Civil courts primarily serve a compensatory function, restoring injured plaintiffs to their original status to the greatest extent possible by forcing the party responsible for causing harm to pay monetary damages. But, civil courts have also subsumed a punitive role in cases involving particularly egregious conduct.
Punitive damages were first officially recognized on the American continent over a decade before the United States was even formed. Since their introduction, punitive damages have become deeply engrained in the civil law. Yet, despite this rich historical tradition, a ruling from a federal tax commissioner currently allows companies to circumvent the purpose of punitive damages by deducting them when paying state and federal income taxes.
Punitive damages are not typical in every case; they are only warranted in response to especially shocking or outrageous misconduct (when officers of a company authorized wrongful actions, for example). Punitive damages force an organization to pay for its mistakes, and they deter comparable legal missteps.
State and federal income tax codes allow deductions for "ordinary and necessary" expenses of running a business. Of course, companies do incur expense when they are forced to pay punitive damages. But, it is hard to characterize a punitive financial sanction as ordinary and necessary; by definition, punitive damages are levied against a company for improperly engaging in some activity. Allowing organizations to realize tax savings from punitive damages undercuts their purpose.
One State Seeks an End to Punitive Damages Deductions
In California, some lawmakers are trying to close the loophole that allows companies to deduct punitive damages from state income taxes.
If passed, AB 1276 would disallow the deduction of any expenses incurred for punitive damages. The change in the law would go into effect beginning in the 2012 taxable year. As a measure that would result in higher taxes for some organizations and individuals, under the California Constitution, the approval of two thirds of the members of both legislative houses would be required for passage.
Following Suite in Quashing Punitive Deductions?
Punitive damages have served an important function in civil courts for hundreds of years; California's AB 1276 could help preserve their intended purpose. If AB 1276 proves successful, it may not be long until other states, and perhaps even the federal government, follow California's example.