Appellate Court Rules That Damages for Emotional Distress Are Not Taxable

The U.S. Court of Appeals for the District of Columbia Circuit ruled on August 22, 2006 that damage awards for non-physical injury, such as emotional distress and harm to reputation, are not subject to federal income taxes. In Murphy et al. v. Internal Revenue Service, No. 03cv02414 (D.C. Cir. 2006), the court ruled that the section of the Internal Revenue Code which provides that mental anguish damages are taxable income is unconstitutional.

The case arose out of a damage award obtained by Marrita Murphy, a former employee of the New York National Guard. Murphy had filed an administrative complaint with the Department of Labor alleging that her prior employer violated various whistleblower statutes by blacklisting her and by providing negative employment references after she complained about environmental hazards at the workplace. Murphy was awarded $45,000 for emotional distress and an additional $25,000 for injury to her reputation. Thereafter, Murphy brought suit seeking the return of $20,665 in income taxes that she had paid on the damage award. The district court rejected her claim, relying upon section 104(a)(2) of the Internal Revenue Code, which excludes from gross income damages received for “physical injuries and physical sickness,” but does not similarly exclude damages such as those Murphy had received for emotional injuries. Murphy appealed, and the Court of Appeals reversed the district court’s decision.

In reaching this result, the court found that the Internal Revenue Code section in question is unconstitutional. The Sixteenth Amendment to the Constitution, the source of the Government’s power to collect income taxes, provides that Congress may impose “taxes on income, from whatever source derived.” The court found that the framers of the Sixteenth Amendment, and the state legislatures that ratified it, would not have considered damages for emotional injuries to constitute “income.” Accordingly, by excluding from the definition of income only damages for physical injuries, and not non-physical injuries, section 104(a)(2) is inconsistent with the Sixteenth Amendment and therefore invalid.

The Internal Revenue Service has announced its intention to appeal this ruling. However, if ultimately sustained, the Murphy decision will have a significant impact on employment cases, particularly in the area of settlement. Until now, amounts offered in settlement of a plaintiff’s claims for emotional injury have been considered to be taxable, significantly reducing the value of the settlement to the plaintiff. If such payments are not taxable, an employer’s settlement offer will have a greater value to the plaintiff, which should make the settlement of employment cases easier to accomplish.