Much is said about punitive damages and how they are used topunish wrongdoers. Plaintiffs dream of large punitive damageawards. Plaintiffs’ lawyers who obtain large punitive damage awardsuse them to brag about their ability as tort lawyers and as abludgeon on other defendants to convince them to settle for morethan they owe. What the litigants and litigators seldom considerare the tax consequences of a large punitive damage award. Failureto properly advise a plaintiff seeking punitive damages about thetax consequences of success can result in claims of legalmalpractice.

|

What is the purpose of punitive damages?

|

Punitive damages are intended to punish the wrongdoer. They donot compensate the plaintiff for lost wages, pain, suffering,property damage or any other damages designed to place theplaintiff back to the way he was before the tort caused damage.Punitive damages are considered a windfall to the taxpayer and mustbe included when the plaintiff files his tax return as taxableincome. Section 104 of the Internal Revenue Code deals with thetreatment of punitive damages. Section 104(a)(2) excludes fromincome only "damages (other than punitive damages) received . . .on account of personal physical injuries or physical sickness."Therefore, punitive damages, even in connection with personalinjuries, may not be excluded from income.

|

What happens when the recipient of punitive damagesfails to pay income tax on the recovery?

|

In Gary L. Greenberg and Irene Greenberg v. Commissioner ofInternal Revenue, No. 25420-07. (U.S.T.C. 01/24/2011) theUnited States Tax Court dealt with a recipient of insurance badfaith punitive damages who tried to avoid tax on the award. Thecourt stated:

|

The definition of gross income under section 61(a) broadlyencompasses any accession to a taxpayer’s wealth. [Commissioner v.Schleier, 515 U.S. 323, 327-328 (1995).] Therefore, absent anexception by another statutory provision, damage awards from alawsuit must be included in gross income.

|

As a result, the recipient of the award of punitive damages forthe bad faith conduct of their insurer resulted in a major taxconsequence and not the windfall the plaintiffs thought theyreceived. Because the Greenbergs could not convince the Tax Courtof their position the Court not only slapped the Greenbergs down inaffirming a tax deficiency of over $1 million, but furthersanctioned them with an accuracy-related penalty because thetaxpayers had neither substantial authority, nor reasonable causeunderlying their posture on the damage award. In assessing thepenalty the court stated:

|

Section 6662(a) and (b)(1) and (2) imposes a 20%accuracy-related penalty on any underpayment of Federal income taxattributable to a taxpayer’s negligence or disregard of rules orregulations or substantial understatement of income tax.

|

Since the punitive award exceeded $2.4 million, the Tax Courtassessed a penalty over the tax owed of $480,000. The court notedthat the definition of gross income broadly encompasses anyaddition to a taxpayer's wealth. Therefore, absent an exception byanother statutory provision, damage awards from a lawsuit must beincluded in gross income.

|

|
Insurance policy
|

(Photo: alexskopjeShutterstock)

|

In general, exclusions from income are narrowly construed by theTax Court. The Greenbergs argued that the punitive damages theyreceived in their insurance bad faith case may be excluded fromincome under section 104(a)(3) primarily because punitive damagescould not have been awarded without the insurance policy. The TaxCourt discounted the "but for" argument and found it wasdiscredited by the Supreme Court's analysis of section 104(a)(2) inO'Gilvie v. United States, 519 U.S. 79 (1996).

|

In that case the Supreme Court considered an earlier version ofsection 104(a)(2) that excluded from income "the amount of anydamages received (whether by suit or agreement and whether as lumpsums or as periodic payments) on account of personal injuries orsickness". The Court reasoned that both the statute and theintention of Congress to exclude only those damages that compensatefor personal injuries or sickness indicated that the exclusion doesnot include punitive damages.

|

The Tax Court noted the clear intent of the law as follows:

|

Any punitive damages award arguably is made because of someinjury and thus would not be awarded "but for" the injury. Punitivedamages are for the purposes of punishment, not compensation for"personal injuries or sickness" and therefore do not meet therequirements of the statute.

|

The Greenbergs claimed to the Tax Court that the punitivedamages they received were not punitive, but "bad faith damages."They contended without citation to any relevant authority, that"damage awards that serve both to compensate and punish areexcludable." The tax court did not buy the argument because “badfaith damages” are, by definition, “punitive damages” and thepunitive damages they received were ineligible to be excludedbecause they are not compensating "for personal injuries orsickness." The Tax Court also noted that the legal fees and costsreceived in a judgment that correspond to taxable damages are alsotaxable.

|

|
taxes due
|

(Photo: JohnKwan/Shutterstock)

|

So, does an insured who receives a punitive damage award get tokeep much, if any, of the punitive damages award?

|

Consider an insurance bad faith judgment where the jury awardsthe plaintiffs $1,000,000 in compensatory damages and $9,000,000 inpunitive damages. The plaintiffs’ lawyer in a standard contingencyfee agreement takes 40% of the gross award or $4,000,000 andexpenses of $500,000 for experts and other litigation expenses. Theplaintiffs’ share of the recovery is $5,500,000. If theplaintiffs live in California or New York, they will payapproximately 39% federal income tax and approximately 10% stateincome tax on their gross earnings in that year. Assuming theplaintiffs earned nothing in the year of the judgment, they areresponsible to pay taxes on the $9,000,000 punitive damage award orslightly less than $4,500,000. In essence, they receive none of thepunitive damage award and the lawyer only pays taxes on his$4,000,000 recovery of legal fees. Also, if they attempt to avoidpaying tax on the punitive damage award they may be assessed a 20%penalty.

|

The need for tax advice before suit ortrial

|

Most tort lawyers – both plaintiff and defendant – are notknowledgeable about tax consequences. Counsel for plaintiffs whoare seeking punitive damages should carefully advise their clientsof the tax consequences of the recovery of punitive damages if theyknow enough or should require that each plaintiff seek the adviceof a tax professional before agreeing to proceed with a trialseeking punitive damages.

|

If the Greenbergs had consulted with tax lawyers and beenadvised that they would be required to pay the top tax rate on thefull amount of punitive damages awarded to them (even though 40 to50% of those damages were paid as part of the contingency feeagreement with their lawyers), they might have agreed to thedefendants’ settlement offers that did not include punitivedamages. If not brought to the plaintiffs’ attention by theirlawyers insurance claims professionals, defense counsel, mediatorsand settlement judges must make that information available to theplaintiffs. Such information will be a great incentive to avoidtrial and a punitive damages award.

|

Barry Zalma, Esq., CFE, is an insurance coverage attorney,consultant and expert witness. Excerpted from the Insurance Claims Coverage Guide.

|

Want to continue reading?
Become a Free PropertyCasualty360 Digital Reader

  • All PropertyCasualty360.com news coverage, best practices, and in-depth analysis.
  • Educational webcasts, resources from industry leaders, and informative newsletters.
  • Other award-winning websites including BenefitsPRO.com and ThinkAdvisor.com.
NOT FOR REPRINT

© 2024 ALM Global, LLC, All Rights Reserved. Request academic re-use from www.copyright.com. All other uses, submit a request to [email protected]. For more information visit Asset & Logo Licensing.