Update: Court of Appeals for the District of Columbia Circuit Reverses Ruling On Taxability of Emotional Distress Damages

On July 3, 2007, the U.S. Court of Appeals for the District of Columbia Circuit, reversing its prior ruling, confirmed that damage awards for non-physical injury, such as emotional distress and injury to professional reputation, are indeed subject to federal income taxes under Section 104(a)(2) of the Internal Revenue Code. Murphy et al. v. Internal Revenue Service, No. 05-5139, (D.C. Cir. 2007). In issuing this ruling, the three-judge panel overturned its own decision of August 2006, in which it found taxation of such damage awards under Section 104(a)(2) to be unconstitutional. (See “Appellate Court Rules That Damages for Emotional Distress Are Not Taxable”). On December 22, 2006, the panel chose to vacate its earlier decision and rehear the case, in light of new constitutional issues raised by the federal government.

Section 104(a)(2) provides that mental anguish damages are subject to federal income taxes even though damages received for “physical injuries and physical sickness” are excludable from gross income. The Court of Appeals supported this distinction, and ruled that damage awards for emotional distress and injury to professional reputation are considered part of gross income under Section 61(a) of the tax code. Additionally, the court determined, such taxation of non-physical injuries passes constitutional muster.

The court’s ruling is significant to employers because when the damages sought in a lawsuit are taxable, an employer’s settlement offer is less valuable to a plaintiff than otherwise would be the case. Accordingly, the court’s new decision will, in many instances, make the settlement of discrimination and other employment cases more difficult.