IN our recent article, Taxing Punitive Damages,1 we argued (i) that plaintiffs in punitive damages cases should be allowed to introduce to the jury evidence regarding the deductibility of those damages by defendants, and (ii) that this jury tax-awareness approach is better than the Obama Administration's suggested alternative of disallowing those deductions.2 To our delight, Professor Larry Zelenak and Paul Mogin have each provided comments to our piece.3 Professor Zelenak's thoughtful response focuses on our prescriptive claim that jury tax-awareness is better than nondeductibility while Mr. Mogin disputes our doctrinal claim that the tax evidence is admissible.4 We thank them for their contributions and provide our replies below.

Professor Zelenak raises two challenges in response to our piece and offers a general reaction, as well. We address these in turn.

Although we are pleased by Professor Zelenak's general approval of our analysis,5 we note our disagreement with his view that the preferable solution might be to disallow deductions for payments of punitive damage judgments, while still allowing full deductions for settlements that include a punitive damages component.

Professor Zelenak's alternative proposal would avoid the practical problems we describe in Taxing Punitive Damages relating to allocations of pretrial settlements because settlements would always be deductible in full. Also, as Professor Zelenak notes, the vast majority of fully litigated cases do not involve an award of punitive damages.6 Accordingly, his proposal's "presumption" that settled amounts do not have a punitive damages component will usually be accurate.

Nonetheless, we still prefer our proposal over Professor Zelenak's suggestion. First, while it is true that the majority of cases do not involve a substantial punitive damages component (because most cases do not involve sufficiently egregious misconduct to warrant a threshold determination of malice or recklessness), the empirical reality is that some cases certainly do. In those "punitive-flavored" cases, defendants will, under Professor Zelenak's proposal, be able to avoid the full sting of their expected punishment simply by settling before a jury verdict; the resulting underpunishment effect is precisely the problem that has stimulated the various reform proposals.7 In other words, while Professor Zelenak's proposal attempts to solve the underpunishment problem by disallowing deductions for paying punitive damages judgments, it simultaneously allows an extremely easy end-run: settle before the jury comes back for the expected jury award.8 In fact, we expect that in practice Professor Zelenak's approach would work almost precisely like the Obama Administration's blanket nondeductibility approach. Under the blanket nondeductibility approach, it would be nearly impossible for the Internal Revenue Service (IRS) to find and prosecute those relatively few heavily punitive-flavored cases because both plaintiffs and defendants have significant incentives to downplay punitives at the point of settlement—a point we emphasized in our article.9 Accordingly, the IRS would likely be successful in enforcing the nondeductibility rule only in those cases that have resulted in a jury verdict of punitive damages. Thus, Professor Zelenak's proposal merely formalizes the IRS practices that are expected under the Obama Administration's approach. As a result, our principal objection to both proposals is the same: they both permit easy circumvention of the solution to the underpunishment problem.10

Second, while Professor Zelenak's proposal has the virtue of not even pretending to enforce the nondeductibility rule in settlements (unlike the Obama Administration's proposal), it is not devoid of administrative problems. Professor Zelenak's proposal would deny deductions for payment of punitive damages judgments. But what if the case settles after the jury verdict but before the judge formally enters the judgment? Does it matter if there remain outstanding legal issues, such as whether the judge ought to reduce the judgment or order a new trial, at the time of settlement? Likewise, what if the case settles after the judgment is entered but while it is being appealed? For instance, what if the judgment is for $1,000,000 of compensatory damages and $2,000,000 of punitive damages, and the case settles for $500,000 or $1,000,000 or $1,500,000 while on appeal? Does it matter whether both the plaintiff and the defendant have appealed, such that a new trial could conceivably end up with a larger recovery for the plaintiff? The point is that even a seemingly bright line rule like "punitive damage judgments are nondeductible but settlement payments are" can be difficult to apply in a whole slew of cases. As a result of this difficulty, it can be gamed by the parties to their mutual advantage.

Furthermore, to the extent the rule becomes more formalistic (for example, by applying nondeductibility only where a formal judgment is entered), the end-run strategy becomes that much clearer (for example, simply settle before the judge enters the judgment). Meanwhile, if the rule is less formalistic (for example, by applying a rule of reason to apportion post-judgment settlements pending appeal), the rule operates more like the Obama Administration's proposal. Either way, we prefer our rule, which neutralizes the tax consequences between paying settlements and paying judgments.

Professor Zelenak also argues that our proposed solution to the underpunishment problem, like other solutions, would be inapposite if the current punitive damages system were designed to achieve optimal deterrence.11 We wholeheartedly agree with this view and said as much in the piece itself12 and in a companion piece authored by one of us.13 Our proposal is premised on current punitive damages regimes,14 which, by requiring a threshold showing of reprehensibility, very clearly do not attempt to achieve optimal deterrence.15 Indeed both proponents and critics of the idea of using punitive damages to achieve optimal deterrence acknowledge that the current landscape does not even remotely resemble an optimal deterrence regime.16 Consequently, readers interested in a comprehensive analysis of the proper tax treatment of punitive damages meant to achieve optimal deterrence should consult Professor Markel's companion article.17

Last, Professor Zelenak asks why, if evidence of tax consequences is both admissible and useful to plaintiffs' lawyers, it has not been sought to be admitted.18 We share his curiosity. Anecdotally, we have heard a number of conjectures ranging from "litigators don't think about tax" and "litigators lack imagination" to "it's too complex for juries" and "tax evidence is generally inadmissible." We have attempted to show that it is not all that complex and that this particular type of tax evidence should be admissible.19 As to lack of imagination or education, our hope is that our article should solve that problem to the extent it exists.

As noted at the outset, we argue that under current law, evidence of punitive damages tax deductibility ought to be admissible against the defendant in cases where those damages are deductible. In his response to this claim, Mr. Mogin, an experienced advocate with an extensive practice in defending corporations against punitive damages awards, raises several issues, which we take up in turn below.

Mr. Mogin first registers concern that our analysis "would create a substantial pro-plaintiff imbalance."20 The purported imbalance stems from the fact that while tax evidence regarding plaintiffs is generally inadmissible by defendants, we are asserting that punitive damages tax evidence regarding defendants is admissible. In our article, we address this precise argument and we would call Mr. Mogin's attention to that discussion; in fact, it is the first counterargument we discuss and we devote three full pages to it.21 Given that we fully develop the response in our article, we will merely provide the Cliff's Notes version here.

While the symmetry argument touted by Mr. Mogin is superficially attractive, it breaks down once one considers the reasons that courts are reluctant to allow defendants to introduce tax evidence against plaintiffs. First, there is the complexity concern, which Mr. Mogin notes. We argue that the punitive damages tax evidence sought to be introduced by plaintiffs is not complex and certainly not as complex as the tax evidence that defendants have sought to introduce.22 Second, and more significantly, we note how courts faced with admitting plaintiff-related tax evidence are forced into a dilemma: they can either overcompensate plaintiffs (by disallowing the tax evidence) or underdeter defendants (by allowing the tax evidence).23

Both options are theoretically unsatisfying from a conventional torts policy perspective. Faced with this unfortunate choice in the context of compensatory damages, courts generally (but not universally) choose to overcompensate plaintiffs by excluding the evidence. But, in the punitive damages context, there simply is no such dilemma because the focus is on punishing and completely deterring the defendant's malicious or reckless misconduct; the plaintiff's enrichment is simply an incidental by-product of those goals. As we show in our article, courts can thus either advance existing punitive damages policy by educating juries about tax effects or undermine it by obscuring the fact that there are tax deductions available to business defendants that pay punitive damages.24

In addition, as we argued, it is clear that there is no blanket rule about tax evidence admissibility.25 In some contexts and jurisdictions, the tax evidence is excluded; in others, it is admitted. The trend appears to be towards admissibility.26 Regardless, like all relevant evidence, a very good reason should be required to keep it away from juries. None exists with respect to punitive damages tax evidence.

Mr. Mogin also points to the collateral source rule as another rule where juries are precluded from hearing certain evidence that, like evidence regarding the plaintiff's taxes, relates to the plaintiff's true harm. Again, the argument seems to be that it is unfair to exclude this pro-defendant evidence while admitting our suggested pro-plaintiff evidence. But again, there is a plausible policy reason for the collateral source rule: the concern about underdeterrence. When courts apply the collateral source rule, they are saying that it is more important to properly incentivize defendants than it is to accurately compensate plaintiffs.27 While everyone may not agree with this view, it is undoubtedly plausible. On the other hand, there is no justifiable policy rationale to keep juries in the dark about the tax effects of punitive damage payments by defendants.

Mr. Mogin next argues that "existing law is already skewed in favor of overly large punitive awards against organizational defendants because of the way it treats evidence of wealth."28 In our piece, we addressed the argument that tax blindness is justified on the ground that punitive damage amounts are "too large."29 Unfortunately, Mr. Mogin provides no benchmark or analysis as to what is the optimal amount of punitive damages for society to have.30 Even assuming arguendo that punitive damages are too high, solving that problem through tax blindness is extremely imprecise because the blunting effect depends idiosyncratically on the defendant's marginal tax rate.31

Mr. Mogin also argues that the jury's intent in a punitive damages case is not "critically important."32 We disagree. Under our system, the jury hears the evidence and, absent exceptional circumstances, determines the punishment. Given that responsibility, the jury (or the judge in certain situations) should be educated as much as reasonably possible to the real, after-tax cost of the punishment. While we firmly agree with Mr. Mogin that judicial review of jury determinations is appropriate, we would add that appellate judges should also be tax-aware and consider after-tax effects in assessing the constitutional implications of large punitive damage awards.33

We are grateful to Professor Zelenak and Mr. Mogin for their responses and to the Virginia Law Review for the opportunity to continue the conversation about this important and difficult set of issues.

Preferred citation: Gregg D. Polsky and Dan Markel, Revisiting the Taxation of Punitive Damages, 97 Va. L. Rev. In Brief 73 (2011), http://www.virginialawreview.org/inbrief/2011/09/08/polsky-markel.pdf.

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Revisiting the Taxation of Punitive Damages | Reply by Gregg D. Polsky and Dan Markel