Section 104 Survives Non-Murphy Constitutional Challenge

Published Categorized as Federal Income Tax
Section 104 Survives Non-murphy Constitutional Challenge
Section 104 Survives Non-murphy Constitutional Challenge

The now famous Murphy decision has left some uncertainties with regard to whether compensation for a personal injuries that are unrelated to lost wages or earnings are taxable. There can be little doubt that the IRS will ask the Supreme Court to settle the issue if the IRS is not successful in the coming Murphy rehearing. Two days ago the Ninth Circuit Court of Appeals issued its opinion in Polone v. Commissioner, solidifying its view that this type of compensation is in fact taxable and upholding Section 104 in light of a different Constitutional challenge.

Polone was a talent agent for United Talent Agency (UTA). UTA fired Polone and its agents allegedly made defamatory statements about Polone’s termination. Polone brought an action against UTA for wrongful termination and defamation. Polone and UTA agreed to settle the claims on May 3, 1996. Four million dollars of the six million dollar settlement was to compensate Polone for UTA’s alleged defamatory statements. The $4 million was to be paid in four biannual installment payments starting on May 3, 1996.

Polone did not report the first payment on his tax return, but he did report the second payment. Polone, believing that none of the installment payments were taxable, then filed an amended tax return seeking a refund of the taxes paid on the second settlement installment payment. The IRS asserted that Polone must report every one of the four payments and tax litigation ensued.

The tax court and the ninth circuit held the last three installment payments were taxable, but the first installment payment was not taxable. The courts concluded that the first payment was not taxable because it was received before the date that Congress amended Section 104 to exempt only payments on account of physical injuries.

Polone was not successful in arguing that the entire amount of the settlement payments was not taxable due to the agreement being finalized prior to Congress amending Section 104, because, according to the Ninth Circuit Court, California law provides that defamation claims are not transferable; therefore, applying Section 1001, the court took the position that Polone was selling his right to sue for defamation (i.e., a chose in action) in incremental sales with each sale being made at the time an installment payment was received.

According to the Ninth Circuit Court, the payments would not have been taxable if Polone entered into a formal agreement eight months prior to the date that the settlement agreement was entered into, because that agreement would have fit in to the grandfather exclusion provision set out in the new amended Section 104.

Polone argued that it was unconstitutional for Congress to enact a tax law that changes the tax consequences for his settlement agreement, because the change only provides a grandfather clause for agreements that were entered into one year or more prior to the enactment of the law (Section 104 was amended effective on August 20, 1996, the grandfather provision exempts agreements in effect as of September 13, 1995, and Polone’s agreement was entered into on May 3, 1996). In other words, Polone argued that Section 104, as amended, amounted to retroactive legislation that violated his Fifth Amendment due process rights.

The Ninth Circuit Court rejected Polone’s Constitutional argument because it held that the last three installment payments did not arise until after Section 104 was amended.

The Ninth Circuit Court of Appeals did not address the direct question of whether Section 104 is Constitutional (as challenged in the Murphy decision) because Polone did not specifically raise that issue; however, the Polone case represents yet another ninth circuit opinion that has held that personal injuries that are unrelated to lost wages or earnings are taxable.

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