netsmithie[at]gmail.com wrote:

- quote -

Yes, file a protective claim of refund, particularly if the
statute is about to run.

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"Business" <GrandMarquis99[at]gmail.com> wrote:

- quote -

I don't think it's particularly badly written, but it is
badly reasoned. It used to be the law that emotional
distress damages were considered personal injuries for tax
purposes. The law was changed. This court decided that
emotional distress should still be treated as personal
injuries dispite the change in the law.

- quote -

I'm sometimes surprised which cases the IRS decides to
acquiesce to and which they don't. If they think this could
be a big money loser for them,

- quote -

Agreed.

Stu

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netsmith wrote:
- quote -

As it stands, under Murphy v. IRS, if your damages were for
loss of noneconomic human capital, which includes mental
anguish, pain and suffering, etc., then the damages you
received were merely a replacement for the "capital" you
lost, and as a result there was no "accession to wealth" and
thus no income. In simple terms, since your damages were
paid for mental anguish, they would be nontaxable (because
not "income") under Murphy v. IRS.

However, that doesn't put you on easy street - i.e., don't
start ordering architectural drawings for that new vacation
home just yet.

First and foremost, Murphy is only precedent in the District
of Columbia circuit. That means that, unless you live in
the District of Columbia, that case will not be
precedential, which means that a US District Court outside
of D.C. is not bound by that case.

Second, the case is so badly written, and draws such
startling conclusions with a breath-taking lack of analysis,
which means that it is very, very unlikely to be relied upon
as persuasive precedent in any other district court other
than those in D.C.

Third, while the IRS has so far been mum on the decision, I
don't think they're going to just lie down and take this one
- the opinion is almost certainly wrong on the law, and the
consequences of letting it stand are too far-ranging (e.g.,
if noneconomic human capital is recoverable, and since a
portion of it is "expended" earning income, and since it has
a limited useful life, then, arguably, a portion of it
should be allowed as an amortization deduction against gross
income - or even worse, since it's not "income," as a cost
of goods sold above the line deduction).

Fourth, even if it stands, it will only be "the law" in the
DC circuit, and the IRS will continue to contest the issue
in all of the other federal judicial districts. Further,
even in DC, the IRS cannot be bound to the result by
collateral estoppel, and will continue to vociferously
oppose the holding in any additional cases brought in DC.

So, on the basis of the foregoing, I would say that you have
a colorable basis for filing a refund claim; however, the
IRS is almost guaranteed to deny the claim, and the chances
of winning a subsequent refund suit against the IRS
(technically speaking, as the Murphy case pointed out,
against the United States) are almost nil - your odds of
winning the lottery are probably better.

Good luck.

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Tim wrote:

- quote -

So, it doesn't sound likely that this will pan out. I might
also not have understood the basics of this. My situation
was one where the settelement was in a class-action lawsuit
(regarding the Tri-state Crematory case). The funeral home
settled. I gather that the payments were deemed to be
compensation for mental anguish; I understood at the time
that the payment was taxable (a 1099 was issued). It may be
that is not covered by the Murphy case.

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"Shyster1040" <Shyster1040[at]nospamhotmail.com> wrote:

- quote -

I agree. They ruled this was not "personal injuries" so
that should have ended the discussion. Their analysis is
just another way to say it really was personal injuries and
should be exempt on that basis.

If you follow the court's reasoning to its logical (or
perhaps illogical) conclusion, money earned by physical
labor also depletes the body, and so should be (at least in
part) tax exempt for that reason.

Stu

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The next level is actually a hearing before the DC Circuit
en banc. This is granted at the discretion of the court by
petition.

Tim

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netsmithie[at]gmail.com wrote:

- quote -

Oops - sorry! I didn't read closely enough. It is a DC
Circuit Court of Appeals decision, which means the next
level will be SCOTUS.

A Court of Appeals decision is precedential, technically,
only in the circuit where it was issued. So the IRS may or
may not decide to follow this (acquiesce) elsewhere. I'd
still file a protective claim if the SOL is close to
expiration.

Katie in San Diego

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netsmithie[at]gmail.com wrote:

- quote -

Well, it's just a trial court decision and could be
overturned on appeal. And the IRS may nonacquiesce.
However, if the statute is close and the facts are similar,
I'd go ahead and file the claim.

Katie in San Diego

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Sure, I wouldn't count on getting a refund, however. I
haven't had a chance to properly read, and think about, the
case, but I really don't think that the decision will stand.
At least it'll be interesting to have the Supreme Court
forced into taking another good, hopefully comprehensive,
look at the fundamentals of the income tax. Perhaps I'll
write an amicus brief.

From what I've read, the DC court of appeals hangs its
argument on two primary hooks, first, that a damages award
is analogous to financial capital and that, just as a return
of financial capital is nontaxable, so too is a "return" of
personal capital. Second, that the damages award was in
lieu of something that was itself nontaxable.

On the first hook, the court's argument from the analogy to
replacement of financial capital is not very persuasive and
completely ignores the whole issue of basis, notwithstanding
that the government raised it. Had the court bothered to
look a little farther than its own sentimental views, it
might have pushed the analogy a little farther and taken a
look at Section 1033. Under Section 1033, if property is
"compulsorily or involuntarily converted" into money, then,
unless the taxpayer acquires the appropriate replacement
property within the appropriate time period, then the gain,
if any, shall be recognized.

Section 1033 does not have a special definition of gain, so
the general definition applies, namely, that "gain" is the
excess of the amount received over the taxpayer's adjusted
cost basis in the involuntarily converted property. Cost
basis is, in general terms, the amount of after-tax dollars
that the taxpayer has directly or indirectly invested in the
property in question.

To put this into a concrete example, assume that in Year 1 A
buys a painting for $1,000. Assume that by Year 5 the
painting has appreciated to $100,000, at which time B breaks
into A's house and steals the painting, which gets destroyed
when the basement where B hid the painting is flooded.
Finally, assume that A sues B and recovers a judgment, which
is fully satisfied, against B for $110,000 in Year 6, which
A uses as a down payment for a vacation home in Hawaii.

Under Section 1033, A has a recognized gain of $109,000,
calculated as follows: $110,00 received on judgment against
B, less A's basis (i.e., A's after-tax investment in the
painting) of $1,000 = $109,000. This is the correct result
because the only amount of capital that A had invested in
the painting, the only amount that did not constitute
"income" with respect to A's ownership of the painting, the
only amount that A owned prior to his acquisition of the
property, was $1,000. A's "capital" that was returned to
him as part of the judgment against B was the identifiable
value that A parted with when he acquired the painting. The
simplest case, obviously, is if A had $1,000 in cash that he
had either earned (and which had already been taxed as
income) or which had been given to him as a gift (assuming
for these purposes that gifts are nontaxable, as currently
provided in the IRC).

What A did not get to treat as a nontaxable return of
"capital" was either the $99,000 of appreciation that was
built into the painting at the time that B stole it, nor the
additional $10,000 over and above this amount that the court
hearing the case ultimately awarded to A. And yet, clearly,
all of that $99,000 in appreciation was clearly A's capital
- A could have borrowed against it, or contributed it to a
business, or he could have sold it and realized that
inherent gain. The problem is - and this is the point that
the Appeals Court in Murphy clearly failed to appreciate -
is that the amounts of $99,000 and $109,000 in my example
are capital gain.

If we now take Section 1033 and use it to inform the
return-of-capital analogy we've drawn, then we have to
conclude that, to the extent that the amount of damages
Murphy received exceeds her basis in her physical/mental
well-being, her teeth, and her professional reputation, then
she has income. That therefore requires that we determine
what her basis was, that is, what amount of after-tax
dollars did she part with in acquiring the assets the
damages were intended to replace? Furthermore, deductions
such as for depreciation are designed to permit recovery of
invested capital prior to ultimate disposition and reduce
the taxpayer's basis in an asset for that reason; thus, we
have to determine whether Murphy had already recovered any
of her invested capital through deductions attributable
thereto.

This presents quite a formidable task; however, there are
several other aspects of the tax system (woefully ignored by
the DC Court of Appeals) that come to our, but not Murphy's,
aid.

First, with respect to Murphy's human capital proper - her
emotional balance and her teeth, undoubtedly some of the
food, clothing, and shelter she purchased with her after-tax
dollars went into developing those, so one can find some
sort of a non-zero investment therein.

Given that there is the possibility of there being some sort
of a non-zero investment, we have to try and quantify it
somehow. Clearly, every dollar of after-tax income Murhpy
spent on food, clothing, housing, and the like cannot
constitute an investment of recoverable capital - to hold
otherwise would effectively get rid of the entire concept of
personal consumption. It should be rather uncontroversial to
posit that the Founders would not have considered every
personal expenditure to be an investment of recoverable
capital rather than pure consumption of resources that, once
consumed, provide no further tax benefit. Or, to put it
into simpler words, at least some of the food, clothing,
housing and the like Ms. Murphy bought went into providing
the human "capital" she then expended pursuing personal
pleasures, such as horse-riding, fine dining, and sex.

Thus, it would be entirely reasonable to limit Murphy's
basis in her personal "capital" to an amount that was
reasonable under the circumstances.

Second, we need to determine if Murphy has already, either
directly or indirectly, recovered her capital expenditures
in acquiring her human capital by being permitted some form
of deduction.

As to both the amount that would be a reasonable allowance
for her recoverable capital expenditures, and as to the
receipt of prior tax benefits, we have a more-or-less ready
made answer in the form of the personal exemption and the
standard deduction. Combined, these two deductions from
gross income stand in as a rough measure of the reasonable
expenditures allowed in acquiring one's human capital, and,
unfortunately for Ms. Murphy, indicate that she has already
recovered her capital investment therein. Essentially, what
the personal exemption and the standardized deduction do is
to provide a deduction for the reasonable costs that a
hypothetical taxpayer must pay in order to acquire and
maintain the human capital she/he uses to earn the income
being taxed. In other words, these deductions are to an
employee and to the trade/business of being an employee and
earning wages (or, the t/b of being an independent
contractor and earning compensation for personal services,
if you like) what the deductions for plant, equipment and
salaries are to a business such as a manufacturer.

The fact that the personal exemption and the standard
deduction don't cover completely what a lot of people spend
to support themselves is irrelevant; just as an unreasonable
business expenditure will be disallowed, such as putting
solid gold fixtures in the employee wash room when stainless
steel would have done just as well, so too should
unreasonable expenditures for acquisition and maintenance of
personal capital - to do otherwise is to throw the baby of
personal consumption out with the bath-water.

The end result is, first, Ms. Murphy has invested
recoverable capital in her personal capital; second, that
amount is clearly not equal to the total of her personal
expenditures for food, clothing, housing and the like, and
can therefore be limited to only a portion of such
expenditures; third, the personal exemption and the standard
deduction indicate the dollar amount of that reasonable
expense, and therefore Ms. Murphy's investment of
recoverable capital in her personal capital can be limited
to this amount - any of her expenditures over that amount
constitute nonrecoverable personal consumption; fourth, by
virtue of the personal exemption and the standard deduction
(or the itemized deduction, if greater), Ms. Murphy has
already recovered all of her investment in her personal
capital.

As a consequence, Ms. Murphy has a basis of zero in her
emotional balance and her teeth, and therefore, by analogy
to Section 1033, any amounts she receives on account of the
involuntary conversion of those "assets" constitutes gain
(capital gain, although if used in a trade or business,
ordinary income ??).

In short, Ms. Murphy has income of $45,000 for the amount of
damages she received on account of her emotional distress
and her teeth, and the Court of Appeals for the District of
Columbia f**ked up royally.

As to the damages for her professional reputation, such a
reputation is in the nature of self-created goodwill in
which a taxpayer generally has a zero-basis. To the extent
that Ms. Murphy has actually paid out amounts that resulted
in the development of her professional reputation, such
expenditures would have constituted ordinary business
expenses in the year in which made, and thus deductible. As
a result, Ms. Murphy also has a zero basis in her
professional reputation, and any damages recovered on
account of the involuntary conversion thereof is income.

I hate to say it, but if the DC Court of Appeals could not
get its collective mind around such simple concepts as
invested capital versus capital gain, and the determination
of basis and adjustments thereto, even if in a somewhat
novel context, then that court should not be hearing tax
cases any more.

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Does the ruling in this case in DC
(http://pacer.cadc.uscourts.gov/docs/...8/05-5139a.pdf)
mean that I should consider filing an amended return to
recapture the tax on an award I received a few years ago?

Regards,

Steve Smith

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