BILL ANALYSIS Ó
AB 1276
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Date of Hearing: May 16, 2011
ASSEMBLY COMMITTEE ON REVENUE AND TAXATION
Henry T. Perea, Chair
AB 1276 (Feuer) - As Amended: March 31, 2011
2/3 vote. Tax levy. Fiscal committee.
SUBJECT : Income taxes: deductions: punitive damages
SUMMARY : Bars taxpayers from claiming a deduction for amounts
paid for punitive damages. Specifically, this bill :
1)Provides that no deduction shall be allowed for any amount
paid or incurred for punitive damages in connection with any
judgment in, or settlement of, any action.
2)Applies to taxable years beginning on or after January 1,
2012.
3)Takes immediate effect as a tax levy.
EXISTING LAW :
1) Allows plaintiffs, in non-contract cases, to recover
"punitive" or "exemplary" damages. These damages are
limited to cases where it is proven, by clear and
convincing evidence, that the defendant has been guilty of
"oppression, fraud, or malice," as defined.
2) Allows taxpayers to deduct ordinary and necessary
business expenses incurred in carrying on a trade or
business.
3) Allows for the deduction of punitive damages paid by
businesses as an ordinary and necessary business expense.
4) Disallows deductions for fines or similar penalties paid
to the government for the violation of any law.
FISCAL EFFECT : The Franchise Tax Board estimates no revenue
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impact in fiscal year (FY) 2011-12, and revenue gains of $1.8
million in FY 2012-13, and $1.3 million in FY 2013-14.
COMMENTS :
1) The author has provided the following statement in
support of this bill:
There has been much discussion recently about whether
California corporations pay their fair share of taxes.
This bill does not attempt to address that issue, but it
does take on one business tax deduction that I believe
ÝRepublicans] and Democrats can agree is logically
indefensible.
Punitive Ýdamages] should not be tax-deductible as ordinary
and necessary business expenses. Punitive damages are not
like salaries, equipment or operating expenses. They are
penalties for the most reprehensible violations of our laws
that are proven Ýby] the highest standard of evidence in
civil courts. (Reference omitted).
Tax deductions are intended to reward or incentivize good
behavior. A deduction for punitive damages works in
exactly the opposite direction - it rewards and subsidizes
the worst behavior by the most irresponsible corporate
citizens.
The purpose of punitive damages penalties is to penalize
and deter egregious misconduct - malice, oppression and
fraud. "Malice" means conduct which is intended by the
defendant to cause injury or despicable conduct that is
carried on with a willful and conscious disregard of the
rights or safety of others. "Oppression" means despicable
conduct that subjects a person to cruel and unjust hardship
in conscious disregard of that person's rights. "Fraud"
means an intentional misrepresentation, deceit, or
concealment of a material fact known to the defendant with
the intention on the part of the defendant of thereby
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depriving a person of property or legal rights or otherwise
causing injury.
Allowing wrongdoers to deduct punitive damages payments on
their taxes undermines the very purpose of punitive damages
by making them significantly less punitive, as New
Hampshire Republican Sen. Judd Gregg has noted. Sen. Gregg
is one of many Republicans in recent years who have given
bipartisan support in Congress for proposals to eliminate
the federal tax deduction for punitive damages, calling it
the most outrageous section of American tax law.
(Reference omitted.) Like others, President Obama has
again proposed eliminating this nonsensical tax policy in
his FY 11-12 budget proposal.
Although federal efforts have not been successful,
California does not need to wait for federal action to
correct this irrational and self-defeating tax policy that
rewards the worst wrongdoers with a significant tax break.
California has never affirmatively adopted this policy - we
simply follow the general federal rule allowing deductions
for ordinary and necessary business expenses. But punitive
damages are neither ordinary nor necessary. They are
financial penalties that are intended to serve the same
purpose as criminal fines and statutory penalties, which
appropriately are not deductible. (See 26 U.S.C. §162(f).)
In fact, like California the federal deduction is not found
in the U.S. Internal Revenue Code; it is simply the absurd
result of a 1980 IRS administrative ruling. We need not
continue to follow this unintended and irresponsible IRS
decision, and we should not. Eliminating this deduction
will certainly not balance California's budget, or even
make a significant dent in the problem. But that is not
the purpose of this bill. What it is designed to do is to
prevent the worst kind of wrongdoing, and to take away the
rewards we now provide to those bad actors.
2) Proponents state:
Tax deductions are intended to reward or incentivize good
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behavior, based upon bona fide business expenses incurred
in the production of income. Punitive damages, however,
are by definition expenses incurred not in the production
of income, but to further some other type of malicious
agenda. In the employment context, that could be racism,
sexism, homophobia, or any number of other civil rights
violations. In other contexts it could be the calculated
decision to put corporate profits ahead of public health
and safety, or a widespread ÝPonzi] scheme directed at the
elderly. There really isn't any limit on how one goes
about categorizing the broad range of misconduct that
occurs in contemporary society, but one thing rings true:
punitive damages exist to punish and deter wrongdoing, and
reflect the Ýantithesis] of a bona fide business expense.
(Emphasis in original).
3) Committee Staff Comments:
a) An overview of current law . As the name implies,
"compensatory" damages are awarded to compensate a
plaintiff for a loss or injury suffered as a result of
another's breach of duty. "Punitive" or "exemplary"
damages, by contrast, are generally not designed to
compensate the plaintiff for actual losses, but rather to
deter the defendant (and other similarly situated persons)
from engaging in the underlying behavior that caused harm.
Thus, juries typically assess punitive damages in an amount
that they believe will be sufficient to "punish" the
defendant and deter future wrongdoing. Defendants,
however, are not always punished to the degree sought.
This is because punitive damages paid by business
defendants are tax deductible.<1> As a result, these
businesses often pay far less (in real dollars) than the
jury intended.
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<1> Internal Revenue Code Section 162(a) (allowing deductions
for ordinary and necessary business expenses incurred in
carrying on a trade or business); Rev. Rul. 80-211, 1980-2 C.B.
58 ("Amounts paid as punitive damages incurred by the taxpayer
in the ordinary conduct of its business operations are
deductible as an ordinary and necessary business expense under
section 162 of the Code.").
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b) Proposals for reform . To address this problem of
"under-punishment," several scholars and policymakers,
including President Obama, have suggested eliminating the
deductibility of punitive damages payments.<2> President
Obama's proposal, in particular, would deny a deduction for
punitive damage payments, whether made pursuant to a
judgment or in settlement of a claim. Because it has
become increasingly common for companies to carry insurance
covering punitive damages, the administration proposal
would also treat damages paid by an insurer as gross income
of the insured. Moreover, to aid enforcement of this
provision, insurers would be required to report such
payments to both the insured and the Internal Revenue
Service.
c) Arguments in favor of non-deductibility . Reform
proponents argue that, by providing a deduction, current
law hinders both the deterrent and punitive functions of
exemplary damage awards. Reform proponents also argue that
the public fisc should not subsidize acts of egregious
corporate wrongdoing and that punitive damages should be
treated like civil and criminal fines, for which no tax
deduction is allowed. Finally, proponents note that
current law treats similarly situated defendants
inequitably, based solely on whether their wrongdoing was
business-related. Professors Gregg D. Polsky and Dan
Markel provide a useful example of this inequity in a
recent article published in the Virginia Law Review.<3>
Assume Defendant A, a self-employed courier, drives
recklessly to deliver a package on time, while Defendant B
drives in a similarly reckless manner to attend a concert.
Assume also that in both cases, the defendant causes the
same harm to a victim and each defendant is in the same
financial position. In both cases, a jury might award
punitive damages of $100,000. Under current law, however,
--------------------------
<2> This proposal has been made several times at the federal
level, notably during the Clinton administration. (See Joint
Committee on Taxation, "Summary of Tax Provisions Contained in
the President's Fiscal Year 2001 Budget Proposal," Feb. 7, 2000
(JCX-13-00), Doc 2000-3833, 2000 TNT 27-25).
<3> Gregg D. Polsky and Dan Markel, Taxing Punitive Damages, 96
Va. L. Rev. 1295 (2010).
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Defendant A would be able to deduct the $100,000 award,
significantly reducing his/her after-tax cost. Meanwhile,
Defendant B would not receive the benefit of a deduction.
d) The arguments in opposition : In an article published by
The Heritage Foundation, Hans A. von Spakovsky notes that
punitive damages are most often awarded in cases involving
malpractice, products liability, and business torts. As
such, von Spakovsky argues that eliminating deductibility
would "increase taxes on businesses, as well as the net
costs of litigation, burdening the economy and increasing
the costs of goods and services to the average consumer,
including health care."<4>
e) An alternative approach? : Professors Polsky and Markel
argue that a blanket non-deductibility rule would, despite
its theoretical elegance, be ineffective in solving the
"under-punishment" problem. Specifically, the authors
argue that businesses could circumvent this rule by
disguising punitive damages as deductible compensatory
damages in pre-trial settlements.<5> Instead, they argue
that the problem would be best addressed by state action to
make juries "tax-aware." Such tax-aware juries, in turn,
would be in a better position to adjust punitive damage
awards to impose the desired after-tax cost on defendants.
--------------------------
<4> Hans A. von Spakovsky, "Punitive Damages and the Tax Code:
Punishing Business and the Economy." The Heritage Foundation,
No. 60, Nov. 15, 2010.
<5> Of course, existing law already provides many plaintiffs a
strong incentive to characterize pre-trial settlement awards as
compensatory. This is because, unlike compensatory damages for
physical injuries, punitive damage awards are generally treated
as income for the recipient. (See O'Gilvie v. United States ,
519 U.S. 79 (1996)).
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<6> Specifically, the authors state:
If a rule of nondeductibility is easily circumvented, as
we are confident it would be, a rule of tax awareness is
always the better solution to the under-punishment
problem. This is primarily because, when a rule of
nondeductibility is circumvented through settlement,
defendants would participate in the gains from
circumvention in the form of lower after-tax settlement
costs, resulting in precisely the same under-punishment
problem that nonductibility is intended to correct.
REGISTERED SUPPORT / OPPOSITION :
Support
California Church Impact
California Employment Lawyers Association
California Labor Federation
California Rural Legal Assistance Foundation
Consumer Federation of California
Disability Rights California
Public Advocates
Public Counsel
Western Center on Law and Poverty
Opposition
None on file
Analysis Prepared by : M. David Ruff / REV. & TAX. / (916)
319-2098
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<6> In determining an appropriate financial punishment for
misconduct, jurors are typically instructed to consider a number
of factors, including the defendant's financial condition.
Currently, however, it would not appear that jurors are informed
of the fact that businesses are able to deduct punitive damage
payments as a business-related expense.