TaxProf Blog

Editor: Paul L. Caron, Dean
Pepperdine University School of Law

Tuesday, February 27, 2007

TP & Government Debate Application of Murphy in 4th Circuit § 104 Case

The taxpayer and the Government have filed briefs on the application of Murphy v. IRS, 460 F.3d 79 (D.C. Cir. 8/22/06), vacated & reh'g granted (12/22/06), in a 4th Circuit § 104(a)(2) case.  Clayton v. United States, No. 06-1976 (4th Cir.), on appeal from No. 5:04CV143 (N.D. W.Va. 7/31/06).  See below the fold for the excerpts from the parties' briefs.

Taxpayer's Brief (2/2/07):

Statement of the Issues

  1. Whether settlement funds obtained by plaintiffs constituted restoration of capital?
  2. Whether 26 U.S.C. § 104(a)(2) is unconstitutional because compensation for a non-physical personal injury is not income under the Sixteenth Amendment? Murphy v. IRS, 460 F.3d 79 (D.C. Cir. 2006).

Argument

II. The district court erred in granting summary judgment in favor of defendant because settlement funds constituted restoration of capital.

Congress may "tax all gains" or "accessions to wealth". Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 430-31 (1955). Broad though this power is, the Supreme Court has long recognized "the principle that a restoration of capital [i]s not income; hence it [falls] outside the definition of 'income' upon which the law impose[s] tax." O'Gilvie v. United States, 519 U.S. 79, 84, (1996). ... The underlying tort case should be viewed as though the court awarded $3,400,000 to Denise Clayton and LeAnn Harris and their brothers. The settlement included $900,000 due to malfeasance by some of the defendants in the underlying case. The trust was not properly funded and the settlement money was deposited in the trust to replace what should have already been there. If the trust had been funded properly, there would have been other assets to pay the $3,400,000. JA 45. ...

III. After the district court granted summary judgment, Murphy v. IRS, 460 F.3d 79 (D.C. Cir. 2006) was decided finding § 104(a)(2) unconstitutional, and this Court should also so find.

Congress' power to tax income is explicitly found in the Sixteenth Amendment ... § 104(a)(2) excludes from gross income "the amount of any damage (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness." In Murphy v. I.R.S., 460 F.3d 79 (D.C. Cir. 2006), the court held that § 104(a)(2) is unconstitutional insofar as it permits the taxation of compensation for a personal injury, which is unrelated to lost wages or earnings. In Murphy, the taxpayer received a settlement for emotional distress, mental anguish and injury to her professional reputation. None of the award was for lost wages. The court first held that because the taxpayer's settlement was not "received ...on account of personal physical injuries", the settlement was taxable. The court went on to find § 104(a)(2) unconstitutional as applied to the taxpayer's settlement because compensation for a non-physical personal injury is not income under the Sixteenth Amendment. The court traced the history of the Amendment and concluded:

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 well-being 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.

Id. at 92.

In the event this Court finds that plaintiffs' settlement is not restoration of capital, then this Court should join with the D.C. Court of Appeals' holding in Murphy and find § 104(a)(2) unconstitutional because compensation for a non-physical personal injury is not income under the Sixteenth Amendment.

DOJ's Brief (2/9/07):

A. The District Court correctly concluded that taxpayers could not exclude the relevant settlement proceeds from their gross income under I.R.C. § 102(a) because these proceeds compensated taxpayers for tortious wrongs rather than restored the missing inheritance ...

B. The District Court correctly held that taxpayers could not qualify to exclude the relevant settlement proceeds under I.R.C. § 104(a)(2) as compensation on account of personal physical injuries or sickness. ...

Taxpayers challenge the constitutionality of I.R.C. § 104(a)(2) based solely on Murphy v. I.R.S., 460 F.3d 79 (D.C. Cir. 2006), vacated, 2006 U.S. App. LEXIS 32293, at *1 (D.C. Cir. Dec. 22, 2006). To begin with, Murphy is no longer good law in any court, including the one that issued it. On December 22, 2006, the United States Court of Appeals for the District of Columbia Circuit granted rehearing in Murphy, expressly vacating the judgment on which taxpayers attempt to rely. See Murphy, 2006 U.S. App. LEXIS 32293, at *1. Taxpayers fail to give any reason, independent of this vacated decision, for this Court to disregard I.R.C. § 104(a)(2) as unconstitutional.

In any event, taxpayers have completely failed to explain how the constitutionality of this section, or lack thereof, would have any effect in their case. The vacated Murphy decision, on which taxpayers rely, explored the question of whether "a damage award for personal injuries - including nonphysical injuries - is not income but simply a return of capital." Murphy, 460 F.3d at 85. In the instant case, however, *29 taxpayers failed to establish the very starting point for Murphy's (now-withdrawn) analysis: a damage award on account of personal physical injuries or sickness. As the District Court noted, "[a]lthough plaintiffs provided testimony that they each suffered from physical sickness around the time of the proceedings, they have failed to show a direct link between the personal injuries and the settlement recovery." (JA 195.) While taxpayers mentioned in their depositions some nausea and headaches during the pendency of the state court suit (JA 166, 170), neither connected the relevant settlement funds to these symptoms.

Nor does the underlying complaint provide any support to taxpayers. While the complaint alleges mental and physical harm stemming from each of the first six charged torts, such contentions only apply to Joseph Tankovits, the named plaintiff. "Plaintiff has suffered mental and physical harm and anguish, humiliation and inconvenience." (JA 98, 100, 102, 104, 106, 110) (emphasis added). These are the only allegations of mental or physical harm in the complaint, and they relate exclusively to the named plaintiff. Further, taxpayers cannot argue that this language implicitly included them, as the complaint contained *30 a different, consistent refrain about the harms the beneficiaries as a whole suffered, to wit, "Plaintiff, similarly situated beneficiaries under the Estate and trusts, and the Estate and trusts themselves have suffered economic losses." (JA 98, 100, 102, 104, 106, 110-12) (emphasis added). As the claims in the complaint that relate to taxpayers seek to remedy solely economic harms, the $900,000, which settled these claims, cannot have been received on account of personal physical injuries or sickness.

Showing that the settlement proceeds were paid because of injuries or sickness is a sine qua non for Murphy's analysis. By failing in this regard, taxpayers' contentions are rendered meaningless.

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