Incomes, Taxes and the Constitution: Why the D.C. Circuit Court of Appeals Got it Right in Murphy
FORDHAM JOURNAL OF
CORPORATE & FINANCIAL LAW
Fordham Journal of Corporate & Financial Law
Russell F. Romond
Copyright c 2007 by the authors. Fordham Journal of Corporate & Financial Law is produced
by The Berkeley Electronic Press (bepress). http://ir.lawnet.fordham.edu/jcfl
J.D. candidate, Fordham University School of Law, 2007; B.S., Fordham
College of Business Administration, 1999. I would like to thank Professor Jeffrey M.
Colón of Fordham University School of Law for his thoughtful insight and advice, as
well as the members of the Fordham Journal of Corporate & Financial Law for their
diligent editorial assistance.
1. In 1920, the Supreme Court struck down a statute taxing stock dividends as
income in Eisner v. Macomber, 252 U.S. 189 (1920). However, in 1972, the Tenth
Circuit cited constitutional grounds to expand the application of a statutory tax
exemption in Moritz v. Comm’r, 469 F.2d 466 (10th Cir. 1972).
2. 460 F.3d 79, 81 (D.C. Cir.), vacated, Murphy v. IRS, 2006 WL 4005276 (D.C.
Cir. Dec 22, 2006).
3. Professor Paul Caron, of the University of Cincinnati College of Law, said of
Murphy, “It is difficult to overstate the importance and potential harm of this decision.”
Ryan J. Donmoyer, Tax Law Ruling by Court May Encourage New Challenges (Aug.
23, 2006), available at http://www.bloomberg.com/apps/news?pid=20601103&sid=az
SsFNBVDjJ8&refer=us. See also Paul Caron, Tax Prof Commentary on Murphy, (Aug.
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
IRS promptly filed a petition for a rehearing en banc, 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
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
23, 2006), available at http://taxprof.typepad.com/taxprof_blog/2006/08/tax_prof_
4. See Nordlinger v. Hahn, 505 U.S. 1, 11 (1992) (“In structuring internal taxation
schemes the States have large leeway in making classifications and drawing lines which
in their judgment produce reasonable systems of taxation.”).
5. Order Dismissing Appellees’ Petition for Rehearing En Banc, No. 05-5139
(D.C. Cir. Dec. 22, 2006).
6. Order for Reh’g, No. 05-5139 (D.C. Cir. Dec. 22, 2006).
7. 348 U.S. 426 (1955).
8. This rule is referred to as the “accession to wealth” rule, discussed infra notes
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:
BBwe = [P + T + (Emw * 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. This methodology provides three
advantages over the way the Code currently taxes wages. First, a wage
expenditure basis is equitable because it brings wages, as a source of
income, into parity with capital gains and income from a trade or
business, both of which incorporate the notion of “gain” by adjusting for
the costs of production of income. Second, it would enhance the
progressive nature of the current tax structure and provide tax relief to
low income workers and two-earner families. Finally, it is relatively
easy to implement and leaves intact the other provisions of the Code that
provide credits, deductions and exemptions for dependents and personal
9. I.R.C. § 61(a) (2000).
Bwe = Wage expenditure basis;
P = Payroll taxes;
T = State and local income taxes withheld; and
Emw = Minimum wage equivalent for the amount of labor performed.
I. MURPHY V. INTERNAL REVENUE SERVICE
Marrita Murphy filed a claim with the Department of Labor
alleging unlawful discrimination and retaliation by her former
employer.11 An administrative law judge awarded Murphy $70,000 in
compensatory damages, $45,000 of which was for “emotional distress or
mental anguish” and $25,000 of which was for “injury to professional
reputation.”12 Murphy included her award as “gross income” on her
2000 tax return and paid $20,665 in taxes.13
Murphy later filed an amended return with the Internal Revenue
Service (“IRS”) seeking a tax refund for this payment.14 After the IRS
denied Murphy’s request, she filed suit in federal court.15 The district
court ruled against her and Murphy appealed to the D.C. Circuit.16 In
her complaint, Murphy first claimed that she was entitled to a refund
under § 104(a)(2) of the Code because her award compensated for
physical injuries, and thus should have been excluded from gross
income.17 Murphy alternatively claimed that § 104(a)(2) was
unconstitutional as applied to her award because her damages were
compensatory and thus not “income” within the meaning of the
Sixteenth Amendment.18 The court rejected Murphy’s first claim on the
merits.19 Their ruling on her second claim is the basis for this article.
In her second claim, Murphy argued that her award was neither a
gain nor an accession to wealth, but instead a return of “human capital”
and thus not income.20 According to this human capital theory, “a
damage award for personal injuries—including nonphysical injuries—is
not income but simply return of capital—‘human capital.’”21 Murphy
cited to the Supreme Court’s decision in Commissioner v. Glenshaw
Glass Co., a 1918 Attorney General Opinion (“1918 Opinion”), a 1918
revenue ruling (“1918 Ruling”), and a House Report on the Revenue Act
of 1918 (“1918 House Report”) in support of her argument.22 In
Glenshaw Glass, the Court recognized the “long history of . . . holding
personal injury recoveries nontaxable on the theory that they roughly
correspond to a return of capital” when it distinguished punitive
damages from compensatory damages as a source of taxable income.23
Similarly, the 1918 Opinion stated that proceeds from an accident
insurance policy are capital, as distinguished from income, because they
“merely take the place of capital in human ability which was destroyed
by the accident.”24 The 1918 Ruling made the same conclusion with
respect to damages or settlement awards received for accident injuries.25
The 1918 House Report also expressed doubt as to whether
compensatory damages would be required to be included in gross
income.26 Murphy argued that compensatory damages of this sort were
commonly understood to be excluded from income at the time the
Sixteenth Amendment was ratified.27
The Government responded with several arguments. First, it
invoked the presumption that “Congress enacts laws within its
constitutional limits.”28 Second, it asserted that Congress could, at its
discretion, repeal § 104(a)(2) in its entirety and constitutionally tax all
compensatory damages.29 Third, it argued that the Court’s discussion of
“human capital” in footnote eight of Glenshaw Glass referred only to a
since-abandoned congressional policy.30 Finally, they dismissed
Murphy’s “human capital” argument as a flawed analogy to financial
capital or property because the latter items have a “basis,” from which
income is calculated as “the excess of the amount realized therefrom
over the adjusted basis.”31 Unlike property, the Government contended,
22. Id. at 85-86 (citing Comm’r v. Glenshaw Glass Co., 348 U.S. 426 (1955); 31
Op. Att’y. Gen. 304 (1918); T.D. 2747, 20 Treas. Dec. Int. Rev. 457 (1918); H.R. Rep.
No. 65-767 (1918)).
23. Id. at 85 (citing Glenshaw Glass Co., 348 U.S. at 432 n.8).
24. Id. at 86 (citing 31 Op. Att’y. Gen. at 308).
25. Id. at 86.
26. Id. at 86 (citing H.R. Rep. No. 65-767, at 9-10).
27. Id. at 86.
30. Id. at 86-87.
31. Id. (citing I.R.C. § 1001(a)).
“people do not pay cash or its equivalent to acquire their well being,
[thus] they have no basis in it for measuring a gain (or loss) upon the
realization of compensatory damages.”32
B. The D.C. Circuit’s Decision
The D.C. Circuit ruled in Murphy’s favor and awarded her a refund
of her tax payment, plus applicable interest.33 The court held that “[t]he
Sixteenth Amendment simply does not authorize the Congress to tax as
incomes every sort of revenue a taxpayer may receive.”34 While the
court did concede that “the Supreme Court has broadly construed the
phrase ‘gross income,’” the court noted that the Supreme Court also “has
made plain that the power to tax incomes extends only to ‘gains’ or
‘accessions to wealth.’”35
The court first applied the Supreme Court’s analysis in O’Gilvie v.
United States,36 and considered “whether the taxpayer’s award of
compensatory damages is ‘a substitute for [a] normally untaxed personal
. . . quality, good, or ‘asset.’”37 The court reasoned that Murphy’s
emotional well-being and good reputation were not taxable as income;
therefore, compensatory damages for their loss likewise could not be
considered income.38 Thus, the court held that “the Sixteenth
Amendment does not empower the Congress to tax her award.”39
The D.C. Circuit next applied the Supreme Court’s approach in
Merchant’s Loan & Trust Co. v. Smietanka,40 and examined the original
understanding of “income” at the time the Sixteenth Amendment was
adopted.41 Although the court did not rely on the 1918 House Report, it
agreed with Murphy that the 1918 Opinion and the 1918 Ruling
indicated that incomes did not include “monies received solely in
compensation for a personal injury and unrelated to lost wages or
earnings.”42 The court noted a number of nonphysical injuries for which
compensatory damages were available under state tort law as support for
the conclusion that they were “not regarded differently than was
compensation for injuries and, therefore, not considered income” by
those who ratified the Sixteenth Amendment.43 Then, in a conclusion
that was nothing short of astonishing, the D.C. Circuit concluded:
In sum, every indication is that damages received solely in
compensation for a personal injury are not income within the
meaning of that term in the Sixteenth Amendment. First, as
compensation for the loss of a personal attribute, such as well-being
or a good reputation, the damages are not received in lieu of income.
Second, the framers of the Sixteenth Amendment would not have
understood compensation for a personal injury—including a
nonphysical injury—to be income. Therefore, we hold § 104(a)(2)
unconstitutional insofar as it permits the taxation of an award of
damages for mental distress and loss of reputation.44
Murphy is the first decision to strike down a tax statute as
unconstitutional in over 80 years.45 The decision has generated as much
controversy as can be expected from a milestone of this magnitude and
has captured the attention of both tax professionals and the public at
large. Reaction from tax professionals and academics has been
overwhelmingly negative. Tax professors and constitutional law
professors united (in what would be an unlikely alliance under any other
circumstance) to denounce the opinion as “flawed,” “odd,” “bizarre,”
and “horrible.”46 Tax professionals fear that the decision will give
renewed inspiration to “tax protestors,” while legal scholars caution
about the risks of increased judicial scrutiny of Congress’s power to
43. Id. at 91.
44. Id. at 92 (emphasis added).
45. See supra note 1.
46. See Paul Caron, Tax Profs Weigh in on Murphy in Tax Notes (Sept. 5, 2006),
available at http://taxprof.typepad.com/taxprof_blog/2006/09/tax_profs_weigh.html;
see also Caron, supra note 3.
tax.47 Personal injury lawyers, by contrast, have applauded the court’s
ruling,48 and at least one economist has suggested that its rationale
applies with equal force to the risk-free rate of interest.49
The reaction to Murphy should not be surprising. Courts have
traditionally deferred to legislatures’ exercise of the power of taxation,
and the legal community has both accepted and defended this practice.
Courts justify this deference not only on the basis of the need for tax
revenue to enable a functioning government, but also on the basis of the
Court’s broader practice of legislative deference with respect to
Tax legislation, however, can be distinguished from other economic
legislation in a number of ways. Generally, regulatory economic
legislation is designed to set basic “ground rules” for, and ensure a level
playing field among, those who voluntarily participate in the object of
the regulation.51 Tax legislation, by contrast, draws hundreds of
distinctions among otherwise similarly situated taxpayers according to
varied and specific criteria.52 Tax legislation also implicates a number
of personal rights that the Court has held to be fundamental in other
contexts, such as marriage, family, the right to work and property.53 In
this context, it is far from intuitive why courts should afford legislators
more deference to define “income” than to define “speech,” “due
process,” or “cruel and unusual.”54
The next part of this article will analyze Murphy in the context of
Congress’s power to tax, as well as Supreme Court precedent
interpreting this power. As discussed in detail below, the D.C. Circuit
ultimately took the wrong road, but arrived at the right place. Critics are
right to call attention to the flaws in the decision; however, these flaws
are not the real cause of the controversy. Court decisions do not attract
widespread and sustained assault simply for holding a statute
inapplicable to one specific type of compensatory damage award. The
controversy surrounding Murphy is the result of one sentence: “The
Sixteenth Amendment simply does not authorize the Congress to tax as
‘incomes’ every sort of revenue a taxpayer may receive.”55 The
controversy surrounding Murphy exists because although courts have
long recognized the truth in this proposition,56 few courts have acted to
52. For example, § 1 classifies tax liability according to income amount (5 tax
brackets) and filing status (4 classifications). I.R.C. § 1. Eligibility for certain
adjustments to gross income are determined by gross income thresholds, and
exemptions and itemized deductions are available only where adjusted gross income is
below a stipulated amount and phases out when adjusted gross income exceeds a
stipulated amount. See discussion infra notes 183-84.
53. See, e.g., Meyer v. Nebraska, 262 U.S. 390 (1923); see also Loving v. Virginia,
388 U.S. 1 (1967); see also Moore v. East Cleveland, 431 U.S. 494 (1977).
54. U.S. CONST. amends. I, V, VIII, XIV and XVI.
55. See Murphy v. IRS, 460 F.3d 79, 87 (D.C. Cir. 2006) (emphasis added).
56. See discussion infra Part II.D.
57. See supra notes 1, 4 and 50.
II. MURPHY, TAXATION & THE “ACCESSION TO WEALTH RULE”
A. Analysis: The Wrong Road to the Right Place
1. The Wrong Road
a. Constitutional Interpretation
The D.C. Circuit traced Congress’s taxation power to the Sixteenth
Amendment; however, the Constitution expressly grants Congress the
authority to tax in Article I,58 subject to two constraints. Article I, § 8
requires that all indirect taxes “be uniform throughout the United
States.”59 Article I, § 9 requires Congress to apportion direct taxes
among the states according to population as determined by a census.60
The Sixteenth Amendment did not grant Congress any new power;
it merely removed the apportionment requirement with respect to one
object of taxation—incomes.61 This much is plain from the text of the
amendment: “The Congress shall have the power to lay and collect taxes
on incomes, from whatever source derived, without apportionment
among the several states, and without regard to any census or
This fact is not a minor technical point. States ratified the Sixteenth
Amendment in direct response to a Supreme Court decision that struck
down a federal income tax act as an unconstitutional direct tax.63 The
distinction between direct and indirect taxes, though largely academic
today, must be understood in this historical context. The Supreme Court
has interpreted “direct tax” to mean a tax levied directly on property
because of its ownership and “indirect tax” as a tax “not levied directly
on property because of its ownership, but rather on its use.”64 Thus, as a
general rule, indirect taxes include taxes imposed on activity, such as
consumption, the exercise of a privilege, or some other transaction,
while direct taxes are taxes imposed on persons or property.65
The Court struck down the Tariff Act of 1894 (the “Act”) in
Pollock v. Farmer’s Loan and Trust Co. on the basis of these
definitions.66 In Pollock I, the Court reasoned that apportionment, by
operation, produced inequalities among the states and thus “must be held
to have been contemplated, and was manifestly designed to operate to
restrain the exercise of the power of direct taxation to extraordinary
emergencies, and to prevent an attack upon accumulated property by
mere force of numbers.”67 Stating that Congress cannot be allowed to
accomplish indirectly what it cannot do directly, the Court concluded
that a tax on income from property was not “so intrinsically different
from a tax on [the property] itself as belonging to a wholly different
class of taxes,” and therefore must be apportioned among the states.68
Prior to Pollock I, income taxes were generally regarded as indirect
excise taxes.69 To the extent that Pollock I held otherwise, its holding
rested squarely on the basis of the underlying source of the income.70
Indeed, when considering the constitutionality of the remainder of the
Act upon rehearing, the Court was careful to state:
We have considered the act only in respect of the tax on income
derived from real estate, and from invested personal property, and
have not commented on so much of it as bears on gains or profits
from business, privileges, or employments [sic], in view of the
instances in which taxation on business, privileges, or employments
has assumed the guise of an excise tax and has been sustained as
The Court did not hold that Congress could not tax incomes, nor did
it in any way limit the scope of incomes that Congress could tax.72
Pollock I simply held that certain incomes must be taxed in a certain
way.73 It is clear from the opinion that, if it wished, Congress could
have levied an apportioned direct tax on incomes derived from property.
To the extent that the Court considered the definition of income at all, it
was only in the context of considering the Act’s definition of income as
applied to property.74
States ratified the Sixteenth Amendment specifically to release
Congress from the obligation of classifying incomes by source and
providing for apportionment where necessary.75 The Amendment did
not alter Congress’s power with the phrase “Congress shall have the
power to lay and collect taxes on incomes,” but with the words “from
whatever source derived, without apportionment among the several
States, and without regard to any census or enumeration.”76
The D.C. Circuit erred in Murphy because a statute could not
possibly violate an enabling amendment that serves to remove a
limitation upon what is otherwise plenary authority under Article I.77 It
is impossible to hold that Murphy’s award was not income as defined by
71. Id. at 635.
72. Brushaber, 240 U.S. at 16-17.
74. Pollock v. Farmers’ Loan & Trust Co. (Pollock I), 157 U.S. 429, 583 (1895).
75. Brushaber, 240 U.S. at 18. There, the Supreme Court reasoned that
the [Sixteenth] Amendment was drawn for the purpose of doing away for the future
with the principle upon which the Pollock Case was decided, that is, of determining
whether a tax on income was direct not by a consideration of the burden placed on the
taxed income upon which it directly operated, but by taking into view the burden
which resulted on the property from which the income was derived, since in express
terms the Amendment provides that income taxes, from whatever source the income
may be derived, shall not be subject to the regulation of apportionment.
76. U.S. CONST. amend. XVI.
77. Prior to the Sixteenth Amendment (but after Pollock I), Congress could have
chosen to enact apportioned taxes on incomes from property. The Sixteenth
Amendment served only to remove that constraint. To the extent that the award is
capital or property, it may still be subject to taxation under Article I, § 9. Therefore, to
the extent that the taxation of Murphy’s award violated any constitutional provision, it
violated Article I, § 9.
the Sixteenth Amendment because the Sixteenth Amendment makes no
attempt to define income. The Sixteenth Amendment is relevant only to
the extent that if Murphy’s award was in fact income, then Congress had
plenary authority to tax it under Article I. Consequently, the court had
three options in Murphy: (1) decide whether the award was income
subject to income tax, (2) hold the award to be property subject only to
apportioned direct taxes, or (3) sustain the tax as an excise tax on the
entire amount of the award, regardless of whether it was income.78
b. Statutory Construction
The court also erred in its interpretation of § 104(a)(2) of the
Code79 and its construction of that section’s relationship to § 61(a).80
Section 104(a)(2) does not, as the court stated, “make [Murphy’s] award
taxable as income.”81 Rather, § 104(a)(2) fails to exclude Murphy’s
award from taxable income.82 Absent another statutory exclusion, the
proper inquiry should focus on whether § 61(a) includes the award in
Section 61(a) defines “gross income” as “all income from whatever
source derived, including (but not limited to) [15 enumerated
sources].”84 The Supreme Court has interpreted this section to extend to
“all gains,” from whatever source derived, “except those specifically
exempted.”85 It follows then, that courts should first consider whether a
specific exclusion applies to a particular receipt, and if it finds no such
exclusion, consider whether the amount in question is in fact a “gain . . .
78. The court was correct to choose the first option. See discussion infra notes
79. I.R.C. § 104(a)(2).
80. Id. § 61(a).
81. See Murphy v. IRS, 460 F.3d 79, 85 (D.C. Cir. 2006).
82. I.R.C. § 104(a) states that for purposes of § 104(a)(2), emotional distress shall
not be treated as a physical injury or sickness, except to the extent of medical expenses
attributable to emotional distress. This text in effect renders unnecessary an inquiry
into whether the amounts spent are actually income. It does not justify the conclusion
that the remainder of such awards are in fact income.
83. See Comm’r v. Banks, 543 U.S. 426, 433 (2005) (“The definition [of gross
income] extends broadly to all economic gains not otherwise exempted.”).
84. I.R.C. § 61(a).
85. Comm’r v. Glenshaw Glass Co., 348 U.S. 426, 430 (1955); accord Banks, 543
U.S. at 433.
derived from any source whatever.”86
Neither § 104(a)(2) nor any other exclusionary statute specifically
provides for the exclusion of Murphy’s award. This fact alone,
however, fails to affirmatively establish that the award is actually
income. The absence of an exclusionary statute only establishes that
compensatory damage awards are a source of income for the purpose of
calculating gross income.87 It does not necessitate a conclusion that the
award is in fact income to the taxpayer. Such a conclusion could only
be the result of an analysis of the nature, characteristics, and
circumstances giving rise to the award.
The D.C. Circuit should have held that Murphy was not required to
include the award as gross income under § 61(a). Alternatively, because
such awards fall within the scope of sources from which gross income
could be derived, the court also could have held that Murphy was
required to report “0” as the amount of income attributable to her award.
There was no need, however, for the court to declare § 104(a)(2)
unconstitutional for failing to stipulate certain exclusions, but not
others,88 particularly when the court was able to arrive at the same result
simply by applying the language of the statute to the facts at issue.
c. Glenshaw Glass, Not O’Gilvie or Merchant’s
The D.C. Circuit’s mistaken interpretation of the Sixteenth
Amendment could be set aside as a point more important to
constitutional scholars than to the outcome of the case. Even the court’s
striking of § 104(a)(2) “as applied” to Murphy’s award could stand on
the basis that the section would still apply to the theoretically
conceivable yet practically impossible instance where a court awards a
taxpayer compensatory damages for nonphysical injuries that exceed the
value of the actual injury.89 The D.C. Circuit erred more seriously,
86. Glenshaw Glass Co., 348 U.S. at 429.
87. See discussion infra notes 186-91 and accompanying text.
88. In Moritz v. Commissioner, 469 F.2d 466, 470 (10th Cir. 1972), the Tenth
Circuit held that eligibility for a dependent care deduction (I.R.C. § 214(a))
impermissibly discriminated on the basis of gender. Instead of holding § 214(a)
unconstitutional, the court expanded the eligibility for the deduction to include both
89. “Damages for personal injury are by definition compensatory only.” Glenshaw
Glass Co., 348 U.S. at 432 n.11. As a matter of law, compensatory damages will
always equal the value of the injury, resulting in no gain to the injured party. Any
excess damages would be punitive.
however, when it mistakenly applied the Supreme Court’s decisions in
O’Gilvie v. United States90 and Merchants’ Loan & Trust Co. v.
Smietanka91 instead of the rule set forth in Commissioner v. Glenshaw
O’Gilvie was a case about statutory interpretation, not a case about
the definition of income.93 The question at issue in O’Gilvie was
whether the prior version of § 104(a)(2), which excluded the “amount of
any damages . . . on account of personal injuries or sickness,” excluded
punitive as well as compensatory damages through the use of the phrase
“on account of.”94 The issue in O’Gilvie was not whether Congress
could tax punitive damages as income—that issue was decided over
forty years earlier in Glenshaw Glass.95 The issue was whether the
ambiguous language of the statute actually excluded punitive damages.96
The Court considered whether the damages were “a substitute for [a]
normally untaxed personal . . . quality, good, or ‘asset’” only to the
extent that it was indicative of congressional intent.97 In Murphy,
Congress’s intent to tax compensatory damages for nonphysical injuries
was clear—the issue before the court was whether Congress could.
Though the “substitute” analysis applied in O’Gilvie can be
indicative of whether an item is “income,” it is not determinative.
Congress can, and does, choose not to tax certain forms of income as a
matter of public policy.98 Similarly, the Court has never given
significant weight to whether an item is historically untaxed in deciding
whether or not it is income. To the contrary, the Court in Glenshaw
Glass expressly dismissed the argument that punitive damages were not
taxable because they were not taxed in prior versions of the Code.99
The “substitute” analysis would require not only the exclusion of
other compensation payments that would be “accessions to wealth”
under Glenshaw Glass, but would also exclude other items currently
taxed under the Code. For example, suppose a company purchased a
building for $600,000. Now suppose that five years later, when the
building had a fair market value of $700,000, it was destroyed due to a
contractor’s negligence. The company recovers $700,000 from the
contractor. Even though a building is an asset normally untaxed by
Congress, the taxpayer has realized a gain of $100,000.100 While this
gain is properly taxed as income under § 170 of the Code,101 the
O’Gilvie analysis would dictate the opposite result.
Furthermore, the court’s reliance on original understanding is
unnecessary. Although the court cited Merchants’ Bank as authoritative,
courts have since emphasized plain meaning in its interpretations of tax
laws.102 “Income” is a limited concept with certain characteristics that
have been consistently recognized, similar to “property” and
“contracts.”103 Moreover, while the Court did look to original
understanding in O’Gilvie, it did so only to determine the legislative
intent of a statute, not for guidance on the definition of income.104
d. No Accession to Wealth
The D.C. Circuit should have resolved Murphy through a
straightforward application of Glenshaw Glass. In Glenshaw Glass, the
Court addressed whether income from a particular source is taxable.105
The definition of income was not at issue, as the Court recognized the
100. See William A. Klein et al., Federal Income Taxation, 140 (13th ed. 2003).
101. See I.R.C. § 170(h)(2).
102. See Glenshaw Glass Co., 348 U.S. at 432; see also Helvering v. Edison Bros.
Stores, Inc., 133 F.2d 575, 579 (8th Cir. 1943) (“The meaning of the word ‘income’ in
the Sixteenth Amendment and the acts of Congress pursuant [thereto] is that given it in
common speech and every day usage.”).
103. See discussion infra notes 116-17 and 130-31.
104. See supra notes 93-103 and accompanying text.
105. 348 U.S. at 430. Punitive damages were not specifically enumerated, and the
Court was interpreting the effect of the “catchall provision” of § 22(a) (the predecessor
statute to § 61(a)). Id. The Court explained “we cannot but ascribe content to the
catchall provision of § 22(a), ‘gains or profits and income derived from any source
whatever.’ The importance of that phrase has been too [sic] frequently recognized since
its first appearance in the Revenue Act of 1913 to say now that it adds nothing to the
meaning of ‘gross income.’” Id.
award was (1) an accession to wealth, (2) clearly realized, and (3) one
over which the recipient exercised complete dominion.106 The Court has
since consistently defined income in the context of these three
elements.107 Murphy presented a different issue: the parties contested
the award’s classification as income, not whether the award was a
source of taxable income. Still, an examination of Murphy’s award in
the context of the Court’s definition of income in Glenshaw Glass
suggests that the D.C. Circuit was correct in holding that the award was
Realization and dominion were not at issue in Murphy; the record is
clear that both elements were satisfied.108 The decisive issue was
whether Murphy’s award was in fact an “accession to wealth.” The
Government argued that Murphy’s entire award was an accession to
wealth, while Murphy argued that no part of the award met that
Unfortunately, the Supreme Court has not provided clear guidance
on how to determine whether an amount is an “accession to wealth,” as
each subsequent case turned on its own set of facts.110 As a result, each
party in Murphy had to articulate its points in terms of existing tax
concepts, resulting in awkward arguments on both sides. Murphy’s
claim rested on the notion of “human capital,” a notion discussed in
dicta but never completely adopted by either Congress or the Court.111
The Government argued that human beings have a “zero basis” in their
well-being and that taxpayers are not permitted to depreciate
Not surprisingly, awkward arguments resulted in an awkward
opinion. Without accepting Murphy’s “human capital argument,” the
court held that the purpose of Murphy’s award was to restore her to the
“status quo ante,” e.g., the economic equivalent of her position prior to
106. Id. at 431. The Court thus adopted a broader definition of income than it had
previously applied in Eisner v. Macomber, 252 U.S. 189, 207 (1920) (defining income
as “the gain derived from capital, from labor, or from both combined”).
107. See, e.g., Comm’r v. Banks, 543 U.S. 426 (2005), discussed infra notes 125-29;
see also Comm’r v. Kowalski, 434 U.S. 77, 83 (1977).
108. See Murphy v. IRS, 460 F.3d 79, 81 (D.C. Cir. 2006).
109. Id. at 85-88.
110. The “substitute” analysis from O’Gilvie would be helpful here as the results
would often be similar, but from a doctrinal perspective, that approach has flaws for the
reasons discussed supra notes 98-100.
111. See Murphy, 460 F.3d at 85.
112. See id. at 87.
her injury, and thus the award was neither a “gain” nor an “accession to
wealth.”113 While the court’s decision was intuitively correct, the fact
that its opinion was not written in conventional tax terminology
provided the basis for a substantial amount of criticism.114
B. A Rule for Determining an “Accession to Wealth”
Murphy demonstrates the need for the Supreme Court to provide
clear guidance on how to distinguish “accessions to wealth” from the
broader category of receipts. This distinction is necessary because the
Supreme Court has recognized that “income” is not simply a label that
Congress may apply to any item it wishes to tax. As Murphy correctly
noted, “Congress cannot make a thing income which is not so in fact.”115
It is currently unclear what facts courts should consider when
determining whether there has been an “accession to wealth” under
Glenshaw Glass. Should courts examine the receipt of the award, in
isolation, as the Government suggested in Murphy or should courts look
to events as a whole, and consider amounts in the context of the events
that resulted in their receipt? Are courts constrained only to those
principles recognized in the Code or should courts also consider the
inherent characteristics of the alleged taxable event?
The Supreme Court has consistently recognized an event or
transaction as a gain or an accession to wealth where the total accretion
of wealth to the taxpayer attributable to a transaction or event exceeds
the diminution of wealth the taxpayer incurred from such transaction or
event.116 This interpretation, referred to throughout the remainder of this
article as the “accession to wealth rule” (or, “the rule”), applied within
the Glenshaw Glass framework, justifies early precedents involving
punitive damages, windfalls, and treasure troves, as well as the
exclusion of compensatory damages, returns of capital, and stock
dividends, and is consistent with the Code’s existing notion of basis.117
113. See id. at 88.
114. See discussion supra notes 3 and 46.
115. Murphy, 460 F.3d at 87.
116. In this context, the O’Gilvie analysis is helpful in separating the gain from what
would normally go untaxed. Thus, in the example in Part A, supra, the $100,000 gain
would be separated from the cost of the untaxed house destroyed, which would be
consistent with recognizing no gain attributable to compensating Murphy for her
untaxed well-being and reputation.
117. Indeed, the denial of a recognition of a “net gain” concept would require a
C. The Accession to Wealth Rule in the Context of
Supreme Court Precedent
In Glenshaw Glass, both awards at issue were accessions to wealth
because the accretions and diminutions of wealth were presumed, as a
matter of law, when the trial court awarded the respondents
compensation for lost profits.118 The court’s punishment of the
offending parties, by contrast, did not in any way diminish the victims’
wealth.119 Consequently, the accretion of the victims’ wealth
attributable to punitive damages exceeded the victims’ diminution of
wealth by the entire amount of the award. It was clear from the record
that the victims each realized and exercised dominion over these awards,
so the Court properly deemed the damages to be income.
The rule also justifies the exclusion of stock dividends in Eisner v.
Macomber because although there was an accession to wealth over
which shareholders exercised complete dominion, the shareholders did
not realize these dividends.120 In that case, there would have been an
accession to wealth to the shareholder due to the increase in the value of
the net assets of the underlying corporation. This much would be true
whether Standard Oil issued a stock dividend or no dividend
whatsoever.121 Each shareholder exercised complete dominion over its
curious interpretation of Glenshaw Glass—that wherever receipt of an amount results in
any accession to wealth to the recipient, the entire amount received would be taxable
regardless of the actual amount of the accession to wealth by the recipient. Such an
interpretation would be inconsistent with prior decisions distinguishing receipts from
incomes, particularly Stewart Dry Goods Co. v. Lewis, discussed infra, notes 138-47.
118. Compensatory damages for lost profits are calculated by assuming, as a matter
of law, that business operations prevented by the events giving rise to plaintiff’s claim
had, in fact, occurred. Therefore, courts construct sales (accretions of wealth) and costs
(diminutions of wealth) and award the lost profit (the accession to wealth). Even
though these damages are “compensatory,” they compensate for an accession to wealth,
and are rightly taxable. The determination of lost profits in Glenshaw Glass is
discussed at length in the lower court opinions. See Comm’r v. Glenshaw Glass Co.,
211 F.2d 928 (3d Cir. 1954); see also Glenshaw Glass Co. v. Comm’r, 18 T.C. 860
119. See Comm’r v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955); see also supra
notes 93-101 and accompanying text.
120. 252 U.S. 189, 208-12 (1920).
121. See id. at 211-12. The shareholder’s wealth would increase by the incremental
increase in value of the corporation’s assets as represented by that shareholder’s shares,
regardless of whether the corporation retains this value or distributes it as a dividend.
shares by virtue of their ownership,122 yet did not realize this accession
to wealth, because, as the Court stated, the “essential and controlling fact
is that the stockholder has received nothing out of the company’s assets
for his separate use and benefit.”123 The Court then added that “[f]ar
from being a realization of profits . . . [stock dividends] tend rather to
postpone such realization.”124
At first glance, the Court’s holding in Commissioner v. Banks
seems inconsistent with the accession to wealth rule.125 In Banks, the
taxpayers received punitive damages and excluded from gross income
the portion of the award paid as contingency fees to their attorneys.126
The taxpayers argued that they never exercised complete dominion over
the portion of the award paid as contingency fees, and the Court ruled
against them by applying the anticipatory assignment of income
doctrine.127 The taxpayers did not challenge the inclusion of the entire
award as an accession to wealth nor did they argue that the denial of a
deduction for legal fees was inequitable. In an amicus brief, the
Association of Trial Lawyers of America argued that the fees should be
subtracted as a capital expense from the disposition of personal
property.128 This argument bears similarities to arguments challenging
the amount of an accession to wealth, but the Court declined to consider
the argument because it was the first time the argument was presented in
the case and it had not been examined by the Court of Appeals.129
D. A Tax on Net Income
This is not to say that courts should apply the accession to wealth
rule in every case where a taxpayer claims a payment is not income, but
only to say that courts should ensure that Congress levies the income tax
122. See id. at 208-09.
123. Id. at 211.
125. 543 U.S. 426 (2005). Banks is the Court’s most recent occasion to consider the
issue of income in the context of Glenshaw Glass.
126. Id. at 429-32.
127. Id. at 434-38.
128. Id. at 437.
129. Id. at 438. Had the taxpayers in Banks challenged the inclusion by claiming
that portion was not an “accession to wealth,” the Court may not even have reached the
issues decided in Banks, because if there was no accession to wealth in the first place,
there would have been no need to consider whether the taxpayers exercised complete
dominion over the award or if the taxpayers’ income had been assigned.
on incomes and not receipts. Courts have long ago recognized that
Congress implemented the income tax to “carry out a broad basic policy
of taxing net, not gross income,”130 and the “term ‘[i]ncome’ as used in
the Revenue Acts includes only gain or profit as a basis for income
taxation and they exclude gross receipts or gross income as such a
basis.”131 Where a taxpayer claims an amount is not income and
Congress has prescribed a method to derive income from revenues,132
then, barring any constitutional infirmity,133 courts need only determine
whether the prescribed method is correctly applied.134 Courts should
apply the accession to wealth rule, however, in cases like Murphy, where
it is unclear whether an amount is revenue or income and Congress is
silent on how to make the distinction.
This practice would not turn judges into tax law activists. To the
contrary, courts have given legislatures a substantial degree of latitude in
how they exercise their taxing power as well as how they design tax
policy.135 Courts place no limitations on the items Congress may tax.
Courts routinely support how Congress imposes taxes.136 Congress has
plenary power to impose excise taxes on revenues if it wishes.137 It is
not activism to ensure that Congress actually taxes income when it
purports to do so.
In 1935, the Supreme Court decided Stewart Dry Goods Co. v.
Lewis, a case involving the state of Kentucky’s graduated tax on gross
sales receipts.138 The tax rate on sales increased by three-twentieths of
one percent for each additional $100,000 of sales volume.139 The Court
struck down the tax as a violation of due process, holding the tax to be
“unjustifiably unequal, whimsical, and arbitrary . . . .”140 The Court’s
underlying rationale in Stewart was based on two key principles. First, a
graduated tax on gross sales imposed an incremental tax on volume, and
arbitrarily imposed increasing taxes on identical transactions solely
because one was performed “more often [sic] than the other.”141 The
second principle was that a graduated tax on gross sales, unlike a
graduated tax on income, did not bear a rational relation to a taxpayer’s
ability to pay.142 The Court expressly distinguished sales from income,
and graduated taxes on each, because “[a]n income levy by its very
nature assures equality of treatment, because the burden of the exaction
varies with increase or decrease of return on capital invested and with
the comparative success or failure of the enterprise.”143 Ability to pay
was determined from profitability—by accounting for the business’s
costs and management decisions.144 Prior to this decision, the Court had
consistently upheld progressive taxes based upon wealth or the ability to
pay.145 The Court expressly rejected Kentucky’s argument that gross
sales were an acceptable proxy for income or ability to pay, as well as
the argument that administrative convenience justified this simpler
method.146 Thus, the Court held that graduated taxes on receipts are
unjustified when marginal receipts are a function of increasing
140. Id. at 557.
141. Id. at 566 (“It exacts from two persons different amounts for the privilege of
doing exactly similar acts because the one has performed the act oftener than the
142. Id. at 558.
143. Id. at 560.
145. See Magoun v. Ill. Trust & Sav. Bank, 170 U.S. 283 (1898) (upholding a
progressive tax based on the value of the estate); see also Knowlton v. Moore, 178 U.S.
41, 109 (1900) (upholding a similar inheritance tax against a uniformity clause
challenge); see also Brushaber v. Union Pac. R.R. Co., 240 U.S. 1, 24-25 (1916)
(upholding the progressive rate structure of a federal income tax statute).
146. Stewart Dry Goods Co., 294 U.S. at 560 (“If the commonwealth desires to tax
incomes, it must take the trouble equitably to distribute the burden of the impost. Gross
inequalities may not be ignored for the sake of ease of collection.”); see also id. at 563
(“The record fails to show that an income tax or a flat tax on sales would not
accomplish the desired end.”).
147. Id. at 565-66; see also Valentine v. Great Atl. & Pac. Tea Co., 299 U.S. 32
(1936) (invalidating an Iowa gross sales tax, citing Stewart); In re Williams, 1995 U.S.
Dist. LEXIS 16222 at 23 (discussing Stewart when distinguishing a gross receipts tax
E. The Right Place: Murphy Revisited
A straightforward application of the accession to wealth rule within
the framework of Glenshaw Glass illustrates why the D.C. Circuit
decided Murphy correctly. Murphy’s award caused her wealth to
accrete by $70,000 in compensation for nonphysical injuries.148 An
administrative law judge determined that these same nonphysical
injuries diminished her wealth by $70,000.149 Her accession to wealth
from these injuries, therefore, was $0.
The Government’s “basis” argument misses the point. At its core,
“basis” is nothing more than the mechanism chosen by Congress to
measure the cost of property.150 This mechanism serves two functions:
(1) it measures taxpayers’ gains, and (2) it ensures that Congress does
not overstep its constitutional bounds and tax underlying property.151
Depreciation, depletion and amortization are simply statutory
from a gains tax). Compare N.Y. Rapid Transit Corp. v. City of N.Y., 303 U.S. 573,
583 (1938) (upholding a fixed-rate gross receipts tax).
148. Murphy v. IRS, 460 F.3d 79, 81 (D.C. Cir. 2006).
150. I.R.C. § 1012 provides that “the basis of property shall be the cost of such
property, except as otherwise provided . . . .” The Code defines property as “tangible
items.” Treas. Reg. § 1.61-6(a) (1986).
151. See discussion supra note 68. Some argue that the primary purpose of basis is
to ensure that the same dollars should not be taxed to the same taxpayer more than once.
See Deborah A. Geier, Murphy and the Evolution of “Basis,” 113 TAX NOTES 576, 578
(Nov. 6, 2006). While basis does generally operate so as to prevent the taxation of
previously taxed dollars, in Murphy’s case such previous taxation of her well-being
could not constitutionally occur without apportionment as either a direct or capitation
tax. If, as the Court discussed in O’Gilvie, Congress can tax a substitute payment in the
same way manner as it could the original, why would constraints that protect the
original not extend to the substitute? See discussion supra note 97. If the sole purpose
of basis is to further a congressional policy, then there is no reason why Congress could
not do away with the notion of basis entirely and impose an income tax on, for example,
the entire amount of a purchase price received by a seller of property. It is unclear why
such a tax would not be a direct tax imposed upon the value of the seller’s property,
simply deferred until such property is sold. Indeed, if such deferred direct taxes are
constitutionally permissible, then it is not clear why it was necessary for the Supreme
Court to recast inheritance taxes as excise taxes levied on the beneficiaries’ right to
receive an inheritance, as opposed to the owner’s right to devise. Furthermore, if a
parallel rationale applies that would enable Congress to levy an excise tax on a property
owner’s right to sell his or her property, then it is hard to see why it was necessary to
adopt the 16th Amendment in the first place.
innovations to apply this mechanism over a period of time.152 Basis is
not a constitutional requirement, but merely the method Congress chose
to measure particular costs. It does not follow that basis is the only way
to measure costs, nor does it follow that costs to which the concept of
basis does not extend should not be measured. In Murphy’s case, the
costs of her loss were valued at trial, where the judge determined she
had suffered harm in the amount of $70,000.153
Because Congress’s power to tax is plenary and extends far beyond
the power to tax incomes, Congress could tax Murphy’s award whether
or not it was income, as the IRS argued.154 As stated above, the court
had three options: (1) analyze whether the award was income subject to
income tax, (2) hold the award to be property subject only to
apportioned direct taxes, or (3) sustain the tax as an excise tax on the
entire amount of the award. Although the court chose the first option, it
is worth briefly discussing the other two.
First, had the court accepted Murphy’s “human capital” argument,
the award would operate as a restoration of capital.155 As such, a tax on
the award would be an unapportioned direct tax, and consequently fail
for that defect.156 Second, Congress could clearly levy an excise tax on
the “right” to receive compensatory damages, as it has done with respect
to inheritances in Magoun.157 However, courts should be wary of
converting tax statutes suffering from constitutional defect into other
“legitimate” taxes.158 While the Supreme Court has stated that the
152. I.R.C. § 1016 provides for “adjustments to basis”—a method by which a
taxpayer can “recover” the cost of property over its useful life. Depreciation,
amortization and depletion are conventions by which the taxpayer recovers the costs of
property against the income the property produces. At the time of disposition, the
adjusted basis of property is substantially below cost (possibly zero) and the taxpayer
will pay tax on a larger (possibly the entire) amount of gain. However, since the cost is
recovered over the life of its use, the Code ensures that the value of the property itself is
accounted for at some point, and thus not taxed. See, e.g., I.R.C. §§ 167-69, 197 and
153. See Murphy, 460 F.3d at 81.
154. See id. at 86.
155. See discussion supra notes 20-21, 58-68.
156. See discussion supra notes 58-68.
157. See discussion supra note 65.
158. See Gould v. Gould, 245 U.S. 151, 153 (1917). In Gould, the Court held:
In the interpretation of statutes levying taxes it is the established rule not to extend
their provisions, by implication, beyond the clear import of the language used, or to
enlarge their operations so as to embrace matters not specifically pointed out. In case
of doubt they are construed most strongly against the government, and in favor of the
Sixteenth Amendment operated so as to bring all income taxes within
the category of indirect taxes,159 it has also recognized that income taxes
are distinct from other forms of excise taxes.160
If the court held that a defective income tax converted into a valid
excise tax by default, several issues would arise. First, the court would
have to determine what rate the tax would impose. Would the court
impose a judicially determined rate? If so, they would violate the
separation of powers. If not, would the court apply the Code’s
graduated rate structure to the award? Second, if courts apply the
Code’s graduated rates, would these rates apply to the award in isolation
or at the marginal rate of the recipient’s last dollar of taxable income?
The absence of a statute authorizing a different excise tax would either
result in a judicially-imposed tax or make the tax impossible to
administer and arbitrary in operation.
A. Is Murphy Really a Tax Protestor’s Dream Come True?
After Murphy was decided, tax experts predicted the decision
would give new inspiration to “tax protestors”—taxpayers who
challenge (usually pro se) the government’s power to tax wages based
on a variety of long discredited constitutional theories, one of which
happens to be a variation of the “human capital” theory.161 Tax
protestors have made three general arguments based on this theory, none
of which are any stronger after Murphy.
The first argument is that wages and labor are a “like kind
exchange” from which neither the wage earner nor the employer
recognize a gain. Tax exemptions for such exchanges are predicated
upon an exchange of property of similar classification.162 This argument
fails for two reasons. First, labor is not “property” as defined in Treas.
Reg. § 1.61-6.163 Second, even if labor were property, an exchange of
159. See Brushaber v. Union Pac. R.R. Co., 240 U.S. 1, 19 (1916) (stating that the
Sixteenth Amendment’s effect was to prevent taking “an income tax out of the class of
excises, duties and imposts and place it in the class of direct taxes”).
160. See supra notes 138-47 and accompanying text.
161. See, e.g., Yuen v. United States, 290 F. Supp. 2d 1220 (D. Nev. 2003).
162. I.R.C. § 1031(a)(1).
163. See supra note 150.
labor for money would not qualify as an exchange of “property of like
kind which is to be held either for productive use in a trade or business
or for investment.”164
The second tax protestor argument is that labor is human capital;
therefore, the payment of wages for this labor constitutes a non-taxable
return of capital.165 This argument fails because a taxpayer’s labor is not
capital, human or otherwise, for much the same reason a stock dividend
was not income in Eisner v. Macomber. Assuming that labor is the
result of an investment in human capital (one’s person), labor is severed
from the employee when provided to the employer, while the person
remains intact and undiminished after his labor is complete.166 Murphy
in no way alters the responses to these arguments.
Another related argument of tax protestors is that no gain is realized
upon the payment of wages because wages represent the fair market
value of the labor the employee provided.167 This argument is equally
frivolous as a matter of law, as the Code is clear that gains are calculated
on the basis of cost, not fair market value at the time of exchange.168
According to this rationale, no business would ever recognize gains
from the sale of goods, as the very act of purchase is prima facie
evidence of fair market value.169 However, by rejecting the claim that
no amount of wages received constitutes gain, does it necessarily follow
that the entire amount of wages received is gain?
164. I.R.C. § 1031(a)(1) (emphasis added).
165. See Parker v. Comm’r, 724 F.2d 469 (5th Cir. 1984).
166. Compare Eisner v. Macomber, 252 U.S. 189, 212 (1920) (holding that stock
dividends were not income because no separate property or capital was severed from
the corporation and distributed to the shareholder).
167. See Lonsdale v. Comm’r, 661 F.2d 71, 72 (5th Cir. 1981) (appellants arguing
that “the exchange of services for money is a zero-sum transaction, the value of the
wages being exactly that of the labor exchanged for them and hence containing no
element of profit”); see also Davis v. United States, 742 F.2d 171, 172 (5th Cir. 1984)
(taxpayer arguing “that an individual receives no taxable gain from the exchange of
labor for money because the wages received are offset by an equal amount of ‘costs of
168. I.R.C. § 1012. Treas. Reg. § 1.1012-1(a) defines “cost” as “the amount paid for
such property in cash or other property.” Thus, the cost basis of property may be the
fair market value of property surrendered in the exchange, but not the property received.
169. Rational actors acting at arm’s-length usually transact at fair market value in
the conduct of their daily affairs.
B. Wages in the Context of Glenshaw Glass
The Code distinguishes a taxpayer’s gross income (the taxpayer’s
aggregate amount of income received in a given period) from its taxable
income (the amount of income the government taxes).170 The Code
provides for this distinction through a statutory framework that generally
operates as follows:
Less: Adjustments to Gross Income
= Adjusted Gross Income171
Adjusted Gross Income
Less: Standard or Itemized Deduction(s)
Less: Personal and Dependency Exemptions
= Taxable Income172
This statutory framework is generally faithful to the historical
notion of income as net income (as well as the principles set forth in
Glenshaw Glass and the proposed accession to wealth rule) with respect
to property or business operations. Consequently, taxpayers include
only the gain from sales of property in gross income.173 For example,
the Code uses basis to determine gains from transactions in property.174
Taxpayers calculate this amount on Schedule D and report this result as
gross income on Form 1040.175 Similarly, gross income derived from
business is defined as “total sales, less the cost of goods sold, plus any
income from investments and from incidental operations or outside
operations or sources.”176 Thus, business owners subtract both the basis
of property sold, as well as an “expenditure basis” in the form of
“ordinary and necessary” business expenses such as salaries, taxes paid
170. I.R.C. §§ 62-63.
171. Id. § 62.
172. Id. § 63.
173. I.R.C. § 61(a) (“[G]ross income means . . . gains derived from dealings in
174. Treas. Reg. § 1.61-6 (“gain is the excess of the amount realized over the
unrecovered cost or other basis for the property sold or exchanged”).
175. Form 1040 (“U.S. Individual Income Tax Return”) is the form most individual
taxpayers use to report their income tax liability. Gains and losses calculated on
Schedule D (“Capital Gains and Losses”) are reported on Form 1040, line 13.
176. Treas. Reg. § 1.61-3.
and travel expenses.177 They calculate their net income on Schedule C
and report this result as gross income on Form 1040.178 Similar methods
are stipulated for rental and royalty income.179 Each of these methods
ensures that taxpayers report gains, and not aggregate receipts, from
There is no analogous statutory provision for wages and
compensation for services. Taxpayers earning wages report the entire
amount of earned wages as gross income, despite the fact that they may
not receive the entire amount.180 The Code does not allow wage earners
to subtract the costs of earning those wages to arrive at “gross income
from wages,” despite the fact that these costs can be substantial.181
Payroll taxes, state and local income taxes, and travel expenses are all
costs that employees incur as a result of their employment, and these
expenses would certainly qualify as ordinary and necessary business
expenses under § 162.182 Yet the Code expressly prohibits a deduction
for payroll taxes and commuting expenses, and allows deductions for
state and local taxes only as itemized deductions.183 Any taxpayer may
elect to itemize their deductions, but these deductions may ultimately be
disallowed by operation of phase-outs or the Alternative Minimum
Tax.184 The Code also assigns no value to the labor the wage earner
177. I.R.C. § 162 (“There shall be allowed as a deduction all the ordinary and
necessary expenses paid or incurred during the taxable year in carrying on any trade or
business . . . .”).
178. Schedule C (“Profit or Loss From Business”), reported on Form 1040, line 12.
179. Schedule E (“Supplemental Income and Loss”), reported on Form 1040, line
180. Form 1040, line 7.
181. For example, the Federal Insurance Contributions Act (“FICA”) imposes
payroll taxes at a rate of 7.65% of gross wages (6.2% for Social Security taxes, and
1.45% for Medicare taxes). I.R.C. § 3101.
182. I.R.C. § 162. Payroll taxes paid by employers pursuant to I.R.C. § 3111 are
deductible under this section. See Kornhauser v. United States, 276 U.S. 145 (1928)
(holding that where a matter relating to business ordinarily and necessarily requires
expenditure, it is an ‘ordinary and necessary’ expense of that business”).
183. I.R.C. §§ 164, 275. These deductions would be “above the line” for taxpayers
operating a trade or business, and not subject to any limitation, see infra note 184, and
taxpayers could still take either the standard or itemized deduction. Taxpayers earning
wages, however, could only take these deductions if their aggregate itemized deductions
exceed the standard deduction
($5,150 for unmarried individuals in 2006)
, and are
subject to limitations. I.R.C. § 63.
184. Personal exemption amounts are reduced when a taxpayer’s adjusted gross
income exceeds $100,000 (if unmarried) or $150,000 (if married and filing a joint
provided. Thus, employees who work 75 hours are deemed to provide
the same value of labor to their employers—$0—as those who work 40
The income tax thus operates upon wage earners in a manner
contrary to its original purpose, not only as recognized by the Supreme
Court, but also as expressed by the language of § 61(a), its authorizing
statute. Section 61(a) is ultimately a source statute. It embodies “the
full measure of [Congress’s] taxing power,” and has been deemed
“coextensive with” (and therefore given the same interpretation as) the
Sixteenth Amendment, and thus establishes sources of income, not
Section 61(a) states, with respect to wages, “gross income means all
income from whatever source derived, including (but not limited to) . . .
compensation for services . . . .”187 If the purpose of the sentence was to
define what constitutes gross income, as opposed to where it is to be
found, it would read as follows: “gross income means all income, from
whatever source derived, including (but not limited to) . . . compensation
for services . . . .” The word “including” would instead modify
“income,” not “source,” and the phrase “from whatever source derived”
would be nothing more than an appositive phrase evincing Congress’s
acknowledgement of the fact that gross income may be found in other
sources not listed therein. As written, however, the word “including”
must be taken to modify “source,” and thus interpreted as Congress
expressing its intent to tax income regardless of where it is found. This
interpretation is consistent with the Court’s interpretation of the
Predecessor statutes to § 61(a) support this reading. Section 22(a)
of the Internal Revenue Code of 1939, for example, stated “‘Gross
income’ includes gains, profits, and income derived from salaries,
wages, or compensation for personal service . . . of whatever kind and in
whatever form paid, or from professions, vocations, trades, businesses,
return). See I.R.C. § 151. Itemized deductions generally are phased-out when adjusted
gross income exceeds $150,500. See I.R.C. § 68(a) and (b). In calculating Alternative
Minimum Tax liability, deductions for state and local taxes are disallowed. See I.R.C.
185. See discussion infra notes 204-05.
186. See Helvering v. Clifford, 309 U.S. 331, 334 (1940); see also discussion supra
notes 75 and 76.
187. I.R.C. § 61.
188. See generally Brushaber v. Union Pac. R.R. Co., 240 U.S. 1 (1916).
commerce, or sales, or dealings in property, whether real or personal,
growing out of the ownership or use of or interest in such property; also
from interest, rent, dividends, securities, or the transaction of any
business carried on for gain or profit, or gains or profits and income
derived from any source whatever. . . .”189 The placement of “income”
in this sentence, after the terms “gains” and “profits,” justifies
interpreting the word consistent with its definition as a gain, as opposed
to its broader definition of “inflows” or “receipts.”190 Furthermore, the
Tariff Act of 1894 provided for the exclusion of costs incurred when
paying taxes on wages.191
These statutes and the Court’s statements together illustrate the
historical understanding that the amount of wages that constitutes
income to a wage earner is less than the full amount of wages he actually
earns. So why is it that Congress never made provisions for employees
to adjust for the costs they incur when earning their income? The
Revenue Act of 1913 imposed a tax of 1% on income exceeding the first
$3,000 of taxable income ($4,000 if married).192 At the time, this
amount excluded 98% of workers.193 Congress could have realistically
determined that such a provision was unnecessary based on the
improbability that the costs incurred would exceed that amount.194
Moreover, the personal income tax evolved over time to encompass a
variety of personal deductions and exemptions unrelated to income, such
as deductions for the mortgage interest paid on a primary residence,
college tuition, interest on student loans, retirement savings and medical
expenses. It could be argued that these deductions have the effect of
accounting for the costs of earning wages.195
189. I.R.C. § 22(a); see also Comm’r v. Glenshaw Glass Co., 348 U.S. 426, 429
190. According to the rule of noscitur a sociis, a canon of interpretation meaning “a
word is known by the company it keeps.” See generally Jarecki v. G. D. Searle & Co.,
367 U.S. 303, 307 (1961). Congress did not change the definition’s application to
wages with subsequent textual changes to the definition of gross income, because, as
the Court acknowledged in Glenshaw Glass, Congress did not intend to alter the scope
of “gross income” in any way when it altered the language of the statute. See Glenshaw
Glass Co., 348 U.S. at 432.
191. See Pollock v. Farmers’ Loan & Trust Co., 157 U.S. 429, 429 n.1 (1895).
192. See Brushaber, 240 U.S. at 23.
193. See Deborah A. Geier, Integrating the Tax Burdens of the Federal Income and
Payroll Taxes on Labor Income, 22 VA. TAX REV. 1, 15 n.40 (2002).
194. See supra note 50 and accompanying text.
195. I.R.C. §§ 62(a)(6)-(20), 163(h)(3), and 213.
While each of these justifications may have been true at some point,
none are true today. With the exception of the standard deduction, there
is no single exemption amount available to all wage earners. The
current amount of the standard deduction does not have the effect of
exempting reasonably conceivable costs, as the amount is less than the
statutory cap on payroll taxes.196 Personal exemptions and itemized
deductions “phase out” after a certain adjusted gross income is
exceeded.197 Moreover, these are personal deductions—a product of
legislative policy designed to ease burdens on taxpayers unrelated to the
cost of producing income.198 Finally, deductions are a matter of
“legislative grace.”199 Congress is bound by few constitutional
constraints when determining eligibility of deductions, and can grant or
disallow them on the basis of almost any condition.200
C. The Accession to Wealth Rule Applied:
How Much of Wages are Income?
When an employee earns its salary, its wealth accretes by the
amount of the salary earned. However, the employee’s wealth
196. The standard deduction for single taxpayers in 2006 is $5,150. I.R.C. § 63.
FICA imposes a payroll tax of 7.65% on the first $94,200 of wages ($7,206.30). I.R.C.
197. I.R.C. §§ 68 and 151.
198. See General Explanation of the Tax Reform Act of 1986, H.R. Rep. No.
993838, at 8-10 (Conf. Rep.). The Joint Committee report reveals that the overriding
goals for these deductions were simplicity and progressivity:
Significant increases in the standard deduction and modifications to certain personal
deductions provide further simplicity by greatly reducing the number of taxpayers
who will itemize their deductions. . . . The Act retains the most widely utilized
itemized deductions, including deductions for home mortgage interest, state and local
income taxes, real estate and personal property taxes, charitable contributions,
casualty and theft losses, and medical expenses (above an increased floor). . . . In
addition to ensuring that high-income taxpayers pay their share of the Federal tax
burden, the Act provides tax relief to low-and middle-income wage earners. To
achieve this goal, the Act substantially increases the standard deduction (the prior-law
zero bracket amount) and almost doubles the personal exemption . . . to ensure that no
families below the poverty level will have Federal income tax liability.
199. See New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934).
200. See Comm’r v. Nat’l Alfalfa Dehydrating & Milling Co., 417 U.S. 134, 148-49
(1974) (“The propriety of a deduction does not turn upon general equitable
considerations, such as a demonstration of effective economic and practical
diminishes by the amount of payroll, state and local income taxes
assessed on this salary, as well as other expenses “ordinary and
necessary” to earning this salary, such as commuting expenses.201 Thus,
under the accession to wealth rule, the amount of gain that should be
reported as gross income is the amount by which the employee’s salary
exceeds these costs. Congress should adopt provisions to recognize an
“expenditure basis” in these costs and ensure that it taxes wages in parity
with other sources of income.
Assuming the entire amount of wages are receipts and not income,
Congress can, and does, tax these receipts through the imposition of
excise taxes.202 The FICA tax, for example, is an excise tax on the first
$94,200 of wage receipts.203 Why, then, should Congress provide for
the determination of wage income from wage receipts in light of this
excise tax alternative? For two reasons: (1) the income tax’s graduated
rate structure, and (2) the Alternative Minimum Tax and phase-out of
1. Graduated Structure of Income Tax Rates
This Court’s rationale in Stewart is theoretically applicable to wage
earners.204 A merchant’s sale of a good to a customer is economically
indistinguishable from an employee’s “sale” of labor to his employer.
Volume factors into calculating employee wages in a number of ways:
hourly rates, commissions on sales, or bonuses calculated on the basis of
working in excess of a fixed number of hours or number of deals closed
in a year.
Consider the following example. Two employees, A and B, each
earn $10 per hour. A state law imposes a 10% tax on the first $300 of
wages, and a 20% tax on the next $300 of wages. In week 1, A works
20 hours and B works 30 hours. A earns $200 and pays $20 in taxes,
201. An argument can be made that wealth does not diminish because the state
provides services in exchange for taxes paid. While taxpayers may enjoy such benefits,
they do not necessarily have an enforceable right to them vested to the extent that they
should be considered an “accession to wealth.” See generally, Calvin R. Massey,
Takings and Progressive Rate Taxation, 20 HARV. J.L. & PUB. POL’Y 85 (1996).
202. See discussion supra notes 69-71, 181 and 196.
203. I.R.C. § 3101. The taxable amount of wages is schedule to increase to $97,500
for 2007. See “History of the OASDI contribution and benefit base,” available at
http://www.ssa.gov/OACT/COLA/cbb.html; see also supra notes 181 and 196.
204. See supra notes 138-47 and accompanying text.
while B earns $300 and pays $30 in taxes. In week 2, A and B each
work an additional 10 hours—30 and 40 respectively. A earns $300 and
pays $30 in taxes. B earns $400, but pays $50 in taxes. While A and B
each pay a $1 tax on their 30th hour of labor, B pays a $2 tax on his 31st
hour. B pays an additional 10% tax on each additional hour worked,
essentially, according to Stewart, for engaging in a work hour “more
often” than A—with no recognition of the incremental costs B incurs by
working that additional hour.205
Consequently, the Court’s rationale in Stewart could theoretically
limit Congress to assessing a uniform tax rate on wage receipts
calculated on the basis of volume. Where employees are paid a salary,
however, Congress would still be free to impose a progressive rate
excise tax, as clearly indicated in Magoun and Knowlton.206 Congress
would thus need to establish a method to distinguish volume-based
wages, yet should also anticipate a significant shift away from salaries to
some type of volume-based wage structure.
2. Deductions, Exemptions, Phase-Outs and the Alternative Minimum Tax
The Court’s decision in Stewart carried few implications for wages
when the Court decided the case, as income tax exemptions were large
enough at the time to compensate for the costs employees incurred.207
The current Code likewise provides for numerous deductions and
205. See Stewart Dry Goods Co. v. Lewis, 294 U.S. 550, 566 (1935). Volume also
distorts income calculations if A and B earn different hourly rates. For example, if A
earned $15 per hour and B earned $10, each would pay $30 in taxes on $300 of wages,
despite the fact that B had to work 10 additional hours for the additional $100.
206. See discussion supra notes 65 and 145.
207. See Geier, supra note 193, at 24.
In 1939 (and, indeed, through 1949), the combined employer and employee Social
Security tax was two percent (one percent each), which was imposed on wages up to
$3,000. Because of the generous personal exemptions under the income tax—$2,500
for married couples and $1,000 for single taxpayers, along with $400 for each
dependent, at a time when few households earned as much each year—the
twopercent payroll tax was the only tax paid by the vast majority of lower- and
Id. This contrasts sharply with 2004, where only 17.2% of taxpayers earning wages
earned less than $10,000, and the standard deduction and personal exemptions were
$4,850 and $3,100, respectively. See IRS Statistics of Income Tax Stats, Individual
Income Tax Returns Publication 1304 (Complete Report) (2004), available at
exemptions from income.208 Some could argue that these provisions
also function as an approximate209 calculation of income from receipts,
to which a few observations are available in response. First, while there
are personal and dependency exemptions available to taxpayers, these
amounts are far lower in proportion to wages than those of 1935, and do
not have the same compensating effect.210 Second, the deductions and
exemptions currently available are mostly for personal expenditures.211
Certain deductions that would be considered wage expenditures are
allowable, but only as itemized deductions.212 Third, to the extent
deductions and exemptions are available, they are denied to many wage
earners due to limitations such as phase-outs and the Alternative
Minimum Tax.213 Itemized deductions are also subject to certain
limitations.214 Since adjusted gross income is calculated before
subtracting itemized deductions, phase-outs deny many wage earners the
ability to deduct the wage expenditures that the Code actually allows.
Furthermore, whereas other taxpayers’ adjusted gross income reflects
their net income, eligibility for permitted deductions is determined by
wage earners’ gross receipts.215 Both structural inequities are especially
acute where adjusted gross income thresholds are exceeded because of
an increased volume of labor.216 Finally, the Alternative Minimum Tax,
a parallel mandatory maximum tax system, disallows deductions for
wage expenditures when calculating alternative minimum taxable
208. See supra note 195 and accompanying text.
209. See, e.g., Stewart Dry Goods Co., 294 U.S. at 559-60 (Kentucky asserting that
a gross receipts tax was a “rough and ready method of taxing gains” and a “less
complicated and more convenient [method] of administration than an income tax”).
210. See discussion supra note 193; compare Geier, supra note 193, at 24 (reporting
that by 1939, only about 5% of the population paid income taxes), with Individual
Income Tax Returns Publication 1304, supra note 207 (publishing that in 2004, the IRS
reported receiving 132.2 million tax returns, 67.9% of which paid income taxes).
211. See discussion supra note 195 and accompanying text.
212. See discussion supra notes 183-84.
213. See discussion supra note 184.
214. Medical expenses are deductible only to the extent they exceed 7.5% of
adjusted gross income. I.R.C. § 213. Other miscellaneous itemized deductions are
subject to a 2% floor. I.R.C. § 67.
215. See discussion supra notes 180-85.
216. See discussion supra notes 204-05.
217. I.R.C. § 56(b).
IV. A PROPOSAL FOR A WAGE EXPENDITURE BASIS
The preceding sections discussed why it is entirely proper for courts
to play a role in interpreting tax laws and identified current issues with
respect to wages in the context of Supreme Court precedent. The
discussion above demonstrates that tax laws should recognize and adjust
for some form of wage expenditure; however, it is Congress, and not the
courts, that must ultimately address how to recognize such a provision.
This Part proposes the adoption of a “wage expenditure basis,” a concept
that balances the notion of equity for wage earners with established
federal policies and administrative convenience.
A. The Wage Expenditure Basis
As discussed in Part II, basis is the mechanism by which the Code
measures the costs of property.218 The Code also incorporates an
“expenditure basis” for taxpayers who operate a trade or business to
deduct from their gross receipts.219 This expenditure basis includes
salary expenses, taxes, fees, rents, travel and other costs unrelated to
property.220 A wage expenditure basis would operate in a similar
fashion, i.e., a separate schedule on which wage earners calculate their
“gross income from wages” from their “wage receipts.”
The wage expenditure basis would be calculated by the following
BBwe = [P + T + (Emw * 92.35%)]
= Wage expenditure basis;
= Payroll taxes withheld;
= State and local income taxes withheld; and
= Minimum wage equivalent.
See discussion supra notes 173-75.
See discussion supra notes 176-78.
See discussion supra notes 177 and 182.
Gross income from wages would then be calculated as follows:
Iw = Wa – Bwe
= Gross income from wages;
= Aggregate wage receipts; and
= Wage expenditure basis.
Payroll taxes and income taxes each qualify as expenses “ordinary
and necessary . . . in carrying on any trade or business.”221 The costs to
employees for these items increase in direct proportion to the amount of
wages earned. The Code, however, expressly disallows deductions for
employee payroll taxes,222 and state and local taxes are available only as
itemized deductions.223 The wage expenditure basis recognizes these
significant costs to all employees without imposing an additional
administrative burden on the government. These items are each reported
on Form W-2, which is available to both employees and tax
authorities.224 While each employee taxpayer’s state and local tax
liability may vary from the amounts actually withheld from wages, these
taxpayers can include refunds as income and deduct additional payments
on the subsequent year’s wage expenditure basis schedule.225
2. The Minimum Wage Equivalent
The minimum wage equivalent concept allows Congress to assign a
base value to the employee taxpayer’s labor, recognize variations in the
amount of time worked, and account for other miscellaneous costs of
labor in an administratively convenient way. The federal minimum
wage represents Congress’s determination of the amount of income
221. See discussion supra notes 177 and 182.
222. I.R.C. § 275.
223. I.R.C. § 164.
224. Employers send end of year W-2 forms to their employees as well as to the IRS
and state tax authorities.
225. Such an approach would be consistent with current practice. State and local
income tax refunds are includible in gross income in the year received under the Tax
Benefit Rule. See I.R.C. § 111.
necessary to maintain “the minimum standard of living necessary for the
health, efficiency, and general-well-being of workers.”226 Congress thus
frustrates its labor policy through its tax policy by imposing income
taxes on employees who earn the minimum wage. By providing a
deduction on the basis of the minimum wage the employee would have
earned for the work performed, the Code would truly embody a policy
of taxing “gains” derived from labor, while Congress would move
further toward its stated goal of ensuring a minimum standard of living
for low-income workers by exempting minimum wage earners from
The minimum wage equivalent is also administratively convenient.
Congress could reasonably conclude, for example, that when it sets the
minimum wage rate, it takes into account the various incidental costs of
earning wages, such as commuting and meals. The minimum wage
equivalent thus operates as a “catch-all” exclusion, eliminating the need
to provide a detailed itemization of varied miscellaneous costs, and
ensuring simplicity for taxpayers and tax agencies alike.
Furthermore, the minimum wage equivalent eliminates the bias
against taxpayers who earn higher wages by working longer hours.
Employees who are compensated on the basis of volume would deduct a
minimum wage equivalent calculated on such basis. Without adjusting
for quantity of work, an employee who works 30 hours a week yet earns
less per hour could pay higher income taxes than an employee who
works 20 hours per week yet earns more per hour.228 With the minimum
wage equivalent, the employee working 30 hours per week and paid
hourly subtracts a larger minimum wage equivalent than the employee
226. Fair Labor Standards Act, 29 U.S.C. § 202 [hereinafter “FLSA”]. A number of
states have minimum wage laws requiring higher compensation than that of FLSA. See
Minimum Wage Laws in the States—January 1, 2007, http://www.dol.gov/esa/minwage
/america.htm. Congress could allow a deduction for these amounts, thus deferring to
state determinations of minimum standards of living, or it could use the federal
minimum wage for the sake of simplicity. The same administrative convenience also
makes a federal minimum wage equivalent more advantageous than unemployment
compensation, which also varies by state. Unemployment compensation may be more
doctrinally “pure” to the extent that it represents value that accrues to a wage earner
who does not engage in any labor, and any wages in excess of this amount would be—
literally—“gains from labor.”
227. By imposing taxes only on the gains that accrue to taxpayers after providing for
“minimum living standards.” See 29 U.S.C. § 202.
228. See example supra note 205.
working 20 hours per week, and their tax liability adjusts accordingly.229
Employees paid a salary, by contrast, could deduct the equivalent of 40
hours per week, the standard workweek under the FLSA.230
Minimum wage earners also currently pay payroll taxes of 7.65%
under FICA.231 The wage expenditure basis formula adjusts the
minimum wage equivalent to 92.35% of the minimum wage payable
because the entire amount of payroll taxes withheld is also excluded.232
3. The Impact of the Wage Expenditure Basis
The wage expenditure basis adjusts wages for the costs employees
incur in earning them. This concept is consistent with the accession to
wealth rule because employees’ wealth increases by their net wages.
Tax withholdings, for instance, are neither realized nor subject to an
employee’s complete dominion, as understood within the context of
Glenshaw Glass. The minimum wage equivalent, though possibly
greater than the costs some employees would incur, strikes the
appropriate balance between the equity in recognizing these costs and
the need to minimize the administrative burden in so doing.
Congress could adopt the wage expenditure basis with minimal
impact on the statutory framework of the Code. Ultimately, the wage
229. The minimum wage equivalent would allow each earner to subtract their wage
expenditure basis and report only their “gains” from wages as gross income. Thus, in
the example in note 205, supra, A and B’s minimum wage equivalent would be $95.12
and $142.68, respectively. Their gross income from wages would be $181.93 and
$134.37, respectively. For a similar reason, the minimum wage equivalent concept
would also alleviate the inequity of the marriage penalty, the repeal of which is
scheduled to expire in 2010. In two-earner families, the second earner’s first dollar of
income is taxed at the marginal tax rate of the first earner’s last dollar of income. The
minimum wage equivalent could also obviate the need for personal exemptions for each
worker, while continuing to allow for dependency exemptions, which could still be
phased-out for high-income workers.
230. Employees with a portion of their compensation calculated on the basis of time,
such as bonuses in excess of a minimum hour threshold, could also deduct the hourly
equivalent of their work since there would be evidence provided by employers of hours
231. See supra note 181.
232. These adjustments thus continue Congress’s policy of disallowing “double
deductions.” See I.R.C. § 62 (“Nothing in this section shall permit the same item to be
deducted more than once.”). State and local income taxes did not significantly affect
this percentage, and thus were excluded from the minimum wage equivalent
expenditure basis would: (1) require a new schedule similar to Schedule
C or Schedule E, (2) add two new exclusions from income—payroll
taxes and the minimum wage equivalent, and (3) reclassify the itemized
deductions for state and local income taxes as an exclusion on this new
schedule. The wage expenditure basis would make the Code far more
progressive and Congress could also offset the cost of correcting these
structural inequities by adjusting marginal tax rates accordingly.233
Congress would also be free to continue its practice of allowing
additional personal deductions both above and below the line to support
worthwhile public policies, subject to the same adjusted gross income
ceilings, phase-outs and inclusions under the Alternative Minimum Tax.
Each increase in the minimum wage would carry greater economic
effect, as workers would receive each additional dollar tax-free. Finally,
each minimum wage increase would also operate as an income tax
reduction, and Congress would no longer “stand on both sides” of the
transaction by voting itself more tax revenue with each additional
increase in the minimum wage.234
As of this writing, it is not yet known how Murphy will finally be
resolved. The original panel’s decision to vacate and rehear the case is
just one of many unexpected developments in Ms. Murphy’s long quest
for her refund. This unusual move places the panel in an interesting
position. The panel can reaffirm a controversial and widely criticized
decision, strengthened by a more comprehensive constitutional analysis
233. Taxpayers earning less than $10,712 would not need to file at all (assuming a
minimum wage of $5.15, a 40-hour week and a 52-week year).
234. The current proposal to raise the minimum wage to $7.25 would, if passed,
reduce each taxpayer’s taxable income by an average $4,368 (based on a 40-hour week
and a 52-week year) using the minimum wage equivalent. When Congress raises the
minimum wage, it is requiring third parties—employers—to increase the amount of
wages paid to employees. Congress directly benefits from increased income and
payroll tax revenue. The structural design of the minimum wage equivalent eliminates
this benefit. Under analogous circumstances in corporate law, when a corporation’s
board of directors engages in self-dealing, courts review such transactions under a more
stringent standard. See Sinclair Oil Corp. v. Levien, 280 A.2d 717, 720 (Del. 1971)
(applying the test of intrinsic fairness to a self-dealing transaction); see also Weinberger
v. UOP, Inc., 457 A.2d 701 (Del. 1983) (“When directors of a . . . corporation are on
both sides of a transaction, they are required to demonstrate their utmost good faith and
the most scrupulous inherent fairness of the bargain.”).
and free of the original opinion’s mistakes. In so doing, the panel risks
reversal either en banc or by the Supreme Court. Alternatively, the
panel could reverse itself, avoiding the controversy and criticism, yet
risking public perception that the panel is vulnerable to both. The
unpredictable history of this case undermines the utility of predictions; I
will note only that the panel could have achieved the latter result without
risking the negative consequences by allowing the case to proceed en
banc. The panel will hear oral arguments on April 23, 2007.
Whatever the ultimate outcome, the D.C. Circuit provided a public
service by reminding Congress of the difference between receipts and
income. Courts do not often have the opportunity to make this
distinction, but they have recognized it, and Murphy will hopefully serve
to remind legislatures of their obligation to do so as well. Going
forward, Congress should ensure that the Internal Revenue Code taxes
gains, not receipts.
Where the Code may have at one time taxed wages at a level where
the distinction between revenues and income was largely an academic
question, today the distinction is very real to taxpayers. Congress now
taxes a greater proportion of wage earners as well as a larger proportion
of the wages they earn. At the same time, wage earners bear increasing
costs of employment. The wage expenditure basis proposed in this
article seeks to resolve the disparity between the taxation of wages and
the taxation of other forms of income, and succeeds in a way that is
faithful to the notions of equity, progressivity and simplicity.
47. See Tom Herman, Court Ruling in Damages Case Deals Big Setback to the IRS, WALL ST . J., Aug . 30 , 2006 , at D2; see also Peter Lattman, Bombshell Tax Decision From D.C. Circuit (Aug . 24, 2006 ), available at http://blogs.wsj.com /law/2006/08/24/bombshell-tax -decision-from-dc-circuit/; see also Caron, supra notes 3 and 46 .
48. See Robert W. Wood , Tax-Free Damages : Murphy's Law Opens Floodgates (Sept. 4 , 2006 ), available at: http://www.rothcpa.com/archives/002117.php# 002117 .
49. See Bruce Bartlett , What Can the Government Tax? (Aug. 30 , 2006 ), available at http://www.woodporter.com/pdf/TN090406.pdf.
50. See , e.g., United States v . Carlton , 512 U.S. 26 ( 1994 ) (holding that retroactive federal estate tax legislation was neither illegitimate nor so arbitrary as to violate the Due Process Clause of the Fifth Amendment); see also Nordlinger v . Hahn , 505 U.S. 1 ( 1992 ) (declaring that tax classifications need only rationally further a legitimate state interest, so long as there is any plausible policy reason for the classification); see also Madden v . Kentucky , 309 U.S. 83 , 88 ( 1940 ) (“the presumption of constitutionality can be overcome only by the most explicit demonstration that a classification is a hostile and oppressive discrimination against particular persons and classes”); see also Brushaber v . Union Pac. R.R. Co ., 240 U.S. 1 , 24 ( 1916 ). In Brushaber, the Supreme Court held that a constitutional violation is warranted only where although there was a seeming exercise of the taxing power, the act complained of was so arbitrary as to constrain to the conclusion that it was not the exertion of taxation but a confiscation of property, that is, a taking of the same in violation of the Fifth Amendment, or, what is equivalent thereto, was so wanting in basis for classification as to produce such a gross and patent inequality as to inevitably lead to the same conclusion . Brushaber , 240 U.S. at 24.
51. See , e.g., 29 U.S.C. §§ 201 - 219 ( 2000 ) (“The Fair Labor Standards Act”); see also 15 U .S.C. § § 78a- nn ( 2000 ) (“The Securities Exchange Act” ).
58. U.S. CONST. art. I, § 8. This power is plenary, as the Court has recognized that Congress's power to tax is “exhaustive and embraces every conceivable power of taxation [that it] has never been questioned, or if it has, has been so often authoritatively declared as to render it necessary only to state the doctrine .” Brushaber v. Union Pac. R.R. Co ., 240 U.S. 1 , 12 ( 1916 ).
59. U.S. CONST. art. I, § 8 , cl . 1.
60. U.S. CONST. art. I, § 9 , cl . 4.
61. See Brushaber, 240 U.S. at 18.
62. U.S. CONST. amend. XVI.
63. Pollock v. Farmers' Loan & Trust Co. (Pollock I) , 157 U.S. 429 ( 1895 ).
64. Brushaber , 240 U.S. at 14 ( emphasis added) (discussing Pollock I).
65. Prior to the Sixteenth Amendment, courts strained to classify taxes as indirect . In Magoun v. Illinois Trust and Savings Bank , 170 U.S. 283 ( 1898 ), the Court held that an inheritance tax was a tax on succession-a beneficiary's right to receive propertyrather than as a direct tax on the decedent's estate itself . See also Knowlton v. Moore , 178 U.S. 41 ( 1900 ). In Hylton v. United States , 3 U.S. 171 ( 1796 ), the Court held that a federal tax on carriages was an excise tax on the carriage owners' operations (the “conveyance of persons”), and not a direct tax on the ownership of the carriages themselves .
66. Pollock I , 157 U.S. at 583.
67. Id .
68. Id . at 581.
69. Brushaber , 240 U.S. at 15.
70. See Pollock v. Farmers' Loan & Trust Co. (Pollock II) , 158 U.S. 601 , 633 - 36 ( 1895 ). Upon rehearing, the Court considered whether the remainder of the Tariff Act of 1894 was constitutional after the Court invalidated the provisions taxing income from property in Pollock I. Id. The Court held that Congress could not have intended for the burden of the tax to fall on labor and occupations, and struck the remainder of the act . Id. at 637.
90. 519 U.S. 79 ( 1996 ).
91. 255 U.S. 509 ( 1921 ).
92. 348 U.S. at 431.
93. See O'Gilvie , 519 U.S. at 81.
94. Id .
95. See Glenshaw Glass Co., 348 U.S. at 432-33.
96. See O'Gilvie , 519 U.S. at 81.
97. Id . at 86-87.
98. For example, in Gould v. Gould , 245 U.S. 151 ( 1917 ), the Supreme Court held that alimony payments made to a wife are taxable to the husband. Currently, the Code allows a taxpayer to exclude payments for a spouse and requires the payee spouse to include the payments in gross income . See I.R.C. §§ 71 , 215 .
99. See Glenshaw Glass Co., 348 U.S. at 431-32; see also Cent. Ill. Pub. Serv. Co. v. United States , 435 U.S. 21 , 25 ( 1978 ) (holding that the fact that item is not subject to withholding does not mean that it is not gross income).
130. Tank Truck Rentals v . Comm'r , 356 U.S. 30 , 33 ( 1958 ) (internal citations omitted); see also McDonald v . Comm'r , 323 U.S. 57 , 66 ( 1944 ).
131. St . Paul Fire & Marine Ins . Co. v. Reynolds, 44 F. Supp . 863 , 865 (D. Minn . 1942 ).
132. See discussion infra, notes 173- 79 .
133. See , e.g., Eisner v . Macomber , 252 U.S. 189 , 218 ( 1920 ) (although the income tax statute prescribed a way to calculate the gain from a stock dividend, the Court held that stock dividends were not income ).
134. See supra notes 125-29 and accompanying text.
135. See discussion supra notes 4 and 50.
136. See discussion supra note 50.
137. See discussion supra notes 58-77.
138. 294 U.S. 550 ( 1935 ).
139. Id . at 554. The tax rate on gross sales was 0 .05% on the first $ 400 ,000 of gross sales, 0 .10% on the next $ 100 , 000 of gross sales, and then increased by 0.15% for each additional $100,000 of gross sales not exceeding an aggregate of $1 , 000 , 000 . The statute assessed a 1% tax rate on gross sales in excess of $1,000,000 . III. MURPHY & WAGES: NO, THE SKY IS NOT FALLING