When a Plaintiff in an Insurance Bad Faith Case Seeks Punitive Damages The Plaintiff and Counsel Must Consider the Effect of State and Federal Income Taxes
Punitive Damages Must Be Added to Gross Income for Tax Purposes
© 2025 - Barry Zalma
The stated purpose of punitive damages is to punish a wrongdoer civilly to deter the wrongdoer and others from acting wrongfully. Insurance Bad Faith litigants dream of large punitive damage awards as a bonus and revenge upon the insurer that did not treat them fairly.
Punitive damages do not compensate plaintiffs for injuries suffered. [Memphis Cmty. Sch. Dist. v. Stachura, 477 U.S. 299, 306 & n.9, 106 S. Ct. 2537, 2542 & n.9, 91 L.Ed.2d 249 (1986). Rather, their purpose is to punish the defendant for his willful or malicious conduct and to deter others from similar behavior; see also Exxon Shipping Co. v. Baker, 554 U.S. 471, 492, 128 S. Ct. 2605 2621, 171 L.Ed.2d 570 (2008) Punitive damages are aimed not at compensation but principally at retribution and deterring harmful conduct.
Unlike compensatory damages, punitive damages are not intended to make the plaintiff whole again they are intended to punish the tortfeasor. If both kinds of damages are awarded, punitive damages provide relief "over and above" the award of compensatory damages that itself remedies a plaintiff's injury. [Smith v. Wade, 461 U.S. 30, 54, 103 S. Ct. 1625 1639, 75 L.Ed.2d 632 (1983).
It should be presumed a plaintiff has been made whole for his injuries by compensatory damages, so punitive damages should only be awarded if the defendant's culpability, after having paid compensatory damages, is so reprehensible as to warrant the imposition of further sanctions to achieve punishment or deterrence.)
Punitive damages may be awarded where there is substantial harm and where there is none. [Restatement (First) of Torts § 908 cmt. c (Am. L. Inst. 1939); see also Smith, 461 U.S. at 54–55, 103 S. Ct. at 1639] Society has an interest in deterring and punishing all intentional or reckless invasions of the rights of others, even though it sometimes chooses not to impose any liability for lesser degrees of fault..
The "focus [of punitive damages] is on the character of the tortfeasor's conduct" not on any compensable injury that may flow from that conduct. Meanwhile, compensatory damages, even if they deter illegal conduct as a byproduct, Imbler v. Pachtman, 424 U.S. 409, 442, 96 S. Ct. 984 1000, 47 L.Ed.2d 128 (1976) are grounded in determinations of plaintiffs’ actual losses. In other words, except for the comparative purposes of ensuring that they are proportional and not unconstitutionally excessive [BMW of N. Am., Inc. v. Gore, 517 U.S. 559, 580, 116 S. Ct. 1589 1601, 134 L.Ed.2d 809 (1996)] punitive damages, when awarded, stand on an entirely different footing from the compensatory damages, Dan B. Dobbs, Law of Remedies § 3.11(13), at 529 (2d ed. 1993).
Therefore, punitive damages are not awarded to a plaintiff for compensation of his mental or emotional injury; they are imposed on a defendant for deterrence and punishment of his egregious misconduct. [Calhoun v. DeTella, 319 F.3d 936, 942 (7th Cir. 2003)]
Policyholders’ lawyers who obtain large punitive damage awards use them to brag about their ability as tort lawyers and show them to other defendants they have sued to bludgeon them to put up multiple millions to settle for more than they owe.
Litigants and litigators seldom consider the tax consequences of a large punitive damage award. Failure by a plaintiffs’ lawyer to properly advise a plaintiff seeking punitive damages about the tax consequences of success should, and probably will, result in claims of legal malpractice.
What Does the Insured Get to Keep of a Punitive Damages Award?
Consider an insurance bad faith judgment, like the one obtained by the Greenbergs, where the jury awards the plaintiffs (for ease of calculation) $1,000,000 in compensatory damages and $9,000,000 in punitive damages. The Plaintiffs’ lawyer, in a standard contingency fee agreement, takes 40% of the gross award or $4,000,000 and expenses of $500,000 for experts and other litigation expenses.
The plaintiffs’ share of the recovery is $5,500,000. If the Plaintiffs live in California or New York they will pay approximately 39% federal income tax and approximately 10% state income tax on their gross earnings in that year. Assuming the Plaintiffs earned nothing in the year of the judgment they are responsible to pay taxes on the $9,000,000 punitive damage award or slightly less than $4,500,000. In essence they receive none of the punitive damage award and the lawyer pays taxes on his $4,000,000 recovery of legal fees. If the plaintiff attempts to avoid paying tax on the punitive damage award they may be assessed a 20% penalty.
The IRS and Punitive Damages
When tort damages are paid the plaintiff gains nothing he or she is just made whole and need not pay income taxes on the tort recovery.
Punitive damages, on the other hand, do not compensate the plaintiff for lost wages, pain, suffering, property damage or any other damages designed to place the plaintiff back the way he was before the tort occurred. Punitive damages are considered by the tort bar, judges, and the government to be income. The Internal Revenue Service requires the plaintiff who receives a punitive damages award to include the amount of punitive damages awarded as income when the plaintiff files his or her tax return.
The Internal Revenue Code is clear on the subject because § 104 provides, in relevant part:
§104. Compensation for injuries or sickness
(a) In general
Except in the case of amounts attributable to (and not in excess of) deductions allowed under section 213 (relating to medical, etc., expenses) for any prior taxable year, gross income does not include—
(1) amounts received under workmen's compensation acts as compensation for personal injuries or sickness;
(2) the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness; … (emphasis added)