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Court Tosses Federal Tax Statute covering Emotional Damages

By Scott P. Borsack
October 30, 2006

It is not every day that a Circuit Court of Appeals sets aside as unconstitutional a federal tax statute. When the taxability of untold millions of dollars of personal injury settlements and verdicts is affected, people generally take note. The U.S. Court of Appeals for the Fifth Circuit on Aug. 22 struck down as unconstitutional an amendment made to Code ' 104(a)(2) (All references to the Code are to the Internal Revenue Code of 1986 as amended). If the decision stands, it could be one of the most significant tax developments in decades.

What did the offending amendment to Code ' 104(a)(2) provide? That is the section that limits the exclusion from taxable income for personal injury recoveries only to those amounts paid on account of injuries with physical manifestations. The Fifth Circuit has concluded that all personal injury recoveries, not only involving those with physical manifestation, are not taxable under the Sixteenth Amend-ment, not-withstanding the contrary command of Code ' 104(a). For those who have not looked at the Sixteenth Amendment lately, it provides that '[t]he Congress shall have power to lay and collect taxes on incomes, from whatever source derived ' ' In Murphy v. IRS, '- F.3d ”, 2006 WL 2411372 (D.C. Cir. 8/22/06), the court was asked whether recoveries for personal injuries were within the Framers' understanding of 'incomes.' Before we get into the significance of the holding or practical advice to counsel and clients, some background is in order.

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