Section of Taxation Publications
  VOL. 60
NO. 2

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Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.


Murphy’s Mistakes: How the Circuit Court Should Analyze Section 104(A)(2) Upon Rehearing
Elizabeth Rose


[ Editors’ Note: Every case-note author’s worst nightmare is to have a development of Homeric proportions occur to the subject case after the note has gone to the printer. That happened here. On the same day the final page proofs for this issue arrived from the printer, the D.C. circuit, having earlier granted the Government’s petition for rehearing, vacated its earlier decision and affirmed the trial court’s judgment in favor of the Government. Murphy v. Internal Revenue Service, 2007-2 U.S.T.C. (CCH) par. 50,531 (D.C. Cir. 2007).

As the Note below indicates, the major issue before the court on rehearing was its initial determination that the taxpayer’s compensatory personal injury award was not exempt from taxation under the language of section 104(a)(2), but that the award was not income within the meaning of the Sixteenth Amendment, hence the amount in question was not required to be included in gross income. The court’s final opinion retreated from that position and held that gross income treatment was proper, reasoning that “even if [the damage award] is not income within the meaning of the Sixteenth Amendment, [it] is within the reach of the congressional power to tax under Article I, Section 8 of the Constitution.”

Even with the unfortunate timing, we have decided to publish the Note in unaltered form because it provides useful background on the nature of certain professional perceptions regarding the court’s original opinion, and presages several of the arguments now considered or adopted by the court, notwithstanding the Note’s effective umbration by the court’s final opinion.]

In Murphy v. Internal Revenue Service, the District of Columbia Circuit Court of Appeals pronounced a section of the Code unconstitutional. In a case involving the inclusion of damages in gross income, a three judge panel held that “[section] 104(a)(2) is unconstitutional as applied to [the taxpayer’s] award because compensation for a non-physical personal injury is not income under the Sixteenth Amendment.” The court’s holding essentially returned section 104(a)(2) to its pre-1996 version, which did not distinguish between physical and nonphysical injuries.

In the Small Business Job Protection Act of 1996, Congress amended section 104(a)(2) by narrowing the exclusion provision to those damages received “on account of personal physical injuries or physical sickness.” Congress explicitly stated within the Act that “for purposes of [subsection 104(a)(2)], emotional distress shall not be treated as a physical injury or physical sickness.”

As a result of these amendments, for the first time in over 70 years, the tax consequences for tort victims with initial nonphysical injury differed from those with initial physical injury. All compensatory damages—whether for medical expenses, lost wages, or pain and suffering—remained excludable from income for those plaintiffs whose claims arose from physical injuries, whereas all compensatory damages—with the exception of medical expenses—were required to be included in taxable income for plaintiffs whose claims arose from nonphysical injuries. The differential treatment of compensatory damages created by section 104(a)(2) rests on an artificial distinction between tort victims.

Resolving the question whether Congress has the authority to tax compensatory damages arising from nonphysical injury requires a complex constitutional analysis, but not the type of analysis undertaken by the D.C. Circuit. Although the court’s outcome intuitively may seem correct from the perspective of a nontax practitioner because it eliminates seemingly unjustifiable differential tax treatment, the court’s constitutional analysis simply does not support its conclusion. The court could have offered more defensible reasons for finding that Congress did not have the constitutional authority to tax Murphy’s damages; nonetheless, these reasons still might not have been enough to declare a provision of the Code unconstitutional. Given the challenges of justifying a constitutional invalidation of a Code provision, the court should have elaborated on the policy reasons for not taxing damages such as Murphy’s, and in doing so, sent a clear message to Congress and the Service to right this wrong.

Part I of this Note provides the relevant factual background of Murphy and tracks the developments of the case. Part II summarizes the circuit court’s reasoning and holding in Murphy and identifies the criticisms that the Government raises in its en banc rehearing petition. Part III discusses how the court should have approached the constitutional questions raised in Murphy and serves as a possible guide to analyzing this case in the process of rehearing. Part III also offers policy reasons why Congress should amend this provision. Part IV summarizes the unresolved issues pertaining to Murphy and section 104(a)(2) and suggests how the court should decide the case upon rehearing.


Published by
Section of Taxation, American Bar Association
With the Assistance of
Georgetown University Law Center


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