Failure to Address Punitive Damages Could Result in Unexpected Tax Ruling

The Small Business Job Protection Act of 1996 made it clear that punitive damages would be taxable to the claimant, regardless of whether the origin of the claim was a personal physical injury or physical sickness. The taxation of punitive damages makes the careful preparation of settlement documents very critical if the claimant expects to avoid an unfavorable allocation ruling by the IRS, whenever punitive damages were included in the pleadings filed with the court, mentioned in trial or discussed during settlement negotiations.

This bill, which became public law on August 20, 1996, amended Section 104(a)(2) of the Internal Revenue Code of 1986, which exempts physical injury or physical sickness damage payments from the taxpayer’s current year income, whether by suit or agreement and whether by lump sum or paid over time. The law also inserted the word physical before the words injury and sickness, further limiting what used to be exempt. Previously, whether punitive damages were to be taxed was unclear in the law, and the courts were divided on the issue.

U.S. Tax Court, in Barnes v. Commissioner of Internal Revenue, held that the Internal Revenue Service was correct in allocating half of the damages paid in a personal physical injury case to taxable punitive damages, the remaining half to excludable personal injury damages. (See Tax Court Memo, 1997-25, Jan. 15., 1997.) Punitive damages had been mentioned in the pleadings and the plaintiff’s attorney also referred in the negotiations to the “likelihood” of there being punitive damages. The settlement agreement did not include any specific allocation of damages.

For the protection of the taxpayer, the settlement agreement should allocate between taxable and nontaxable damages. If punitives were sought in the pleadings or otherwise raised in demands during negotiations, and the parties agree to a compromise settlement that will not include punitive damages, the settlement agreement might contain language such as: “The parties hereby agree that none of the sums set forth herein constitute punitive damages. The parties stipulate further that it is in their own respective best interests that punitive damages were not paid as a part of this settlement.” All parties should sign the agreement, and it should be clear that the stipulation is not simply an accommodation by the defendant or casualty insurer to the plaintiff. If no punitive damages were sought, it would not be out of line to state such in the settlement agreement.