TaxProf Blog

Editor: Paul L. Caron, Dean
Pepperdine University School of Law

Wednesday, November 10, 2010

Markel & Polsky: Taxing Punitive Damages

Dan Markel (Florida State) & Gregg Polsky (North Carolina) have published Taxing Punitive Damages, 96 Va. L. Rev. 1295 (2010).  Here is the abstract:

There is a curious anomaly in the law of punitive damages. Jurors assess punitive damages in an amount that they believe will best “punish” the defendant. But, in fact, defendants are not always punished to the degree that the jury intends. Under the Internal Revenue Code, punitive damages paid by business defendants are tax deductible and, as a result, these defendants often pay (in real dollars) far less than the jury believed they deserved to pay.

To solve this problem of under-punishment, many scholars and policymakers, including President Obama, have proposed making punitive damages nondeductible in all cases. In our view, however, such a blanket nondeductibility rule would, notwithstanding its theoretical elegance, be ineffective in solving the under-punishment problem. In particular, defendants could easily circumvent the nondeductibility rule by disguising punitive damages as compensatory damages in pre-trial settlements.

Instead, the under-punishment problem is best addressed at the state level by making juries “tax aware.” Tax-aware juries would adjust the amount of punitive damages to impose the desired after-tax cost to the defendant. As we explain, the effect of tax awareness cannot be circumvented by defendants through pre-trial settlements. For this and a number of other reasons, tax awareness would best solve the under-punishment problem even though it does come at the cost of enlarging plaintiff windfalls. Given the defendant-focused features of current punitive damages doctrine, this cost is not particularly troubling. Nonetheless, a related paper of ours furnishes a strategy for overcoming this tradeoff through some basic reforms to punitive damages law.

Dan blogs the piece here.

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Interesting concept, but two concerns: (1) How far do we really want to go in using the tax code to deal with this kind of issue? and (2) Should a defendant's marginal tax rate be that important in this context? Does that mean that a defendant with $1 billion of NOLs is treated less harshly than one with no NOLs? And what if the NOLs arose from earlier deductible punitive awards?

Bottom line, seems like it may be a bit too complicated in practice.

Posted by: Andrew Gantman | Nov 11, 2010 6:10:15 PM