Don't Mess With Taxes

Albert Einstein once said that the hardest thing in the world to understand is the income tax.

Now some tax scholars say a ruling on what is -- or more precisely, isn't -- taxable as income in legal awards is equally incomprehensible.

On Aug. 22, a Washington, D.C., federal appeals court judge ruled that the U.S. government cannot tax money individuals receive as compensation for emotional distress and other intangible injuries.

Some brief background: In 1994, Marrita Murphy filed a complaint with the Department of Labor claiming that her former employer, New York Air National Guard, had blacklisted her because she blew the whistle on environmental hazards on a National Guard base.

She alleged both physical and emotional injuries and was subsequently awarded $70,000 in compensatory damages; $45,000 of that was for "emotional distress or mental anguish" and the remainder for "injury to professional reputation." None of the money was for any lost wages or diminished earning capacity.

When the award became final in 1999, Murphy reported the income on her tax return for that year as "other income." But she later amended the filing in an effort to get a refund of the $20,665 in taxes (plus interest) she paid. Her argument was that gross income does not include damages paid in connection with physical injuries.

She, i.e., her attorneys, also added an alternate reason Murphy should get the tax payment back: Section 1040(a)(2) of the Internal Revenue Code as applied to her complaint award was unconstitutional because the money was not "income" within the meaning of the 16th Amendment.

Thus, the legal wheels started turning.

And now, in the wake of the Murphy ruling, so too do the gears grind in the heads of every tax protester.

A legal opening for tax protestors? While the case doesn't deal with wage income, the core of those loony arguments against the most basic of IRS collections, "unconstitutional taxation" fruitcakes have got to be salivating at what they no doubt will see as a chink in the 16th Amendment armor.

Those who contend that the IRS has no legal standing to tax us at all have been creating frivolous arguments for ages with no shred of official documentation to back them up. I'm sure they'll go even crazier now that they can point to this ruling.

ProfessorBainbridge.com takes a look at what the tax nuts will find comforting in the ruling, while Taxable Talk examines the short-term (since he thinks it will eventually be overturned) implications of the ruling.

Technically, the case applies only to the District of Columbia, unless the IRS and/or Congress decide to make the ruling applicable to similar awards in other types of court cases. Given the tax gap, don't expect the feds to give up an avenue of tax collections so easily. The ruling also could be more widely applied if the appellate process goes all the way to the Supreme Court, a much more likely route.

Meanwhile, there are other side affects as this continues to play out. Will recipients of previous emotional distress awards now be stampeding to their lawyers' offices? Will the courts, depending on what finally shakes out in Murphy, become clogged with similar filings? What advice does a tax pro give a client now in a similar situation?

These, along with more esoteric discussions of tax and tort case law, have been filling up tax and law blogs and discussion forums since the minute the ruling was released earlier this week.

Kaye Thomas at Fairmark.com offers a very good backgrounder on the case and the apparently idiosyncratic judge, Douglas H. Ginsburg, who issued the ruling. Dan Shaviro at Start Making Sense pulls no punches in telling us why he believes Ginsburg makes absolutely no sense in this case.

TaxProf, the blog keeper of all things tax, both academic and practical, has been tracking these and other key writings and comments on Murphy, with compilations here and here.

Or, if you prefer, you can read the ruling itself and come to your own conclusions.

Please, just don't let it upset you too much.