Don't Make Punitive Damages Worse!

By Robert W. Wood

Defendants and their lawyers don't usually consider tax issues when settling cases. Plaintiffs usually do. Why the difference? Plaintiffs have to worry whether their settlement is income and if so, what type. Plaintiffs may also have trouble deducting their attorney fees.

In contrast, one reason business defendants don't consider tax issues is that they know they will deduct all settlements, judgments, and legal fees as business expenses. Yet given these facts, it is surprising that many defendants and their lawyers assume punitive damages are not tax deductible.

In fact, the contrary is true. As long as they arise in the course of the trade or business, punitive damages are clearly tax deductible. That has always been the law. It is only fines and penalties paid to governmental entities that are not. But all that may change.

Under a proposal made by the Obama administration - which the Senate has already approved - all punitive damages will become non-deductible. What's more, if you buy insurance to cover punitive damages, this rule will impact you too. If the policy ever pays, the Internal Revenue Service will tax you on the policy benefits as income (even if the money goes directly from the insurance company to the plaintiffs). The idea of this provision is to prevent businesses from reducing the sting of punitive damages by buying insurance. Each defendant ends up with the same tax result - non-deductible treatment for a company that self-insures, and taxable income for a defendant with punitive damage insurance. Of course, you may not care about this if you don't face punitive damage verdicts. No one does willingly.

Yet if a business finds itself saddled with a surprise punitive damage verdict, the financial impact will be huge. If you pay $5 million in punitive damages on a tax deductible basis, it costs you about $3 million after tax. If you pay $5 million in punitive damages and can't deduct it, your cost is the full $5 million.

That means, if this proposal becomes law, punitive damages will become even more painful. One answer will be to settle cases, to make sure you avoid the punitive damage taint. Defendants who worry about punitive damage exposure claim this proposed law will compel them to settle. They assert that settling will prevent any amount being treated as punitive damages, which will amount to extortion.

Of course, this assumes defendants will be able to avoid the punitive taint by settling, and that is not clear. How could any "punitive damages" be payable if the settlement agreement resolves the case and expressly recites that the defendant admits no wrongdoing and that no punitive damages are being paid? Simple. Amazingly, the IRS has prevailed in several cases on just this point, treating an amount as punitive even though it was paid pursuant to a settlement before trial.

In fact, making punitive damages non-deductible may require an allocation between compensatory and punitive damages even in a settlement. Otherwise defendants could easily avoid the punitive damage taint with the stroke of a settlement pen. Plus, an allocation between compensatory and punitive damages may be required not only where a case settles after a verdict and on appeal, but even when a case settles before trial. Of course, just because a complaint seeks punitive damages doesn't mean they will be awarded. Although any possibility of a punitive award before trial seems entirely speculative, the IRS may not agree.

Whatever happens on the pending tax bill, some say that judges and juries will take tax issues into account. They could award a smaller or greater amount of punitive damages depending on their perceptions of tax deductions. This sounds good in theory but is unrealistic. Where plaintiffs or defendants try to introduce tax effects into a civil case, the judge often won't allow it.

Congress may determine as a matter of social policy that bad conduct (as manifested in a punitive damage award) should not be subsidized with a tax deduction no matter what. In the 1960s, Congress did that by making government fines and penalties non-deductible. However, the non-deductibility of government fines and penalties stems from a different tradition, emanating from the criminal law where the standards of proof are different.

Moreover, even fine or penalty non-deductibility has exceptions. Many government fines designed to encourage compliance with the law or to be remedial are still deductible. Only government fines and penalties that are expressly intended to be penal are not. To be parallel, a deduction for punitive damages should still be allowed where they are quasi-compensatory.

Washington needs revenue, and making punitive damages non-deductible would raise some. Nevertheless, this measure should not be passed without careful analysis of what behavior it would invite. At a minimum, settlement discussions will involve one more element, and not just when a case is on appeal. The law would open a hopelessly factual debate. So far no one has even broached this morass.

This discussion is not intended as legal advice, and cannot be relied upon for any purpose without the services of a qualified professional.

Robert W. Wood is a tax lawyer with Wood & Porter, a nationwide practice (www.woodporter.com). The author of more than 30 books including "Taxation of Damage Awards & Settlement Payments" (4th Ed. 2009 www.taxinstitute.com), he can be reached at wood@woodporter.com. <!-- Don't Make Punitive Damages Worse! -->