Taxability of Damages

Damage paid for personal injury claims are not taxable, right?  Wrong.  Damages paid for personal injury claims "“on account of personal physical  injuries or physical sickness” are not taxable.  26 U.S.C. § 104(a)(2).   Damages paid for purely emotional injuries are taxable, at least in the opinion of the IRS. 

Now, along comes Murphy v. Internal Revenue Service,  No. 05-5139 (D.C. Cir.  August 22, 2006).  Murphy received "damages for emotional distress and loss of reputation she was awarded in  an adminstrative action she brought against her former employer."  She was asked to, and did, pay taxes on the award, and then sued to get her tax payments back.  She tried to argue that the payments fell within the exclusion of § 104(a)(2), but that failed.  However, the Court held that  "§ 104(a)(2) is unconstitutional as  applied to her award because compensation for a non-physical  personal injury is not income under the Sixteenth Amendment  if, as here, it is unrelated to lost wages or earnings."

The Court said "it is clear from the record that the damages were awarded to make Murphy emotionally and  reputationally “whole” and not to compensate her for lost wages  or taxable earnings of any kind. The emotional well-being and  good reputation she enjoyed before they were diminished by her  former employer were not taxable as income. Under this  analysis, therefore, the compensation she received in lieu of  what she lost cannot be considered income and, hence, it would  appear the Sixteenth Amendment does not empower the  Congress to tax her award."  It went on to say that "every indication is that damages received solely in  compensation for a personal injury are not income within the  meaning of that term in the Sixteenth Amendment. First, as  compensation for the loss of a personal attribute, such as wellbeing  or a good reputation, the damages are not received in lieu  of income. Second, the framers of the Sixteenth Amendment  would not have understood compensation for a personal injury —  including a nonphysical injury — to be income. Therefore, we  hold § 104(a)(2) unconstitutional insofar as it permits the  taxation of an award of damages for mental distress and loss of  reputation."