After proof that a defendant acted with intent to cause injury or with a knowing disregard of the rights or safety of another, a jury can award punitive damages.
Against a corporation, it is also necessary to prove that a managing agent acted willfully in causing harm or after learning that an employee caused harm ratified the misconduct by keeping the wrongdoer in their job.
Punitive damages allow the wealth of the wrongdoer to be considered by the jury so that the penalty will deter future misconduct and make a public example of despicable misconduct.
For these reasons, punitive damage verdicts are rare because they require substantial proof and must be tried to verdict. Less than 2% of all lawsuits are heard by a jury. Only a handful result in punitive damage awards.
Despite the extra effort needed to win punitive damages, they are of little value to an injured plaintiff because, unlike personal injury recoveries, there are horrendous tax consequences for those who win punitive damages. After taxes, only a small portion of a punitive damage verdict benefits the plaintiff.
Recoveries for damages in personal injury cases are excluded from gross income, providing the recovery was a result of a physical injury or sickness.
That exclusion does not apply to punitive damages awarded as part of a verdict. Punitive damages are taxable as ordinary income, all of them, even the portion paid to the plaintiff’s lawyers.
Sound crazy? It is. A plaintiff awarded punitive damages must pay tax on the full amount without a deduction for attorneys’ fees. Delaney v. Commissioner of Internal Revenue., Tax Court Memo. 1995–378, affirmed (1st Cir. 1996) 99 F3d 20 held that the full amount of punitive damages must be reported as taxable income.
Assume a jury awards $1,000,000 in punitive damages and the attorneys’ fees are 40%. The plaintiff would receive $600,000 in cash, would have to report $1,000,000 in ordinary income.
In 2020 the federal and California income taxes for a single person would be approximately $465,000 to be paid from the plaintiff’s $600,000 share of the winnings, leaving a net recovery after taxes of just $135,000.
The government is the big winner. In addition to the $465,000 received from the plaintiff, it collects tax on the $400,000 paid to the plaintiff’s attorneys.
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