Why are punitive damage payments not excluded from income?
Public policy. Congress was looking for a way to achieve tort reform, and was able to achieve that through tax reform. Until 1996, the Code was not clear on this issue, and the court jurisdictions were divided. Public Law 104-88 § 16 said that the exclusion “shall not apply to any punitive damages in connection with a case not involving physical injury or physical sickness.” This law, known as the Small Business Job Protection Act of 1996, also marked the first time the word physical had been used in section 104 as a requirement for exclusion from gross income. (However, section 130 always has contained the word physical as a prerequisite to a qualified assignment, in referring to tort claims under IRC § 104(a)(2).) Damages for emotional distress alone, even if that condition leads to a physical injury, say for example an ulcer, do not qualify for the exclusion under section 104(a)(2) for tort claims. However, workers’ compensation claims based solely on emotional distress remain exemp
