Introduction:
Punitive damages are awarded to a party in order to punish the other party in the litigation. If a judge or jury determines that the act committed by the defendant was so onerous that the defendant should be punished, it can award sums sufficient, in the jury’s mind, to punish the wrongdoer and deter other persons from engaging in such conduct.
This should be compared to compensatory damages which are awarded to the party to compensate for losses suffered. As an example, assume you are negligent and drive your car into mine, causing injury. You can recover compensatory damages for the loss of your vehicle, to pay for medical treatment, for your lost wages while you are recovering, and for the pain and suffering you have suffered. Those compensate you for what you have lost so it is not income and reportable by you to the Internal Revenue Service.
But assume you were intoxicated and driving wildly, trying to outrun a police vehicle and then you ram into me. The angry jury not only awards me compensation for what I have lost but can claim your gross negligence should allow punitive damages to be awarded to punish you.
Punitive damages are treated quite differently tax-wise and that is the topic of this article.
Basic Law:
The Internal Revenue Service has ruled that all punitive damages are fully taxable as ordinary income, even if the underlying compensatory damages are tax-free. This means that even if a plaintiff receives compensatory damages that are excluded from income, any additional punitive damages received will be fully taxable as ordinary income. There are no exceptions to this rule.
It gets even grimmer. Often attorney’s fees are paid as a percentage of recovery, usually one-third to forty percent. Before 2018, legal fees were deductible from the total punitive damages in determining taxes as a miscellaneous itemized deduction, albeit with some limitations. Now, miscellaneous itemized deductions are completely suspended from 2018-2025 due to the Tax Cuts and Jobs Act of 2017.
This means that for the 2018-2025 tax years, legal fees attributable to punitive damages are entirely non-deductible. Assume you receive a ten-million-dollar punitive damages award. Assume you have to pay one-third to your attorney under the attorney-client fee agreement. That leaves you about 6.6 million to take home, but you have to pay what, in California, would be 40% combined State and Federal tax on the full ten million, or four million dollars in taxes. You would only net a bit over two million dollars from that ten-million-dollar reward. Note that pre-judgment interest and post-judgment interest are also always taxable.
This is due to lawmakers voting in the 2017 Tax Act which considers a client’s attorney fees, like a contingency fee, as not deductible. Before 2017, clients were able to deduct their contingency fees from the overall payout of the settlement. That isn't the case anymore, so you can expect less from the overall sum of your settlements once state, federal, and attorney fees come into play.
And delaying payment of that tax is expensive. A failure-to-pay penalty is charged for failing to pay your tax by the due date. The late payment penalty is 0.5% of the tax owed after the due date, for each month or part of a month the tax remains unpaid, up to 25%.
Practical Considerations:
As one client commented, anything is better than nothing so even if punitive damages are taxed heavily, it is better than not to be awarded them. However, some proactive planning may minimize the cost.
Contingency Fee Negotiation: If there is a chance for punitive damages being awarded in your case you should seek to have an attorney-client fee agreement that has a contingency amount lowered for punitive damages. Before signing the agreement, ask the attorneys if they will agree to a contingency of half the amount for any punitive damages awarded. Thus, you would pay 33% on compensatory damages and, say, 15% on any punitive damages. Attorney’s fees are subject to negotiation, and you might find an attorney, anxious to get your case, willing to so agree.
Punitive damages are not common and in personal injury are only likely when there is gross negligence that is likely to anger a jury. A driver driving his Jaguar who is high on illegal drugs and has had prior arrests for that type of driving is facing quite possible punitive damages. A simple fender bender is unlikely to generate punitive damages. If you feel there is any chance for them or if your attorney tells you that you should seek punitive damages, see if you can negotiate the contingency fee down.
Settlement Negotiations: Settlement is how most cases are resolved, well over 90 percent of them. During settlement discussions, punitive damages are normally claimed as impossible by most defendants regardless of the acts committed, but experienced counsel will often be aware that such damages are a distinct possibility and so advise his clients. If the settlement increases the amount of compensatory damages significantly instead of having punitive damages, there are significant tax advantages. This cannot be tax fraud. But if a good argument can be made that pain and suffering compensation may be increased, then the bottom line for the plaintiff may be protected.
Post-Settlement Negotiations: If and only if an appeal has been filed by the defendant, you may be justified in engaging in settlement discussions that reduce the punitive damages and increase the compensation as above. The IRS may claim a conspiracy to avoid taxes, but if the appeal has good grounds so that your settlement makes economic sense, there is a good chance that such a settlement would not be set aside by the IRS.
Consider your Domicile: California and certain other states have their own income tax which mirrors the Federal and can be substantial, often over ten percent. That is added to the Federal income tax. If you are truly domiciled in another State, you do not have to pay those taxes. But the domicile must be real. The state income tax personnel will check and will want to see proof of residence (at least 185 days a year) and will be examining utility bills and the like. And if you move back a few months after getting the damages, they will be even more suspicious and there is interest and fines that may be levied as well as the extra costs of a tax attorney or CPA arguing your case. That said, if you know a one-million-dollar punitive damages award is coming in a few months a move to Nevada could save you over a hundred thousand dollars in taxes. Federal tax would not be altered.
Conclusion:
Concentrating on recovery for injuries and for making the defendant suffer for his or her wrongdoing, most plaintiffs do not concentrate on the issue of taxation of results. Since it is advance planning that can perhaps minimize the tax cost, this delay in confronting the issue of taxation can be very expensive indeed.
Note that at the end of 2025, the current tax law expires. However, there is no reason to believe that the regulations that will follow that year will be more beneficial. It is best to plan and plan early.