A Video Explaining the Tax Consequences of an Award of Bad Faith Punitive Damages on the Recipient

The Tax Problems Raised by Punitive Damages

See the full video at https://youtu.be/hJKvhzUeJGs

In O’Gilvie v. United States, 519 U.S. 79, 117 S.Ct. 452, 136 L.Ed.2d 454 (1996) the Supreme Court held that punitive damages are included as gross income for tax purposes. According to the Supreme Court, “Congress’s primary focus [in enacting the amendment] was upon what to do about nonphysical personal injuries, not upon the provision’s coverage of punitive damages under pre-existing law.” The Court clarified the law and established that punitive damages are not excludable from gross income. [Fabry v. Comm’r, 223 F.3d 1261, 1265 n. 14 (11th Cir.2000) and Foster v. U.S. (11th Cir., 2001)

If Congress were to select one kind of receipt of money which, above all others, would be a fair mark for taxation, it might well be “windfalls.” There can be no question that punitive damages recovered by the respondent greatly enhanced its ability to pay. Realizing that one reason for the adoption of the Sixteenth Amendment was to place the burden of taxation according to the ability to pay, the Seventh Circuit concluded that the term “income” as used in that Amendment Congress intended to include punitive damages in income if it had the constitutional power to do so. Section 22(a) of the Internal Revenue Code provides:

“Gross income” includes gains, profits, and income derived from salaries, wages, or compensation for personal service * * * of whatever kind and in whatever form paid, or from professions, vocations, trades, businesses, commerce, or sales, or dealings in property, whether real or personal, growing out of the ownership or use of or interest in such property; also from interest, rent, dividends, securities, or the transaction of any business carried on for gain or profit, or gains or profits and income derived from any source whatever. [26 U.S. C.A. § 22(a), Commissioner of Int. Rev. v. Obear-Nester Glass Co., 217 F.2d 56 (7th Cir., 1954)

When that portion of settlement proceeds representing punitive damages was not entitled to the exclusion from gross income under 26 U.S.C. Sec. 104(a)(2) it is income and subject to income tax. [Commissioner v. Miller, 914 F.2d 586 (4th Cir.1990)]

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. 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.

 


© 2020 – Barry Zalma

Barry Zalma, Esq., CFE, now limits his practice to service as an insurance consultant  specializing in insurance coverage, insurance claims handling, insurance bad faith and insurance fraud almost equally for insurers and policyholders. He also serves as an arbitrator or mediator for insurance related disputes. He practiced law in California for more than 44 years as an insurance coverage and claims handling lawyer and more than 52 years in the insurance business. He is available at http://www.zalma.com and zalma@zalma.com.

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