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 as a bludgeon on other defendants to convince them to settle for more than they owe. What the litigants and litigators seldom consider are 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 to the way he was before the tort caused damage. Punitive damages are considered a windfall to the taxpayer and must be included when the plaintiff files his tax return as 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. The court stated:

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

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. In assessing the penalty the court stated:

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.

Since the punitive award exceeded $2.4 million, the Tax Court assessed a penalty over the tax owed of $480,000. The 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 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.

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

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 percent 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 percent federal income tax and approximately 10 percent 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 percent 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 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 percent 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. If not brought to the plaintiffs' attention by their lawyers insurance claims professionals, defense counsel, mediators and settlement judges must make that information available to the plaintiffs. Such information will be a great incentive to avoid trial and a punitive damages award.