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D.C. Court of Appeals to Review Ruling On Taxability of Emotional Distress Damages

January 24, 2007

As reported on this website, last August the U.S. Court of Appeals for the District of Columbia Circuit ruled, in Murphy et al. v. Internal Revenue Service, No. 03cv02414 (D.C. Cir. 2006), that damage awards for non-physical injury, such as emotional distress and harm to reputation, are not subject to federal income taxes. See Appellate Court Rules That Damages for Emotional Distress Are Not Taxable. [August 25, 2006]

On December 22, 2006, however, the three-judge panel that issued the decision in Murphy vacated its ruling and will reconsider the decision. At issue is a section of the Internal Revenue Code, Section 104(a)(2), under which mental anguish damages are subject to federal income taxes even though damages received for "physical injuries and physical sickness," are excludable from gross income. In the August opinion, the Court of Appeals held that Section 104(a)(2) was unconstitutional. This issue is of great import to employers because, as noted in our earlier article, if damages for emotional distress are not taxable, an employer’s settlement offer will have a greater value to a plaintiff, which should facilitate the settlement of employment cases. Oral argument in Murphy is scheduled for April 23, 2007. We will report on further developments as they occur.