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Tax on emotional damages held unconstitutional: how to protect clients in the short term.

Since 1996, Sec. 104(a)(2) has specifically excluded awards for personal physical injuries or physical sickness from taxation. Sec. 104(a) adds that "emotional distress shall not be treated as a physical injury or physical sickness." Accordingly, awards for emotional distress, mental anguish or loss of reputation (i.e., nonphysical injury awards) have been firmly recognized as taxable income. In Murphy, DC Cir., 8/22/06, the court held that the taxation of nonphysical injury awards is unconstitutional, as it taxes receipt of money that is not "income" under the 16th Amendment. Practitioners should advise taxpayers immediately to file refund claims or protective refund claims to protect their rights under Sec. 6511.


Marita Murphy filed a complaint with the Department of Labor in 1994, alleging that her former employer "had 'blacklisted' her and provided unfavorable references to potential employers." Ms. Murphy was successful; an administrative law judge awarded compensatory damages totaling $70,000, $45,000 for "emotional distress or mental anguish" and $25,000 for "injury to professional reputation." No portion of the award was "for lost wages or taxable earnings of any kind" (i.e., items normally taxed). The court cited the Supreme Court test first enunciated in O'Gilvie, 519 US 79 (1996), which held that damages received "in lieu of" something ordinarily not subject to tax shall not be taxed as well. The Murphy court concluded that the award was to make her "emotionally and reputationally 'whole,'" and not to compensate her for lost income. This conclusion was a major factor in declaring that Murphy's awards for emotional distress were exempt from taxation.

The $70,000 was awarded for nonphysical injuries and, thus, was taxable under Sec. 104(a). Murphy included the award on her 2000 return and paid related income taxes of $20,665. Subsequently, she filed an amended return for that year, seeking a refund of the taxes paid. After the IRS denied the claim, Murphy then filed a complaint in district court, which also ruled against her.

Murphy appealed on two legal grounds. First, she claimed that the award was for "physical personal injuries" and, thus, was excludible under Sec. 104(a)(2). Second, she asserted that the award was not "income" under the "16th Amendment and that taxation of it was unconstitutional. The court found that the awards (emotional distress and injury to professional reputation) were clearly for nonphysical injuries and ruled against her on this issue.

The court then examined whether the award represented a "gain or accession to wealth," as contemplated by the 16th Amendment, an analysis first enunciated in Glenshaw Glass Co., 348 US 426 (1955). Applying this analysis, the Murphy 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 not income under the 16th Amendment. Accordingly, the taxation of nonphysical injury awards was unconstitutional and the government was ordered to refund Murphy's taxes.

Protecting a Refund Claim

Despite this decision, this area of law is far from settled. Currently, this ruling only affects taxpayers in Washington, DC; thus, Sec. 104(a)(2) still applies to taxpayers in all other jurisdictions. The government petitioned for an en banc rehearing in Murphy on Oct. 5, 2006.

While this uncertainty persists, the statute of limitations under Sec. 6511 is running for those individuals who have paid taxes on awards for emotional distress or other nonphysical injuries. Sec. 6511 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 later, or if no return was filed by the taxpayer, within 2 years from the time the tax was paid."

Given this uncertainty, affected taxpayers should immediately file a refund claim or a protective refund claim. The latter is filed to protect the taxpayer's right to a potential refund based on a contingent event. To ensure that it is processed as a protective claim, the request should be properly identified as such, and should state that the refund request is for taxes previously paid on a nonphysical injury award. This action will protect the taxpayer's right to a refund should the Murphy ruling stand.

Filing the refund claim within the time prescribed by Sec. 6511 is of utmost importance in protecting the taxpayer's right to seek a civil action for a refund. Sec. 7422 prohibits filing a refund suit "until a claim for refund or credit has been duly filed with the Secretary, according to the provisions of law." The Supreme Court has affirmed Sec. 7422 as limiting a taxpayer's right to seek a remedy in court, by stating, "unless a claim for refund of a tax has been filed within the time limits imposed by [section] 6511(a), a suit for refund ... may not be maintained in any court" (Dalm, 494 US 596 (1990)).


The taxation of awards for emotional distress, mental anguish or loss of reputation is currently uncertain, and has left many taxpayers who previously paid taxes on such awards in a precarious situation. Until there is a final outcome, taxpayers are advised to file refund claims immediately. This will protect them from being barred from seeking relief in court should the IRS reject their refund applications. Practitioners should advise clients who have recently received such awards to pay taxes on them and then immediately file refund claims. It is advantageous to pay the taxes first and then seek a refund; this avoids incurring interest on taxes owed should Sec. 104(a) be upheld. Additionally, there is no risk the money will be spent by the taxpayer should it eventually have to be paid to Treasury.

Developments regarding Sec. 104(a) and the Murphy case should be closely monitored. However, until a final determination, affected taxpayers must take action immediately to preserve their rights.

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Article Details
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Title Annotation:GROSS INCOME
Author:Fornaro, James M.
Publication:The Tax Adviser
Date:Dec 1, 2006
Previous Article:IRS issues additional guidance on Sec. 7874 inversions.
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