Unprecedented

Judicial activism at its worst

By Kaye A. Thomas
Posted August 23, 2006
Updated July 5, 2007

Using the Constitution to shape the tax law.

Update: In a surprise announcement on December 27, 2006, the Court of Appeals granted a rehearing in this case, and on July 3, 2007 the court issued a new opinion reversing its earlier decision. The case described here now stands as nothing more than a bizarre episode in which judges on a prominent court temporarily lost sight of reality.

Tax professionals will be talking about this decision for a long time. Even assuming it ends up being reversed, it will cause immeasurable mischief in the meantime. CPAs may one day be seen wearing tee shirts that say, "I survived Murphy." In this August 22 decision (PDF), the court declared section 104(a)(2) of the Internal Revenue Code unconstitutional on the ground that a cash award for emotional distress, mental anguish or injury to professional reputation is not "income" as defined in the Sixteenth Amendment.
Why is this decision significant? For one thing, the opinion was written by a prominent judge. Judge Ginsburg, formerly a professor at Harvard Law School,* has served on the Court of Appeals for the District of Columbia Circuit for nearly 20 years and has been its chief judge since 2001. He is a vigorous advocate of limiting Congressional authority by dramatically changing the way the Constitution is interpreted. We can't dismiss this as a wacky decision by an oddball judge.

* In 1987 Ronald Reagan nominated Ginsburg to be associate justice of the Supreme Court but withdrew the nomination in the wake of allegations Ginsburg smoked marijuana, not just when he was a student, but also when he was a law professor. I was a student at Harvard Law School when Ginsburg was a professor there but deny taking any of his classes or smoking marijuana with him.

Then there are the far-reaching implications of the decision itself. It raises countless questions about what other provisions of the tax law might be held unconstitutional. And, if sustained, it represents a huge shift of power from Congress to the judiciary, as judges will be deciding what can and cannot be taxed as income.

Compensatory Damages

Marissa Murphy sued the New York Air National Guard for violating whistle-blowing statutes after she complained to state authorities of environmental hazards on an airbase. She was awarded $45,000 for emotional distress or mental anguish and $25,000 for injury to professional reputation.
At one time these damages might not have been taxable under a provision that excluded damages for personal injuries from taxable income. In 1996 Congress changed the law so it excludes only damages for personal physical injuries, and specifically provided that emotional distress shall not be treated as a physical injury. In this case, Murphy argued that she had physical injuries (for example, from grinding her teeth due to stress) but the courts rejected this argument because the damage award clearly specified it was for non-physical injuries.

The Court's Reasoning, Part 1

The court found that the damages were awarded to make Murphy "emotionally and reputationally whole" and not to compensate her for lost wages or taxable earnings of any kind. (Apparently it made no difference to the court that part of the award was for damage to professional reputation, and therefore presumably based on diminished earning power.) The court pointed out that the emotional well-being and good reputation Murphy enjoyed before her employer's misconduct "were not taxable as income," and concluded that cash received as compensation for what she lost cannot be considered income.
There are countless situations where an individual may hold something that is "not taxable as income" and yet have taxable income upon receiving cash for that item. For example, we do not have to report income for maintaining our privacy, but we must report income if we receive cash in exchange for our agreement give up a portion of that privacy in allowing someone to use our name or photograph in an advertising campaign. Our continued use of a piece of real estate we own is not taxable, even if its value is far greater than the amount we paid to obtain it, but we may have to report taxable gain if we sell it, or even if there is an involuntary conversion as when the property is taken under eminent domain authority. The first part of the court's reasoning makes no sense at all in the context of our income tax system.
Indeed, the court comes perilously close to accepting an argument often made by tax protestors. They frequently argue that wages represent an equal exchange of cash for labor, and in an equal exchange there cannot be income as that term is used in the Sixteenth Amendment. The courts routinely rule against these protestors and impose penalties for making frivolous arguments. Yet there is not much difference between cash received in exchange for damage to professional reputation and cash received in exchange for professional services.

The Court's Reasoning, Part 2

The court did not rely exclusively on the argument described above. It went on to ask whether the receipt of this money is within "the commonly understood meaning" of income at the time the Sixteenth Amendment was added to the Constitution. Delving into history we find that shortly after the amendment took effect, Congress chose to exclude damages for personal injuries from taxable income. Because Congress chose not to tax these payments, and did not at that time distinguish between physical and non-physical injuries, the court concluded that people at that time did not understand these payments to be income.
This part of the decision draws on Judge Ginsburg's philosophy of adhering strictly to original intent in interpreting the Constitution. Yet it is difficult to see the logical connection between the choice Congress made not to tax this income and the conclusion that Congress believed it did not have the power to tax this income. Congress has on countless occasions chosen not to tax one or another type of income for a variety of reasons that have nothing to do with whether the item in question is within its constitutional power to tax.
In Glenshaw Glass, a Supreme Court decision studied by every law student who takes a class in taxation, the Court observed:

Here we have instances of undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion. The mere fact that the payments were extracted from the wrongdoers as punishment for unlawful conduct cannot detract from their character as taxable income to the recipients.

That is exactly what happened to Murphy. The damage award she received increased her wealth. It did not replace an item of wealth that was lost when she suffered emotional distress and injury to her professional reputation. This cash award was income by any reasonable definition of that term, now or 100 years ago.

Consequences

This decision will cause mischief for the tax system as long as it remains on the books. Some of the problems will be relatively narrow, while others are broader in scope.

Taxpayers receiving awards similar to the one Murphy received will have to decide whether to report them as income. They expose themselves to a potentially expensive dispute with the IRS if they fail to do so, but tax professionals may feel obliged to advise them not to pay tax on these awards until the decision is reversed.
Taxpayers who received these awards in the past have the same dilemma: should they file for a refund?
Tax professionals will have to consider whether the logic used by the Murphy court extends to other kinds of income. Is the constructive sale rule unconstitutional? What about new section 409A, dealing with nonqualified deferred compensation? Surely these provisions tax items that were not contemplated as income by those who enacted the Sixteenth Amendment.
Tax protestors can take heart in this decision. It is not far-fetched to suppose the courts will have to deal with a substantial increase in frivolous constitutional challenges.

Most striking of all is the court's arrogation of power in this area. Unquestionably the Constitution imposes some limit on Congress' power to tax, and the courts are our last defense when Congress oversteps those bounds. Yet this case stands for the proposition that the courts can substitute its view of what should be taxed for the views of our elected representatives, based on flimsy evidence of how people thought about the word income nearly a century ago. This is a case of judicial activism at its worst.