Compensatory damages in job discrimination claims are no longer taxable
income in the D.C. Circuit.
In the case of Marrita Murphy v. Internal Revenue Service, Murphy filed a
complaint with the Department of Labor alleging that her former employer
"blacklisted" her and provided unfavorable references to potential employers
after she complained about certain environmental hazards. She was awarded
$70,000 for emotional distress and injury to professional reputation. After
paying $20,665 in taxes on the award, she filed an amended return seeking a
refund, which the IRS denied. She brought suit in the U.S. District Court for
the District of Columbia, claiming that the $70,000 award should have been
excluded from her gross income and not taxed. The Court rejected her arguments
and after appealing, the Court of Appeals agreed that the damages for Murphy’s
emotional distress and injury to reputation are not “income."
If Murphy should become the “law of the land,” it could have significant
benefits for employers and plaintiffs/employees:
- Employees would be likely to have a strong incentive to attribute as much of
their settlement as possible to tax-free emotional distress damage
- Employers would not have the duty to report payments that are not considered
“income” (the tax-free portion of the settlement is typically not reported to
the IRS)
- Tax-free payments would not be subject to payroll withholding or the
employer’s additional share of FICA
- This could encourage the early resolution of employment
disputes.
For now, taxpayers outside the D.C. Circuit have, at most, a good argument
that any compensatory damages they receive should be tax-free. It seems unlikely
that plaintiffs' settlement demands will drop significantly based on the mere
possibility that plaintiffs may ultimately succeed in excluding compensatory
damage payments from gross income. Indeed, employers outside of the D.C.
Circuit are still required to treat compensatory damages as "income," and to
report any such payments to the IRS on a Form 1099. Clearly, the safer approach
from the management side is to issue a Form 1099, and leave it to the
plaintiff/employee to battle the IRS over the taxability of the payment.
It is as yet unknown whether the IRS will appeal to the Supreme Court or how
other Courts of Appeal will respond when the issue is raised before them. It is
expected that plaintiffs whose cases have previously settled, and who paid taxes
based on the prevailing view that the recoveries were taxable will file amended
returns and attempt to recover taxes based on this decision.
The court's opinion can be viewed at http://pacer.cadc.uscourts.gov/docs/common/opinions/200608/05-5139a.pdf
Source:
ABA Section of Labor and Employment Law E-Alert
