The Story of Murphy: A New Front in the War on the Income Tax

Abstract

This chapter from the second edition of Tax Stories (Foundation Press) unpacks the D.C. Circuit’s stunning decision in Murphy v. United States, 460 F.3d 79 (D.C. Cir. 2006), which unsettled more than a half-century of tax jurisprudence in holding, based on an originalist view of the Sixteenth Amendment, that a personal injury award for emotional and reputational injuries could not be constitutionally treated as income. The chapter explores the background of the case, examines the parties’ conduct of the litigation, and critically analyzes the flaws and negative implications of the panel’s opinion. Although the D.C. Circuit panel ultimately granted rehearing and reversed its earlier decision in Murphy v. IRS, 493 F.3d 170 (D.C. Cir. 2007), the panel could not unring the bell and undo the lasting damage to the tax system caused by its original opinion. In his chapter on The Story of INDOPCO, Joseph Bankman argues that the income tax often asks too much of judges (and taxpayers, tax accountants, tax lawyers, and the IRS), demanding Solomonic judgments that mere mortals are incapable of consistently getting right. As a result, what initially may appear as an isolated failure instead may be a systemic flaw in the income tax itself. In Murphy, however, the income tax asked very little of the D.C. Circuit: the case merely required understanding of the constitutional source of Congress’s taxing power; the relationship between constitutional and statutory definitions of income; the meaning of tax basis and the difference between financial capital and human capital; and the courts’ duty to the tax system. Instead, the D.C. Circuit turned what should have been a run of the mill tax dispute over the application of § 104(a)(2) into a threat to the very survival of the income tax. The D.C. Circuit, prodded by the tax blogosphere, ultimately backed away from the brink, but the panel’s willingness to arm the anti-tax brigades should give pause to those committed to defend the income tax. Although questions about the taxation of damage recoveries will not bring down the income tax, the willingness of so many to shake its foundations may ultimately prove its undoing.