 2006).
6 Murphy, S. Ct. Dkt. 07-802 (U.S. 4/21/08).
7 See, e.g., Kenney, "Murphy a Boon for Protesters, Critics Say," 112 Tax Notes 832 (September 4, 2006); Prusiecki, "Murphy: The 16th Amendment May Be Irrelevant," 113 Tax Notes 926 (December 4, 2006); Sheppard, "Murphy's Law: Tax Provision Declared Unconstitutional," 112 Tax Notes 825 (September 4, 2006); Stratton, "Experts Ponder Murphy Decision's Many Flaws," 112 Tax Notes 822 (September 4, 2006).
8 See, e.g., Reardon, "Marrita Murphy: The Flip Side of the Economic Substance Doctrine," 112 Tax Notes 1167 (September 25, 2006).
9 Maryland v. Baltimore Radio Show, 338 U.S. 912 (1950).
11 Murphy I, 460 F.3d at 81.
12 Leveille v. New York Air Nat'l Guard, No. 94-TSC-00003 (DOL Off. Adm. App. 2/9/98).
13 Murphy, 362 F. Supp. 2d 206 (D.D.C. 2005).
14 Murphy I, 460 F.3d at 84, quoting Morrison, 529 U.S. 598, 607 (2000).
15 Id. at 84–85, quoting the Sixteenth Amendment to the U.S. Constitution.
16 O'Gilvie, 519 U.S. 79 (1996).
17 Glenshaw Glass Co., 348 U.S. 426 (1955).
18 Merchants' Loan & Trust Co. v. Smietanka, 255 U.S. 509 (1921).
19 Murphy I, 460 F.3d at 88-89, quoting Merchants' Loan & Trust Co., 255 U.S. at 519.
20 Id. at 88, quoting O'Gilvie, 519 U.S. at 86.
22 Revenue Act of 1918, ch. 18, 40 Stat. 1057 (1919).
23 Murphy I, 460 F.3d at 89.
24 31 Op. Att'y Gen. 304 (1918).
25 T.D. 2747, 20 Treas. Dec. Int. Rev. 457 (1918).
26 Murphy I, 460 F.3d at 89.
28 Murphy II, 493 F.3d at 173.
29 Murphy, No. 05-5139 (D.C. Cir. 12/22/06), vact'g 460 F.3d 79 (D.C. Cir. 2006).
30 Murphy II, 493 F.3d at 181, quoting Bromley v. McCaughn, 280 U.S. 124, 136 (1929).
31 Id. at 181, quoting Fernandez v. Wiener, 326 U.S. 340, 352 (1945).
32 Id. at 181, quoting Thomas, 192 U.S. 363, 370 (1904).
33 Id. at 181, citing Pollock v. Farmers' Loan & Trust Co. , 157 U.S. 429 (1895).
37 Murphy I, 460 F.3d at 84.
40 Murphy II, 493 F.3d at 186.
41 Murphy I, 460 F.3d at 84.
42 See, e.g., Winkelman and Fornaro, "Tax on Emotional Damages Held Unconstitutional: How to Protect Clients in the Short Term," Tax Clinic, 37 The Tax Adviser 700 (December 2006); Vincent, "Taxation of Emotional Damages Held Unconstitutional," 62 J. Mo. Bar (September–October 2006).
43 IRS Publication 17, Your Federal Income Tax, Ch. 1 (2007).
44 Dalm, 494 U.S. 596 (1990).
46 The DC Court of Appeals hears appeals from the District Court for the District of Columbia and the Tax Court.
47 See, e.g., Pettit, T.C. Memo. 2008-87; Sanford, T.C. Memo. 2008-158; Ballmer, T.C. Memo. 2007-295; and Hawkins, T.C. Memo. 2007-286.

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