Taxing Punitive Damages for Physical Injury or Sickness

Taxing Punitive Damages for Physical Injury or Sickness

I n 1989, Congress amended Internal Revenue Code section 104(a)(2) by making punitive damages taxable in cases that did not involve physical injury or physical sickness; however, it was not clear whether those punitive damages were excludable. The Small Business Job Protection Act of 1996 generally made all punitive damages taxable but included one exception for punitive damages awarded in a civil action for a wrongful death. This new law became effective for amounts received after August 20, 1996, the date the law was enacted.

A grandfather clause of the legislation said the new law would not apply to any amount received under a written binding agreement, court decree or mediation award in effect on (or issued before) September 13, 1995; therefore, the new law did not affect the taxation of punitive damages received due to physical injury or physical sickness before passage of the 1996 act. However, a recent U.S. Supreme Court decision undermines the argument that punitive damages received in physical injury or physical sickness cases in prior tax years are excludable.

On December 10, 1996, the Court ruled in OGilvie v. U.S. (78 AFTR 2d 96-5636) that punitive damages received in a tort suit for personal injuries were taxable. Betty OGilvie died in 1983 of toxic shock syndrome. Her husband and children sued the maker of the product that caused Bettys death and received a jury award of $1,525,000 actual damages and $10 million punitive damages. While the actual damages were excluded, the Court said the $10 million punitive damages were not received due to personal injuries, the section 104 exclusion provision did not apply and the damages were taxable.

In support of its decision, the Court said:

• Punitive damages were not designed to compensate victims.
• The governments interpretation of section 104 was “more faithful to the history of the statutory provision as well as the basic tax-related purpose” of excluding the amount needed to make up for a loss.
• It had asked why Congress wanted the exclusion to cover punitive damages and had found no good answer.

While this case was governed by pre-1989 law, one of the petitioners arguments relied on the 1989 amendment to section 104, which prohibited punitive damages not involving physical injury or physical sickness from being excluded under section 104(b)(2).

The conference report from the 1996 act recognized that courts differ as to whether the section 104 exclusion applied to punitive damages received in connection with physical injury or physical sickness. Referring to the pending OGilvie case in a footnote, the report said the Supreme Court had recently agreed to decide whether punitive damages awarded in a physical injury lawsuit were excludable from gross income. The report also said the committee intended no inference as to the application of the exclusion to punitive damages prior to the effective date of the bill in connection with a case involving a physical injury or physical sickness. In OGilvie , the Supreme Court quoted the conference report, which said that Congress intended no inference as to the proper interpretation of section 104(a)(2) prior to amendment.

Given the conference reports express recognition of differing court opinions, the acknowledgment of the pending Supreme Court decision in OGilvie and the explicit statement that no inference is intended as to the proper interpretation of prior law, OGilvie puts a taxpayer at significant risk if he or she received punitive damages in open tax years. The IRS now appears to have strong authority to tax punitive damages in all open tax years, regardless of whether they were received in a physical injury or physical sickness case. Given the dollar magnitude of punitive damages in many physical injury cases, the IRS is not likely to relinquish its keen interest in this issue.

—Kenneth F. Abramowicz, CPA, Ph.D., assistant professor of accounting and information systems, University of Alaska, Fairbanks .