> Punitive Damages and Taxes
Much is said about punitive damages and how they are used to punish wrongdoers. Plaintiffs dream of large punitive damage awards. Plaintiffs’ lawyers who obtain large punitive damage awards use them to brag about their ability as tort lawyers and a bludgeon on other defendants to convince them to settle for more than they owe. What the litigants and litigators seldom consider carefully is the tax consequences of a large punitive damage award. Failure to properly advise a plaintiff seeking punitive damages about the tax consequences of success can result in claims of legal malpractice.
What is the Purpose of Punitive Damages?
Punitive damages are intended to punish the wrongdoer. They do not compensate the plaintiff for lost wages, pain, suffering, property damage or any other damages designed to place the plaintiff back the way he was before the tort caused damage. Punitive damages are considered, therefore, a windfall to the taxpayer and must be be included in taxable income. Section 104 of the Internal Revenue Code deals with the treatment of punitive damages. Section 104(a)(2) excludes from income only “damages (other than punitive damages) received . . . on account of personal physical injuries or physical sickness.” Therefore, punitive damages, even in connection with personal injuries, may not be excluded from income.
What Happens When the Recipient of Punitive Damages Fails to Pay Income Tax on the Recovery?
In Gary L. Greenberg and Irene Greenberg v. Commissioner of Internal Revenue, No. 25420-07. (U.S.T.C. 01/24/2011) the United States Tax Court dealt with a recipient of insurance bad faith punitive damages who tried to avoid tax on the award. As a result the recipient of the award of punitive damages for the bad faith conduct of their insurer, resulted in a major tax consequence and not the windfall the plaintiffs thought they received. Because the Greenbergs could not convince the Tax Court of their position the Court not only slapped the Greenbergs down in affirming a tax deficiency of over $1 million, but further sanctioned them with an accuracy-related penalty, because the taxpayers had neither substantial authority, nor reasonable cause underlying their posture on the damage award.
The Tax Court noted that the definition of gross income broadly encompasses any addition to a taxpayer’s wealth. Therefore, absent an exception by another statutory provision, damage awards from a lawsuit must be included in gross income.
In general, exclusions from income are narrowly construed by the tax court. The Greenbergs argued that the punitive damages they received in their insurance bad faith case may be excluded from income under section 104(a)(3) primarily because punitive damages could not have been awarded without the insurance policy. The Tax Court discounted the “but for” argument, and found it was discredited by the Supreme Court’s analysis of section 104(a)(2) in O’Gilvie v. United States, 519 U.S. 79 (1996). In that case the Supreme Court considered an earlier version of section 104(a)(2) that excluded from income “the amount of any damages received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal injuries or sickness”. The Court reasoned that both the statute and the intention of Congress to exclude only those damages that compensate for personal injuries or sickness indicated that the exclusion does not include punitive damages. The Tax Court noted the clear intent of the law as follows:
Any punitive damages award arguably is made because of some injury and thus would not be awarded “but for” the injury. Punitive damages are for the purposes of punishment, not compensation for “personal injuries or sickness” and therefore do not meet the requirements of the statute.
The Greenbergs claimed to the Tax Court that the punitive damages 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 are excludable”. The tax court did not buy the argument because “bad faith damages” are, by definition, “punitive damages” and that the punitive damages they received were ineligible to be excluded because they are not compensating “for personal injuries or sickness.” The Tax Court also noted that the legal fees and costs received in a judgment that correspond to taxable damages are also taxable.
Section 6662(a) and (b)(1) and (2) imposes a 20-percent accuracy-related penalty on any underpayment of Federal income tax attributable to a taxpayer’s negligence or disregard of rules or regulations or substantial understatement of income tax. A substantial understatement of income tax exists if the understatement exceeds the greater of 10 percent of the tax required to be shown on the return or $5,000.
Consider an insurance bad faith judgment where the jury awards the plaintiffs $1,000,000 in compensatory damages and $9,000,000 in punitive damages. The Plaintiffs’ lawyer, in a standard contingency fee agreement, takes 40% of the gross award or $4,000,000 and expenses of $500,000 for experts and other litigation expenses. The plaintiffs’ share of the recovery is $5,500,000. If the Plaintiffs live in California or New York they will pay approximately 39% federal income tax and approximately 10% state income tax on their gross earnings in that year. Assuming the Plaintiffs earned nothing in the year of the judgment they are responsible to pay taxes on the $9,000,000 punitive damage award or slightly less than $4,500,000. In essence they receive none of the punitive damage award and the lawyer only pays taxes on his $4,000,000 recovery of legal fees. Also, if they attempt to avoid paying tax on the punitive damage award they may be assessed a 20% penalty.
The Need for Tax Advice Before Suit or Trial
Most tort lawyers – both plaintiff and defendant – are not knowledgeable about tax consequences. Counsel for plaintiffs who are seeking punitive damages should carefully advise their clients of the tax consequences of the recovery of punitive damages if they know enough or should require that each plaintiff seek the advice of a tax professional before agreeing to proceed with a suit or trial seeking punitive damages. If the Greenbergs had consulted with tax lawyers and been advised that they would be required to pay the top tax rate on the full amount of punitive damages awarded to them (even though 40% to 50% of those damages were paid as part of the contingency fee agreement with their lawyers, they might have agreed to the defendants’ settlement offers that did not include punitive damages.
Is this The End of the Tort of Bad Faith?
In 2008 I wrote an article titled: “Time to Put A Stake Through the Heart of the Tort of Bad Faith”.
In that article I noted:
The law of unintended consequences came into play and instead of protecting the consumer imprecise language, an attempt to force insurers to deal “fairly” with the insureds, resulted in thousands of lawsuits determined to impose penalties on insurers for attempting to enforce ambiguous “easy to read” language. The multiple lawsuits cost insurers and their insureds millions (if not billions) of dollars to get court opinions that interpret the language and reword their “easy to read” policies to comply with the court decisions. For more than thirty years the unintended consequence of a law designed to avoid litigation has done exactly the opposite.
* * *
In more than 60 years of application across the U.S. the tort of bad faith has not had a salutary effect on the insurance business. Insurance costs more than is reasonable or necessary so that sufficient funds exist to pay claims and tort damages from those insureds who believed they were done wrong. Suits relating to claims presented for the 1994 Northridge earthquake in California are still pending seeking tort and punitive damages for failure to pay what the insureds’ believed they were owed. In Louisiana and Mississippi multiple millions were paid to settle claims that flood damage was covered as a result of hurricane Katrina although the policies excluded flood and the plaintiff insureds failed to buy flood insurance. Abuse of insurers is so rampant and so successful that lawyers argue of multimillion dollar fees and have even attempted to (or successfully) bribed judges to increase their recovery.
The tort of bad faith is like the mythical Vampire. It hides in the dark. The truth about the tort of bad faith will die only if it is put into the light of day. It does not solve the problem anticipated. Rather it makes a few lawyers very rich, a few insureds receive indemnity for which they did not bargain and makes the cost of insurance to those who wish only to receive the benefits of the contract prohibitive.
The tax consequences on the plaintiff merely adds to the application of the law of unintended consequences. If only lawyers obtain the benefit of punitive damages and what the Greenbergs claimed to be “bad faith” damages much effort is being incurred to make some lawyers rich and the litigant in worse shape than they would have been had no punitive or bad faith damages been awarded.