What may prove to be the most profound change in federal tax policy of our era emerged from Washington this summer without any congressional or presidential action whatsoever.
In a bolt-from-the-blue ruling, the U.S. Court of Appeals for the District of Columbia Circuit found that although the Constitution’s 16th Amendment authorizes the federal income tax, Congress is not free to define “income” in any way it wants. A three-judge panel struck down a rule making compensatory damages for nonphysical personal injuries, such as for defamation or emotional distress, taxable. Because such payments merely compensate for something the recipient possessed before suffering damages, there is no income and therefore no power to tax, the court said.
The ruling in Murphy and Leveille v. United States applies only to District of Columbia taxpayers and addresses only Internal Revenue Code Section 104(a)(2), which sets out the rule on compensatory damages. But I believe the decision will set off a wave of litigation over other aspects of the income tax law, and probably the wealth transfer taxes on estates, gifts and generation-skipping transfers as well.
If the Murphy court’s view of the limits on congressional taxing power is widely adopted, either because other circuits agree or because the Supreme Court ultimately takes the same position, dozens of other income tax provisions could be overturned. Some, or conceivably all, of the wealth transfer taxes could be stricken, too. To fund the government, Congress likely would be forced to consider major changes in other rules governing income and deduction items that clearly are within federal tax reach.
Although it caught tax professionals by surprise, the Murphy ruling is the predictable product of a federal bench that steadily has grown more conservative over the past four decades. Chief Judge Douglas Ginsburg of the D.C. Circuit authored the decision. In 1995, he coined the term “Constitution-in-exile” to refer to a group of constitutional principles defining federal power that he described as “ancient exiles, banished for standing in opposition to unlimited government … kept alive by a few scholars who labor on in the hope of a restoration, a second coming of the Constitution of liberty — even if perhaps not in their own lifetimes.”
Today the term Constitution-in-exile is mostly rejected by Ginsburg’s intellectual sympathizers and is used primarily by his opponents. Ginsburg’s philosophy about government powers, however, probably is widely shared, at least by fellow Republican judicial appointees.
President Reagan appointed Ginsburg to the circuit court in 1986. A year later, after the Senate rejected Robert Bork’s nomination to the Supreme Court, Reagan nominated Ginsburg in his place. Ginsburg withdrew from consideration after disclosures that he used marijuana in the 1960s and 1970s while he was a university student and later a law professor. He remained on the appeals court, however, and was appointed chief judge in 2001. He was joined in the Murphy ruling by U.S. Circuit Judge Janice Brown, a former California Supreme Court justice appointed to the federal bench last year by President Bush, and by U.S. Circuit Judge Judith Rogers, who was appointed to the appeals court by President Clinton in 1994 to fill the seat vacated when Clarence Thomas became a Supreme Court justice.
Suit Seeks Refund Of Taxes On Award
Marrita Murphy, then known as Marrita Leveille, filed a federal complaint in 1994 alleging that her former employer, the New York Air National Guard, violated whistleblower statutes by firing her and giving unfavorable references to potential employers. The Department of Labor awarded her $45,000 for “emotional distress or mental anguish” and $25,000 for “injury to professional reputation.” The Leveilles reported the $70,000 on their tax return, paid more than $20,000 in federal taxes, and then sued for a refund. A federal district judge threw out the Leveilles’ claims, and they appealed.
Ginsburg’s opinion looked to the language of the 16th Amendment, adopted in 1913 after earlier decisions held that the federal government could not levy a direct tax on income from property, such as dividends or rents, unless the taxes were apportioned among the states according to population. The amendment said: “The Congress shall have the 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.”
But what are the “incomes” Congress can tax? Ginsburg cited two seminal cases. In Eisner v. Macomber, decided in 1920, the Supreme Court said that the taxing power extended to any “gain derived from capital, from labor, or from both combined.” The court then held 5-4 that stock dividends, in which shareholders receive only shares that leave their proportionate stakes in the corporation unchanged, are not taxable under that definition. In 1955, the Supreme Court said in Commissioner v. Glenshaw Glass Co. that the Eisner definition was not “meant to provide a touchstone for all future gross income questions” and that Congress can tax all “gains” or “accessions to wealth.”
The Ginsburg opinion then accepted the taxpayer’s contention that her compensatory award represented neither a gain nor an accession to wealth. Ginsburg noted that from the early years of the income tax until Congress changed the law in 1996, compensatory damages for nonphysical personal injuries were untaxed. The early case law and legislative practice indicate that such payments were not viewed as income at the time the 16th Amendment was adopted, he wrote. Further, because the payment was intended “to make Murphy emotionally and reputationally ‘whole’ and not to compensate her for lost wages or taxable earnings of any kind,” the damage award could not be considered a substitute for other taxable income.
The government argued that Congress has broad power to tax all economic gains, including even damage awards for physical injuries if it so chooses. Compensation that is a return of “human capital,” as the taxpayer contended her award represents, is not comparable to a nontaxable return of financial capital, government lawyers contended, noting that “Because people do not pay cash or its equivalent to acquire their well-being, they have no basis in it for purposes of measuring a gain (or loss) upon the realization of compensatory damages.”
The appeals court rejected the government’s position that compensatory damages “plainly constitute economic gain, for the taxpayer unquestionably has more money after receiving the damages than she had prior to the receipt of the award.” This aspect of Ginsburg’s opinion may draw the most fire when other courts consider the issue.
The damage award Murphy received is analogous to an insurance payment that a property owner might obtain after a building burns down. If the building was fully depreciated (so that its cost for tax purposes is zero), and the owner receives $100,000, the payment is nontaxable only if the owner reinvests the insurance proceeds in a similar property within two years after the year of the fire. Any cash not reinvested is taxable. The cost basis of the new building is reduced by the amount of the unrecognized gain on the destroyed building, so the gain on the first building is eventually taxed when the replacement building is sold.
In contrast, Murphy was not required to spend her $70,000 on advertising, counseling or other expenses that might have repaired her damaged reputation or emotional injuries. She could spend the money in any way she wanted or not at all, with no tax at present or later, according to the Ginsburg opinion. Other courts may decline to follow the D.C. Circuit’s decision invalidating Section 104(a)(2) on the basis that compensatory damage awards really are income. In that case, Congress is within its powers to tax such awards for nonphysical personal injuries, while exempting awards for physical injuries.
Ruling Opens Tax Laws To Dispute
This would not put to rest the bigger issue that the Ginsburg opinion put on the table for the first time in decades: Even if compensatory damage awards are income and therefore fair game for federal taxation, what about the many other provisions of the tax code that create taxable income out of thin legislative air?
Several broad classes of tax laws are subject to challenge under the Murphy decision’s reasoning. Perhaps the most vulnerable are rules that disallow deductions for certain business expenses which, while properly incurred by the business and economically reasonable in amount, have drawn legislative disfavor over the years. Such provisions include:
- Business meals and entertainment expenses (50 percent disallowed).
- Executive salaries, with exceptions, greater than $1 million per year for chief executives and other top officers of public companies.
- Lobbying expenses.
- Advertising on foreign broadcast outlets.
- Employee business expenses (allowed only as miscellaneous itemized deductions and subject to limits and disallowances of such deductions).
- “Parachute payments” from companies to executives who are released or demoted.
- Club dues, including airport executive lounges.
- Professional gamblers’ losses that exceed winnings.
- Interest paid on unregistered (bearer) bonds.
- Travel expenses for taxpayers (known as “tax turtles” among tax professionals) who have no fixed tax home, but whose work requires them to move from one location to another.
Another, economically more important, group of tax provisions open to challenge creates artificial delays and limitations in recognizing business losses and expenses. Sometimes such costs may be permanently disallowed, especially under the Alternative Minimum Tax system. It remains to be seen whether the courts will uphold Congress’s power to overstate, and tax, current income on the premise that deductions will be allowed in future years. This group of questionable provisions includes:
- Limits on deductible losses from “passive” business activities, in which the taxpayer does not personally work a sufficient number of hours to qualify for deductions against wages and other “nonpassive” income.
- Limits on capital losses, deductible only against capital gains plus up to $3,000 per year of other income for individuals.
- Limits on depreciation for automobiles used in a business.
- Limits on deductions for investment interest expense.
- Limits on deductions for organizing or starting up a business.
- Limits on amortization expenses for leasehold improvements.
- Nonrecognition of losses realized in transactions between related parties.
More aggressive taxpayers also may challenge various rules that trigger taxable income recognition when taxpayers receive cash or property but are arguably not enriched in the process, or that require income to be recognized even if the taxpayer does not immediately receive cash. These provisions include many rules governing offshore investments and the stringent requirements for avoiding immediate taxation of proceeds from casualty losses, condemnations and other “involuntary conversions,” as well as exchanges of one business or investment asset for another.
The Murphy case’s impact may extend well beyond the income tax area. Because the 16th Amendment only authorized taxes on income, courts have upheld federal taxes on estates, gifts and other wealth transfers on the basis that these are indirect taxes on the transfer, rather than direct taxes on the underlying property. Such direct taxes must be apportioned among the states according to population.
Over time, however, the rules for wealth transfer taxes have increasingly aimed at the underlying property rather than the asset that actually is being transferred. The Internal Revenue Service has recently had some success persuading courts to tax the assets held by a decedent’s family limited partnership, rather than the decedent’s interest in the partnership, which typically is subject to substantial valuation discounts for lack of marketability and control. In other cases, property such as life insurance policies that a decedent no longer held at death is brought back into the calculation of the taxable estate.
The Murphy ruling may indicate that federal judges will be less tolerant in the future of arguments that Congress has constitutional power to tax property as long as it waits for a gift or death to open a window for such taxes. Certainly, if I found myself in a high-stakes valuation dispute with the IRS — especially in the D.C. Circuit — I would recommend that the attorneys consider a constitutional challenge to the transfer tax, if only to increase the government’s litigation risk and willingness to settle. For the government, losing the ability to tax certain personal injury settlements is a pretty small matter. Losing the ability to tax estates or gifts altogether is not.