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Federal Court Reverses Controversial Tax Ruling

As abruptly as it tossed out a provision of the federal tax code — and called many other provisions into question — a federal appeals court has reversed itself, saying, in effect, “Never mind.”

Law professors and tax professionals widely criticized the original decision by the U.S. Court of Appeals for the District of Columbia Circuit, which struck down a rule that made compensatory damages for non-physical personal injuries taxable. A three-judge panel, in an opinion written by Chief Judge Douglas Ginsberg, held that such damages are not “income” and that Congress is not authorized under the 16th Amendment to define income any way it wants. (See “Surprise Ruling May Transform Tax Policy,” Sentinel, October 2006.)

Government attorneys asked the entire circuit court to review the panel’s decision. But in December 2006, before that request was addressed, the three panel judges — Ginsberg and U.S. Circuit Judges Janice Brown and Judith Rogers — vacated their original ruling and agreed to reconsider the case themselves. The case was reargued in April 2007, and in July, the judges issued a new opinion that was in many respects opposite their original holding.

The panel explained its unusual do-over by saying the government had, in its appeal of the panel’s first ruling, raised an important new argument: Even if the damages award is not income, Congress is nevertheless free to tax it under the Constitution’s general taxing powers. “In view of the importance of the issue thus belatedly raised,” the panel said, it agreed to revisit the case, notwithstanding court rules that generally require legal arguments to be raised in the original proceeding.

In its revised ruling, the panel agreed with the government that the tax code can define “income” to apply even in cases in which there is no actual economic gain. Marrita Murphy had argued that her defamation award was not income because it merely compensated her for damage to her reputation, emotional well-being and other “human capital.”

The panel also accepted the government’s contention that taxing the damage award, even if the award is not income, is not a “direct tax” prohibited by the Constitution, and thus falls under Congress’s general taxing powers. This, too, reversed a conclusion in the original decision.

The panel’s original decision last year was widely criticized as ignoring long-standing tax principles and precedent. Critics also said the ruling would encourage tax protesters to continue using baseless arguments and strategies. But commentators also noted that, as long as it stood, the ruling would raise questions about the validity of numerous tax code provisions dealing with the definition of income.

Larry M. Elkin is the founder and president of Palisades Hudson, and is based out of Palisades Hudson’s Fort Lauderdale, Florida headquarters. He wrote several of the chapters in the firm’s recently updated book, Looking Ahead: Life, Family, Wealth and Business After 55. His contributions include Chapter 1, “Looking Ahead When Youth Is Behind Us,” and Chapter 4, “The Family Business.” Larry was also among the authors of the firm’s book The High Achiever’s Guide To Wealth.