Tax Law Center





It’s over. After years of battle and as a consequence of meticulous preparation and presentation, you’ve finally prevailed. Your client has been awarded substantial damages either by way of settlement or verdict from a contentious lawsuit. No more worries. Right? Wrong. The fun has just started. Your client now wants to know whether and to what extent he/she must pay income tax on that handsome reward. All taxable damages awarded to plaintiff are included in plaintiff’s gross income, even the contingency legal fees paid directly to plaintiff’s attorney albeit such fees are deductible (subject however to the 2% of AGI limit (floor) of Code §67(a)). Sinyard v. Commissioner, 268 F.3d 756 (9th Cir. 2001). Biehl v. Comm., 351 F.3d 982, 92 AFTR 2d 2003-7280 (9th Cir. 2003).

Internal Revenue Code (hereinafter called “Code”)§ 61(a) states in relevant part: “gross income means all income from whatever source derived.” The U.S. Supreme Court has interpreted Code §61 most broadly to extend to “all economic gains not otherwise exempted.” Comm'r v. Glenshaw Glass Co., 348 U.S. 426, 430 [47 AFTR 162]. In other words, unless there’s a specific statutory exemption, it is income.

Code Section 104(a)(2) (“Compensation for injuries or sickness”) provides that “gross income under Code § 61 does not include the amount of any damages (other than punitive damages) received ... on account of personal physical injuries or physical sickness.” Since 1996, Code §104 (a)(2) has further provided that, for purposes of this exclusion, “emotional distress shall not be treated as a physical injury or physical sickness.” In 1996, P.L. 104-188, Sec. 1605(a), amended Code §104 (a)(2) by adding these words “For purposes of paragraph (2), emotional distress shall not be treated as a physical injury or physical sickness”. So that while before 1996, Code §104(a)(2) excluded a broad range of physical and nonphysical injuries from income, now it only excludes physical injuries.

In Commissioner v. Schleier, 515 U.S. 323,337 [75 AFTR 2d 95-2675] (1995), the Supreme Court held that before a taxpayer may exclude compensatory damages from gross income pursuant to Code § 104(a)(2), he must first demonstrate that “the underlying cause of action giving rise to the recovery [was] based upon tort or tort type rights.” Murphy v. IRS, 493 F.3d 170, (D.C. Cir. 04/23/2007) (hereinafter “Murphy 2”) is a most recent case addressing Code §104. 

The Facts in Murphy. In 1994, Murphy filed a complaint with the Department of Labor alleging that her former employer, the New York Air National Guard (NYANG), in violation of various whistle-blower statutes, had “blacklisted” her and provided unfavorable references to potential employers after she had complained to state authorities of environmental hazards on a NYANG airbase.

The Secretary of Labor determined Murphy was right and that the NYANG had unlawfully discriminated and retaliated against Murphy. The Labor Secretary ordered as a consequence, that any adverse references to the taxpayer in the files of the Office of Personnel Management be withdrawn, and remanded her case to an Administrative Law Judge “for findings on compensatory damages.”

On remand, Murphy submitted evidence that she had suffered both mental and physical injuries as a result of the NYANG's blacklisting her. A psychologist testified that Murphy had sustained both “somatic” and “emotional” injuries, basing his conclusion in part upon medical and dental records showing Murphy had “bruxism,” or teeth grinding often associated with stress, which may cause permanent tooth damage. Murphy also suffered from other “physical manifestations of stress” including “anxiety attacks, shortness of breath, and dizziness.”

The ALJ recommended compensatory damages totaling $70,000, of which $45,000 was for “past and future emotional distress,” and $25,000 was for “injury to [Murphy's] vocational reputation” from having been blacklisted.

In 1999, the Department of Labor Administrative Review Board affirmed the ALJ's findings and recommendations. On her tax return for 2000, Murphy included the $70,000 award in her “gross income” pursuant to Code § 61. As a result, she paid $20,665 in taxes on the award.

Murphy later filed an amended return in which she sought a refund of the $20,665 based upon Code § 104(a)(2), which provides that “gross income does not include ... damages ... received ... on account of personal physical injuries or physical sickness.” In support of her amended return, Murphy submitted copies of her dental and medical records. Upon deciding Murphy had failed to demonstrate the compensatory damages were attributable to “physical injury” or “physical sickness,” the Internal Revenue Service denied her request for a refund. Murphy thereafter sued for refund of tax and interest in the United States District Court for the District of Columbia.

The District Court rejected all of Murphy's claims on the merits and granted summary judgment for the IRS. Murphy appealed the judgment to the U.S. Court of Appeals for the D.C. Circuit. In Murphy v. IRS, 460 F.3d 79 [98 AFTR 2d 2006-6088] (2006), (hereinafter called Murphy 1), the D.C. Circuit concluded Murphy's award was not exempt from taxation pursuant to Code § 104(a)(2), id. at 84, but also that it was not “income” within the meaning of the Sixteenth Amendment, id. at 92, because Code §104 (a)(2)’s distinction between physical (excludable from income) and nonphysical injuries (includible in income) was unconstitutional. Murphy 1 therefore reversed the decision of the District Court. Not surprisingly, the Court’s holding that Code §104 (a)(2) was unconstitutional set off a firestorm within IRS.

IRS petitioned for rehearing en banc, arguing for the first time that, even if Murphy's award was not income, there is no constitutional impediment to taxing it because a tax on the award is not a direct tax and is imposed uniformly.

Murphy 2

While the D.C. Circuit generally does not hear new arguments in a rehearing, it made a notable exception this time. “(in view of the importance of the issue thus belatedly raised, the panel sua sponte vacated its judgment and reheard the case).

On rehearing, Murphy argued her award should have been excluded from her gross income because it was compensation received “on account of personal physical injuries or physical sickness.” The new Panel headed by the Chief Judge of the D.C. Circuit flatly rejected Murphy's argument and flatly rejected the notion that Code §104 (a)(2) was somehow unconstitutional. 

The Murphy 2 Court held even though Murphy’s award was “based upon ... tort type rights” in the whistle-blower statutes as required by Schleier, id, she was not compensated “on account of or because of” physical injuries. While Murphy argued she sustained physical injury, the Court said her award was not “on account or because of” those physical injuries. The Court held Murphy's focus upon the word “physical” in Code § 104(a)(2) was misplaced. The Court held more important is the phrase “on account of.” The Murphy 2 court cited O'Gilvie v. United States, 519 U.S. 79 (1996). O’Gilvie, involved a pre 1996 version of Code §104. In O’Gilvie, the Supreme Court read the phrase “on account of” in Code §104 (a) (2) to require a “strong causal connection,” thereby making Code § 104(a)(2) “applicable only to those personal injury lawsuit damages that were awarded by reason of, or because of, the personal injuries.” Id. at 83.

Because the Supreme Court in O’Gilvie, id specifically rejected a “but-for” formulation in favor of a “stronger causal connection.” Id. at 82– 83, the Murphy 2 Court held therefore Murphy must demonstrate she was awarded damages directly “because of” her physical injuries, which the court held she failed to do.

The D.C. Circuit Court held that although Murphy may have suffered from bruxism or other physical symptoms of stress, the Labor Board explicitly granted her an award for “severe anxiety attacks, inability to concentrate, a feeling that she no longer enjoyed ‘anything in life’, marital conflict” and upon her psychologist's testimony about the “substantial effect the negative references had on [Murphy].” The Board made no reference to her bruxism.

The D.C. Circuit noted O’Gilvie's analysis of the phrase “on account of,” was unchanged by the 1996 Amendments, and remained controlling. The Murphy 2 Court stated that while Murphy no doubt suffered from certain physical manifestations of emotional distress, the record clearly indicated the Board awarded her compensation only “for mental pain and anguish” and “for injury to professional reputation.”


Accordingly, for a damage award to pass Code §104 (a)(2) muster and be excludable from income thereunder, Murphy 2 holds it must be (1) based on tort or tort type rights and be awarded directly and not just proximately (2) on account or because of personal physical injuries or physical sickness. Nothing less will satisfy Code §104.

The author holds a B.A. degree in Economics from the University of Virginia, a J.D. from the University of Florida, and an LLM in Taxation from New York University. From 1971-1975, he was employed by the IRS Office of Chief Counsel, Tax Court Litigation Division, Trial Brach in Washington D.C. where he left as a senior trial attorney. From 1975-date, he has been a tax attorney representing taxpayers in tax controversies with IRS and the U.S. Department of Justice. He is admitted to practice law in D.C., and Nevada.

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