Emotional damages are not taxable, D.C. Circuit rules.

A whistleblower "made whole" by her former employer does not owe taxes on her recovery for emotional distress and loss of reputation, the District of Columbia Circuit has ruled.

"Compensation for a nonphysical personal injury is not income under the Sixteenth Amendment if, as here, it is unrelated to lost wages or earnings," Justice Douglas Ginsburg wrote for the unanimous court. (Murphy v. Internal Revenue Serv., 2006 WL 2411372 (D.C. Cir. Aug. 22, 2006).)

After Marrita Leveille (now Murphy) reported environmental hazards on an air base run by her employer, the New York Air National Guard, she claimed she was blacklisted and given unfavorable references. An administrative law judge awarded compensatory damages for "emotional distress or mental anguish" and "injury to professional reputation." None of the damages were for lost wages or diminished earning capacity.

The U.S. Department of Labor affirmed the damages, and Murphy filed her 2000 tax return, including the award in her gross income and paying taxes on it. She followed Internal Revenue Code [section]61, which states that "gross income means all income from whatever source derived." But in 1996, Congress had amended the tax code to exclude from gross income "any damages (other than punitive damages) received ... on account of personal physical injuries or physical sickness." (I.R.C. [section]104(a)(2).)

Murphy filed an amended return seeking a tax refund based on [section] 104 (a) (2), but the IRS refused, saying she hadn't shown that the damages were from physical injury or sickness.

In her suit, Murphy argued that the compensatory award was for "physical personal injuries" and should therefore be excluded from gross income and, alternately, that it was unconstitutional to apply [section]104(a) (2) to the award because it was not "income" as defined in the Sixteenth Amendment.

The court agreed with the second argument, finding that the award was neither a gain nor an accession to wealth, but a restoration of capital.

"Section 104(a)(2) is therefore unconstitutional insofar as it would make the award taxable as income. Broad though the power granted in the Sixteenth Amendment is, the Supreme Court, as Murphy points out, has long recognized 'the principle that a restoration of capital [i] s not income; hence it [falls] outside the definition of 'income' upon which the law impose [s] a tax,'" wrote Ginsburg, citing the 1955 Supreme Court ruling in Commissioner of Internal Revenue v. Glenshaw Glass (348 U.S. 426 (1955)).

"What [the Murphy decision] says is, restoration of a loss is not constitutionally taxable as income. That's an important principle to be defended," said Stephen Kohn, chair of the National Whistleblower Center and a lawyer for Murphy. "The decision is precedent on the scope of the Sixteenth Amendment and the taxation of all compensatory damages."

The IRS argued that under the Sixteenth Amendment it could tax physical injury, he said, "so there was no constitutional impediment to taxing anything related to loss of life, which is absolutely incorrect. Personal injury and restoration of a loss related to it are not taxable.

"We're hoping that legislators and people work to get Congress to restore the personal injury exception to where it was before 1996, and I think Murphy justifies that ultimately a legislative correction is in order," Kohn said.