Emotional Damages Are Not Taxable

In a recent landmark decision, the U.S. Court of Appeals for the District of Columbia Circuit held that compensatory damages for emotional distress and loss of reputation are not taxable.

The issue first surfaced when Marrita Murphy reported environmental hazards at a New York Air National Guard base where she worked. She filed a lawsuit against her employer whom she claimed had blacklisted her and given her bad references. She claimed “emotional distress or mental anguish” and "injury to professional reputation”. She was awarded damages which she paid taxes on. But then she amended her 2000 tax return, excluding the damages from her gross income. But the IRS denied her the tax refund, so Murphy filed a lawsuit against the IRS.

The point of contention was a 1996 congressional amendment to the tax code that excluded "any damages (other than punitive damages) received . . . on account of personal physical injuries or physical sickness" from gross income. Prior to that, the tax code had affirmed that taxable "gross income means all income from whatever source derived."

Murphy’s lawyers argued two theories. First, that the award should not be taxable because it was for “physical personal injuries” Murphy had sustained and, second, because the award was not “income” as defined in the Sixteenth Amendment.

It is difficult to argue that compensation for loss of wellbeing or a good reputation are received in lieu of income, and Murphy had not sought compensation for economic losses. There was also precedent in Commissioner v. Glenshaw Glass Co. and Commissioner v. William Goldman Theatres, Inc. in which the defendants had argued that punitive damages for anti-trust violations are tax-exempt. The Supreme Court had found that the restoration of “human capital” was exempted from income in the tax code as defined in the Sixteenth Amendment. Murphy’s lawyers argued that compensation for a personal injury is analogous to a “return of capital”.

The DC Circuit Court disagreed with the first theory but held for Murphy based on the second one. In sum, the court found that the award was a restoration of capital, not a gain or an accession to wealth. In other words, it is not constitutional to tax the recovery of a loss.

Please contact a personal injury lawyer for information about your legal rights if you or a loved one has been injured as a result of someone else’s negligence or recklessness.