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.)
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.
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.
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.
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.
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?
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.
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.
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.