CHAPTER 11 PUNITIVE DAMAGES AND INCOME TAX

• Jurisdiction: United States
• Publication year: 2018

In Greenberg v. Commissioner of Internal Revenue, 2011 TC Memo. 18, No. 25420-07. (U.S.T.C. Jan. 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 result was 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:

[T]he definition of gross income broadly encompasses any accession 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. This "but for" argument is 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 of relevant authority, that "damage awards that serve both to compensate and punish are excludable."

The...