From How Appealing:
D.C. Circuit declares a provision of the federal tax code unconstitutional as applied: Today’s ruling, by a unanimous three-judge panel, holds that “insofar as §104(a)(2) permits the taxation of compensation for a personal injury, which compensation is unrelated to lost wages or earnings, that provision is unconstitutional.” You can access the complete ruling at this link.According to today’s opinion, written by Chief Judge Douglas H. Ginsburg, “The Sixteenth Amendment simply does not authorize the Congress to tax as ‘incomes’ every sort of revenue a taxpayer may receive.”
The opinion goes on to explain:
As we have seen, 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.
And the opinion concludes:
In sum, 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 well-being 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.
(The Sixteenth Amendment states:
The Congress shall have 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.)
Summary from the TaxProf Blog:
The D.C. Circuit held today, in Murphy v. United States, No. 03cv02414 (D.C. Cir. 9/22/06), that § 104(a)(2) is unconstitutional under the 16th Amendment as applied to a recovery for a non-physical personal injury (emotional distress and loss of reputation) unrelated to lost wages or earnings. Murphy received $70,000 from New York State for anxiety suffered and injury to her reputation as a result of being “blacklisted” after becoming a whistleblower against her employer (the New York Air National Guard).
RothCPA.com has comments and a good compilation of links as to what people are saying about the case here.