Legal Lottery Winner Wins Twice

The IRS collects tax money from those who win judgments for emotional distress. That may change though as a result of a new court decision in the District of Columbia.

Most of us would like to have more money. And, if you enter America’s legal lottery and emerge as a winner, you probably want to keep as much of that in your own pocket as possible.

Unfortunately for those who happen to win the big bucks through the legal system, the Internal Revenue Service will want to a cut. But this may change as a result of a new case.

Marrita Murphy had argued that the New York Air National Guard violated various whistle-blower statutes, had “blacklisted” her and given unfavorable references to potential employers after she complained to state authorities of environmental hazards at a New York Air National Guard air base. She won a $70,000 payment from her former employer for “emotional distress” and “loss of reputation.” $45,000 of the award was for “emotional distress or mental anguish” and $25,000 for “injury to professional reputation” from having been blacklisted.

But, in addition to her attorney’s fees, she also owed Uncle Sam $20,665 in income taxes. Keeping the money from the IRS was not a viable option, so she paid it. But, having suffered the financial bite, she filed an amended return to get it back. As expected, the IRS denied the refund. Murphy then filed another legal appeal–this time against the Internal Revenue Service.

And, in a decision that surprised some in the legal field, she won her case. (Murphy and Leveille v. IRS, US Court of Appeals for DC (No. 05-5139), August 22, 2006) The Court of Appeals for the District of Columbia Circuit said the $70,000 award didn’t represent “income”. The court noted that [C]ompensation for a non-physical personal injury is not income under the Sixteenth Amendment if, as here, it is unrelated to lost wages or earnings.” That sounds like a legal distinction, and it is, but it also saved Ms. Murphy tax money she had forked over to the IRS. The court said that a 1996 tax-law change “unconstitutional” in that it allowed the taxing of damage awards for mental distress and loss of reputation.

So what does this mean for federal employees?

It could mean that winning the legal lottery just got more lucrative.

For now at least, this only applies to cases in the District of Columbia. And, according to an analysis by the Wall Street Journal, a likely outcome of the decision will be that thousands of people who have won judgments in court cases for emotional distress compensation are likely to file for a refund from the Internal Revenue Service. No doubt, the issue will be tested in other courts in the near future.

Josh Bowers, an attorney in Washington, DC said this about the case: “Unless overturned by the Supreme Court, this is a monumental decision that will have immediate national impact. Under the law in this decision, employees in DC will no longer need to seek extra compensation for taxation of their emotional distress damages while employees outside of DC will still see nearly half of what their emotional distress compensation wiped out by taxes. Taxation is the ten ton weight on any discrimination or whistleblower case because emotional distress compensation has been subject to Federal income tax.”

The final outcome is still elusive. Former IRS Commissioner Donald Alexander told the Wall Street Journal he thinks the case will be overturned on appeal. But, for those federal employees who contend through the legal appeal system they have suffered emotional distress–and win their case–the final payoff could end up being free from the federal income tax.

About the Author

Ralph Smith has several decades of experience working with federal human resources issues. He has written extensively on a full range of human resources topics in books and newsletters and is a co-founder of two companies and several newsletters on federal human resources. Follow Ralph on Twitter: @RalphSmith47