Supreme Court Holds Punitive Damages Not Excludible (July 1997)

The Supreme Court, resolving a conflict among the circuits, has held that the exclusion from gross income provided for by IRC Sec. 104(a)(2) for the “amount of any damages received…on account of personal injuries” does not extend to punitive damages.  O’Gilvie v. U.S., 117 S.Ct. 452 (1997). The petitioners in this case, the husband and children of a woman who died of toxic shock syndrome, had received a jury award of $1,525,000 in actual damages and $10 million in punitive damages. The petitioners paid income tax on the punitive award, then sought a refund.

Justice Breyer, writing for the majority, agreed with the government’s argument that the punitive portion of the damage award was not “received … on account of” the personal injuries, but rather was awarded “on account of” the defendant’s reprehensible conduct, and the jury’s need to punish and deter it.

The Court also found the Government’s reading “more faithful to the history of the statutory provision as well as the basic tax-related purpose that the history reveals.” The Court observed that when the statute was enacted, the Supreme Court “had recently decided several cases based on the principal that a restoration of capital was not income. Punitive damages, according to the Court, fell outside the scope of a mere restoration of income.

The taxpayer had argued that from the perspective of tax policy, noncompensatory punitive damages should stand on equal footing with compensatory damages, which are excludible. However, the court reasoned that the “language and history” of the statute indicated that even the exclusion from income of compensatory damages was an “anomaly” in the general tax scheme. That circumstance would not, according to the court, warrant “extension of the anomaly or the creation of another.”

The court also rejected the taxpayer’s argument that the exclusion from income of punitive damages was warranted as such a construction would avoid “administrative problems” which could occur when trying to separate punitive and separate portions of a global settlement. Noting first that “[t]ax generosity has its limits,” the Court then discounted the severity of the administrative problem in distinguishing punitive from compensatory elements. Finally, the Court observed that the problem of “identifying the elements of an ostensibly punitive award does not exist where, as here, relevant state law makes clear that the damages at issue are not at all compensatory, but entirely punitive.”

Congress amended Code Sec. 104(a)(2) in 1996 to provide that excludible damages consist (only) of amounts received “on account of personal physical injuries or physical sickness.” Thus, damages for emotional distress will not be excludible from gross income, except if the damages arise out of a claim for physical injury or sickness. After O’Gilvie, punitive damages appear to be taxable regardless of the nature of the claim from which they arose. Damages arising from wrongful death would continue to be excludible from gross income.

Since the application of Sec. 104, as well as the rule announced in O’Gilvie, apply with equal force to amounts received as a result of a judgment or a settlement, it appears axiomatic — at least from a tax perspective — that settlements awards which maximize nonpunitive physical elements are preferable.

Thus, the 8th Circuit held in an earlier case that the portion of a payment received by the seller of a business in settlement of claims for misrepresentation was excludible from income as damages received on account of personal injuries, since under Kansas law, misrepresentation was a tort. J.R. Fitts, CA-8 (unpublished opinion), 95-1 USTC ¶50,254. However, Fitts was decided before Code Sec. 104 was amended to require that only physical elements of personal injury awards were excludible.

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