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.)

Update:

• Orin Kerr.(Volokh Conspiracy)
• Marty Lederman (Balkinization)