Wednesday, August 23, 2006

DC Circuit Misinterprets the 16th Amendment

On August 22, the DC Circuit declared that it was unconstitutional to tax an individual on compensation for nonphysical personal injuries. See Murphy v. I.R.S. (No. 05-5139). This case is an odd one, to say the least. A full analysis will have to wait, but here is a short synopsis along with a few comments.

The taxpayer had complained that she had been “blacklisted” by the Air National Guard for various whistleblowing activities relating to environmental practices. She sued and successfully recovered $70,000, which was broken down as follows: emotional distress or mental anguish $45,000, and injury to professional reputation $25,000. She reported these amounts on her 2000 tax return and paid just over $20,000 in taxes. She then filed a claim for refund, seeking to recover those taxes based on two alternative theories: (1) the damages were really for physical injuries (as she manifested symptoms such as teeth grinding, and medical records arguably showed some physical responses to the emotional distress), which are excludable under section 104(a)(2) of the Code; and (2) failing that characterization, section 104(a)(2) is unconstitutional to the extent it treats nonphysical injury damages such as these as within the scope of taxable income.

The DC Circuit rejected the first claim, but accepted the second. In doing so, it looked to the understanding of the word “incomes” in the Sixteenth Amendment at the time of enactment – an original intent approach. The Sixteenth Amendment, enacted in 1913, states: The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.

The heart of this case is the definition of “incomes”. Prior Supreme Court precedents had given Congress broad authority to address the scope of income. One formulation that is commonly used focuses on whether there is an “accession to wealth”. In this case, the DC Circuit focused on the concept of a return of capital – human capital –to avoid finding that any such accession occurred. They treated the exclusion for a personal injury – which originally did not discriminate between physical and nonphysical injuries, as the modern statute does – as an example of constitutionally excluding a return of human capital.

That may sound good on a superficial level, and there will doubtful be anti-tax folks who think this is really clever and good. But let’s pause a moment.

First, when we part with a capital asset, we get a tax –free return only to the extent of our previous investment. Taxpayers bear the burden to show what that investment – which we call “basis” – is. Any excess is taxable income. ( Now, there are reasons to argue for an exclusion of capital gains, but they are prudential, not constitutional in nature. Thus, they should be addressed to Congress, not the courts.) Here, the taxpayer wants an exclusion without showing basis. That is novel indeed.

Second, if returns of human capital are excluded from the scope of income, then what about wages? The court recognizes that wages are income, and they go to great lengths to say that these payments are not wages, or analogous to wages. But of course, I think they are wrong on this point. We get paid for working because it is valuable to other people. Other people may not want to engage in sweat, tears, and toil, so they pay you to do it for them. You get paid, in effect, for the use of your intellect, strength, and for the inconvenience and suffering that goes along with the work. (After all, it is an imperfect world; not all work is delightful and redemptive.) In this case, the employer treated the taxpayer (a misnomer, it seems) quite badly, and the court provided a measure of damages that tried to make it worth her while to endure that suffering. In my mind, this is hard to distinguish from compensation for other forms of returns on human capital.

Congress did say that if you lose an arm or leg, for example, or even if you just get bruised and hurt physically, they will exclude that from income. However, I view that exclusion as a prudential one, and not one that is dictated by the constitution. When we consider how to value limbs and harm, we often take into account earning power. We also take into account lost enjoyment – which we compensate with money. True enough, most people who are injured would rather be made whole than have the money. But money still functions as compensation for the inconveniences of life, whether received for compensation for work performed or for an injury to the person.

I predict that this case will not be followed in other jurisdictions, and that perhaps the SCT will even step in to address this matter. And they will give the power to Congress to address the issue. And that is the appropriate result.


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