Court, IRS Disagree on Whether Punitive Damages are Taxable

A Kentucky couples home blows up as a result of a gas companys failure to detect a gas leak. The family sued the utility company and recovered $100,000 in compensatory damages and $400,000 in punitive damages. They did not report it as income and the Internal Revenue Service tried to recover income tax on the money. But the court found the punitive damage award properly excluded as income. Horton v. Commissioner of Internal Revenue Service, 33 F.3d 625 (6th Cir.1994).

A prominent Mississippi surgeon dies in a plane crash.

Punitive damages of $1.5 million are paid in a life insurance dispute to the family. The estate is forced to pay over $300,000 in income taxes to the federal government following a bad faith action against the insurance company. Wesson v. United States, 843 F.Supp. 1119 (S.D.Miss.1994).

It's not enough that personal injury plaintiffs have to battle tough defense lawyers over their liability claims. But, after recovery, they often have to do battle with the Internal Revenue Service over a multi-million-dollar question: are punitive damages taxable?

Historically, compensatory personal injury damages, including those for non-physical injuries, have been excluded from income. But the tax treatment of punitive damages has been less clear.

In 1989, Congress amended section 104(a)(2) to provide that the exclusion of income "[s]hall not apply to any punitive damages in connection with a case not involving physical injury or physical sickness." The interpretation of this paragraph is far from universal.

For instance, a recent Seventh Circuit case held that punitive damages in an employment discrimination action are taxable as income. Downey v. Commissioner of Internal Revenue, 33 F.3d 836 (7th Cir.1994). This court, as others, have found that such damages are taxable as income unless tort-type personal injuries are pleaded and proven, even for intangible elements such as pain and suffering, emotional distress or personal humiliation. In Wesson, for example, punitive damages were taxable because they were awarded in a bad faith action, even though the original action stemmed from a personal injury lawsuit.

The plaintiff's position generally is that any damages received pursuant to a personal injury lawsuit are excluded as income.

But the determination of a physical injury case often depends on the wording, not of federal law, but of state laws, which dictate the nature of the remedy. Given the confusion, the proper focus, though, should be on the nature of the underlying claim, rather than on the label given to the damages.

The IRS position, on the other hand, has been that the exclusion in the Code applies only to compensatory damage awards and that punitive damages, meant solely to punish and deter, are awarded as a measure of the degree of the defendant's culpability. Punitive damages, the IRS argues, are a windfall and should be taxed as if they were income.

However, not all federal courts agree.

The U.S. Tax Court, a special court that hears cases brought by the IRS against alleged delinquent taxpayers, has ruled that punitive damages aren't taxable as income.

This split has created an anomalous situation for personal injury claimants: those who report the damages as income, pay the tax and then seek a refund must do so through federal court, where the taxpayer generally loses. However, if instead the taxpayer decides not to report the punitive damages as income, he is likely to face a claim brought by the IRS and wind up in Tax Court. In Horton, the taxpayer fared better there because the IRS position was rejected and the income was held not to be taxable.

Personal injury recoveries have been tax exempt since 1918.

For years, very little litigation arose over this exemption. It wasn't until the landmark case of Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1954), that the Supreme Court held that punitive damages were taxable in a fraud and antitrust action.

Since then, the courts have been grappling with the distinction between physical and non-physical injuries and the taxability of damages for such recovery.

Perhaps Congress should re-examine and clarify its policy reasons for the 1989 change which excludes punitive damages from taxation in cases involving physical injury or physical sickness.

For example, are damages excluded as gross income as an attempt to make a taxpayer "whole" from a loss of personal rights? Or was Congress' intent to tax damages that were mere accessions to wealth?

Even this distinction creates a false dichotomy because in a personal injury suit compensatory damages never really make a maimed person "whole." Oftentime, punitive damages are awarded because of the aggravation of the injury or because of the way in which it was inflicted or because of the injury to society as a result of the egregious conduct.

Given the current uneven, unpredictable tax treatment of punitive damages, perhaps trial lawyers representing plaintiffs should be allowed to argue taxability to the jury which could take this significant financial issue into consideration for the injured plaintiffs. If not, then plaintiffs' lawyers should be sensitive to potential tax treatment when alleging a personal injury claim in the complaint and in drafting any settlement agreement to include a release of all claims for personal injuries.

In the meantime, the confusion leads to a source of additional litigation for a family or injury victim at a time when they probably have had just about enough with the courts.