Punitive damages taxable, Supreme Court says.

Plaintiffs who won punitive damages awards before August 20, 1996, must share them with the federal government, according to a recent Supreme Court opinion.

In a 6-3 decision, the Court ruled that punitive damages awarded before that date are subject to federal income tax. (O'Gilvie v. United States, Nos. 95-966, 95-977 (U.S. Dec. 10, 1996).) Most punitive damages awarded since that date have been taxable under the Small Business Protection Act of 1996.

The case arose out of a tort suit against a tampon manufacturer brought by the family of a woman who died of toxic shock syndrome. The woman's family was awarded about $1.5 million in compensatory damages and $10 million in punitive damages.

The plaintiffs paid income taxes on the punitive damages but later sought a refund, claiming 26 U.S.C. [sections]104(a)(2) exempted them from federal income tax. That statute says that damages are tax free if they are awarded "on account of" a personal injury.

The IRS argued the damages were taxable because they were awarded to punish and deter wrongful conduct, not to compensate for a personal injury loss. The Supreme Court agreed, finding the government's interpretation adhered to both the statute's original focus and recent Court opinions interpreting it.

Writing for the majority, justice Stephen Breyer noted that the law was enacted to ensure that those people who received court-ordered compensation for injuries did not pay taxes for simply being restored to the condition they would have been in had they never suffered a loss.

Breyer also observed that the government's position followed the rationale of a 1995 case in which the Court ruled that liquidated damages awarded under the Age Discrimination in Employment Act of 1976 were subject to federal taxes. (See Punitive Damages May Be Taxable After Schleier, Experts Say, TRIAL, Sept. 1995, at 14.) In that case, the Court concluded that liquidated damages, like the punitive damages in the present case, were not "designed to compensate . . . victims."

In a dissenting opinion, Justice Antonin Scalia took issue with the majority's analysis of the statute's language.

"The Court greatly underestimates the connection between an award of punitive damages and the personal injury complained of," Scalia wrote. "It seems to me that the personal injury is as proximate a cause of the punitive damages as it is of the compensatory damages; in both cases it is the reason the damages are awarded. That is why punitive damages are called damages. . . . Both types of damages are awarded on account of personal injury.'"

The dissenting opinion was joined by Justices Sandra Day O'Connor and Clarence Thomas.