D.C. Circuit Reverses Itself in Tax Ruling

D.C. Circuit Reverses Itself in Tax Ruling_

Posted by Peter Lattman

A D.C. Circuit court panel reversed itself in holding that the federal government can tax money individuals receive from their employers for "nonphysical personal injuries." At issue: Whether a $70,000 payment that a woman received from her former employer for "emotional distress" and "loss of reputation" was taxable. "Why are you bothering us with a tax case just hours before the Fourth of July!?" you're surely asking. "Go home Law Blog!" Well we care for a couple of reasons. First, it's rare for a three- member appeals court panel to agree to rehear a case and then reverse itself. Last August, the same three judges ruled that the award didn't represent "income" as defined by the 16th Amendment - and thus wasn't taxable. The court had also called "unconstitutional" a 1996 provision in the tax code that permitted taxation of damage awards for mental distress and loss of reputation. In December, the panel vacated its judgment and said it would rehear the case. (The more common scenario would have been for the entire D.C. Circuit to review the decision - i.e., en banc,) Second, the ruling is a significant win for the IRS. The original ruling last year had set off a firestorm, causing tax lawyers and professors their own emotional distress, with most lambasting the decision. "Let 1000 lawsuits bloom," wrote UCLA law professor Stephen Bainbridge on his blog. Yale law professor Michael Graetz said the case would "launch a thousand [other] constitutionality arguments that people would have thought laughable before." The WSJ reported that after the decision, lawyers urged taxpayers to challenge the taxation of similar awards in the past few years and consider seeking refunds. Today, the court concluded her award was not exempt from tax and could be considered part of her "gross income." The court took up a new argument from the government that, even if Murphy's award is not income, there is no constitutional impediment to taxing it because a tax on the award is not a direct tax and is imposed uniformly. "Murphy's award, even if it is not income within the meaning of the 16th Amendment, is within the reach of the congressional power to tax under Article I, Section 8 of the Constitution," wrote the court. Donald Alexander, a former IRS commissioner and now a lawyer at Akin Gump, just emailed Law Blog colleague and WSJ tax reporter Tom Herman: "Finally, the right result. Our tax system is safe again."