Beyond Structured Settlements

Stressed-Induced Physical Ailments - 1

In a 2010 Tax Notes article, attorney Robert Wood asks: "is physical sickness the new emotional distress?" Recent Tax Court decisions highlight both the tax issues raised by damages for stress-induced physical ailments resulting from physical sickness and the need for careful tax planning when seeking such damages.

S2KM reviewed federal legislative and regulatory tax history related to emotional distress damages as well as recommendations for related legislative changes in a prior blog post. To summarize:

• As the result of a 1996 amendment, section 104(a)(2) now exempts from federal income tax “damages (other than punitive damages) received … on account of personal physical injuries or physical sickness.”
• Section 104(a) now also provides "emotional distress shall not be treated as a physical injury or physical sickness" for purposes of section 104(a) (2).
• However, damages received on account of emotional distress that are attributable to a physical injury or physical sickness are excludable.
• The related legislative history provides that “emotional distress” includes “physical symptoms (e.g., insomnia, headaches, stomach disorders) which may result from such emotional distress.”
• In a private letter ruling issued in 2000 (“the bruise ruling”), the IRS established “the observable bodily harms” standard in a case involving sexual assault and harassment in an employment context: “we believe that direct unwanted or uninvited physical contacts resulting in observable harms such as bruises, cuts, swelling and bleeding are personal physical injuries under section 104(a)(2).”
• Although the 2012 regulations for IRC section 104(a)(2) confirm that damages for emotional distress attributable to a physical injury or physical sickness are excluded from income under section 104(a)(2), they do not provide any explanation to help define “physical” or “physical sickness”.

Some of the most challenging "emotional distress" cases, from a tax perspective, involve damages for stress-induced physical ailments resulting from physical sickness. The U.S. Tax Court has provided guidance for such cases in three recent and related decisions:

• Domeny v. Commissioner, T.C. Memo 2010-9.
• Parkinson v. Commissioner T.C. Memo 2010-142.
• Blackwood v. Commissioner, T.C. Memo, 2012-190.

In an article published July 19, 2012 titled "Recent U.S. Tax Court Decision Highlights Issues Regarding the Tax Treatment of Damages for Stress-Induced Physical Ailments", attorneys Jeremy Babener and Neil Kimmelfield summarize these cases and offer advice for taxpayers seeking damages for stress-induced ailments.

According to their article, the U.S. Tax Court indicated in Domeny and Parkinson "that damages compensating for stress-induced physical ailments may be tax-free where (1) the taxpayer can demonstrate that the damages were actually received on account of those ailments and (2) the physical nature of the ailments was verified by a physician, preferably based on objective medical evidence rather than the taxpayer’s subjective report of symptoms."

In the more recent Blackwood case, however, (where the taxpayer suffered insomnia, migraines, nausea, and pain in her back, shoulder, and neck) Babener and Kimmelfield state: "the taxpayer did not satisfy this standard, highlighting the difficulty of establishing that damages compensating for stress-induced physical ailments are excludable from income."

Based upon these cases, Babener and Kimmelfield conclude:

• Taxpayers seeking damages for stress-induced physical ailments will have difficulty excluding such damages under IRC section 104(a)(2) unless they " (1) obtain a medical diagnosis during the underlying dispute and (2) emphasize diagnosed physical ailments in communications with the defendant..."
• It remains uncertain whether taxpayers who obtain medical diagnoses will receive receive tax-free treatment for stress-induced physical ailments that are less acute what were present in the Domeny (multiple sclerosis) or Parkinson (heart disease) cases.

In an article titled "Tax-free Physical Sickness Recoveries in 2010 and Beyond", written prior to the Tax Court's Blackwood decision, attorney Robert Wood offered the following additional advice based upon his review of the Domeny and Parkinson cases:

1. "The facts matter and your proof of the facts matter. To exclude a payment on account of physical sickness, you need evidence that you really made the claim and that the payer was aware of it, and at least considered the claims in making the payment.
2. "Proving that you were struck isn’t part of physical sickness, but proving that you had demonstrable sickness is. You’ll need evidence of medical care, and evidence that you were claiming the payer caused your condition or caused it to worsen.
3. "The courts and the IRS shouldn’t be put in the position of trying to figure out which payments were for which claims. Spend the time to nail down as much as you can in the settlement agreement. Very frequently the IRS will accept an explicit allocation and will not go behind it.
4. "Be reasonable. If you are allocating which payments are for which claims, do not go overboard. Don’t allocate $10 to wages in an employment dispute. Don’t allocate 90 percent of a recovery in an intentional infliction of emotional distress case to physical injuries or physical sickness.
5. "When there isn’t much of a record of medical expenses and discovery in the litigation, consider what other documents you can collect at settlement time. A letter from the plaintiff’s attorney saying why the physical sickness claims were strong may help. A letter from a treating physician or an expert physician may help. Declarations may be even more persuasive than letters. Prepare what you can at the time of the settlement, or at the latest, at tax return time. Do as much as you can contemporaneously. Don’t wait for an audit to gather those things."

S2P2J Release 50

Publisher Law Journal Press is currently distributing hardcopy supplements for Release 50 of "Structured Settlements and Periodic Payment Judgments" (S2P2J). Online S2P2J was also updated as of October 21, 2011 to include Release 50 materials.

First published in 1986, S2P2J is co-authored and updated semi-annually by Daniel W. Hindert, Joseph J. Dehner and Patrick J. Hindert. Both the National Structured Settlement Trade Association (NSSTA) and the Society of Settlement Planners (SSP) utilize S2P2J as an educational resource for their certification programs.

S2P2J Release 50 Highlights

Release 50 for Structured Settlements and Periodic Payment Judgments reviews the history of the receivership of Executive Life of New York ("ELNY"), tracks the status of its receivership and impending liquidation, updates discussion of the operation and role of U.S. life and health guaranty associations (“GAs”), and provides a comprehensive new chart summarizing coverage limits under the enabling statutes for all GAs in each of the U.S. states and territories.

This Release also expands and updates the discussions of several topics, including:

• Understanding the scope and meaning of “physical” as that crucial term is used in IRC § 104(a)(2) for claimants who receive damages on account of personal injuries that are not “physical” per se, such as wrongful incarceration and PTSD.
• Negotiating the important issue whether and pursuant to what terms a settlement payor will issue an IRS 1099-MISC form in cases where the tax treatment of agreed damages appears to be neither fully excludable under IRC § 104(a)(2) nor fully includable as income to the claimant.
• Determining choice of forum for establishing a 468B fund when one or more claimants against the 468B fund is a protected person.

In addition, Release 50 includes an extensive discussion of the IRS’s Structured Settlement Factoring Audit Technique Guide used to assist its examiners in determining taxability of structured settlement factoring transactions. The Guide describes the interplay between state law requirements and federal tax sanctions and presents a simplified conceptual framework to be used for determining taxability.

Joseph Dehner Interview

Joseph Dehner is a partner in the Frost Brown Todd law firm and co-author of "Structured Settlements and Periodic Payment Judgments" (S2P2J). He has been studying and writing about structured settlements since 1977 and agreed to be interviewed for this S2KM blog post.

S2KM: Your Frost Brown Todd biography highlights your expertise in multinational securities and business disputes. How do structured settlements fit into your legal practice?

Dehner: Through some of my clients, I was part of the birth of the structured settlement industry many years ago. It is great to see the structured settlement industry evolve into a robust part of the U.S. economy. I continue to advise attorneys and firms on structured settlement and periodic payment judgment issues. One example was the honor of serving as the U.S. Government’s expert witness in the criminal trial of James Gibson, who besmirched the good names of structured settlements and US Government bond trusts, and is now serving a long prison term.

S2KM: William T. Robinson lll, your Frost Brown Todd partner and President-Elect of the American Bar Association (ABA), was be a featured speaker at the NSSTA 2011 Annual Meeting. In addition to Robinson and yourself, does Frost Brown Todd have other attorneys with structured settlement expertise?

Dehner: We have a large litigation department, but I am the primary person specializing in structured settlement matters within our firm.

S2KM: You and your co-authors have been writing and updating S2P2J since 1986. Who is your target audience and how to you track new developments?

Dehner: Our target audience includes attorneys, as well as structured settlement consultants, judges and funding providers. We review on a monthly basis all reported cases and news reports about structured settlements and periodic payment judgments, and follow information as it flows about case and other developments.

S2KM: Having recently completed S2P2J Release 49, what important legal issues and developments do you see emerging?

Dehner: There is a growing experience of post-settlement issues emerging from a variety of directions – including fights among beneficiaries of holders of structured settlement rights, factoring company fights and disputes arising from Protection Act hearings, tax rulings (e.g., wrongly incarcerated persons can receive tax-free payments, despite prior uncertainty whether they suffered a “physical” injury), rights in bankruptcy, whether structured settlement rights are marital property, and many other issues that are being resolved over time by individual case rulings. The growing use of structured settlements outside the “tax-free” arena represents recognition that settlement is a time to put into place good financial planning.

S2KM: How do structured settlements in the United States differ from structured settlements in other countries?

Dehner: Many countries have more of a safety net philosophy and less of a litigation-driven means of addressing the needs of injured persons. But for common law countries, many have moved well ahead of the USA in insisting that compensation meet needs – meaning that payments should correspond over time to the actual needs of injured persons. So, in the UK, Ireland and elsewhere, we are seeing a conversion from the ancient lump-sum one-time system to what we in the USA would find normal in the workers compensation context. This is a real sea shift in thinking.

S2KM: Are there any lessons or ideas the United States structured settlement industry can gain from other countries?

Dehner: Sure – read Chapter 1 of our book about other country experiences and approaches.

S2KM: How do you view the secondary market? Are structured settlement transfers good or bad for the industry generally - and more specifically for structured settlement recipients?

Dehner: It’s not a question of bad or good. It’s a question of how individuals react in the real world. People who hold structured settlement rights chose to take money over time at one point, and then decide for various reasons to get cash now in exchange for giving up future rights that have greater value overall. But that’s their choice. The reality is that high-pressure tactics, coupled with what would have been viewed as usury and heresy in the Middle Ages, robbed those individuals of a truly fair and efficient secondary market when the factoring industry arose. Protection Acts now exist in 47 states. When you review the reported decisions about transfers of structured settlement rights, virtually every case where a judge wrote an opinion rejects the transfer and recites in pointed language why discount rates and other factors compel denial of a transfer application. Most transfers go through anyway because of no real contest and no real focus by the court on the underlying issues. I would hope that the impact of factoring over time does not dissuade Congress from maintaining favorable government support for structured settlements through a continuation of 104(a)(2) treatment.

S2KM: What factors, in your opinion, have contributed to the recent decline in growth of the structured settlement annuity premium?

Dehner: It’s pretty simple really. Interest rates are so low for so long that structured settlements have not stood out as bargains compared to receiving a lump sum and investing it for potentially greater returns (though the performance of the US equity markets should cause a reasonable observer to think twice).

S2KM: Do you have any thoughts or ideas about how to improve and/or grow the structured settlement industry?

Dehner: Greater focus on its basic point is where to start. Regardless of tax treatment, putting into place a compensation plan that actually aims to match needs with resources makes sense. Although there is no solid statistical evidence to support the concept that recipients of windfalls have nothing left after five years, we all know the realities that confront anyone who obtains a large sum as a first time experience with wealth. Charities, friends and relatives want a piece. It’s easy to spend money sitting in the bank. And then at some point there is nothing left to deal with what in some cases is a lifetime of needs. My favorite structured settlement example was an elderly fellow I represented who was pushed over in a grocery store, broke his hip and ended up in a nursing home that at the time cost about $1100/month. He would have run out of money from his savings in about two years. Instead of getting a small lump sum settlement for what happened, the insurer provided a structured settlement that paid $1400/month for the rest of his life. The cost was minimal, given his age and the magic of actuarial science. He died 15 years later, but never had to worry about his nursing home bills. Keep the focus on this example and what it represents, and the structured settlement industry merits a bright and expanding future.

S2KM: What lessons, if any, do the Spencer v. Hartford and Macomber v. Travelers class action settlements provide for the structured settlement industry?

Dehner: Transparency. As long as underlying economic realities are known and disclosed to those involved, I don’t see an issue. One can argue about Spence and Macomber should ultimately have been decided, but there is an easy solution to the issues that underlay both cases – being up front and clear in documentation and negotiation as to what was going on. When we wrote "Structured Settlements and Periodic Payment Judgments" in 1986 (since updated 49 times), our negotiation chapter talked about how a good structured settlement negotiation should be about how much a claimant would receive when over time. It was not about negotiating an amount first, and then finding out what it would buy. Focusing on what payments will be received when (and the reliability of the financing mechanism) and disclosure of who does what and receives what are consistent with best practices, and should not be subject to later court challenges about what participants earned how much in the process.

S2KM: What impact, if any, would the expanded use of 468B funds in single event tort cases have on structured settlements?

Dehner: It would simplify matters for a defendant, of course, but would require clear IRS or statutory guidance that is missing now. It would give greater leverage to the claimant than exists now, so the defense side understandably is reluctant to embrace the tool generally, and absent clear guidance on the efficacy of single-claimant 468B funds, there is no point in the rhetorical debate that rages about this issue.

S2KM: Assuming federal malpractice reform legislation is enacted, should periodic payment of judgments be included?

Dehner: Of course. Read the recent paper of the Irish judiciary, or the UK Government’s papers that led to widespread use of periodic payment judgments there as a matter of course. Or just think about what the law really accomplishes at its best – matching compensation with actual need. This is not about favoring the defense or plaintiff side of the bar. And it is not about who wins and loses. This is about trying to make sure as well as possible that injured persons receive compensation that meets their needs. If it lowers cost, fine. If it increases cost, fine. I would argue that this is unknowable, but it is obvious to a rational individual that trying to match compensation against need is better than the equivalent of a lottery, where some people lose completely, others win it big, and many get a lump sum that does not last enough to get them through their lifetimes.

S2KM: Are there any opportunities for the structured settlement industry to benefit from proposed changes (including budget decreases) for Medicare, Medicaid and/or Social Security?

Dehner: Yes, and one can expect both further pressures for Medicare and Medicaid reimbursement at settlement time, as well as increasingly sophisticated settlement planning. Our book tries to keep abreast of these rapidly changing areas and how attorneys and other participants in the structured settlement industry can do a good job for their clients (and not make serious mistakes in the process).

S2KM: From an historic legal perspective, what impact have structured settlements and periodic payment judgments had on the U.S. tort system?

Dehner: The rule thought to be enunciated first in England in Fetter v. Beale that an injury should be compensated with a single one-time payment – the lump-sum system – has been met with deviation when it matters most – in workers compensation systems, in vaccine cases, in other applications. And even in England, the lump sum award system is slowly disappearing based on statutory changes. Structured settlements in the US have continued to chip away at lump sum thinking in America. History should show that structured settlements and periodic payment judgments will prove to be a far better alternative to the jackpot theory of litigation. Do we really want injured people to go to courthouse casinos for justice?

SSP and NSSTA 2011 Annual Meetings - 3

Whether and when personal injury settlements are taxable to their recipients represents one of the most important structured settlement legal issues. Both the Society of Settlement Planners (SSP) and the National Structured Settlement Trade Association (NSSTA) featured multiple tax presentations during their 2011 educational conferences.

At the SSP conference, Robert Wood and Jeremy Babener each separately addressed multiple settlement tax issues. Wood discussed: "468B Qualified Settlement Funds" (QSFs) and "Common Settlement Tax Mistakes and How to Fix Them". Babener's SSP presentation addressed three topics:

• Maximizing the medical expense deduction;
• Emotional distress and the medical care exception; and
• Inheritance of personal injury proceeds.

The NSSTA conference also featured a QSF presentation by Martin Jacobson titled "The Ins and Outs of 468B Funds". In addition, NSSTA's Legal Committee Update included a summary of a 2011 tax case, Espinoza v. Commissioner, plus an introduction to IRC Section 5891 as part of a discussion about the secondary structured settlement market.

Wood, who has written both a textbook and a Tax Management portfolio about QSFs, utilized case examples to explain several QSF issues: when is a QSF available; formation of a QSF; who should serve as QSF administrator; what are the QSF administrator's responsibilities; determining QSF income and deductions; information reporting responsibilities; amounts to report and forms to use; reporting of structured settlements; and terminating a QSF.

In his presentation about identifying and fixing settlement tax mistakes, Wood highlighted several issues: the need for professional tax computations; interest is always taxable; punitive damages; attorney fees; tax allocations; miscellaneous itemized deductions; above-the-line deductions; the unclear scope of section 104; sex abuse and wrongful imprisonment cases; the Murphy case; constructive receipt; employment disputes; Form 1099; as well as qualified and non-qualified structured settlements. For related writing by Wood, see the Wood & Porter website as well as S2KM's structured settlement public policy wiki.

Like Wood, Babener is both a prolific writer about settlement tax issues, as evidenced by Babener's website and related commentary appearing on S2KM's structured settlement public policy wiki, and a frequent speaker at educational conferences sponsored by SSP and the National Association of Settlement Purchasers (NASP). Also similar to Wood, Babener's SSP presentation and handouts utilized case examples (as well as tables) to help communicate his analysis. Equally appropriate for their audience, both Wood and Babener emphasized settlement tax planning and incorporated structured settlements into their discussions.

Jacobson's QSF discussion at the NSSTA conference specifically addressed the single claimant issue. Jacobson focused his analysis on the statutory language of IRC 468B, related Treasury Regulation 1.468B-1(c) and related Revenue Procedure 93-34.

• Treasury Regulation 1.468B-1(c) requires and permits a QSF to be "established to resolve or satisfy one or more contested or uncontested claims that have resulted or may result from an event (or related series of events) that has occurred and that has given rise to at least one claim asserting liability ..." (emphasis added).
• Revenue Procedure 93-34 sets forth the rules under which a QSF will be considered a "party to the suit or agreement" for purposes of Section 130 and includes a stipulation that all Section 130 requirements still apply (emphasis added).

Jacobson highlighted the issue of whether Revenue Procedure 93-34 means that constructive receipt and economic benefit apply to single claimant QSF-funded Section 130 Qualified Assignments. For purposes of the single claimant QSF issue, Jacobson identified what he termed "the real questions":

• Does a single claimant have economic benefit of the funds placed in the QSF?
• Does the single claimant have "unqualified availability" of those funds?
• Has IRC Section 130(c) been satisfied?
• Is there going to be an IRS ruling applicable to single claimant QSFs?
• In the continuing absence of such an IRS ruling, Jacobson quoted Robert Wood's recommendation to "avoid the single claimant controversy" by establishing QSFs with multiple claimants.

With deference to Martin Jacobson for his valuable presentation and gratitude that NSSTA's educational programs have begun to address important and controversial industry issues, S2KM suggests these additional "real questions" concerning single claimant QSFs:

• Why haven't any NSSTA or SSP members applied for one or more IRS rulings applicable to single claimant QSFs?
• For example, what constitutes "multiple claimants" for purposes of QSFs - multiple family members as claimants? government liens? a plaintiff attorney's compensation claim?
• Does public policy favor or not favor single claimant QSFs? If not, why not?
• As Jeremy Babener addresses in his important QSF paper, how far has existing federal legislation eroded the applicability of the constructive receipt and economic benefit tax doctrines to structured settlements:
  • Technical and Miscellaneous Revenue Act of 1988 - allowing "secured creditor status"; and
  • Victims of Terrorism Tax Relief Act of 2001 - allowing transfers of payment rights ("factoring") pursuant to state protection statutes.

For additional information about:

• Structured settlement tax issues - see Chapter 2 of "Structured Settlements and Periodic Payment Judgments" (S2P2J);
• Single claimant 468B QSFs - see S2KM's blog post "Single Claimant QSF Update"
• SSP and NSSTA 2011 Annual Meetings - see S2KM's structured settlement wiki.

Expanding Section 104(a)(2)'s Tax Exclusion

In a 2010 article titled "How Plaintiffs Might Receive Emotional Distress Damages Tax-Free After 2010", published in the "North Carolina Lawyers Weekly", Jeremy Babener asked a pointed and strategic question: how can the structured settlement industry encourage more damages to be received tax-free? Doing so, presumably, would expand the structured settlement market.

Several proposals to accomplish these objectives have been offered during the past few months - some of which resulted from a U.S. Department of the Treasury public hearing held on February 23, 2010 to consider proposed new Treasury regulations for IRC section 104(a)(2). If adopted, these proposed new Treasury regulations would make two primary changes to current regulations: 

• Eliminate the requirement that damages be based on “tort or tort type rights” in order to qualify for the section 104(a)(2) tax exclusion, and
• Incorporate 1996 legislation requiring that personal injuries and sickness damages be “physical” in order to qualify for the section 104(a)(2) exclusion.

In the context of these proposed new Treasury regulations, the structured settlement industry would benefit from greater discussion and a better understanding of the following recent tax proposals to expand application of the section 104(a)(2) tax exclusion:

• The National Taxpayer Advocate, which considers taxpayer considerations from inside the IRS, has recommended that section 104(a)(2) exempt non-physical damages, specifically emotional distress, mental anguish, and pain and suffering.
• John McCulloch proposed, during the February 23, 2010 public Treasury hearing, that damages received by victims of prolonged sexual abuse or false imprisonment should always be deemed “physical” for purposes of IRC section 104(a)(2) whether or not evidence is available to demonstrate physical injury.
• Richard Risk and Jack Meligan each recommended, during the same public hearing, that Treasury issue regulations explicitly holding the economic benefit doctrine will not be triggered in the context of single-claimant 468B Qualified Settlement Funds.
• David Higgins has proposed two recent tax recommendations. In a written submission for the Treasury public hearing, Higgins argued that the IRS’ definition of "physical" is inadequate: “direct unwanted or uninvited physical contacts resulting in observable bodily harm such as bruises, cuts, swelling, and bleeding.” Higgins recommends a broader definition, including damages for:
  • A doctor’s misdiagnosis resulting in death or serious injury from delayed or missing treatment;
  • Child neglect resulting in starvation or illness;
  • Rape committed under threat of bodily harm; and
  • Other situations where traditional physical injury torts occur without unwanted or uninvited physical contact or observable bodily harm.
• Higgins directed his second recommendation to Senator Max Baucus (Chairman of the Senate Finance Committee), Congressman Dave Camp (Chairman of the House Committee on Ways and Means), and Michael Mundaca (Assistant Secretary of the Treasury for Tax Policy). In his communication, Higgins recommended a "rollover provision" to replace Section 130 of the Tax Code. Higgins' proposal would allow personal injury plaintiffs to accept a check from defendants and invest the money within a given period (likely limiting the investment options to annuities and Treasury bonds), without losing the tax benefit currently available to them only by agreeing to a structured settlement with a counter-party.
• Jeremy Babener has proposed a legislative conversion of the structured settlement exclusion to a refundable tax credit. The premise of Babener's proposal is that high-income taxpayers benefit more from the structured settlement subsidy than low-income taxpayers, who sometimes do not benefit at all. A refundable tax credit would provide the same incentive value to all structured settlement recipients, high-income or low-income.

Most recently, McCulloch has incorporated his earlier recommendations into a request to Treasury and the IRS that final regulations under IRC Section 104(a)(2) should clarify the scope of the exclusion for damages received on account of personal "physical" injuries or "physical" sickness. McCulloch's request seeks guidance and a determination as part of Treasury's 2011-2012 Guidance Priority List that sexual abuse cases and long-term wrongful incarceration (at least one year of restraint) are per se physical injuries under Section 104(a)(2).

In support of his proposal, McCulloch states: "There is a significant body of literature that recognizes sexual abuse as a serious medical problem with long lasting and severe physical effects, many of which can only be treated by a licensed medical practitioner or through the prescription of controlled medications. There are similar medical studies that demonstrate the persistent physical damage that results from long-term incarceration."

The purpose of the Treasury's Priority Guidance Plan is to focus United States government resources "on guidance items that are most important to taxpayers and tax administration." In reviewing recommendations and selecting projects for inclusion on the 2011-2012 Guidance Priority list, the Treasury and the IRS have stated they will consider whether the recommended guidance:

• Resolves significant issues relevant to many taxpayers;
• Promotes sound tax administration;
• Can be drafted in a manner that will enable taxpayers to easily understand and apply the guidance;
• Involves regulations that are outmoded, ineffective, insufficient, or excessively burdensome and that should be modified, streamlined, expanded, or repealed;
• Reduces controversy and lessens the burden on taxpayers or the IRS; and
• Whether the IRS can administer the recommended guidance on a uniform basis.

McCulloch maintains his request for guidance satisfies the above criteria:

• Since Section 104(a)(2) was amended in 1996, taxpayers have needed guidance to determine the scope of the terms "physical injury" and "physical sickness" for which no definitions exist.
• The 1996 amendment did not specifically consider its application to victims of sexual abuse and wrongful incarceration and needs modification because it affects a large and growing number of taxpayers:
  • For sexual abuse victims, because of greater opportunities for victims resulting from legislation in many states which extends applicable statutes of limitations.
  • For wrongful incarceration victims, because more widely available DNA-testing absolves wrongfully convicted prisoners.
• The requested guidance would promote sound tax administration by providing an understandable tax rule thereby minimizing the likelihood of future controversies.
• It would also provide consistency in tax treatment among such victims who face uncertainties and expense when they currently attempt to address these issues individually.

In S2KM's opinion, industry support for McCulloch's proposal would provide one immediate answer to Jeremy Babener's strategic question about how the structured settlement industry can cooperate to improve and grow its market by encouraging more damages to be received tax-free under IRC section 104(a)(2).

For additional information about taxation of damages received by personal injury victims, see Chapter 2 of "Structured Settlements and Periodic Payment Judgments" (S2P2J)

Deducting Punitive Damages

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.

Introduction

As part of his 2010, 2011, and 2012 revenue proposals, President Obama proposed to end defendants’ ability to deduct punitive damages.

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.

Zelenak

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.

Mogin

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".