Opinion ID: 75238
Heading Depth: 2
Heading Rank: 1

Heading: Taxation of Punitive Damages

Text: Foster argues that the full $1 million punitive damages award should be withheld from her gross income under § 104(a)(2).5 The district court agreed with Foster as to the $500,000 paid directly to her attorneys per the contingency fee agreement. However, the district court held that the $500,000 in punitive damages that Foster received was taxable. Foster relies on the 1989 amendment to § 104, which states, “Paragraph (2) shall not apply to any punitive damages in connection with a case not involving physical injury or physical sickness.” 26 U.S.C. § 104(a).6 Foster contends that, if the double negative is removed from the sentence, it states that the exclusion allowed by paragraph 2 shall apply to any punitive damages in connection with a case involving physical injuries or physical sickness. Foster cites United States v. Burke, 504 U.S. 229, 112 S.Ct. 1867 (1992) to support her interpretation of § 5 “[G]ross income does not include . . . the amount of any damages received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal injuries or sickness.” 26 U.S.C. § 104(a)(2). 6 In August of 1996, Congress amended this section again, and removed the language added in 1989. 26 U.S.C. § 104(a) (1997). 5 104(a). In Burke, the Supreme Court stated that, in 1989, “Congress amended § 104(a) to allow the exclusion of punitive damages only in cases involving ‘physical injury or sickness.’” Id. at 235 n. 6, 112 S.Ct. at 1871 n. 6. A later Supreme Court opinion forecloses this interpretation of § 104(a). See O’Gilvie v. United States, 519 U.S. 79, 117 S.Ct. 452 (1996). In O’Gilvie, the Supreme Court held that punitive damages are included as gross income for tax purposes. Though the Court was examining § 104 before the 1989 amendment that added the exception, the opinion discusses the 1989 amendment. According to the Supreme Court, “Congress’s primary focus [in enacting the amendment] was upon what to do about nonphysical personal injuries, not upon the provision’s coverage of punitive damages under pre-existing law.” Id. at 90, 117 S.Ct. at 458. The Court states that the law at the time was uncertain, but based on the legislative history, it is certain that punitive damages were not meant to be exempt from income tax. In addressing Burke, the Court said that it “includ[ed] a passing reference to the 1989 amendment, in dicta, as support for a view somewhat like that of the petitioners.” Id. By referring to the Burke footnote as dicta and reducing its significance to a “But cf.” cite, the Court clarified the law and established that punitive damages are not excludable from gross income. See Fabry v. Comm’r, 223 F.3d 1261, 1265 n. 6 14 (11th Cir. 2000) (“In O’Gilvie . . . the Court found that punitive damages were not excludable under IRC § 104(a)(2).”). Foster argues that she should not be assessed the penalty for failure to pay under § 6651 because she had reasonable cause not to pay, namely, that the law at that time did not require her to pay taxes on her punitive damages. While Foster’s argument is an accurate portrayal of the federal tax law as it stood in 1994, the penalty was assessed for her failure to pay in 1997 when the deficiency was asserted, not for her failure to pay in 1994. At that time, Foster’s argument had been foreclosed by the Supreme Court’s 1996 holding in O’Gilvie. She therefore should have paid the taxes on her punitive damages when the deficiency was asserted in 1997. Furthermore, the amendment that supports her claim refers only to physical injuries and physical sickness. The evidence in this case suggests that Foster received compensatory damages for emotional distress, which is not considered a physical injury under Alabama law. The case that Foster uses to suggest that mental anguish is a physical injury in Alabama, Alfa Mutual Ins. Co., Inc. v. Morrison, 613 So.2d 381, 382 (Ala. 1993), is an insurance case dealing directly with how the term “bodily injury” is defined in a specific insurance contract, and not a general statement that emotional distress is a bodily injury. Id. Therefore, this argument fails. 7