What will Congress do regarding the tax treatment of punitive damages?

For the last couple years, I've been interested in the proper tax treatment of punitive damages as a consequence of my collaboration with my erstwhile colleague, Gregg Polsky, who's now at UNC. There have been some developments on this front that should be of interest to both practitioners and legal academics interested in litigation, tax, and torts. And that's why I'm curious, as the title of the post suggests, what Congress will do. To begin, Gregg and I wrote a piece that came out last fall in which we argued that (1) plaintiffs should be able to introduce evidence to the jury or judge regarding the marginal tax rate associated with business defendants in punitive damages cases so as to allow a tax-informed "gross-up" of punitive damages, and (2) that the tax-informed jury/judge (with an ability to gross-up) was a better solution to "the insufficient sting" concern than the option touted by President Obama, which was simply to remove the ability of businesses to deduct payments of punitive damages as ordinary business expenses. The arguments we made in this piece were largely analytic and prescriptive given the constraints and goals established by the current doctrine as we saw it. Importantly, we think the arguments of our paper should trigger lots more interest by plaintiffs' tort lawyers, since they now have a set of tools that can increase the recovery for their clients in a variety of tort cases involving malicious or reckless misconduct.* In response to these arguments, we were delighted to see that Professor Larry Zelenak from Duke and Paul Mogin (from Williams and Connolly) wrote responses to our piece for Virginia Law Review's online companion, In Brief. Gregg and I now have a working draft of our reply up on SSRN, entitled, Revisiting the Taxation of Punitive Damages. Thus, in an Escheresque-turn, we now invite comments on our comments on their comments on our paper :-)

On a related note, I earlier this year published a companion paper that took a more expressly normative perspective on the optimal design of the tax treatment of punitive damages. That piece -- Overcoming Tradeoffs in the Taxation of Punitive Damages -- is now out, and I've just recently put up a final version on SSRN. In that article, I explained that the tradeoffs created under current law between ostensibly unnecessary plaintiff enrichment and proper tax incentives for business defendants could be overcome by implementing the punitive damages reforms of the sort I have recommended elsewhere.  These reforms would disaggregate the purposes of punitive damages more clearly so that the optimal deterrence function and the victim vindication function could be separated cleanly from the function of vindicating the public's interest in meting out a retributive intermediate civil sanction. More specifically, I argued that the proper tax treatment of the punitive damages (with respect to whether the defendant's payments should be deductible or not) will depend on what goals states have for their punitive damages regimes, and what goals the federal government has with respect to subsidizing those regimes.  Now, if I were you, I'd be wondering, what's Markel know about tax? That's not an unsound intuition. But I had a lot of help from Gregg and a gaggle of other tax prawfs, and my hope is that this piece will be of interest to anyone intent on understanding the full tax dimensions of punitive damages design specifically (and penalties more generally), especially and insofar as these penalties relate to optimal deterrence, victim-vindication, or public-interested retributive justice. 

Last, Gregg and I have just seen one of Congress' Joint Committee on Taxation reports for 2011, and we noticed that the Committee has acknowledged our argument, but hasn't really grappled with its implications fully. So, at this point, we are waiting to see what happens. Our hope is that the Obama Administration and folks in Congress (and the relevant lobbyists too!) read our work and realize that a repeal of the deductibility of punitive damages will interfere with both the appropriate punishment of business defendants and the states' choices to run their tort system in a way that achieves the goals they intend to set out for themselves.   

* Here's how a friend of mine described to his partners at a prominent class action firm the gist of the claim Gregg and I advance with respect to settlement dynamics and the benefits of our argument.

I think the upshot is that if Ds know you have a credible threat of getting the jury to award more in punis because of the gross-up threat, they'll settle for a higher amount.  Same logic as when you try to get a high pre-trial settlement based on the argument that the jury pool in the particular area is plaintiff-friendly.  Eg:

 

1.  expected compensatories = 1m

2.  expected punis (with jury unaware of tax issues) = 3m

    expected punis (with jury informed about tax deductibility) = 4m (because they know the pain to D is only gonna be 2m)

3.  chance of victory = 25%

 

settlement value under old scenario = (1+3)*25% = 1.00m

 

settlement value under new scenario = (1+4)*25% = 1.25m