Monday, July 9, 2007

MURPHY'S LAW

A federal appeals court ruled on July 3rd that awards for "nonphysical injuries", such as emotional distress, are taxable. This reverses the same court’s ruling in the same case last August 22nd.

Damages for personal injuries have been tax exempt from federal income tax since 1996, while money received for emotional distress and other “intangible” injuries had been taxable until the 2006 ruling.

The decision came in the case of Murphy v IRS. Marrita Murphy was awarded a $70,000 judgment for “emotional distress and loss of reputation” by the Department of Labor Administrative Review Board after she “blew the whistle” to authorities about environmental hazards at the New York Air National Guard base where she worked.

The IRS claimed that Murphy owed $20,665 in taxes, plus interest, as a result of her $70,000 award. When the judges agreed with the taxpayer that the settlement was exempt from taxes the IRS asked the full appeals court to consider the matter. Instead, the same three-judge panel decided to rehear the case, and reversed its original decision.

Our fellow blogger Kelly Phillips Erb at TAX GIRL had this to say about the recent decision. I do believe that I agree with her reasoning.

“While I feel for Ms. Murphy (I don’t even want to think what her legal bills are like), I believe that this is the correct ruling. Awards in these kinds of cases are meant to punish the defendant - not give the plaintiff a windfall. In contrast, awards for personal injury are not (in theory) meant to punish the defendant but make the plaintiff whole. Those are different results and should be taxed differently.”

In most cases that result in a legal judgment or settlement, taxable or otherwise, the recipient must pay a substantial percentage of the award to his/her lawyer. A problem arises when it comes to the tax treatment of such “contingent legal fees”.

The US Supreme Court has ruled that individuals receiving a taxable legal award must include the entire amount of the award, including any contingent legal fees and other costs that are deducted from the amount the individual actually receives, in gross income – generally on Line 21 (other income) of Form 1040. The legal fees and costs are deducted on Schedule A as a “miscellaneous deduction” subject to the 2% of AGI exclusion.

Under this treatment the taxpayer is royally screwed. By reporting the gross award on Page 1 his/her AGI is artificially inflated, reducing or eliminating a myriad of tax deductions and credits that are affected by AGI (see my posting on "The Most Important Number on Your Tax Return"). Plus, if the award is substantial enough, the taxpayer will fall victim to the dreaded Alternative Minimum Tax (AMT). Miscellaneous deductions are not allowed in calculating AMT – so the taxpayer gets no tax benefit from the legal fees deducted from the award. Even if not subject to the AMT, the taxpayer will only be able to deduct a portion of the legal fees due to the 2% of AGI exclusion. After paying legal fees and federal and state taxes the poor taxpayer is not left with very much.

However, an “above-the-line” deduction as an “adjustment to income” is allowed for legal fees and costs involved with taxable awards from claims of “unlawful discrimination”. This includes actions related to violations of

· The Civil Rights Act of 1964 and 1991,
· The Congressional Accountability Act of 1995,
· The National Labor Relations Act,
· The Family and Medical Leave Act of 1993,
· The Fair Housing Act,
· The Americans with Disabilities Act of 1990, and
· various whistle blower statutes

As the Murphy case involves a whistleblower action it appears that while Marrita must pay tax on the award she will effectively only pay tax on the “net” amount - after deducting her legal fees and costs.

TTFN

2 comments:

David K. Colapinto said...

Your reporting and analysis is wrong on so many levels and I wish bloggers would actually read the decision and report the facts before making comments and reporting false information posted on other blogs.

First, all personal injury awards were treated as non-taxable under the tax code since the courts, the Treasury Dept and Attorney General considered this issue between 1918 and 1922. These early rulings interpreted damages received for both physical and non-physical injuries not to be income under the tax code or the Sixteenth Amendment.

Second, in 1996 Congress changed the statutory exemption (26 USC 104) to withdraw the statutory exclusion for damages received non-physical personal injury. However, Congress did not enact a separate tax on compensatory damages for non-physical injuries in 1996, thus creating one of the legal problems that arises in Ms. Murphy's case.

Third, Ms. Murphy filed a claim under six federal environmental whistleblower statutes which provide for awards of tort-type compensatory damages, and the Department of Labor determined the amount of her "make whole" damages. None of Ms. Murphy's award was for punitive or exemplary damages. Rather, this case involved only "make whole" tort-type damages to restore Ms. Murphy's personal injury losses.

Fourth, this was not a settlement. The Department of Labor issued an order setting the amount of damages that had to be paid by the Respondent to restore Ms. Murphy's health and reputation. This was purely "make whole" relief and the amount was determined by the court of competent jurisdiction.

Fifth, Ms. Murphy paid taxes and requested a refund because, among other things, the award does not constitute "income" under the Sixteenth amendment or the tax code. She initiated a tax refund action in U.S. District Court which affirmed the tax. Ms. Murphy then appealed to the D.C. Circuit and on August 22, 2006, the 3-judge panel agreed with Ms. Murphy that her award was not "income" and she should receive a refund. However, due to pressure from the IRS and others, the panel chose to rehear the case and vacated its August 22, 2006 decision.

Sixth, the portion of the Taxgirl blog that you cite is also wrong. I pointed out Ms. Erb's errors in a comment on her blog but you did not cite to that.

Seventh, if you or your readers are interested, they can read the actual rulings and briefs submitted by the parties in the case online at: http://www.whistleblowers.org


For the record, I am Ms. Murphy's attorney. I am submitting this comment to correct factual errors contained in your blog, and the errors that you compounded by reporting false information from the Taxgirl blog. I request that you make appropriate corrections to your blog article so others do not fall victim to reporting the factual errors contained on Taxgirl.

Robert D Flach said...

The previous comment identifies the author as the lawyer for Ms Murphy.

I am not aware of factual errors in my blog posting. Nor am I aware of any reporting of false information from the Tax Girl blog. I merely presented a quote by Kelly which reflected her opinion on the decision. My posting was written based on news articles from several sources as well as the Tax Girl's posting. While the author goes into detail on various background information I do not find anything that contradicts what I reported.

THE WANDERING TAX PRO