Tuesday, August 22, 2006

Murphy v. U.S., make a note of it

A couple decades ago, a federal District Court held that the federal gift tax could not be applied to the transfer of certain public housing bonds, because those bonds were intended by Congress to be tax free for all purposes. Smart tax lawyers immediately saw that if there was any asset whose transfer was exempt from the gift tax, the entire gift tax must fall. It seems to me that the decision was handed down in late summer, and as soon as the August recess ended Congress prospectively overruled that District Court decision.

I remember thinking at the time that it's quite amazing how quickly a new tax law can be enacted when Congress is properly motivated.

Now another tax decision has been handed down with possibly large consequences.
Here's one of several summaries I've seen, and here's another with some reasonably well informed comments. The question is whether damages for emotional distress and loss of reputation are subject to the income tax. Under the tax code, only damages related to physical injuries are exempt. The Court declares that rule to be unconstitutionally narrow.

The tricky part of the opinion is that the Court bases its conclusion on the understanding of the concept of "income" at the time that the 16th amendment was ratified. The interesting question will be, how far can we run with that logic?

Murphy is the unanimous decision of a three-judge appelate court. Many commenters expect it to be reversed after appeal to the full court or the Supreme Court. I would predict a quick Congressional response, but it might not be so easy to trump the Constitution with a mere statute.


JLM said...

As I rmember the tax-free bond decision (and it's been a long time) a higher court rather than Congress saved the day. Of course the bonds were "tax free." And of course the estate tax applies to transfers, not property, so the "transfer" of the bonds was-YES!-taxable.

Jim Gust said...

Sorry Jim, your memory has failed you. But because mine failed me also, I looked it up.

The case was Haffner v. U.S., and it was actually affirmed by a divided 7th Circuit Court of Appeals, with Judge Posner dissenting. But long before that affirmance, the result of the case was reversed by the Tax Reform Act of 1984, which terminated the favorable tax treatment for transfers after June 18, 1984 (though the legislation was not completed until later that summer, I believe).

TRA 84 also imposed crucial reporting requirements for transfers before June 19, 1984, which were intended to eliminate any taxpayer argument that gift tax returns weren't needed in the absence of a taxable gift. The effect would be to preserve the IRS' chance of collecting gift taxes in the event of a reversal.