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US Appeals Court Reverses Decision On Taxation Of Emotional Distress Awards

by Mike Godfrey, Tax-News.com, Washington

05 July 2007

The US Court of Appeals for the District of Columbia Circuit has held that the Internal Revenue Service can tax damages awards based solely on compensating victims who suffer emotional injuries.

The Court's decision on Tuesday reverses a previous ruling by the same panel of judges last year in the case of Marrita Murphy, who was awarded $70,000 by the US Labor Administrative Review Board for emotional distress after complaining about environmental hazards at the New York Air National Guard base.

Murphy took the government to court after the IRS demanded $20,665 in tax from the damages, and in August 2006 was successful in persuading the judges that the award wasn't taxable income under the Constitution's 16th Amendment because it didn't compensate for lost wages or earnings.

However, the IRS challenged the verdict, and in a ruling issued on Tuesday, the same judges reversed their original decision.

"Murphy no doubt suffered from certain physical manifestations of emotional distress," wrote the appeals court's chief judge, Douglas Ginsburg. However, the judgment concluded that the award was based upon mental pain and anguish and for injury to professional reputation.

While legal compensation for physical injuries is tax-free under a 1996 statute, monies awarded for mental anguish and injury to reputation are not.

The judges also said that "Murphy’s situation was "akin to an involuntary conversion of assets; she was forced to surrender some part of her mental health and reputation in return for monetary damages".

David K. Colapinto, who argued on behalf of Murphy, stated that the court's new verdict "stands reality on its head".

"When whistleblowers suffer retaliation, they do not ’sell’ their mental health. If people are injured in a car accident, they do not ’sell’ their arms and legs. These are real human losses, and compensation to restore that human loss was never intended to be ’income’ under our Constitution or the tax code."

Stephen M. Kohn, the President of the National Whistleblower Center and co-counsel for Murphy, added that the decision was a setback for victims of civil rights abuses.

"It permits Congress to enact retaliatory taxes, stripping people from the Constitutional protections afforded property. Damages to whistleblowers are not part of a business transaction - forced or otherwise. They are part of harm caused by illegal conduct. This decision threatens fundamental human rights," he argued.


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