Labor E-Bulletin - Federal Appeals Court Concludes Recovery of Damages for Emotional Distress, Menatl Anguish and Loss of Reputation is Not Taxable as Income
August 28, 2006
The Court’s decision -- striking down part of the Internal Revenue Code as unconstitutional -- is especially important to employers because under many federal and state employment discrimination and retaliation laws, an employee may recover damages for emotional distress, mental anguish and loss of reputation. Many charges and lawsuits are resolved by settlement agreements without a trial. Plaintiff may demand a lower settlement amount when payment is for emotional distress, mental anguish and loss of reputation not subject to federal income tax. Cases could become easier and cheaper to settle if the employer wishes to settle.
This case arose when Marrita Murphy filed an administrative complaint, alleging that her former employer, The New York Air National Guard (NYANG), in violation of various whistle‑blower laws, had “blacklisted” her and provided unfavorable references to potential employers after she had complained of environmental hazards on a NYANG air base. As a result of the administrative proceeding, Murphy was awarded $45,000.00 for “emotional distress or mental anguish” and $25,000.00 for “injury to professional reputation.” None of the award was for lost wages or diminished earning capacity.
The United States Court of Appeals for the District of Columbia Circuit concluded the damages for emotional distress or mental anguish and injury to professional reputation were not “income” and that the attempt by the United States to tax those awards as income violated the 16th Amendment to the United States Constitution. That amendment provides, in relevant part: “The Congress shall have power to lay and collect taxes on incomes, from whatever source derived. . . .” In finding the taxation of Murphy’s award was unconstitutional, the Court first concluded that what she had received in damages was unrelated to lost wages or earnings and was therefore not income. Second, the Court determined that the framers of the 16th Amendment would not have understood compensation for personal injury, including non‑physical injury, to be income at the time the 16th Amendment became effective. The Court ordered the United States to refund the taxes paid by Murphy, plus interest.
The United States Supreme Court could review the case. As of now, the case is not binding precedent in the other eleven federal courts of appeals, including the 6th Circuit Court of Appeals covering Ohio, Kentucky, Tennessee and Michigan.
Settlement agreements by plaintiffs and employers to allocate settlement dollars to non-taxable emotional distress, mental anguish and loss of reputation, may be reviewed by the IRS as to their bona fides. These need to be carefully thought out and constructed.
This case arose when Marrita Murphy filed an administrative complaint, alleging that her former employer, The New York Air National Guard (NYANG), in violation of various whistle‑blower laws, had “blacklisted” her and provided unfavorable references to potential employers after she had complained of environmental hazards on a NYANG air base. As a result of the administrative proceeding, Murphy was awarded $45,000.00 for “emotional distress or mental anguish” and $25,000.00 for “injury to professional reputation.” None of the award was for lost wages or diminished earning capacity.
The United States Court of Appeals for the District of Columbia Circuit concluded the damages for emotional distress or mental anguish and injury to professional reputation were not “income” and that the attempt by the United States to tax those awards as income violated the 16th Amendment to the United States Constitution. That amendment provides, in relevant part: “The Congress shall have power to lay and collect taxes on incomes, from whatever source derived. . . .” In finding the taxation of Murphy’s award was unconstitutional, the Court first concluded that what she had received in damages was unrelated to lost wages or earnings and was therefore not income. Second, the Court determined that the framers of the 16th Amendment would not have understood compensation for personal injury, including non‑physical injury, to be income at the time the 16th Amendment became effective. The Court ordered the United States to refund the taxes paid by Murphy, plus interest.
The United States Supreme Court could review the case. As of now, the case is not binding precedent in the other eleven federal courts of appeals, including the 6th Circuit Court of Appeals covering Ohio, Kentucky, Tennessee and Michigan.
Settlement agreements by plaintiffs and employers to allocate settlement dollars to non-taxable emotional distress, mental anguish and loss of reputation, may be reviewed by the IRS as to their bona fides. These need to be carefully thought out and constructed.
