In enacting its new punitive damages tax, California failed to consider the plaintiff’s likely federal income tax impact. As a result, plaintiffs in certain cases are better off not getting any punitive damage award at all. Because of (i) the conflict of interest between the plaintiff lawyer and his client and (ii) the large redistribution of how punitive damages would otherwise be distributed, attorneys must understand this law to negotiate a better outcome.
California’s New Punitive Damage Tax
On August 16, 2004, California enacted new Civil Code Sections 3294.5 through SB 1102. It requires 75 percent of punitive damage awards falling within its time window to be paid to the state of California. Punitive damages paid to California “shall be available for annual appropriation in the Budget Act and shall be used for purposes consistent with the nature of the award, but in no case shall be used to fund the courts or the judicial process.”
Plaintiff attorneys will not be seriously shortchanged under this law. A contingency lawyer will get almost twice what his client receives. Under Civil Code Section 3294.5, “the plaintiff’s lawyer in the action giving rise to those proceeds shall be entitled to 25 percent of the proceeds received by the fund from the punitive damages award in that action.” Since the contingency agreement with the client remains in effect, the plaintiff’s lawyer in a typical arrangement will receive almost 29% percent of the total award. Here’s the math:
|From the State||25% of 75%||18.75%|
|From the Client||40% of 25%||10.00%|
However, the client will receive 60% of 25% or 15% – approximately half what the plaintiff’s attorney receives.
Smart parties will ensure that the state never receives any money
Unless the punitive damage tax is extended, the law will not impact many cases. The law applies only to actions that are filed on or after August 16, 2004, and are:
“finally adjudicated, including the resolution of all mandatory or discretionary appeals, the resolution of any motion for attorney’s fees on appeal, and any appeals therefrom, and the issue of a final remittitur, prior to … July 1, 2006 … unless a later enacted statute extends or deletes that date.”
This maximum 22-month period will miss practically all large punitive damage cases, since continuances, procedural delays and appeals take longer. For this reason, plaintiffs will likely continue filing punitive damage cases, with the hope that this law will expire before the punitive damages become “finally adjudicated”.
The state will not likely receive any of the $450 million that was included in its budget estimates. Obviously, the definition of final adjudication means that parties have both the ability and the mutual desire to negotiate a settlement and thereby re-characterize the amounts being paid. By settling the case before it becomes “finally adjudicated”, the state’s share of the punitive damage award can be split between the plaintiff and the defendant.
The new punitive damage law creates an obvious conflict of interest between a contingency lawyer and his client on the issue of settling the case before the matter becomes “finally adjudicated”. Any such settlement will likely increase the client’s recovery, while decreasing the amount paid to the attorney. This conflict is increased by the tax treatment described in the next section.
After federal taxes, non-business California plaintiffs are better with NO punitive damages at all
If a punitive damage case falls under the law’s time period (or the law gets extended), plaintiffs in a non-employment case (see link below) will not want any punitive damage awards. The reason is the client will pay more in federal taxes than the net amount he receives after the state and plaintiff attorney is paid.
By way of background, successful plaintiffs who are not businesses face an unintended and unfair tax result. For individuals, the litigation proceeds or gross settlement is income, while the related legal fees are deductible only as an itemized deduction. This causes some or all of the deduction benefit to be lost because of:
- the 2% limitation on miscellaneous itemized deductions, and more importantly,
- the loss of a deduction for legal fees for purposes of calculating the alternative minimum tax or AMT – Under the AMT, either no or reduced benefit is allowed for (i) personal exemptions, (ii) the majority of itemized deductions, (iii) certain tax credits, (iv) accelerated depreciation, (v) certain tax-exempt bonds, and (vi) incentive stock option profits. A special deduction called an AMT exemption is provided, but this exemption is phased out as your income reaches higher levels.
The AMT tax is applied at 26% and 28%. The taxpayer pays the larger of the regular tax or the AMT tax. The AMT tax rates are greater than the 15 percent that the client receives after payment of attorney’s fees. Even if the attorney waives his fees from his client, the maximum amount that the client receives is 25 percent, which is still lower than the AMT rates.
The treatment of gross litigation proceeds as gross taxable income was recently confirmed by the U.S. Supreme Court in Commissioner vs. Banks & Banaitis. In an 8-0 ruling, the Supreme Court agreed with the lower courts that (i) state law creates or defines the legal interests and property rights, but (ii) federal law defines when and how these interests and rights are taxed. For more background information, see Avoiding a Contingency Fee Tax Trap. For employment-related disputes, these federal tax concerns do not exist.
California can not change federal income tax law. This is true despite California taking a taxation approach that is the opposite of the federal government. California’s new punitive damage law specifically states that the “attorney’s fees paid to the attorney from the plaintiff’s share of the award shall be deemed the income of the attorney, and not income to the plaintiff for state and local income taxation purposes.”
None of these issues appear to have been seriously considered in the legislative history for California’s new punitive damage law. This likely occurred because the legislature was simply trying to raise money for California’s budget crisis. As noted above, this ill-conceived law will not even accomplish this intended budgetary purpose.