Section 104(a) (2) Declared Unconstitutional?!
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During a Court-ordered mediation this past week, the Judge casually turned to me in chambers and asked if I knew that the U.S. Court of Appeals had just declared structured settlements unconstitutional. Luckily, I was familiar with the case and had read the decision. The Judge got it half right.
The case he was referring to was Murphy v. IRS, and indeed, the U. S. Court of Appeals for the District of Columbia recently ruled that portions of Internal Revenue Code Section 104 were unconstitutional. [Section 104(a) (2) provides that gross income does not include the amount of any damages received (whether by suit or agreement) on account of personal injuries or sickness. This Section serves as the very foundation of structured settlements; without it, the ability to exclude future settlement income as a matter of law would not exist.]
Fortunately, rather than limiting the Section 104 tax break, the Court’s decision actually expanded it. The ruling struck down on constitutional grounds key elements of IRC section 104(a) (2) that relate to issues such as emotional distress, mental anguish, defamation, slander, wrongful imprisonment, etc. If upheld, this would seem to put things back as they were prior to 1996 when a revenue-hungry Treasury department sought to distinguish between physical and non-physical injuries and leave the non-physically injured out in the tax cold.
The Murphy case involved one Marrita Murphy who filed an administrative action against her former employer, the New York Air National Guard, alleging violation of several whistleblower statutes. She further alleged that, as a result of her actions, she had been black-listed and given unfavorable references to potential future employers. She prevailed in her action and was awarded $ 70,000 in compensatory damages, of which $ 45,000 was allocated to emotional distress or mental anguish and $ 25,000 to injury to professional reputation. None of the award was allocated to lost wages or diminished earning capacity.
Ms. Murphy paid taxes on the award and later filed an amended return seeking a refund of the taxes paid on the award. The IRS declined to issue a refund, so Ms. Murphy brought an action against the IRS in district court to recover the income taxes she paid on the compensatory damages for emotional distress and loss of reputation she was awarded. She lost her case and appealed to the U.S. Court of Appeals for the District of Columbia.
Her appeal contended that under Section 104(a) (2) of the Internal Revenue Code, her award should have been excluded from gross income because it was compensation received “on account of personal injuries or sickness.” In the alternative, she maintained that Section 104(a) (2) is unconstitutional insofar as it fails to exclude from gross income revenue that is not “income” within the meaning of the Sixteenth Amendment to the U.S. Constitution.
The three-Judge panel ruled against her in the first matter, declaring that Murphy’s compensation was not received on account of personal physical injuries and thus not excludable from gross income under IRC Section 104(a) (2). But the Court agreed, however, with Murphy that Section 104(a)(2) is unconstitutional as applied to her award because compensation for a non-physical personal injury is not income under the Sixteenth Amendment if, as here, it is unrelated to lost wages or earnings. It comes down to the same “return of principal” argument used to define what is and is not a capital gain for tax purposes. A tort recovery is considered to be return of “human capital”.
Most of the tax and legal community (not to mention industry lobbyists) were caught by surprise by this ruling. It pulled the rug out from under a tax rule no one thought could be reversed. Previously taxable elements of damages in certain personal injury cases were now declared unconstitutionally taxed in violation of the 16th amendment. Amazing stuff.
Bear in mind that the Murphy decision is only binding in cases involving taxpayers in Washington D.C. However, it is likely to have big implications for other people around the nation who expect to receive damages for nonphysical personal injuries or who have received such damages in recent years. It is thought the likely immediate effect of this case will be to trigger thousands of refund claims. Perhaps that is why the case has gained such a high level of notoriety (even earning an article in the Wall Street Journal).
Back to my Hearing: this ruling put me in the unenviable position of trying to explain a U.S. Court of Appeals decision to a sitting Judge, (not generally my idea of a good time). But the Judge followed what I said and we were able to proceed with the case.
Some of you may find yourselves in similar situations, where one party or another has “heard about” this decision but not read it. You now know that not only are structured settlements still an effective way to resolve difficult cases, we may soon be able to extend their benefits even further.
This case illustrates nicely what some litigants breezily take for granted: if Ms. Murphy found it worth battling the IRS over the taxability of her $70,000 recovery, AND her attorneys had the guts to take on the legitimacy of the law on constitutional grounds, AND the U.S. Court of Appeals was willing to reverse ten years of tax interpretation to grant this woman the tax break that all injured people enjoyed prior to 1996…one might conclude that these tax benefits I write about every month might just be worth something.
Care to give your claimants what the U.S. Court of Appeals says they should have? Call Frank C. Kilcoyne, C.S.S.C. at 800 544 5533, I am here to help.
