In Murphy v. IRS, the D.C. Circuit held that the money plaintiff received for emotional distress could not be constitutionally taxed as income.
The plaintiff argued "that, being neither a gain nor an accession to wealth, her award is not income and § 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.” O’Gilvie, 519 U.S. at 84; see, e.g., Doyle v. Mitchell Bros. Co., 247 U.S. 179, 187-88 (1918); S. Pac. Co. v. Lowe, 247 U.S. 330, 335 (1918) (return of capital not income under IRC or Sixteenth Amendment). By analogy, Murphy contends a damage award for personal injuries -- including nonphysical injuries -- is not income but simply a return of capital -- “human capital,” as it were." The government, predictably, rejected everything that Murphy presented in support of this view.
Beginning its analysis, the Court observed:
"At the outset, we reject the Government’s breathtakingly expansive claim of congressional power under the Sixteenth Amendment -- upon which it founds the more far-reaching arguments it advances here. The Sixteenth Amendment simply does not authorize the Congress to tax as “incomes” every sort of revenue a taxpayer may receive. As the Supreme Court noted long ago, the “Congress cannot make a thing income which is not so in fact.” Burk-Waggoner Oil Ass’n v. Hopkins, 269 U.S. 110, 114 (1925). Indeed, because the “the power to tax involves the power to destroy,” McCulloch v. Maryland, 17 U.S. (4 Wheat.) 316, 431 (1819), it would not be consistent with our constitutional government, and the sanctity of property in our system, merely to rely upon the legislature to decide what constitutes income." The Court added, however, that "we must inquire whether “the people when they adopted the Sixteenth Amendment,” or the Congress when it implemented the Amendment, would have understood compensatory damages for a nonphysical injury to be “income.”"
The Court reasoned:
"As we have seen, it is clear from the record that the damages were awarded to make Murphy emotionally and reputationally “whole” and not to compensate her for lost wages or taxable earnings of any kind. The emotional well-being and good reputation she enjoyed before they were diminished by her former employer were not taxable as income. Under this analysis, therefore, the compensation she received in lieu of what she lost cannot be considered income and, hence, it would appear the Sixteenth Amendment does not empower the Congress to tax her award."
On the point of whether recovery for emotional distress was considered income when the Sixteenth Amendment was passed, the Court concluded: "That emotional distress and loss of reputation were both actionable in tort when the Sixteenth Amendment was adopted supports the view that compensation for these nonphysical injuries was not regarded differently than was compensation for physical injuries and, therefore, was not considered income by the framers of the Amendment and the state legislatures that ratified it. . . .
"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 reputation, 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."
Section 104(a)(2) was amended in 1996 to limit exclusions from income for personal injuries or sickness to physical injuries or sickness. See Small Business Job Protection Act of 1996, Pub. L. No. 104-188, § 1605(a), 110 Stat. 1755, 1838. Last year in the Banks case, the Supreme Court held: "When a litigant’s recovery constitutes income, the litigant’s income includes the portion of the recovery paid to the attorney as a contingent fee." If emotional distress cannot be income, then perhaps the associated fees cannot be either.
This is a blockbuster decision that affects every employment discrimination and civil rights case.
Here are posts about the case at Taxprof with many links here, Volokh, Balkinization.