The income tax exemption provided in Section 104(a)(2) of the Internal Revenue Code for "any damages" received "on account of personal physical injuries or physical sickness" specifically excludes "punitive damages".
A separate but related issue: should defendants be able to deduct punitive damages on their tax returns? Right now, they can. The benefit to defendants is obvious. What about plaintiffs? Since the after-tax cost of every dollar paid is lower, should plaintiffs receive more?
Proposals to disallow the deduction have been made multiple times. The Clinton administration proposed it in the 1990s, and the Obama Administration has resurrected the idea. In response, several policy articles have been published debating the merits of allowing defendants to deduct punitive damages, and discussing alternative policies. SK2M asked Jeremy Babener, a 2010-11 NYU Tax Policy Fellow, to explain the tax issues involved and the arguments being made.
Currently, punitive damages incurred in connection with a defendant’s business are tax deductible. Consider a plaintiff’s request to a jury for $1 million in punitive damages. If the defendant can deduct the $1 million of damages against $1 million of income taxed at 35%, the true cost of the award to defendant is $650,000. Juries are sometimes informed of the tax consequences of damages, and sometimes not.
The Obama Administration argues that the deduction's effect of lowering the true cost to defendants “undermines the role of such damages in discouraging and penalizing certain undesirable actions or activities.”
Polsky and Markel
Gregg Polsky (University of North Carolina School of Law) and Dan Markel (Florida State University College of Law) argue in Taxing Punitive Damages that rather than changing tax law, juries should be informed of the tax consequences of damages. Thus, in the above example, a jury might award plaintiff $1.5 million, knowing that the after-tax cost to defendant would be $1 million. The effect of the Obama proposal, they posit, would likely be circumvented by settlements that allocate less to nondeductible punitive damages, and more to deductible compensatory damages. The IRS may find it difficult to identify and correct such improper settlement allocations.
Lawrence Zelenak (Duke University School of Law), in response to Polsky and Markel, makes two points. First, he suggests that while it might be better to end deductions for punitive portions of damage awards, punitive portions of settlements should remain deductible. Less than five percent of plaintiffs who go to trial are awarded punitive damages. Since it is impossible to identify which settling defendants would have been forced to pay punitive damages, and to determine the amount of such damages, Zelenak argues that punitive damage portions of settlements should be fully deductible.
Second, Zelenak argues that the Polsky and Markel solution ignores the deterrence role of punitive damages. In part, punitive damages are supposed to force a defendant to pay for the costs to injured parties who could not or would not bring legal action. If those injured parties had sued, the defendant would have been able to deduct the resulting compensatory damages. From a deterrence point of view, therefore, the defendant should be able to deduct the punitive damages paid to plaintiff that substitute for deductible compensatory damages. Zelenak writes that Polsky and Markel focused only on the punishment rationale for punitive damages, which suggests that a reduction in the true cost of punitive damages, via deductibility, reduces defendants' intended punishment. Of course, as Zelenak concludes, balancing the punishment and deterrence rationales of punitive damages is very difficult.
Paul Mogin (Williams & Connolly, LLP), also in response to Polsky and Markel, argues three separate points. First, many courts prevent defendants from encouraging reductions in damage awards by either informing juries when plaintiffs will receive damages tax-free, or by introducing evidence of a plaintiff’s previous reimbursement for economic losses. Therefore, Mogin writes, allowing plaintiff to introduce defendant’s ability to deduct punitive damages would create a “pro-plaintiff imbalance.”
Second, Mogin asserts that providing juries with additional encouragement to increase punitive damages would exacerbate juries’ already distorted pro-plaintiff perception of corporate defendants. While evidence of a defendant’s wealth is generally inadmissible in court, the rule does not typically hold for punitive damages. The U.S. Supreme Court has recognized that the presentation of a defendant’s wealth “creates the potential that juries will use their verdicts to express biases against big business.” Thus, Mogin argues, juries should not be further encouraged to increase punitive damages awards.
Third, Mogin criticizes Polsky and Markel for elevating the jury’s assessment of punitive damages above its rightful place. Historically, judges have reduced or set aside unduly harsh punitive damages. Moreover, while the jury’s role is one of fact-finder, the measure of punitive damages is hardly factual. Why then should it be so important that the true cost of defendant’s damages are exactly equal to the amount the jury intended?
There's Always More
Several other papers have been written on disallowing defendant deductions for punitive damages, including a 2010 article published by the Heritage Foundation, and a 2001 report by the New York State Bar Association.
Jeremy Babener's articles on the taxation of personal injury damages and structured settlements are available at TaxStructuring.Com. Babener is a 2010-11 NYU Tax Policy Fellow. Having worked for the U.S. Department of the Treasury's Office of Tax Policy in the Fall of 2010, he will graduate from NYU School of Law's Graduate Tax Program this Spring.
For additional information about Internal Revenue Code Section 104(a)(2), punitive damages and the allocation of damages for tax purposes, see section 2.03 of "Structured Settlements and Periodic Payment Judgments".