Overcoming tradeoffs in the taxation of punitive damages.

• Author: Markel, Dan

TABLE OF CONTENTS INTRODUCTION I. CURRENT TAX LAW AND THE UNDER-PUNISHMENT PROBLEM A. The Nature of the Under-Punishment Problem B. Overcoming Under-Punishment 1. Two Tactics: Nondeductibility vs. Tax Awareness. 2. An Overview of the Case for Tax Awareness a. The Circumvention Problem b. Federalism and Regulatory Diversity 3. Windfalls and the Dark Side of Tax Awareness 4. An Ineliminable Tradeoff? II. RETHINKING EXTRACOMPENSATORY DAMAGES: A NORMATIVE VISION A. Recent Normative Theories of Punitive Damages B. The Basic Structure of Retributive Damages: A Recap C. Building a Pluralistic Structure: A Summary III. TAXING EXTRACOMPENSATORY DAMAGES PROPERLY A. Taxing Retributive Damages 1. Retributive Damages and Federalism Tradeoffs 2. Circumvention B. Taxing Aggravated Damages C. Taxing Deterrence Damages CONCLUSION INTRODUCTION

A few years ago, an Oregon jury socked tobacco giant Philip Morris with punitive damages of almost $80 million in a case involving one person's death. (1) In another case, a trial court imposed a penalty of $5 billion in punitive damages against Exxon for its reckless conduct in the Valdez oil spill. (2) should these corporate payments of punitive damages be tax-deductible business expenses? Perhaps surprisingly, they are; put simply, punitive damages incurred in connection with the defendant's business are tax deductible. (3)

Consequently, the intersection of tort and tax law in many jurisdictions leads to a curious under-punishment problem. on the one hand, jurors assess punitive damages in an amount that they believe will best "punish" the defendant. (4) On the other hand, defendants are not always punished to the degree that the jury intends because punitive damages paid by business defendants are tax deductible under the Internal Revenue Code. (5) As a result, these defendants often pay far less in real dollars than the jury believed they deserved to pay.

Some scholars argue that the best way to address this problem is simply to make punitive damages nondeductible in all cases. (6) Indeed, President Barack Obama in February 2010 proposed this solution as part of his fiscal year 2011 budget. (7)

As Gregg Polsky and I explained in greater detail in a companion article, (8) the tactic of using a blanket nondeductibility rule for punitive damages would not work in most situations. Defendants could easily circumvent the nondeductibility rule by disguising punitive damages as compensatory damages in settlements. (9) Instead, the under-punishment problem is best addressed at the state (not federal) level by making juries "tax aware," instead of keeping them "tax blind" regarding the fact and effect of deductibility in business-related cases. (10) Tax-aware juries would be informed of business defendants' marginal tax rates, which would enable them to adjust the amount of punitive damages to impose the desired after-tax cost to the defendant. (11) Parties seeking to settle would consequently bargain in the shadow of the (presumptively) larger award that would be made at trial if a verdict were reached.

Unfortunately, while tax awareness would solve the under-punishment problem, it would do so at the cost of enlarging plaintiff recoveries. Many scholars and lawmakers view recoveries that go beyond full compensation as undeserved and unwarranted "windfalls." (12) If characterized correctly as windfalls, (13) then these extracompensatory recoveries raise a number of concerns. For example, an extension of windfalls to plaintiffs risks decreasing incentives for plaintiffs to take adequate precautions and increasing incentives to bring frivolous suits. (14) Additionally, windfalls provide a kind of lottery gain that, ex ante, citizens would prefer to avoid because of their risk aversion. In other words, most people would prefer to have gains realized through lower taxes or more services as opposed to the unlikely prospect of a large windfall, even where these two options have the same risk-adjusted value. (15) Consequently, if there is a way of solving the under-punishment problem without needlessly enriching plaintiffs beyond the full scope of their losses, then that would be more desirable. (16)

This Article provides a strategy for overcoming that tradeoff. Essentially, this punishment/enrichment tradeoff could be mitigated through some basic reforms of punitive damages. Drawing on a recent reform proposal meant to disaggregate and implement the underlying and distinctive purposes of punitive damages, (17) I identify how state and federal governments can avoid this tradeoff. These reforms are predicated on the idea that punitive damages should be disaggregated so as to accommodate three distinct purposes: (a) realizing the public's interest in developing an intermediate civil sanction designed to promote retributive justice; (b) vindicating and compensating the injury to a victim's dignity interest not already covered by noneconomic damages; and (c) facilitating the pursuit of cost internalization (optimal deterrence) to the extent permitted after the Supreme Court's important and recent decision in Philip Morris USA v. Williams. (18)

Per the proposal, these three interests would no longer be conflated under the umbrella term of "punitive damages." Rather, the decision maker (whether jury or judge) would scrutinize each interest separately, and the remedy for a violation of each interest would fall under the labels of retributive, aggravated, and deterrence damages, respectively. (19) Although these reforms are not principally motivated and constructed to reduce the tax-related tradeoff between under-punishment correction and windfall augmentation under current doctrine, one of the incidental benefits of such reforms is that they would avoid such a tradeoff.

At bottom, this Article sketches a pluralistic vision of what a reformed extracompensatory damages landscape might look like and how the tax rules should correspond. Contrary to those who would establish a sweeping rule of deductibility or nondeductibility for all forms of punitive damages, my view is that the appropriate tax treatment of civil damages should depend on the particular purpose that such damages are intended to achieve. Thus, in some respects, these recommendations can be seen as staking a middle path between those, like the President, touting the proposed rule of blanket nondeductibility for all punitive damages and those scholars endorsing the current rule permitting deductions for business-related punitive damages. (20)

The Article unfolds in three Parts. Part I furnishes some background about the taxation of punitive damages with respect to business defendants. (21) I begin by summarizing the concern with the underpunishment punishment problem and the proposed solution of tax awareness as a preferred method to deal with that problem under current law (rather than the nondeductibility rule endorsed by President Obama and other lawmakers and scholars). As mentioned before, regardless of the tactic used--nondeductibility or tax-aware juries and judges (22)--there is an ineluctable tradeoff between plaintiff enrichment on one hand and underpunishing business defendants on the other.

As demonstrated in Part I, while tax awareness best solves the underpunishment problem, (23) it does so at the cost of augmenting plaintiff windfalls. Fortunately, this problematic tradeoff is avoidable, provided that states are willing to reform their punitive damages laws. To that end, the next two Parts of the Article are normative and sketch a way out of this dilemma through some reforms of punitive damages law I recently proposed separately. These reforms are summarized in Part II. (24)

Against the backdrop of this pluralistic framework, Part III examines how the tax law should be structured to complement this redesign of punitive damages law. In particular, I explain why a need for a differentiated taxation approach--i.e., one that allows for deductions of extracompensatory damages with gross ups in some contexts but not necessarily in others--might be valuable and what some of the relevant costs and benefits are with respect to these options. Perhaps surprisingly, I identify the very interesting vertical and horizontal federalism concerns associated with these taxation rules and offer a perspective on how to address them. The analysis here, I hope, will be of significance to the broader academic and policy-making community. The timing of this analysis is especially auspicious in light of the Supreme Court's decision in Philip Morris, (25) which reorients the constitutional landscape for punitive damages and, by doing so, invites the federal and state governments to rethink the allocation and taxation of punitive damages.

1. CURRENT TAX LAW AND THE UNDER-PUNISHMENT PROBLEM

   1. The Nature of the Under-Punishment Problem

      Given the stated goals of punitive damages law in most American jurisdictions, (26) punitive damages are principally and unsurprisingly awarded to punish defendants for torts committed with a malicious or reckless state of mind. In crafting an appropriate financial punishment for such misconduct, jurors are typically instructed to consider, among a number of other factors, the defendant's financial condition. (27)

      However, jurors are not currently informed of the fact that business-related punitive damages are, like other business-related expenses, deductible for federal income tax purposes. (28) Surprisingly, there are no reported cases discussing the tax awareness issue in the punitive damages context, (29) and treatises and articles have largely ignored the issue, (30) despite the fact that state and federal courts have generally allowed such augmentations in cases applying a range of antidiscrimination laws. (31) Some discussions with plaintiffs' lawyers indicate that they, too, have not focused on the issue of tax awareness. (32) Accordingly, as a matter of practice, it appears that punitive damages jurors are...