Aug. 23 (Bloomberg) -- A federal appeals court decision that cited the Constitution to bar the government from taxing some types of damage awards may encourage challenges to other sections of U.S. tax law, legal experts said.

The U.S. Court of Appeals for the D.C. Circuit in Washington ruled yesterday the government can't collect taxes on damage awards for non-physical compensatory damages such as emotional distress or injury to reputation. The court struck down as unconstitutional a provision of a 1996 law allowing taxation of such awards.

Tax law experts said the ruling will encourage legal challenges to other parts of the tax code defining what income can be taxed. They also said the government is likely to appeal the decision to the Supreme Court.

``It's certainly going to launch a thousand constitutionality arguments that people would have thought laughable before,'' said Yale University law school professor Michael Graetz, a former tax official in President George H.W. Bush's administration.

The D.C. Circuit hears most appeals of federal government regulatory decisions. Graetz said the government may ask the full 10-member D.C. Circuit to review the decision of the three-judge panel, though he said it would be unusual for the court to agree because Chief Judge Douglas H. Ginsburg wrote the decision and there was no dissent.

Ginsburg, nominated to the court by President Ronald Reagan, was joined in the ruling by Judge Judith Rogers, nominated by President Bill Clinton, and Judge Janice Rogers Brown, nominated by President George W. Bush.

Appeal Likely

Internal Revenue Service spokesman Bruce Friedland referred calls to the Justice Department. Justice Department spokesman Charles Miller said the department is reviewing the decision and hasn't decided whether it will appeal.

Attorney David Colapinto, representing Marrita Murphy, who won yesterday's ruling, didn't immediately return a telephone call seeking comment. He is with the Washington law firm Kohn, Kohn & Colapinto. Attorney Colin M. Dunham, who filed a brief supporting Murphy on behalf of the No Fear Coalition, also didn't respond to a call seeking comment.

Friedland said the IRS doesn't have a separate figure on how much tax money it collects on damage awards for emotional distress and injury to reputation.

Former IRS Commissioner Donald C. Alexander, now a partner at the law firm Akin, Gump, Strauss, Hauer & Feld LLC in Washington, said the case will likely be appealed to the Supreme Court.

New Challenges Predicted

``I think it will be appealed, the Supreme Court will hear it, and the Supreme Court will reverse it,'' Alexander said.

In the meantime, tax experts predict challenges to the taxation of other money including some insurance proceeds, gambling winnings and windfalls such as found money.

``It is difficult to overstate the importance and potential harm of this decision,'' said Paul Caron, a tax professor at the University of Cincinnati College of Law.

Graetz said tax lawyers will have fewer concerns that their constitutionality claims will be deemed frivolous because most thought the issue decided in the case was frivolous before yesterday's ruling.

``Now it's hard to know what's frivolous and what's serious,'' he said.

The ruling concerned a $70,000 award to Murphy, who filed an administrative complaint with the Department of Labor in 1994 saying the New York Air National Guard ``blacklisted'' her and gave her bad references after she complained about environmental hazards at an air base. She was awarded $45,000 for emotional distress and $25,000 for injury to her reputation.

1996 Tax Law

Under a 1996 law, legal compensation for physical injuries is tax-free while those for mental anguish and injury to reputation are not. Murphy sued for return of $20,665 in taxes she paid on the damage award.

The D.C. Circuit ruled for her, deciding the award wasn't taxable income under the Constitution's 16th Amendment because it didn't compensate for lost wages or earnings. Punitive damages are taxable, the Supreme Court ruled in 1955.

Alexander said one worry for the IRS is that tax protesters will find new arguments to argue that the tax code is illegal.

``Tax protesters will love it because it's what they've been arguing for years,'' he said. ``They will claim this destroys the income tax.''

``A case like this does serious damage to the system even though it involves one provision,'' Alexander said. ``It does not say all the other parts of the code are constitutional.''

Vanessa Astrup, a spokeswoman for the anti-tax group We the People Congress, based in Queensbury, New York, didn't immediately return an e-mail seeking comment.

The case is Murphy v. IRS, No. 03cv02414, U.S. Court of Appeals for the D.C. Circuit in Washington.

Last Updated: August 23, 2006 14:00 EDT