D.C. court reverses itself: awards for nonphysical injury may be taxed.

Last year, the U.S. Court of Appeals for the District of Columbia Circuit ruled that awards for nonphysical damages could not be taxed. In July, it changed its mind.

The court had ruled that although a plaintiff's damages were not exempt from taxes under a 1996 modification to the tax code, the award for nonphysical injuries wasn't income within the meaning of the Sixteenth Amendment, so any tax on it would be unconstitutional. (,See Rebecca Porter, Emotional Damages Are Not Taxable, D.C. Circuit Rules, TRIAL 83 (Nov. 2006).)

In December, after the IRS presented new arguments, the appeals court vacated its decision, and in July overturned it. It found that gross income includes damages for nonphysical injuries, and Congress's power to tax includes the authority to tax these damages. (Murphy v. IRS, 2007 WL 1892238 (D.C. Cir. July 3, 2007).)

The plaintiff, Marrita Murphy, claimed that after she reported environmental hazards on an air base run by her employer, the NewYork Air National Guard, she was blacklisted and given poor references. An administrative law judge awarded compensatory damages for emotional distress and injury to her professional reputation.

Murphy included the award in her gross income and paid taxes on it in 2000, hut later realized that a 1996 amendment to the tax code excluded P-ore gross income damages received for personal physical injuries or physical sickness. Murphy filed an amended return seeking a tax retired, but the IRS refused, saying she hadn't shown that the damages were from physical injury or sickness. In the subsequent lawsuit, the D.C. Circuit ruled for Murphy, finding that damages paid as a "restoration of capital" were not income and therefore not taxable.

When it petitioned for rehearing, the IRS introduced a new argument, saying that even if Murphy's award doesn't qualify as income, a tax on it is not unconstitutional because it would not be a direct tax and it would be imposed uniformly throughout the United States. The appeals court agreed.

"In the present opinion, we affirm the [original] .judgment of the district court [dismissing all Murphy's claims and granting the IRS summary judgment] based upon the newly argued ground that Murphy's award, even if it is not income within the meaning of the Sixteenth Amendment, is within the reach of the congressional power to tax under Article I, Section 8 of the Constitution," wrote Chief Judge Douglas Ginsburg.

That section reads, "The Congress shall have power to lay and collect taxes, duties, imposts, and excises." The court found that Murphy's award didn't fall under limitations on that power and therefore could be taxed.

Murphy's attorneys said the second decision suggests that making a person whole comes with a charge, noting that a damages award is intended to compensate for a loss, not to replace lost income, and shouldn't be taxed. At press time, they hadn't decided whether to appeal.

Legislation to create an exemption for awards like Murphy's may be coming: In March, Rep. John Lewis (D-Ca.) introduced the Civil Rights Tax Relief Act (H.R. 1540), which would exclude awards of noneconmic damages from gross income.

And in June, Sens. Jeff Bingaman (D-N.M.) and Susan Collins (R-Maine) introduced an almost identical act (S. 1689) in the Senate. At press time, the House bill had been referred to the Committee on the Judiciary and the Senate bill to the Committee on Finance.

--REBECCA PORTER