You've got to hand it to the Greenbergs. It was a nice try, attempting to read between the lines of the Internal Revenue Code in an effort to justify excluding a punitive damages award from their income tax return.
Unfortunately, they couldn't convince the Tax Court. In a recent decision, the Court not only slapped the Greenbergs down in affirming a tax deficiency of over $1 million, but further hammered the folks in sanctioning the IRS imposed accuracy-related penalty, because the taxpayers had neither substantial authority, nor reasonable cause underlying their posture on the damage award. (The decision is Gary L. Greenberg, et ux. v. Commissioner, TC Memo 2011-18.)
Seems Mr. Greenberg, owner of a disability income policy, became disabled, thus precipitating a claim. The insurer paid some benefits, but not as much as Greenberg thought was proper, so he sued, alleging breach of contract and insurance bad faith. And, by golly, he won a damage award which included $2.4 million of punitive damages, which the taxpayers excluded from their return, justifying the exclusion on the basis of Internal Revenue Code Section 104(a)(3). (Learn more from Nolo: I won a lawsuit; do I have to pay tax on my damage award?)
Unfortunately that section only permits exclusion of "amounts received through accident or health insurance.....for personal injuries or sickness...." which "amounts" Mr. Greenberg liberally interpreted to include the punitive damages.
But the Court wasn't buying it, noting that, "In general, exclusions from income are narrowly construed," and with specific reference to IRC Section 104, that the Supreme Court had clearly spoken in the O'Gilvie case, to the effect that punitive damages received in a suit for personal injuries are not received "on account of" the personal injuries, themselves, but rather in connection with assessing a form of punishment on the offending party. Bottom line: punitive damages are taxable.
Attempting a novel twist on words, the Greenbergs also claimed that the punitive damages they received were not punitive, but "bad faith damages" (whatever that means), and that "damage awards that serve both to compensate and punish are excludable."
Perhaps the Greenbergs would have gotten farther had they found some citation in the published authority for this position, which they apparently did not.
One last point, of course, should be notation of the fact that the current application of IRC 104 only pertains to exclusion of compensatory damages "on account of personal physical injuries or physical sickness."
Pain and suffering just won't cut it.