A federal appeals court ruling this week offers a rare opportunity to loosen the stranglehold the IRS has on our income. In its ruling, the court agreed with a woman who argued that a settlement she received for emotional distress should be considered tax exempt because it was not income as defined in the 16th Amendment to the Constitution. Traditionally, insurance claims and awards for physical injury have been tax exempt because they do not add to a person’s income—they simply make a person whole after a loss.
This is important because, for the reams upon reams of paperwork that make up the tax code, there is no formal definition of income. The term has been defined differently at different times, and the IRS in practice believes that all income can be taxed. With this ruling, the appeals court has stated that there is a constitutional limit to what can be taxed. If taken to its logical conclusion, the case can be made that interest cannot be taxed, because as some economists state, interest is merely compensation for loss of not being able to enjoy a portion of money immediately.
The IRS and the federal government are sure to fight this one as hard as they can, but it opens up a debate that is long overdue.
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