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Lessons from the Tax Court

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in Small Business Tax

Add tax insult to injury. A new decision by the Court of Appeals for the District of Columbia finally ends one of the most topsy-turvy cases in recent years. The court rejected are quest to review the reversal of a tax-free award for nonphysical damages. This tax treatment is only available for damages resulting from physical injuries.

The case: A taxpayer filed a complaint against her employer for unlawful discrimination in 1994. The administrative law judge awarded her $45,000 for past and future emotional distress and $25,000 for injury to her professional reputation. She reported the entire award as taxable income.

Subsequently, the taxpayer filed for a refund, which the IRS denied. She sued in federal district court, claiming that the award did not represent taxable income within its constitutional meaning. A trial court rejected her claim, but the D.C. Circuit Court surprisingly sided with the taxpayer. After the IRS petitioned for a rehearing, the Court of Appeals, on its own motion, vacated its judgment and reheard the case earlier this year. Then the three-judge panel reversed the original decision. Reason: The panel said that imposing tax on compensatory damages for emotional distress and injury to professional reputation was not unconstitutional.

The taxpayer requested that the full court rehear the panel’s decision. On Sept. 14, the court denied the request. It noted that no member of the court had requested a vote on the petition. (Murphy, CA-DC, No. 05-5139, 9/14/07)

Bottom line: Awards for nonphysical injuries, such as emotional distress, will continue to be taxable. You can choose to fight this issue in a different jurisdiction, but you’ll face an uphill battle.

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