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In early 1995, the conventional wisdom was that if punitive damages were received in a personal injury action there was at least support for a tax return position to treat the punitive damages as being "on account of" personal injuries and exempt from taxation. Then came the Supreme Court's Schleier case which held that punitive damages received in a case based on age or sex discrimination were taxable.

In the Small Business Job Protection Act of 1996, Congress snuffed out tax-free treatment for punitive damages prospectively. And now the Supreme Court has held that they were never exempt from taxation in the first place.

The case involved the husband and two children of a woman who died from toxic shock syndrome. The O'Gilvies sued the manufacturer of the tampon they believed caused Mrs. O'Gilvie's death and won the case. In addition to actual damages, they were awarded $10 million in punitive damages, one half to the widower and a quarter each to the two children.

The O'Gilvies paid tax on the punitive damages then filed claims for refunds and the IRS processed the refunds. Later the IRS sued to recover the "improperly" refunded taxes. In the case of the children, the IRS's suit was begun more than two years after it mailed the refund checks but less than two years after the children received the refunds. The Kansas District Court held in favor of the O'Gilvies, but the Tenth Circuit Court of Appeals overruled.

The Supreme Court had two issues to consider: whether the punitive damages were taxable and whether the IRS was timely in its suit to recover the children's refunds. Regarding the first, the Supreme court noted that the Sixth Circuit Court of Appeals had held punitive damages awarded in a personal injury action to be nontaxable and the Tenth, Fourth, Ninth, and Federal Circuits had held punitive damages were taxable.

The statute, IRC section 104, says that damages awarded "on account of" personal injury are excluded from income. The court construed "on account of" to mean "for the sake of," "by reason of," or "because of." Also, the court noted that punitive damages are awarded not as compensation for injury, but instead "as fines levied by civil juries to punish reprehensible conduct and to deter future occurrence." The punitive damages in this case, therefore, were not on account of personal injuries, but were on account of the reprehensibleness of the defendant manufacturer's behavior. As a result, the punitive damages were taxable.

Concerning the timing of the IRS' suit for recovery of the children's refunds, the court concluded that the statute of limitations began running at the time of their receipt of the refunds not the date the IRS mailed them. The IRS recovery suit was, therefore, timely. *

Source: O'Gilvie v. U.S., __ US __, Nos. 95-966 and 95-977 (12/10/96)

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