The Lochner decision, in which the U.S. Supreme Court invalided basic economic legislation on constitutional grounds like the "freedom of contract" is widely regarded as a low point of U.S. Supreme Court jurisprudence.
The U.S. Court of Appeals for the D.C. Circuit has made a similar decision in the Murphy case. It held that the subsection of the Internal Revenue Code that provides that fails to exclude from income non-physical personal injury damages (which not in lieu of lost wages) is unconstitutional as exceeding the power of Congress to tax income under the 16th Amendment because this is not income.
Almost everyone in the academic community and community of tax lawyers finds this notion absurd, the stuff of crackpot tax protestors, rather than an unanimous panel of judges on one of the most prestigious appellate courts in the land. Simply put, Congress has always been granted wide discretion to determine what is and is not income. There was not a consensus about it at the time the 16th Amendment was adopted. There is not a consensus about it now. And, even if it isn't an income tax, it might be some other kind of valid tax that Congress has the power to impose. The broad authority of Congress to define income was set forth by the U.S. Supreme Court in the Glenshaw Glass case in 1955 and has become settled law. As Professor Maule notes tax provisions have been declared unconstitutional excactly twice since the 16th Amendment was adopted. Once in 1920, and once in 1972. The 1972 ruling arose from the fact that the provision in question distinguished between unmarried men and unmarried women in violation of equal protection principals.
Professor Maule also correctly notes that if this kind of receipt of funds is not income, then it still isn't a constitutional question. Section 61 say "income" is subject to taxation, and Section 104 (the provision held unconstitutional) states that certain things that could be considered income still don't count. If something is not income under the 16th Amendment, then the correct holding is to interpret Section 61 of the Internal Revenue Code to hold that the money received is not part of gross income, not to declare Section 104 unconstitutional.
The D.C. Circuit Panel's argument is that these damage awards are neither a "gain" nor an "accession to wealth", and hence not income because it merely restores to her human capital that she has lost, based largely on dicta in the Glenshaw Glass case that noted a distinction made under the income tax laws at the time between compensatory damages in tort (then excluded from taxation), and punitive damages in tort (then taxable). But, the notion that this dicta imposed a constitutional boundary on what Congress could tax has never previously been established.
Part of their problem is that they misjudge the status quo. The status quo is not pre-injury. The tax law has, without constitutional objection, never allowed anyone to take a deduction strictly for suffering emotional distress, which the reasoning of the case suggests is a constitutional requirement on the tax code. Yet, to think that any bad day entitles you as a matter of constitutional law to a tax deduction is absurd.
The true status quo is where the litigant sits on the day before the damages award is awarded. On that day, if the litigant loses her case, she gets nothing, which is all she has received since the day of her injury, preserving the status quo. If she wins her case, she gets an award, making her better off. But, it is not the injury itself that causes her to gain wealth, it is the winning of a lawsuit as a result of the injury.
Either the U.S. Supreme Court, or the en banc D.C. Circuit, sitting en banc, could reverse, and this is a likely case for such treatment.