Wednesday, August 23, 2006
Tax Prof Commentary on Murphy
I have assembled commentary from the following Tax Profs on yesterday's bombshell tax decision in Murphy v. United States, No. 03cv02414 (D.C. Cir. 8/22/06) (blogged here):
- Steve Bank (UCLA)
- Bryan Camp (Texas Tech)
- Stephen Cohen (Georgetown)
- David Elkins (Netanya)
- Brian Galle (Florida State)
- Jim Maule (Villanova)
- Marty McMahon (Florida)
- Allan Samansky (Ohio State)
- Scott Schumacher (University of Washington)
- Ted Seto (Loyola-L.A.)
- Steve Bank (UCLA):
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.
- Bryan Camp (Texas Tech):
There is no rational basis for the court’s opinion in Murphy v. United States. That is, the court’s opinion misses one of the most important concepts in tax law, the idea of “basis.” Here’s the idea. Say I buy a delivery truck for $50,000. That $50k is my “capital” investment in the truck. If you then immediately destroy my truck and are forced to pay me $30k in damages, I have no reportable income because, even though I’ve got $30k I did not have before, the tax law treats the $30k as a return of my capital. The $30k damages are in lieu of my capital investment. But let’s say you destroy my truck 5 years from now. After 5 years I will have been allowed to deduct all $50,000 I paid for the truck from my other income. That is, I am allowed to recover my capital outlay. As I do so, my basis in the truck goes down so after 5 years it is zero. NOW when you destroy my truck, there is no way I can say the $30k is a return of capital. It’s income.
Basis is one of the toughest ideas to teach first year tax students. Apparently, the three circuit court judges missed that particular lesson. On sure, they recite the government’s argument about basis, but they have no discussion of it, much less any rational discussion, which is proof enough that they just did not understand it. The opinions essential “logic” is (a) Murphy’s emotional well being and reputation were not taxable items in and of themselves, (b) both were diminished by the tort and, therefore (c) the money paid to Murphy to make her emotional state and reputation “whole” should not be taxed because it was “in lieu of” the diminution of a capital asset.
Assuming the vitality of the opinion’s “human capital” concept, which I am sure others will comment on, Murphy’s damages are only excluded from income if Murphy’s basis in her reputation and emotional well being was greater than the damages awarded. If Murphy had zero basis in her emotional well-being and her reputation, then the damages are income just like the damages I would receive if you destroyed my capital asset (the truck) after 5 years.
For the opinion to make any sense, then, it must assume that Murphy’s basis in her reputation and emotional well-being was equal to or greater than her recovery. The court must assume that some dollars Murphy spent at some point in time gave her a basis in her “human capital.” That unstated assumption has huge consequences. For example, if Murphy has a basis in her “human capital” then some portion of wages would also represent a recovery of the capital. Or if Murphy donates her services to a section 501(c)(3) organization, then she should get to take a charitable deduction. Of course, the case law has long held that people cannot take a charitable deduction for the donation of services. That is because it has, until this opinion, been widely accepted that taxpayers have no basis in their labor, their human capital. Karl Marx would undoubtedly give basis to labor, but this county generally has not adopted his economic theories. This opinion moves us in that direction.
- Stephen Cohen (Georgetown):
There may be doubtful authority to declare an income tax provision unconstitutional on policy grounds as did the DC Circuit Court in Murphy. However, there is a strong argument that in principle, for policy reasons, the damages in Murphy should not constitute income. My co-author and I, Laura Sager of NYU, fleshed out that argument in Discrimination Against Damages for Unlawful Discrimination, 35 Harvard Journal on Legislation 447 (1998). Thus, the Murphy court may have been wrong on the law, but I think they are right on the policy issue.
- Brian Galle (Florida State):
The Court asserts, with no authority for the proposition, that [those old Sol. Ops. and cases were constitutional in dimension"] (Page 23 of the pdf download from the D.C. Cir. website). Of course, left unexplained is how the Court would reconcile those views with the rejection, in Glenshaw Glass, of the entire trust-inspired notion of “income.” And shall we talk about the absurdity of citing, as supposed evidence of popular 1913 understandings of the meaning of “income,” opinions prepared more than a decade later under the strong influence of Eisner v. Macomber?
Fortunately, this opinion won’t really shield protesters (since Cheek has that exception for claims of unconstitutionality), but still, it’s pretty bad. I’m astounded that Judge Rogers joined it.
- David Elkins (Netanya):
Isn't taxing damages for "lost human capital" the equivalent of taxing wages? If wages are compensation for giving up leisure or comfort (where higher wages compensate for more stressful or difficult work), why is that not also a "return of capital?" Does is make a difference that one is volentary? Apparently not, because all seem to agree that damages for lost wages are taxable. So why, according to the Murphy court, is a tax on wages constitutional? Or at the very least, why does the constitution not require that the taxable wage is only the excess of the wage over the value (?) of what is given up?
The combination of the court's "human capital" analysis and its declaration of constitutional infirmity in section 104(a)(2) will encourage the tax protest crowd to treat the decision as justification for the invalidity of imposing an income tax on wages....If these cases come before the same panel of the D.C. Circuit that decided Murphy, we'd get an interesting view of a court either agreeing with the tax protestors and spawning a tax crisis of huge proportions or twisting and shifting in an attempt to dig itself out of the mess it has created. Even folks who should know better are mischaracterizing the case: Is the Internal Revenue Code Unconstitutional? No, it isn't, and the post makes that clear, but the headline is more than a wee bit over the top, and certain to attract tax protesters the way sugar attracts ants.
- Marty McMahon (Florida):
I am not commenting on the validity of the constitutional law point (although I find it to verge on tax protester type reasoning, but then again I don't think judges are above being tax protesters), but rather on the holding that § 104(a)(2) suffered the constitutional defect. To reach their decision and properly apply the statute, they should have held that section 61, *as applied to the damages in question* as a result of the 1996 amendments to section 104(a)(2) was unconstitutional. Section 104(a)(2) does not include anything, it's an exclusionary rules. Exclusions from the exclusion fall back into section 61. Sorry, I'm just a stickler for detail. As for the reasoning, wages are just a substitute for lost leisure; thus it's unconstitutional to tax wages. You better bet the tax protesters are going to jump on that. By the way, wasn't the opinion' author they guy who lost a seat on the Supreme's for smoking dope?
- Allan Samansky (Ohio State):
What struck me as most interesting (and bizarre) is the conclusion (assumption?) that the "meaning of the [16th] Amendment as it would have been understood by those who framed, adopted, and ratified it" should prevail today. Thus, whatever was not considered to be "income" in 1916 cannot be subject to an income tax today, absent a Constitutional Amendment. Originalism may have its place in interpreting our Constitution, but its use here seems crazy to me. Our understanding of economics has certainly become more sophisticated, but according to at least three judges our income tax is constrained by the notions prevailing ninety years ago. The implications of this approach are dramatic, to say the least.
- Scott Schumacher (University of Washington):
I wonder what the tax protestors are going to do with the decision, especially the court's implicit acceptance of Murphy's "human capital" argument. Makes me glad I'm not still with the government.
- Ted Seto (Loyola-L.A.):
We tax professors are bewitched by Haig-Simons and comprehensive tax base theory in a way that sometimes makes it hard for us to predict how arguments based on other theories will appeal to non-tax judges. Recall the Supreme Court's comment, in a non-tax context, that “In a real sense, [a rent subsidy] no more embodies the attributes of income or profit than do welfare benefits, food stamps, or other government subsidies,” United Housing Foundation, Inc. v. Forman, 421 U.S. 837, 857 (1975) (addressing issues under the securities laws). If something is not "income", then courts necessarily have to face the question of whether its taxation is authorized under the Sixteenth Amendment. If it's not authorized under the Sixteenth Amendment, we're stuck with the original Constitution's limitations on direct taxation. Granted, those limitations haven't been invoked successfully for almost a century. But that doesn't mean they can't be invoked.
I'm not an originalist, and therefore part ways with the DC circuit in its mode of Constitutional interpretation. But one does not have to be an originalist to conclude that purely compensatory damages not in lieu of income are not themselves "income."
I don't know whether Murphy will survive appeal. (I doubt the Supremes will grant cert.) But I do predict we're going to see a lot more Constitutional claims in tax litigation over the next several decades. Some of those claims will be sustained. The meaning of the term "income" in the Sixteenth Amendment is not purely a political question, unreviewable by courts.
I think there is a dimension implied in this decision that isn’t directly expressed that is really more correct.
Without a doubt, under Art 1 Sec 8, Congress can tax awards for pain and suffering. So lets get that out of the way.
Such a tax would likely be construed as a direct tax, subject to apportionment unless the P&S award is “income” in which case the 16th would permit it to be unapportioned.
So it can be taxed, but does it have to be apportioned? The gravamen is whether it is “income.”.
It is questionable whether Congress or the IRS can ipso facto declare such awards “income.” Any attempt to legislatively define a constitutional term will be met with skepticism no matter what court you are in.
I believe the “in lieu of” argument is a little hokey, but I think the result is correct. They are compensation for something taken and by definition, roughly equivalent in value to the thing taken. So the award equals the loss, ergo no gain.
I think the best counter argument is that the cost basis for pain and suffering is zero, and by that analysis the award is a gain. One can argue reputation is something built from scratch... like a car made from free parts in the junkyard, and your sweat equity. If you sell it, that gain is income. Pain and suffering however, I think don’t fit that argument. But what about payments to test subjects that undergo “pain” and “suffering” as part of medical/psychological tests? SCOTUS has said income includes wages which are a monetary exchange for “labor.” But in the end I can’t construe enduring pain and suffering as a form of “labor” or a P&S award as "income" regardless of whether you resort to textualism, original intent, 1913 definitions, or 2006 definistions of that term.
So if P&S awards are not “income” w/in the 16th, then the 16th amendment does not apply. So I feel the court was wrong to find taxes on P&S awards violates the 16th. The 16th gave no new power to tax, it only removed the apportionment requirement on income taxes. Indeed, I don't see how any act of Congress or a federal agency can violate the 16th amendment, since it is completely permissive, not restrictive.
But I believe the result in Murphy is correct – but for the wrong reason. It is a permissible tax under Art. 1 Sec.8. A direct tax... but not on “income” so it must be apportioned. It violates the Apportionment Clause, not the 16th Amendment.
Posted by: Craig Schiff | Oct 25, 2006 5:11:40 PM
The Problem with Professor Bank's discussion of basis is that it does not take into account that the damages for emotional harm, as any compensatory damages, are, in fact, as a matter of law-- exactly equal to the value of the asset at the time it was damaged. In other words, if your worthless truck is demolished in an accident, you don't get anything for it. thus, if you are awarded $30,000 for the truck there is an implicit finding that the truck was worth $30,000 at the time the truck was destroyed. Prior to the determination that emotional harm damages should be taxed, the applicable law was, as I understand it, that one looked at the underlying claim to see if the item for which loss was being compensated was taxable and then determined whether it was subject to tax-- So in a discrimination case back pay and future loss of pay were taxable but emotional harm damages were not. Plaintiffs and defendants, not being stupid, would structure settlements not to be taxable and avoiding taxation became a big incentive to settlement. If plaintiffs settle for zero back pay and $100,000 in emotional harm damages, they get to keep more of the money. The one thing I remember about tax law is that evasion is illegal but avoidance is not.
Posted by: Susan Salisbury | Aug 31, 2006 11:42:53 AM
Well the only thing that I can relate to is that one day the total compensation award was non-taxable (1996) and the next day it was. So now it's not taxable again? Where does it end? How do you differentiate between lost wages and injury to professional reputation? If you can't get a job because your reputation was tarnished, doesn't any award constitute replacement of lost wages?
Posted by: Ronni Kishlansky | Aug 30, 2006 10:31:24 AM
To follow the reasoning of Murphy through it would seem that there is a constitutional right to take an income tax deduction for emotional distress unrelated to personal injury for which you are not compensated.
After all, your human capital is depleted whether that deprivation was rightful or wrongful, and certainly whether or not a wrongful depletion of human capital is litigated or not.
Who knew you had a constitutional right to a tax break for a really, really bad day?
Posted by: ohwilleke | Aug 24, 2006 5:40:39 PM
If you are going use an original intent approach on this issue, there should be a discussion of how states taxed income (if they did) around that time, and how income was defined under the temporary federal income tax that existed during the civil war and the income tax that was struck down by the supreme court. British income tax law from around that time might be relevant also, once you start going down this road.
Instead of doing that there is that incredibly long footnote about how someone could recover damages for non-physical injuries, such as loss of reputation or alienation of affections, which was belabored and besides the point
Posted by: D Yen | Aug 24, 2006 5:08:35 PM
Appeals from the Court of Federal Claims lie to the Federal Circuit, not the DC Circuit.
Posted by: Jake | Aug 24, 2006 9:43:04 AM
I think the Supreme Court will have to accept cert on this one. All a taxpayer anywhere in the country has to do is pay the tax, file a refund claim, and file suit in the Court of Claims; Voila! They're in the D.C. Circuit. It's a good bet the Supreme Court will reverse, but I wouldn't be surprised if Justices Scalia and/or Alito dissent.
Posted by: Ron Morgan | Aug 24, 2006 8:45:03 AM
The point about mark-to-market accounting is intriguing. M2M accounting addresses realization (and recognition) of income, whereas the analysis in Murphy addresses the measurement of income once realized. The question is whether Congress can constitutionally mandate, through M2M accounting, that the realization of gains and losses be accelerated when no sale or exchange of property, within the ordinary meaning of the term, has occurred.
In the simplest case -- an individual who holds 100 shares of appreciated IBM stock, and has not entered into any related financial transaction with an eye toward monetizing his IBM shares -- of course Congress may not constitutionally create a "sale" when none has occurred.
A couple of instances where Congress has mandated M2M accounting would not seem to violate the realization requirement embedded in the 16th Amendment's definition of "incomes."
Section 475 simply puts dealers in securities on an inventory method of accounting and prescribes an inventory valuation rule -- fair market value at year end. Lower-of-cost-or-market inventory valuation has been around almost as long as the income tax, and is unquestionably valid. Parity of reasoning implies that Congress can mandate the flip side as well -- higher-of-cost-or-market inventory valuation.
Constructive sales under section 1259 are another manifestation of M2M accounting in that realization of gain (but not loss) is accelerated. But constructive sales, as defined in section 1259(c), involve situations where a taxpayer chooses to monetize an appreciated financial instrument by entering into another financial transaction. This is a statutory substance over form rule triggering realization. Judicially crafted substance over form doctrine is constitutional. See, e.g., Gregory v. Helvering; Coltec. Congress plainly acts within its constitutional powers by legislating substance over form rules.
I haven't had time to consider any other M2M provisions in the Code; sections 475 and 1259 are just the two that leap to mind.
For an article with a lot of useful insights on realization issues, see Alex Raskolnikov, Contextual Analysis of Tax Ownership, 85 B.U. L. Rev. 431 (2005).
Posted by: Jake | Aug 24, 2006 7:44:25 AM
i wonder if taxation based on "mark-to-market" principles can be upheld under the DC circuit's reasoning? i'm not an expert on either mark to market or the 16th amendment, but i understand that the Code sometimes mandates mark-to-market tax accounting.
assuming the DC circuit's reasoning is correct (!!??), is there any plausible argument that treating someone as if he has income even though he hasn't sold anything violates the 16th amendment? i don't know if i'm missing anything obvious, because, again, i know very little about M2M.
Posted by: andy | Aug 24, 2006 3:02:20 AM
To add to the very interesting scholarly commentary above, the Murphy panel ignored the federalism implications of its decision. The Supreme Court has long held that federal law, not state law, determines what is subject to income taxation. Nationwide uniformity in federal income taxation is the driving force, for obvious reasons.
So what happens if Murphy stands? A taxpayer who suffers emotional distress, and lives in a state with a stringent cap on noneconomic tort damages, comes out on the short end as compared to another, similarly situated taxpayer who lives in a state that tolerates sky-is-the-limit damages awards for noneconomic injuries.
The restoration/return/recovery of human capital theory the DC Circuit panel adopted fails to distinguish between the taxpayer who gets $50k of noneconomic tort damages under local law, and a similarly situated taxpayer in another locale who gets $1 million. If the touchstone of taxability is whether a payment received is a restoration/return/recovery of human capital, the DC Circuit panel has utterly failed to address, let alone resolve, how the restoration/return/recovery should be measured.
Posted by: Jake | Aug 23, 2006 8:28:16 PM
An utterly stupid decision.
First, other commentators have it right - once the court determines that it's not income, then all they need to say is that the damage awards are not subject to the income tax.
Second, the court seems to have been under the thoroughly mistaken impression that the 16th Amendment is the source of the power to tax incomes, and somehow, if something is not income, it cannot be taxed. ....... says who? The 16th Amendment is not the source of the power to tax incomes, Article I, section 8, clause 1 is! And the 16th Amendment is not a limit on what can be taxed. The first major decision to construe the 16th Amendment (Brushaber v. Union Pacific R., 240 U.S. 1) basically held that the Amendment's purpose was to prevent the income tax from being taking out of the category of indirect taxes, and that it was not a grant of power.
Aye carumba ... I could go on ... but my head is going to explode ... this case is just plain wrong, wrong, wrong.
Posted by: Brian Rookard | Aug 23, 2006 7:57:05 PM
I just read the DOJ Mtn. for rehearing en banc, and found it very interesting. http://www.cheatingfrenzy.com/murphy.pdf
The DOJ argues that *all* personal injury awards (both P&S as well as PI) are income, and by implication, even property damage awards *could* be taxed as income. The non-taxable status of damage awards from physical injury are only a result of “generosity” of congressional policy, citing Breyer’s opinion in O’Gilvie, 519 U.S. 79, 87 (1996)
This got me thinking. If I buy a new car for $20,000, and before I can leave the lot, a truck jumps the curb and totals it. Insurance pays me $20,000. That $20,000 could be taxed as income, based on the DOJ arguments.
I have no problem with the concept that under Art. 1 Sec 8, they COULD tax it. I have a hard time with the notion that this could be defined as “income” so such a tax would be within the 16th amendment.
But assuming that it is, I see a real problem with the insurance proceeds from the totaled car being taxed as income (or otherwise) because under that scenario, I am not made whole. In such an instance, to make me “whole” the damage award should be grossed up so that I have $20K left after paying the taxes.... so the logical solution lies in the civil court judgments for P&S (which are supposed to make one “whole”) being grossed up rather than trying to eliminate the tax liability, and then punies and lost wages not being grossed up.
The DOJ also faults the panel (correctly in my view) for not addressing the threshold question of whether the tax on non-PI damage awards is direct or indirect. If it is indirect, then they claim there is no need for it to be “income” at all, replying on Art 1, sec 8. However, they cite only one case, holding that the federal estate tax was not a direct tax, but a tax on the transfer or property. They seem to advance a very limited view of what is a “direct” tax, limiting it to poll taxes and property taxes.
But this seems a bit incongruous.... since the IRS code applies to “gross income”, even if the code defines P&S awards to be within the term “gross income” for IRC purposes (which they can do) it could be outside the term “income” in the constitutional sense. So the IRC would be multipurpose - calling something “income” that is not within the 16th amendment’s understanding of income, but which is really an indirect excise tax.
Which brings us full circle to the odd-man-out: Pollock.... income taxes should have never been taken out of the realm of indirect taxes.... which is what the first proponents of the 16th amendment have said all along.
Posted by: Craig Schiff | Oct 25, 2006 8:53:39 PM