Documente Academic
Documente Profesional
Documente Cultură
60
November 15, 2010
cles to the settlement of claims, and ultimately fail to Proponents of this change in tax law argue that
meet the purported objectives of its proponents. It is the “deductibility of punitive damages payments
not only bad tax policy; it is also inefficient policy undermines the role of such damages in discourag-
that will only transfer more costs to the American ing and penalizing certain undesirable actions or
consumer in an economy that is already suffering.123 activities,”9 and that eliminating the deductibility
will prevent businesses from circumventing puni-
Current Law and the Proposed Change tive damages imposed on them through tax
Under the federal tax code, businesses are enti- deductible write-offs. But, even under the current
tled to deduct all ordinary and necessary business tax law, “[n]early all defendants already regard
expenses, including operating costs, salaries, and punitive damages as anathema”10 because of the
compensation. “Ordinary and necessary business potential damage such an award can do to the rep-
expenses” also include compensatory and punitive utation of a business, with a resulting loss in sales
damages paid to settle a claim or as the result of a of products or services.
judgment awarded against the business as long as
Proponents are also continuing the unwise
the acts that gave rise to the litigation were per-
practice of trying to use the tax code to achieve
formed in the ordinary course of the taxpayer’s
public policy or social objectives that have noth-
business.4 Unlike compensatory damages for phys-
ical injuries or sickness, punitive damages are also ing to do with a fair and efficient tax system. Such
generally considered income to the recipient.5 objectives should be achieved either through the
market or through legislative regulation that is not
The text of the amendment sponsored by Sena- based on taxes.
tor Harry Reid (D–NV) (as well as the Job Creation
and Tax Cuts Act) stated that “[n]o deduction shall Civil and Criminal Fines and
be allowed under this chapter for any amount paid Punitive Damages
or incurred for punitive damages in connection The Obama Administration claims that punitive
with any judgment in, or settlement of, any damages are similar to civil and criminal fines—for
action.”6 This change was also proposed by the which no tax deduction is allowed11—and, there-
Obama Administration in its 2010 Revenue Pro- fore, they should also not be deductible.12 How-
posals,7 as well as by the Clinton Administration in ever, that argument overlooks significant, relevant
its fiscal year 2000 and 2001 budget proposals.8
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No. 60 November 15, 2010
differences between government fines and punitive are, in effect, a dead weight cost for companies
damages. Unlike fines that are usually fixed by stat- doing business in the United States, one that is far
ute, punitive damages can be imposed under very higher than in most other industrialized nations.
vague standards in almost any amount no matter What is really needed is fundamental tort reform,
how extreme or disproportionate “unless a judge but in the meantime, it does not make sense to
decides that the amount awarded shocks the con- increase such dead weight costs for business.
science or violates broad due process limita-
tions.”13 That very uncertainty, when combined Of Passion and Caprice
with the loss of the deductibility of punitive dam- The U.S. Supreme Court has “expressed concern
ages, could force defendants to settle cases and about punitive damage awards ‘run wild,’ finding
forgo appeals even when they have valid reasons to them inexplicable on any basis but caprice and pas-
believe they would have a successful appeal. sion.”17 In BMW of North America, Inc. v. Gore, the
As the Tax Section of the New York Bar Associa- Court outlined that the states have considerable
tion pointed out, “jurors are asked to determine an flexibility in determining the level of punitive dam-
appropriate dollar amount based on amorphous, ages that they will allow and afford juries “similar
and arguably irrelevant, criteria.”14 Supporters of latitude, requiring only that the damages awarded
this change also wrongly assume that all punitive be reasonably necessary to vindicate the state’s legit-
damages are “punishment.” Punitive damages can imate interest in punishment and deterrence.”18 It
be imposed based on punishment and deterrence, is very difficult to overturn even extremely large
but juries may also award punitive damages if they punitive damages awards that bear little relation to
believe that the legally allowable compensatory the acts of a particular defendant because only
damages in a particular case are insufficient to ade- “when an award can fairly be categorized as ‘grossly
quately compensate a plaintiff. Punitive damages excessive’ in relation to these interests does it enter
are “driven largely by subjective emotions like anger the zone of arbitrariness that violates the Due Pro-
and sympathy.”15 From a practical standpoint, “the cess Clause of the Fourteenth Amendment.”19
jury can and will award whatever the plaintiff’s law- Criminal penalties also require proof beyond a
yer can justify in a powerful closing argument.”16 reasonable doubt, a standard that does not apply in
Thus, punitive damages often are not the equivalent civil cases—punitive damages can be awarded in
of a criminal punishment for a defendant or a civil most states “by a mere ‘preponderance of the evi-
fine but a redistributive boon for a plaintiff to pro- dence.’”20 Finally, criminal fines can be imposed
vide even more compensation. Punitive damages only once for violations of the law because the Fifth
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No. 60 November 15, 2010
Amendment to the Constitution prohibits any per- gation and their expected costs, setting aside assets
son from being “twice put in jeopardy” for the same that could otherwise be put toward productive
offense. That is not true of punitive damages, ventures, such as expanding their production or
which can be imposed repeatedly on the same research and development of new products.23
defendant for the same course of conduct that Making punitive damages taxable will require busi-
affects different plaintiffs. nesses to set aside even larger amounts of assets in
Until—and unless—“punitive damages defen- their budgets, which could include decreasing their
dants are afforded the same basic protections that business expenses by cutting jobs or increasing the
generally apply to criminal defendants,”21 it would prices of their goods and services. Just like any
be unfair to treat punitive damages and criminal other business tax increase, the consumer (and the
fines the same for tax purposes. employee) will bear the costs.
As a result, consumers may see higher prices on
Economic and Litigation Consequences all goods and services, and fewer new jobs will be
Punitive damages are most often awarded “in cases created during troubled economic times. If busi-
involving malpractice, products liability and business nesses choose to go to trial, it will force them to
torts.”22 By eliminating the deductibility of punitive spend more money on litigation because of the
damages, Congress will increase taxes on businesses, higher stakes involved. Litigation costs and taxes
as well as the net costs of litigation, burdening the on businesses would increase significantly if the
economy and increasing the costs of goods and ser- deductibility of punitive damages were eliminated.
vices to the average consumer, including health care. Ending the deductibility of punitive damages
Assuming a corporate tax rate of 35 percent, will also promote further intrusion by the Internal
punitive damage awards would actually cost com- Revenue Service (IRS) into the liability and litiga-
panies an additional $350 for every $1,000 paid out tion arena. Under the proposed law, compensatory
to plaintiffs. Fearing the unpredictability of non- damages would remain tax-deductible while puni-
deductible punitive damages, risk-averse businesses tive damages would not. Although the current dis-
will prudently choose to settle even frivolous claims tinction between punitive and compensatory
with deductible settlements rather than undergo damages is somewhat inconsequential to business
costly litigation that might result in taxable puni- from a tax point of view when executives are pull-
tive damages. This risk shift will make businesses ing out their checkbooks, this distinction would
more hesitant to fight unwarranted liability claims. become crucial under the proposed tax change.24
It will give plaintiffs’ lawyers an incentive to bring
even more lawsuits against businesses without the Increased Government Intrusion
expense of ever setting foot in a courtroom in the The IRS already intrudes into the settlement of
expectation that the businesses will be more likely lawsuits. IRS guidelines warn that the “allocation
to settle such suits. However, it may undermine the among the various claims of the settlement can be
total dollars business defendants have available to challenged where the facts and circumstances indi-
pay plaintiffs in settlements. cate that the allocation does not reflect the eco-
When businesses prepare their annual operating nomic substance of the settlement.”25 The IRS may
budgets, they estimate the risk of damages and liti- disregard the terms of a written settlement to recat-
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No. 60 November 15, 2010
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