Tax Deduction for Punitive Damages Is Justified

By Peter Blocker, CalTax Legislative Advocate

Peter BlockerUnder current law, punitive damages that must be paid as a result of a court decision are classified as ordinary business expenses, and thus are deductible against a business' tax liability. This makes sense, especially in a litigious society where suing businesses is a part of an ordinary day's work for many enterprising lawyers.

The deduction is enshrined in a federal tax rule that California has conformed to for decades. This could change, however, as the result of a recently introduced bill in the state Legislature. SB 66 (Wieckowski) would disallow deductions for punitive damages when determining corporate and personal tax liability, effective January 1, 2018.

This harmful legislation hasn't received its due, in terms of the magnitude of the negative, chilling effect it would have on California businesses.

From an administrative perspective, SB 66 makes the tax code more complicated for taxpayers and government alike. The deductions will continue to be allowed under federal law, so there would be a lack of conformity between state and federal tax laws.

Punitive damages are monetary damages sought by plaintiffs, most often in cases involving malpractice, product liability and business torts, where the defendant is accused of oppression, fraud or malice. Juries typically award these damages to the plaintiff to deter the damaging behavior, or to further punish the defendant – sometimes because the jury does not believe the compensatory damages were sufficient to compensate the plaintiff.

However, open-ended jury instructions and other flaws in the tort system often result in unpredictable and widely varying amounts awarded by juries. This makes it nearly impossible for businesses to effectively plan ahead for what costs they might incur in the event of a suit. Removing deductibility, as SB 66 proposes, only increases the burdens associated with the unpredictability of punitive damages, placing additional pressure on businesses to settle suits instead of seeing them through a long legal process.

If the pressure to settle lawsuits increases, California companies can expect to see more frivolous suits. While punitive damages are intended to be used by the courts as a tool to deter businesses from engaging in harmful practices, we know that this tool is susceptible to abuse.

Deductibility also takes into consideration other negative financial effects – which juries are not instructed to consider – that a business faces as a result of losing a civil trial. When a company pays punitive damages, it typically is required to disclose this to its shareholders, often devaluing the company. Other factors include legal costs and the financial impact of any negative publicity associated with a civil trial.

When businesses are guilty of fraud, negligence, or malpractice, they should be held responsible; but when consumers abuse the legal system for personal profit, the deduction that SB 66 seeks to eliminate ensures that businesses are treated equitably and have the ability to pay their costs.

As long as unpredictable punitive damages can be awarded – without proof beyond a reasonable doubt of intentional misconduct, and without any statutory protections against excessive or repetitive punishment – the deduction for punitive damages is justified.

February 3, 2017

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