The United States Court of Appeals for the District of Columbia Circuit has ruled that the IRS can tax damage awards for nonphysical injuries such as mental distress or injury to reputation. In a case that overturns a decision by the same court just last summer, the three-judge panel ruled that a tax upon nonphysical damages "is within the Congress's power to tax." A 1996 federal law continues to exempt from taxes compensation for physical injuries.

To many analysts, the surprise in this instance was not the reversal of the original decision as much as it was the original decision itself, which led some legal experts to claim it was a threat to the ability of the IRS to collect taxes.

In the recent case, a taxpayer, Marrita Murphy, was awarded $70,000 in a lawsuit against a former employer after she claimed she was blacklisted and received bad job references from the employer. The IRS claimed the income was taxable and assessed $20,665 in taxes. Originally, the Court ruled that the taxation of such income was unconstitutional.

Some analysts suggested that the possibility exists that the framers of the Constitution did not contemplate the concept of income being received for nonphysical injuries. Ms. Murphy's lawyers criticized the decision, saying it could dissuade whistle-blowers from coming forward in the future.

The unusual reversal was prompted by new arguments made by the government after last year's decision. The Court reconsidered the case and issued its ruling on Tuesday.

AccountingWEB.com  July 2007

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