A Video Explaining the Tax Consequences of Bad Faith Punitive Damages

Modern Tax Law Makes Punitive Damages Only For The Benefit Of The Lawyers

In Gary L. Greenberg and Irene Greenberg v. Commissioner of Internal Revenue, No. 25420-07. (U.S.T.C. 01/24/2011) the United States Tax Court dealt with a recipient of insurance bad faith punitive damages who tried to avoid tax on the award. As a result, the recipient of the award of punitive damages for the bad faith conduct of their insurer, resulted in 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 that the definition of gross income broadly encompasses any addition 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. The Tax Court discounted the “but for” argument, and found it was 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.