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August 22, 2006

The Federal Appeals Court for the D.C. Circuit came out with a shocker of a tax case today (hat tip: Volokh Conspiracy). A 3-judge panel ruled that damages for personal injuries were not understood as income when the 16th Amendment was ratified; as a "return of human capital," says the court, such payments are not taxable.

In sum, every indication is that damages received solely in compensation for a personal injury are not income within the meaning of that term in the Sixteenth Amendment. First, as compensation for the loss of a personal attribute, such as wellbeing or a good eputation, the damages are not received in lieu of income. Second, the framers of the Sixteenth Amendment would not have understood compensation for a personal injury -- including a nonphysical injury -- to be income. Therefore, we hold § 104(a)(2) unconstitutional insofar as it permits the taxation of an award of damages for mental distress and loss of reputation.

A few years back Congress legislated that only damages for "physical" injuries would be tax-exempt, while damages for emotional injuries and the like would be taxable. This decision would strike that down. Taxpayers who extended 2002 until October 2003 with taxable injury income on their 2002 returns can keep their rights to a refund alive by filing a claim by October 15, 2006.

My initial thoughts: I would be very surpised to see this decision hold up, as it goes against what I understand to be the accepted constitutional wisdom. Constitutional attacks on the definition of income have failed almost invariably. Conventional scholarship, I believe, holds that "income" was not a particularly well-defined term when the income tax was enacted, and it took a series of Supreme Court cases, such as Glenshaw Glass and Eisner v. Macomber, to come to the current understanding. To say the "framers" of the 16th amendment would have said such damages would not be income relies on a settled definition of income that probably did not exist at the time.

Of course, I would not have expected any three judges to rule this way. The government will surely appeal, and the full D.C. circuit is likely to hear it; if the case survives the full panel, the Supreme Court will surely take the case. We'll be hearing a lot more about this decision in the coming weeks, for sure.

This holding would be huge, if upheld. If it is, expect a wave of challenges to other parts of the tax law covering all sorts of items that weren't thought of in 1913, from original issue discount to gain on stock option excercise. It will be a golden era for tax litigators and a nightmare for Congress and the Treasury.

Cite: Murphy, No. 05-5139 (CA-DC)

UPDATE: After thinking about it during the lunch hour, the obvious occurred to me: this thing is going to trigger lots of refund claims in all sorts of areas starting right now. A great many corporations extend their return, and their 2002 statute of limitations expires September 15. Let the gold rush begin.

The TaxProf now has a post up on Murphy, including this from UCLA lawprof Steve Bank:

More importantly, during this period, the definition of income was far from settled. The income tax was only five years old and Congress was borrowing from economic definitions, legal definitions, and popular definitions. The economic understanding of the term “income” at the time was arguably evenly split between those advocating an accretion tax notion of income (e.g., Haig) and those advocating a consumption tax notion of income (e.g., Fisher). The latter would not have supported a tax on capital gains, although the Supreme Court held that it was permissible in a 1921 decision. As I have argued in the context of tax-free reorganizations, the provisions adopted in 1918 were an attempt to compromise between these conflicting definitions of income so as to assure a proper revenue to pay for war expenses while still maintaining the appearance of fairness and responding to heavy lobbying from business and the wealthy. The notion of taxing people who recovered damages during this war period may have violated our sense of fair play when war profiteers were seeking to avoid paying tax on their bounty.

This from the Appellate Law and Practice blog: "And so the misguided fires of tax protesters are stoked once again."

"How Appealing" also weighs in.

Also a good comment thread has started at the Volokh (Orin Kerr) post listed above.

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