Much is said about punitive damages and how they are used to punish wrongdoers. Plaintiffs dream of large punitive damage awards. Plaintiffs’ lawyers who obtain large punitive damage awards use them to brag about their ability as tort lawyers and as a bludgeon on other defendants to convince them to settle for more than they owe. What the litigants and litigators seldom consider are the tax consequences of a large punitive damage award. Failure to properly advise a plaintiff seeking punitive damages about the tax consequences of success can result in claims of legal malpractice.
What is the purpose of punitive damages?
Punitive damages are intended to punish the wrongdoer. They do not compensate the plaintiff for lost wages, pain, suffering, property damage or any other damages designed to place the plaintiff back to the way he was before the tort caused damage. Punitive damages are considered a windfall to the taxpayer and must be included when the plaintiff files his tax return as taxable income. Section 104 of the Internal Revenue Code deals with the treatment of punitive damages. Section 104(a)(2) excludes from income only “damages (other than punitive damages) received . . . on account of personal physical injuries or physical sickness.” Therefore, punitive damages, even in connection with personal injuries, may not be excluded from income.
