Trial Attorney Tax Summary for Taxation of Settlements and Damages – Part 2: Punitive Damages

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Overview

Part 2 of this series focuses on the payment of punitive damages. One component of the equation focuses on the receipt of punitive damages by a plaintiff. The second part of the equation focuses on the deductibility of punitive damage payments by the defendant. The aspect of deductibility is pretty controversial. The controversy does not center on the issue of the rule of whether or not a punitive damage by the defendant can be deducted but rather the social policy of whether or not the party being punished should be able to take a tax deduction if in fact they are being punished. A number of scholarly articles have been written on the social policy aspects.

This article is designed to outline the tax treatment for both plaintiffs and defendants.

Punitive Damages

The term "compensatory damages" generally merely means that a payment compensates the plaintiff for a loss. This loss may be purely economic, for example, arising out of a contract, or personal, for example, sustained by virtue of a physical injury. Not all torts constitute personal injuries. Some torts may involve invasion of property rights, for example, conversion, or interference with economic interests, for example, tortious interference with contractual relations, or purely personal interests, for example, defamation. Nevertheless, the term itself does not define the tax treatment of payments. As outlined in Part I of this series, unless payment is on account of a physical injury or sickness, the payment is taxable to the recipient.

Punitive damages are not defined in the Internal Revenue Code or Treasury Regulations. Punitive damages are usually assessed not as compensation to the plaintiff but as payment to punish, e.g. retribution and to deter the repetition of harmful conduct. It can be seen as a “private fine” designed to punish and deter reprehensible conduct.

Taxation of Punitive Damages

Punitive damages are virtually always treated as income to the recipient. In O'Gilvie v. United
States, 117 S. Ct. 452, Doc. 96-31894, 96 TNT 240-1 (1996), the Supreme Court ruled that "non-compensatory punitive damages are not received on account of personal injuries, and thus are not excludable from gross income under IRC section 104(a)(2)."This ruling addressed once and for all after much litigation, the tax treatment of punitive damages regardless of whether or not the punitive damages were on account of physical injury or sickness. The remaining mystery remaining is what constitutes punitive damages absent a definition in the Internal Revenue Code. As mentioned in Part I of this series, a small exception exists for punitive damages in Alabama for wrongful death in which punitive damages is the only form of damages.

What constitutes punitive damages absent a definition? The IRS frequently and unreasonably takes the position that if punitive damages are alleged in the complaint; the Service will attempt to allocate a portion of the damages as punitive damages. The Service takes this position regardless of whether or not the legal matter goes to trial. The issue of whether or not damages are compensatory or not, is a matter of state law. It is not uncommon for a state court to refer to damages as either being “compensatory” or “non-compensatory.” It remains to be seen what should be called “punitive” when a case is settled out of court.

Deductibility of Punitive Damages

As previously mentioned, there is considerable controversy regarding whether the payment of punitive damages should be deductible at all. The argument goes something like this’- If the court is trying to punish the defendant and deter the repetition of the defendant’s wrongdoing, then the punitive damages should not be a deductible expenses.

Congress has attempted without success to limit the deductibility several times including 2003 and 2010. The after-tax cost for Exxon in the Exxon Valdez settlement was considerably less ($524 million) compared to the $1.1 billion settlement with the U.S. Government.

The Service has ruled previously in Rev. Rul. 80-211 that punitive damages paid by the taxpayer in the ordinary conduct of its business are fully deductible. Liquidated damages under the Fair Labor Standards Act where deductible as business expenses (Rev. Rul. 69-581). Similarly, liquidated damages under Age Discrimination in Employment are fully deductible.

In antitrust suits, IRC Sec 162(g) provides a limit to the deduction denying deduction for two –thirds of the damages paid pursuant to treble damages anti-trust suit. The deduction is only limited if there is a criminal conviction in a related criminal proceeding, guilty plea or nolo contendere.

The deductibility of punitive damages can be contrasted with the deductibility of the payment of fines and penalties under IRC 162(f). Clearly, there is a point of disconnect in the tax treatment of these two areas as both seem to focus on the “bad conduct” of a defendant.

Summary

Punitive damages are taxable income. The uncertainty of punitive damages centers on a lack of legal definition for tax purposes. Regardless of whether or not a case settles without trial, the IRS will attempt to allocate a portion of the settlement as punitive damages. It is easy to understand why. The IRS is in the business of collecting tax revenue. Any damages that can potentially be characterized as being on account of physical injury or illness receive tax-free treatment under IRC Sec 104.

The “take away” is the importance of considering the tax effects of a settlement. After all, it is not important what you get in a settlement as much as what you get to keep after-taxes. The recent tax changes have resulted in higher marginal tax brackets. Some knowledge of the tax treatment will assist in negotiating better settlements. A future installment will discuss the ability (or lack of ability) to provide a jury with instructions regarding the tax treatment of certain categories of damage payments.