Genrally, personal injury recoveries for bodily injuries are not subject to income tax, but recoveries for lost income are taxable. What, then, about non-physical personal injury (i.e., emotional distress and loss of reputation) unrelated to lost wages or earnings?
Believe it or not, the government wanted to tax this recovery pursuant to Â§ 104(a)(2) of the tax code. Thankfully, the D.C. Circuit disagreed with the government in Murphy v. United States, No. 03cv02414 (D.C. Cir. 8/22/06), and held that Â§ 104(a)(2) is unconstitutional under the 16th Amendment as applied to such recoveries.
Ms. 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). The Court explained:
Albert Einstein may have been correct that “[t]he hardest thing in the world to understand is the income tax,” The Macmillan Book of Business and Economic Quotations 195 (Michael Jackman ed., 1984), but it is not hard to understand that not all receipts of money are income. Murphy’s compensatory award in particular was not received “in lieu of” something normally taxed as income; nor is it within the meaning of the term “incomes” as used in the Sixteenth Amendment. Therefore, insofar as Â§ 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.