Income, Taxes and the Constitution: Why the D.C. Circuit Court of Appeals Got It Right in Murphy
Romond, Russell F., Fordham Journal of Corporate & Financial Law
In August 2006, the U.S. Court of Appeals for the District of Columbia Circuit ("D.C. Circuit") struck down an income tax statute on constitutional grounds-the first time in over eight decades that any court has taken such action.1 In Murphy v. Internal Revenue Service ("Murphy"), the D.C. Circuit held § 104(a)(2) of the Internal Revenue Code (the "Code") unconstitutional because it excluded from gross income awards for compensatory damages on account of physical personal injuries, but included awards for such damages on account of nonphysical personal injuries.2 The decision was widely criticized by academics and tax professionals, particularly with respect to the D.C. Circuit's misconceptions regarding the constitutional source of Congress's taxation power, and many commentators wrote at length about the "parade of horribles" that would inevitably result if the decision were allowed to stand.3
Murphy warrants controversy. Historically, courts have deferred to legislatures with respect to economic and regulatory legislation, especially where such legislation involves "complex tax laws."4 The 1RS promptly filed a petition for a rehearing en bane, but the D.C. Circuit ultimately dismissed the petition as moot.5 In a surprising move, the original three-judge panel vacated its decision on its own motion and scheduled a rehearing of the case.6 As of this writing, the ultimate outcome of the case is unknown. However, the panel's original opinion in Murphy, though vacated, merits discussion because there the court asked a question that goes to the very foundation of our income tax laws, namely: "What does the government tax when it purports to tax income?"
This article will attempt to answer that question. Part I of this article will briefly summarize the D.C. Circuit's opinion in Murphy and present the issues raised by the decision. Part II will analyze the D.C. Circuit's opinion and argue that the court ultimately decided Murphy correctly, despite some errors in its analysis. This Part will then develop a rule for courts to apply to determine whether a transaction results in an "accession to wealth" within the framework provided by the Supreme Court in Commissioner v. Glenshaw Glass Co.,7 and revisit Murphy within the context of this rule.8 This Part will demonstrate that Congress designed the income tax to operate as a tax on net incomes, and not on gross receipts.
Part III will examine and refute the claim that Murphy would undermine the very foundation of the income tax and consequently prohibit the taxation of wages. This Part will first address the most common arguments made by "tax protestors"-taxpayers who cite various constitutional objections to paying income taxes-and explain why Murphy adds nothing to their arguments. Part III will next apply the accession to wealth rule to examine how Congress taxes wages under the income tax. While it is universally recognized that wages are a source of gross income under § 61 (a) of the Code,9 the Court has never actually held whether wages-in their entirety-are gains or receipts to the taxpayer. Part III will explore whether the entirety of wages represent gain to the taxpayer, as opposed to merely receipts, and then explain the tax consequences of this distinction by comparing how the Code treats wages compared to transactions in property and income from a trade or business. Part III concludes by suggesting that the current income tax on wages operates similar to a graduated "sales" tax to the wage earner, and proposes that Congress amend the Code to provide wage earners a method to calculate their gains derived from wages to report as gross income.
Part IV will argue that Congress should adopt a "wage expenditure basis" to calculate the proportion of wages that constitutes gross income to wage earners. This Part proposes a formula for calculating this basis, expressed as follows:
B^sub we^ = [P + T+(E^sub mw^*92.35%)]10
According to this formula, the wage gains accruing to the wage earner are the net wages remaining after adjusting for payroll and state income taxes, as well as an adjusted minimum wage payable for an equivalent quantity of labor. …