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Clay Rossi
Clay Rossi
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Making Punitives More Painful

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The devil is in the details, or so they say. For corporate defendants there is a nasty little IRS demon lurking in President Obama’s budget proposal. The change concerns how punitive damages are handled under the tax code.

For about the last 20 years, corporations have been able to write-off punitive damages as a business expense. This practice has allowed for such absurd results as Exxon being responsible for only $524 million, after taxes, of the $1.1 billion Valdez oil spill settlement. So for “punitive” meaning “punishment.”

Under the new plan, insurer payouts under a company’s policy would be added to the business's taxable income. However, similar language was included in the 2010 budget proposal but failed to make it into law.

If the measure passes, what will be the practical effect on litigation? Last time around, in 2010, the corporate talking points were that:

  • “risk-averse businesses will prudently choose to settle even frivolous claims with deductible settlements rather than undergo costly litigation that might result in taxable punitive damages.”
  • businesses will be “more hesitant to fight unwarranted liability claims.”
  • “plaintiffs’ lawyers [will have] an incentive to bring even more lawsuits against businesses without the expense of ever setting foot in a courtroom.”
  • “consumers may see higher prices on all goods and services, and fewer new jobs will be created during troubled economic times.”
  • “If businesses choose to go to trial, it will force them to spend more money on litigation because of the higher stakes involved. Litigation costs and taxes on businesses would increase significantly if the deductibility of punitive damages were eliminated.”

Under scrutiny these talking points don’t hold water:

  • If these businesses are so frightfully “risk-averse” how do they wind up as defendants in the first place? Experience has proven businesses aren't always so risk averse when manufacturing and designing products or failing to train and supervise employees.
  • The bread-and-butter of tort reform talking points is the fallacy of conflating liability with damages. Truly “frivolous” lawsuits are subject to getting kicked on summary judgment if there is no liability. If there is liability, the subject becomes how much is necessary for compensation for the victim and/or punishment of the defendant. While reasonable minds may disagree on the amount of damages there is no frivolity about it.
  • Another bizarre tort reform concept is that basic economic principles do not apply to plaintiffs’ lawyers but only to businesses. In the world of tort reform, plaintiffs’ lawyers can afford to use their limited time and resources to bring as many junk claims as they can file. That is not a sustainable business model and any attorney who adopted it wouldn’t be in business long.
  • The idea that a flurry of lawsuits will culminate in the systemic conditions of higher prices and less jobs can only be valid if the lawsuits faced are not periodic in nature but to regular to some degree. In other words, lawsuits are a rare occurrence unless you are engaging in risky conduct that you refuse to alter. The only way McDonalds will get bankrupted by “hot coffee” claims is if the company insists on continuing to serve unreasonably hot coffee that injures customers. As the Bible says: “As a dog returns to its vomit, so fools repeat their folly.”
  • Litigation costs are higher when “businesses choose to go to trial.” Just as they are higher when defense attorneys engage in guerilla discovery tactics or file “frivolous” motions for summary judgment. Nowadays, with the advent of alternative dispute resolution, fewer cases than ever are going to trial. If going to trial is the businesses’ choice, they have no one to blame but themselves for the cost. If you chose to “stand on principle” or “send a message” those decisions come with a cost just as a plaintiff’s decision to go to trial comes with the risk of losing everything.

Making punitive damages subject to taxes will not create a tectonic shift in the legal landscape. What it will most likely do is further the trend that most cases are resolved at mediation — where businesses can still enjoy the tax deduction. The change is also a small, perhaps symbolic, measure that wrongdoers like Exxon should not benefit from their bad behavior.