The problem remained, however, of how to deal with taxation of mental anguish damages in such cases. The IRS (and for the most part, the courts) have taken the position that, while these funds are not wages and therefore not subject to payroll taxes, such monies are taxable income. Employee rights advocates have been lobying Congress to pass another portion of the Civil Rights Tax Relief Act that would exclude these damages from taxable income and make their tax treatment more akin to that given to personal injury damages. (Section 104(a)(2) of the Internal Revenue Code excludes from gross income compensation received for mental anguish alleged "on account of personal physical injuries or physical sickness.")Now the DC Circuit has done one better and ruled that the IRS code provision declaring mental anguish damages in employment cases to be taxable income is violative of the Sixteenth Amendment and therefore unconstitutional. From the Court's summary:
"Marrita Murphy brought this suit to recover income taxes she paid on the compensatory damages for emotional distress and loss of reputation she was awarded in an adminstrative [sic] action she brought against her former employer. Murphy contends that under § 104(a)(2) of the Internal Revenue Code (IRC), 26 U.S.C. § 104(a)(2), her award should have been excluded from her gross income because it was compensation received "on account of personal physical injuries or physical sickness." In the alternative, she maintains § 104(a)(2) is unconstitutional insofar as it fails to exclude from gross income revenue that is not "income" within the meaning of the Sixteenth Amendment to the Constitution of the United States.
We hold, first, that Murphy's compensation was not "received ... on account of personal physical injuries" excludable from gross income under § 104(a)(2). We agree with the taxpayer, however, that § 104(a)(2) is unconstitutional as applied to her award because compensation for a non-physical personal injury is not income under the Sixteenth Amendment if, as here, it is unrelated to lost wages or earnings."
The Court concluded this way:
Albert Einstein may have been correct that "[t]he hardest thing in the world to understand is the income tax," The Macmillan Book of Business and Economic Quotations 195 (Michael Jackman ed., 1984), but it is not hard to understand that not all receipts of money are income. Murphy's compensatory award in particular was not received "in lieu of" something normally taxed as income; nor is it within the meaning of the term "incomes" as used in the Sixteenth Amendment. Therefore, insofar as § 104(a)(2) permits the taxation of compensation for a personal injury, which compensation is unrelated to lost wages or earnings, that provision is unconstitutional.
The D.C. Circuit is the most important circuit court when dealing with federal agency and IRS issues so this opinion will be given a great deal of deference by the other circuits. As important an issue as this is, I would expect the IRS to appeal it to the Supreme Court. In the meantime, employment attorneys need to rethink the way they are structuring settlements for tax purposes and inform clients (and past clients) about this decision so that they can consult with their tax advisors and determine if the filing of an amended tax return is in order.