BILL ANALYSIS �
AB 458
Page A
Date of Hearing: April 1, 2013
ASSEMBLY COMMITTEE ON REVENUE AND TAXATION
Raul Bocanegra, Chair
AB 458 (Wieckowski) - As Introduced: February 19, 2013
2/3 vote. Tax levy. Fiscal committee.
SUBJECT : Income taxes: deduction: 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,
2014.
3)Takes effect immediately 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 revenue gains
of $400,000 in fiscal year (FY) 2013-14, $1 million in FY
2014-15, and $1.1 million in FY 2015-16.
COMMENTS :
AB 458
Page B
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
[Republicans] and Democrats can agree is logically
indefensible.
Punitive [damages] 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 [by] 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
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 [former] 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
AB 458
Page C
the most outrageous section of American tax law.
(Reference omitted.) [?]
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:
Deductibility is always permitted for the cost of doing
business, but punitive damages do not represent such costs
- they are court judgments that make clear that the
business has avoided the law in some important way which
endangers the public. Ordinary taxpayers cannot deduct
fines and penalties, and the exception for punitive damages
for businesses is not only unnecessary but inappropriate,
since these damages are not part of the ordinary cost of
doing business. California has not always conformed to
administrative rulings at the IRS level, and it should not
conform to this ruling either.
3)Opponents state:
This bill would eliminate the current deduction allowed for
punitive damages in connection with any judgments,
settlements or actions. Punitive damages are often times
not associated with any culpability on the part of [the]
AB 458
Page D
company or association, but little more than a deep pocket
to pursue. We are concerned that by disadvantaging
California businesses from the current business deduction
will [sic] ultimately hurt employers, employees and our
construction economy overall. We cannot afford to
negatively impact the companies that are still here,
providing critical jobs to Californians.
4)Committee Staff Comments:
a) Current Law . "Compensatory" damages are intended to
redress the concrete loss that a plaintiff has suffered by
reason of the defendant's conduct. In order to be awarded
compensatory damages, a plaintiff must prove that he/she
has suffered legally recognized harm that is compensable by
a certain amount of money that can be objectively
determined by a judge or jury. "Punitive" or "exemplary"
damages, however, are damages intended to punish or deter
the defendant and others from engaging in similar conduct
that served as the basis of the lawsuit. Thus, juries
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 extent sought by the jury. This is because punitive
damages paid by business defendants are tax deductible. In
the end, these businesses often pay far less than the
juries intended.
b) Why have Punitive Damages ? The United States (U.S.)
Supreme Court has continually reaffirmed the goals of
punishment and deterrence, stating that punitive damages
are "private fines levied by civil juries to punish
reprehensible conduct and to deter its future
occurrence.<1>" Absent the threat of punitive damages, a
business, with ample means, might choose to engage in
egregious acts that result in only a small amount of purely
economic damage. In such cases, rectifying the behavior
may be more expensive than paying compensatory damages to
individual plaintiffs. For example, assume ABC Company
operates a grocery store and overcharges $1 to every
customer at the register. Because the economic damages are
nominal and because not everyone who is injured will demand
their dollar back, these egregious acts will likely
--------------------------
<1> Cooper Indus., Inc. v. Leatherman Tool Group, Inc., 532 U.S.
424, 432 (2001).
AB 458
Page E
continue. Punitive damages in this scenario would be
appropriate to punish and deter ABC Company from engaging
in egregious acts of this kind.
c) Frequency of Punitive Damages . Proponents for reform
have argued that punitive damages increase the costs of
doing businesses and, therefore, increase the cost of goods
and services to consumers. However, according to Professor
Patrick A. Gaughan, punitive damages are imposed relatively
infrequently<2>. Specifically, the American Bar Foundation
found that punitive damages were awarded in only 4.9% of
cases<3>. Additionally, the Department of Justice released
a study that showed an aware rate of only 6%<4>. The
numbers vary depending on the study, but it is clear that
punitive damages are not awarded very frequently.
d) Business vs. Non-Business . According to Professors
Gregg D. Polsky and Dan Markel, current law treats
defendants differently based on whether their wrongdoing
was business-related<5>. As an example, assume that
Defendant A, a self-employed courier, drives recklessly to
deliver a package on time, while Defendant B drives
recklessly to get to a movie on time. Assume also that
each defendant injures and causes the same harm to a
victim, and that each defendant is in the same financial
position. In both cases, a jury might award $100,000 in
punitive damages, believing that both defendants will be
equally punished. However, because Defendant A's driving
was in the course of her courier business, Defendant A gets
to deduct the $100,000, significantly reducing after-tax
cost.<6> In addition to treating business and non-business
defendants differently, current law also treats business
defendants differently based on the marginal tax rate<7>.
If two defendants, both in the same financial position,
similarly injure a plaintiff, the defendant with the higher
marginal tax rate will have a lower after-tax punishment.
-------------------------
<2> Patrick A. Gaughan. "The Economics of Punitive Damages."
Econometrix Research Associates, Inc. (2005)
<3> Id.
<4> Id.
<5> Greg D. Polsky and Dan Markel, Taxing Punitive Damages, 96
VA. L. REV. 1295, 1309 (2010).
<6> Id.
<7> Id. at 1310.
AB 458
Page F
e) Hiding Punitive Damages in Pre-trial Settlement
Agreements . Professors Polsky and Markel argue that a
blanket non-deductibility rule would be ineffective in
solving the "under-punishment" problem described above.
Specifically, the authors argue that businesses could
circumvent this rule by disguising punitive damages as
deductible compensatory damages in pre-trial
settlements.<8> 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. <9> However,
making juries tax-aware may be expensive and difficult to
accomplish. Expert testimony would likely be required to
explain the issues of deductibility, gross-up calculations,
and marginal tax rates. Assuming expert testimony can
properly inform the jury, jury instructions may later serve
as a basis for challenging the amount of punitive damages.
Additionally, the U.S. Supreme Court has imposed due
process limitations on punitive damages. In State Farm v.
Campbell, the Court announced that "few awards exceeding a
single-digit ratio between punitive and compensatory
damages, to a significant degree, will satisfy due
process."<10> This raises concerns with respect to
tax-aware juries that have increased the amount of punitive
damages based on after-tax punishment. It is unclear if
courts will address issues of due process based on the pre
or after-tax figures. As of now, it appears that courts
--------------------------
<8> 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)).
<9> 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.
<10> State Farm Mut. Auto. Ins. Co. v. Campbell, 538 U.S. 408,
425 (2003).
AB 458
Page G
only look at pre-tax punitive damages.
f) Related Legislation . AB 1276 (Feuer), disallowed a
deduction for amounts paid or incurred for punitive damages
for taxable years beginning on or after January 1, 2012.
AB 1276 failed passage on the Assembly Floor.
REGISTERED SUPPORT / OPPOSITION :
Support
California Church Impact
California Employment Lawyers Association
California Labor Federation
California Nurses Association
California Professional Firefighters
California Tax Reform Association
Disability Rights California
Public Advocates
SEIU California
Western Center on Law and Poverty
Opposition
California Taxpayers Association
Construction Employers' Association
Analysis Prepared by : Carlos Anguiano / REV. & TAX. / (916)
319-2098