Yesterday, the D.C. Circuit ruled that §104(a)(2) of the Internal Revenue Code (Title 26, U.S.C.) is “…unconstitutional insofar as it permits the taxation of an award of damages for mental distress and loss of reputation.” This is a monumental decision that if upheld will drastically impact taxes. Interestingly, neither my local newspaper (the Orange County Register) or the Wall Street Journal had a word about this decision.
What This Decision Means In the Short-Term
Clearly, personal injury for mental distress and loss of reputation aren’t income under this decision. Given how the court ruled:
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.” Burk-Waggoner Oil Ass’n v. Hopkins, 269 U.S. 110, 114 (1925). Indeed, because the “the power to tax involves the power to destroy,” McCulloch v. Maryland, 17 U.S. (4 Wheat.) 316, 431 (1819), it would not be consistent with our constitutional government, and the sanctity of property in our system, merely to rely upon the legislature to decide what constitutes income.
I’d expect tax attorneys to seek out other similar sections in the I.R.C. (like §104(a)(2)) and file claims. Additionally, given the the expiration of the statute of limitations for filing claims and refunds, the IRS will be inundated with these.
Joe Kristan of Roth Tax Updates wrote yesterday that, “this thing is going to trigger lots of refund claims in all sorts of areas starting right now. A great many corporations extend their return, and their 2002 statute of limitations expires September 15. Let the gold rush begin.” I agree.
The Impact of This Decision in the Long-Term
Probably none. I’m certain that this decision will either be appealed to the Supreme Court, or that the government will request a rehearing in front of the entire D.C. Circuit (an “en banc” hearing). Orrin Kerr in Volokh says that the Supreme Court would probably take the case. Given that this directly impacts taxation, and would change principles of tax that have been upheld for nearly 100 years, I can’t foresee the decision being upheld. But if you had asked me before yesterday the chance that this decision would appear, I would have said zero. So it could happen.
What’s Next
As Professor Bainbridge states, “Let…1000 lawsuits bloom. Evey tax nut in the country is probably getting ready to file suit challenging some tax or another using Murphy as a template.” This will certainly occur—not just with the nuts, but with intelligent tax attorneys making claims with similar sections of the Code. If I were a tax attorney I’d be researching this right now.
Both Joe Kristan and Marty Lederman believe that even if this Code section is unconstitutional under the 16th Amendment, it is still legal under other areas of the Constitution:
My very rough sense is that the tax on the award in Murphy is authorized by Article I, section 8, and by the Necessary and Proper Clause, and, more importantly, is not a prohibited “direct” tax under Article I, section 9, just as with estate taxes (see Manufacturers National Bank, 363 U.S. 194) and gift taxes (see Bromley v. McCaughn, 280 U.S. 124). If I’m correct about this, then the tax on the award of damages therefore is constitutional, wholly without regard to whether it is a tax on “income”….
Employment law attorneys will be crafting their cases and settlements in order to take advantage of this decision. They’ll be spending quite a bit of time figuring this out.
If you happen to have received a settlement which was taxed based on Section 104(a)(2) of the I.R.C., you should file an amended return seeking a refund based on this decision. You must do so before the statute of limitations expires (for the tax year in question), so contact your professional tax adviser today. You will probably not receive a refund (again, I anticipate this court decision being reversed), but a 0.01% chance of a very large refund makes the decision to file an amended return a no-brainer.
In the end, I think that this decision will be reversed. Still, just the fact that this decision was issued will cause the IRS quite a bit of heartburn. If §104(a)(2) is found unconstitutional, might there not be many other similar sections in the Code that an enterprising tax attorney could challenge? I’m sure the answer is yes (though I have no idea which sections these are).
Links:
TaxProf Blog’s Excellent Summary of Blogosphere Reaction
Volokh Conspiracy Article
Roth Tax Updates 8/22
