Paul L. Caron

Tuesday, August 22, 2006

D.C. Circuit Holds § 104(a)(2) Unconstitutional Under 16th Amendment; Not All Receipts Constitute "Income" Under Glenshaw Glass

The D.C. Circuit held today, in Murphy v. United States, No. 03cv02414 (D.C. Cir. 8/22/06), that § 104(a)(2) is unconstitutional under the 16th Amendment as applied to a recovery for a non-physical personal injury (emotional distress and loss of reputation) unrelated to lost wages or earnings. Murphy received $70,000 from New York State for anxiety suffered and injury to her reputation as a result of being "blacklisted" after becoming a whistleblower against her employer (the New York Air National Guard):

Murphy argues that, being neither a gain nor an accession to wealth, her award is not income and § 104(a)(2) is therefore unconstitutional insofar as it would make the award taxable as income....In Murphy’s view, the Court thereby made clear that the recovery of compensatory damages for a “personal injury” -- of whatever type -- is analogous to a “return of capital” and therefore is not income under the IRC or the Sixteenth Amendment.

According to Murphy, the Supreme Court read the concept of “human capital” into the IRC in Glenshaw Glass.... In Murphy’s view, the Court thereby made clear that the recovery of compensatory damages for a “personal injury” -- of whatever type -- is analogous to a “return of capital” and therefore is not income under the IRC or the Sixteenth Amendment.....

Noting that the power of the Congress to tax income “extends broadly to all economic gains,” ... the Government next maintains that compensatory damages “plainly constitute economic gain, for the taxpayer unquestionably has more money after receiving the damages than she had prior to receipt of the award.”...

At the outset, we reject the Government’s breathtakingly expansive claim of congressional power under the Sixteenth Amendment -- upon which it founds the more far-reaching arguments it advances here. The Sixteenth Amendment simply does not authorize the Congress to tax as “incomes” every sort of revenue a taxpayer may receive. As the Supreme Court noted long ago, the “Congress cannot make a thing income which is not so in fact.”...

In sum, every indication is that damages received solely in compensation for a personal injury are not income within the meaning of that term in the Sixteenth Amendment. First, as compensation for the loss of a personal attribute, such as wellbeing or a good reputation, the damages are not received in lieu of income. Second, the framers of the Sixteenth Amendment would not have understood compensation for a personal injury -- including a nonphysical injury -- to be income. Therefore, we hold § 104(a)(2) unconstitutional insofar as it permits the taxation of an award of damages for mental distress and loss of reputation.

Albert Einstein may have been correct that “[t]he hardest thing in the world to understand is the income tax,” The Macmillan Book of Business and Economic Quotations 195 (Michael Jackman ed., 1984), but it is not hard to understand that not all receipts of money are income. Murphy’s compensatory award in particular was not received “in lieu of” something normally taxed as income; nor is it within the meaning of the term “incomes” as used in the Sixteenth Amendment. Therefore, insofar as § 104(a)(2) permits the taxation of compensation for a personal injury, which compensation is unrelated to lost wages or earnings, that provision is unconstitutional.

For more on the definition of income in Glenshaw Glass, see Joseph Dodge, The Story of Glenshaw Glass: Toward a Modern Concept of Gross Income, in Tax Stories (Foundation Press, 2003).

Steve Bank (UCLA) offers these perceptive comments on Murphy:

This is an odd application of original intent or even original meaning analysis (assuming you agree that either is relevant). The court acknowledges that there were a number of revenue acts before Congress even addressed damage recoveries, thus providing at least five years of separation from the ratification of the Sixteenth Amendment to any opinion on this issue. Five years is not long, but the onset of World War I in the intervening years, plus the dramatic increase in the top marginal rates from 6% in 1913 to 65% in 1918, radically changed the landscape under which the issue was considered. That renders the 1918 view of the situation hardly the final word on what was the commonly understood meaning in 1913, prior to World War I. Even then, the opinion was from the Attorney General and not from Congress or any committee of Congress. More importantly, during this period, the definition of income was far from settled. The income tax was only five years old and Congress was borrowing from economic definitions, legal definitions, and popular definitions. The economic understanding of the term “income” at the time was arguably evenly split between those advocating an accretion tax notion of income (e.g., Haig) and those advocating a consumption tax notion of income (e.g., Fisher). The latter would not have supported a tax on capital gains, although the Supreme Court held that it was permissible in a 1921 decision. As I have argued in the context of tax-free reorganizations, the provisions adopted in 1918 were an attempt to compromise between these conflicting definitions of income so as to assure a proper revenue to pay for war expenses while still maintaining the appearance of fairness and responding to heavy lobbying from business and the wealthy. The notion of taxing people who recovered damages during this war period may have violated our sense of fair play when war profiteers were seeking to avoid paying tax on their bounty.

Under the Murphy Court’s analysis, it is not clear whether stock dividends should be taxable (since Treasury held them to be so soon after the 16th amendment was ratified in 1913) or not (since the Supreme Court held their taxation to be unconstitutional – in the only instance in which a tax statute was struck down as unconstitutional – in 1920 in Eisner v. Macomber). There are many other examples, including examples of Treasury flip-flopping on its own positions. The law was in flux in part for the very reason that there had been no “commonly understood” definition of income for tax purposes at the time the 16th amendment was ratified.

(Hat Tip:  Jon Forman, Michael Graetz, Brant Hellwig & Joshua Klein.)


New Cases | Permalink

TrackBack URL for this entry:

Listed below are links to weblogs that reference D.C. Circuit Holds § 104(a)(2) Unconstitutional Under 16th Amendment; Not All Receipts Constitute "Income" Under Glenshaw Glass:

» CADC: § 104 unconstitutional as applied to personal injuries from Appellate Law
It is pretty rare to see a tax provision struck down on constitutional grounds. Even rarer to see one which goes to the theoretical question of income. Today, the DC Circuit holds that 26 U.S.C. § 104(a)(2) is unconstitutional as [Read More]

Tracked on Aug 22, 2006 10:16:32 AM

The Federal Appeals Court for the D.C. Circuit came out with a shocker of a tax case today (hat tip:... [Read More]

Tracked on Aug 22, 2006 11:41:17 AM

» DC Circuit Court Limits 16th Amendment's Definition of "Income" from discarded lies - hyperlinkopotamus
DC Circuit Court Limits 16th Amendment's Definition of "Income" [Read More]

Tracked on Aug 22, 2006 12:58:37 PM

» This One's for the Tax Nuts from
If you troll about the internet long enough, you'll run into a facinating (if somewhat scary) subculture of tax protestors (of varying political stripes) who argue that various taxes (or, indeed, the entire tax code) are unconstitutional. A recent DC [Read More]

Tracked on Aug 22, 2006 3:26:29 PM

» "The Power to ___ is the Power to Destroy"? from A Stitch in Haste
A federal appellate case that one would have thought would be of interest only to scholars and specialists has suddenly broken out into the general domain:The federal governm... [Read More]

Tracked on Aug 23, 2006 9:55:20 AM

» Income-ing!: The D.C. Circuit Holds Congress's Power to Tax Does Not Reach Emotional Distress Damages from Declarations and Exclusions
This weblog is not often concerned with tax law, and this is assuredly not the place to come for tax advice, but the U.S. Court of Appeals for the D.C. Circuit has issued a remarkable new decision concerning taxation of [Read More]

Tracked on Aug 23, 2006 10:10:51 AM

» Federal Court Slaps Down IRS! from WynnBlog
Its nice to see the IRS kept at bay once in a while. And its good to see the federal courts recognize that Congress does has some restrictions to their power of taxation. Relevant exerpt: The Sixteenth Amendment simply does not authorize ... [Read More]

Tracked on Aug 23, 2006 11:40:02 AM


Income should only be a gain. When you barter labor for $ it is an exchange not a gain. WAges resulting from ones labor has no net gain thus no income accrued.. YOu have given and recieved something of equal value.

The entire nation is confused, the definition in the dictionary is not the definition the Supreme court uses to define income. The Entire IRS code hinges on this one word. We are totally mislead if we go to the IRS code to find what income is because the code was written with the understanding of the word income fully understood that it was a tax on gains and profits. The fact that the high court still uses this definition should wake people up to the misleading information they get from people who have never read a law in their life.

Posted by: flo | Apr 16, 2008 7:49:14 AM

Income should only be a gain. When you barter labor for $ it is an exchange not a gain. WAges resulting from ones labor has no net gain thus no income accrued.. YOu have given and recieved something of equal value.

Posted by: Ken Lucier | Apr 5, 2007 10:56:14 AM

Regardless of what you think of the decision, anyone who received an award that might be exempt under Murphy's rationale should be preparing a protective claim for refund to toll the statute of limitations pending the inevitable appeal.

Posted by: C. Gage | Aug 25, 2006 2:19:42 PM

Of course tort damages are income. To follow the hypothetical, if you lose an arm in an accident, you get nothing but for an established civil law system that allocates the cost of accidents among victim, tortfeasor, and third parties (insurers). Consequently, tort damages are accessions to wealth and, under Glenshaw Glass, are taxable unless Congress specifically excludes such damage awards from taxation.

The notion that money received for losing an arm in an accident is not "income" is logically equivalent to the venerable tax protestor argument, rejected by all courts including the one that just issued the Murphy decision, that wages are not income because they are merely a recovery of human effort expended.

The next step in the analysis, if Murphy stands, is that we should all keep track of what we spend on eating, education, housing, clothing, and other necessities of life, from birth to the date of an accident, because such costs are capital expenditures that add to our "basis" in our persons.

This is not a theory of income taxation, but rather, rank fantasy.

Posted by: Jake | Aug 23, 2006 5:44:26 PM

This brings up an interesting point about compensation. If I work for someone, I'm giving them my very essence, time, energy, etc. In compensation, they are giving me money (or the poor substitute for it we have today). So, where is the "gain" or "income". Its a fair exchange at market rate: time/energy for money. Why should anyone's pay or compensation be taxed as income?

Posted by: Reid | Aug 23, 2006 3:42:37 PM

How about the flip side? What are the tax consequences for a person or business repsonsible for paying such an award?

Posted by: tptk | Aug 23, 2006 12:19:12 AM

The argument that the $70,000 was, in essence, a return of capital could be broadened to exempt even wages. I would argue that wages are simply a 'return of capital' expended in your labor. In other words, is it constitutional for the government to take a portion of the capital given in return for the blood sweat and tears of your daily labor?

This would certainly enhance the argument for the Fair Tax, which taxes commerce rather than labor. Before the income tax was established, the U.S. Government's main source of revenue was taxes on commerce in the form of excise taxes, tarrifs, use taxes, etc.

The argument for these kinds of taxes is that commerce is made possible by the government, as it provides the infrastructure, security, monetary structure, etc. for commerce to occur.

Posted by: John | Aug 22, 2006 10:14:21 PM

Compensation for a tortious wrong is not income. If it were taxed, then you would not be made whole. Let's say someone negligently chops off your arm and then pays you a settlement that perfectly compensates you for the loss of your arm. There is no income. There is no gain. The money is just compensation for the loss of your arm. That money = your arm. Because the government cannot take a random piece of your arm, the government cannot tax your compensatory judgment. No level of American government has the right to just hack off a little piece of your arm.

Posted by: ab | Aug 22, 2006 9:29:54 PM

Although the DC Circuit said it was striking down section 104(a)(2) as unconstitutional, the court in fact partially struck down section 61, as interpreted by decades of Supreme Court precedent. What the DC Circuit overlooked, ironically, is that Congress could totally repeal the gross income exclusion under section 104. That Congress generously prescribed the exclusion under section 104, subject to the limitation under section 104(a)(2), scarcely implies that Congress exceeded its authority under the 16th Amendment.

Posted by: Jake | Aug 22, 2006 8:06:28 PM

"making whole"?!? Emotional distress is trial-lawyer contingency crap. Life sucks. It's all distressing. Sometimes we're happy and/or lucky, but in general bad things happen and one has to deal with it.

I agree with the first poster: My job hurts my self-esteem. My paycheck is at least half compensation for that emotional distress. The other half is compensation for the emotional distress of dealing with idiots who think they should be paid for their "distress" regardless of what they produce.

The good part: At least there are limits on the government's power to take our money.

Posted by: mrsizer | Aug 22, 2006 6:04:41 PM

What a mind boggling ruling. I say mind boggling because it both

(1) has the potential to create massive upheaval in the tax code (I don't even want to start thinking of the tax statutes you could strike down using the "it's not income" reasoning.)

(2) is logically and rationally sound (we have to be honest and admit that emotional distress damages are not income, but rather a "making whole.")


Posted by: AMG | Aug 22, 2006 5:03:57 PM

The D.C. Circuit held that this type of recovery was not income within the meaning of the 16 th Amendment, and therefore was unconstitutional , presumably because the tax was not apportioned among the States by population, although that is not clear from the opinion. The opinion could be read to mean that the D.C. Circuit believes that Congress has no power to lay and collect an inocme tax in the absence of the 16th Amendment. In reality , the true issue is whether a tax on this sort of recovery is a direct tax requiring apportionment among the States. It would seem pretty clear that a levy on recoveries for tort claims based on emotional injuires is not a direct tax, under the theory propounded in HYLTON v. UNITED STATES, that when apportionment of a tax would cause great injustice, the tax is not a direct tax, and that the only direct taxes are capitations, and taxes on land. Therefore, the tax in question in MURPHY, while perhaps not a tax on income within the meaning of teh 16 th Amendment, was nevertheless not a direct tax, and was valid even in the absence of apportionment.

Posted by: The NJ Annuitant | Aug 22, 2006 2:11:28 PM

[from the article:]
"the Government next maintains that compensatory damages 'plainly constitute economic gain, for the taxpayer unquestionably has more money after receiving the damages than she had prior to receipt of the award.'"

They're treating the situation as if she received some sort of award or prize, when the $70,000 judgement was clearly intended as attempt to replace a loss *other* than wages. Does this mean, for example, that they could tax an judgement intended to reimburse the cost of a surgical operation?

Posted by: Mike | Aug 22, 2006 1:52:38 PM

Then all I have to do is have my company declare my pay is compensation for emotional distress and loss of reputation (BELIEVE ME, my current work definitely does both), and I can tell the IRS to kiss off, eh?

Posted by: Mike O | Aug 22, 2006 1:25:18 PM