A Tax Break for Plaintiffs
Raises Interesting Issues
By
Chad
L. Staller, J.D., M.B.A., M.A.C. and
Stephen M. Dripps
The Third Circuit
recently delivered a significant clarification on economic damages in
employment matters. In Eshelman v.
Agere Systems Inc., 554 F.3d 426 (2009), the court held that
plaintiffs in employment-discrimination suits may recover for the
negative tax consequences of receiving a lump-sum award for back pay.
(Circuit courts are not in accord on this issue. The 10th Circuit upheld
an enhancement for tax consequences in
Sears v. Atchison, Topeka & Santa Fe
Railway Co., 749 F2.d 1451 (1984), while the District of
Columbia Court of Appeals categorically refused to do so in
Dashnaw v. Pena, 12 F.3d
1112 (1994).)
Successful
claimants in wrongful-discharge actions often receive several years'
compensation as a lump-sum payment. Since the Internal Revenue Service
holds that such awards are taxable in the year that they are received,
the awards often put the claimant into a much higher tax bracket for
that year. In some extreme cases this has led to awards that, after
taxes, leave the prevailing plaintiff poorer than before the award. (see
Pham v. City of
The negative tax
consequences of lump-sum payments are due the progressive nature of the
federal tax code. When a plaintiff receives a lump-sum award
representing several years of back pay or front pay, the lump sum may
push the plaintiff into a higher marginal tax bracket in the year in
which the award is received, and the plaintiff will pay proportionally
more tax than if the income had been spread over several years.
The
Eshelman opinion is certainly good news for plaintiffs, but
it raises some questions about the equitable valuation of negative tax
consequences. As anyone who has ever filled out a 1040 form knows,
computing tax liabilities is anything but simple.
The plaintiff in
Eshelman brought an
Americans with Disabilities Act claim and prevailed. The jury awarded
her $100,000 in back pay and $30,000 in compensatory damages. At the
request of the plaintiff and based on an affidavit from the plaintiff's
economic expert, the district court, post trial, Â ordered an additional
award of $6,893 to compensate the plaintiff for the negative tax impact
of the lump-sum recovery for back pay.
Noting that the
goal of the
While the decision
seems equitable, the Third Circuit did not address how the tax
liabilities were to be determined, other than noting that the burden of
proof is on the plaintiff to show what, if any, extra tax liabilities
arise as the result of a lump-sum award. Here are just a few issues to
consider:
Tax the
Plaintiff Would Have Paid
It would be
inequitable to require the defendant to pay the entire tax liability
stemming from the award, since the plaintiff would have had to pay taxes
on an annual basis had he or she not been discriminated against. The
taxes the plaintiff would have paid had the defendant not discriminated
should be backed out of any enhancement for the negative consequences of
a one-time lump-sum payment.
Also, an award for
lost compensation can include certain fringe benefits that are not taxed
to the employee, such as medical and health benefits and 401k
contributions (which, adding to the complexity, are actually taxed to
the employee during retirement). Certainly, if the claimant is entitled
to be made whole for any taxes he or she would have to pay as the result
of a lump-sum award, these untaxed or deductible benefits should be
dealt with separately from taxed forms of compensation.
Attorneys
Fees
Under the American
Jobs Creation Act of 2004, any contingency fees and costs paid by the
prevailing plaintiff in civil-rights employment claims are 100 percent
deductible as income. While the Americans With Disabilities Act, Title
VII and similar employment laws contain fee-shifting provisions whereby
successful claimants can be awarded attorneys fees in addition to back
pay, front pay and other compensatory damages, some claims are brought
by plaintiffs who have a contingency agreement with counsel. Clearly,
since contingency fees are now by law 100 percent deductible by the
claimant in the year they are received, the claimant cannot expect to be
reimbursed by the defendant for any income tax liability stemming from
these fees -- there is none. Contingency fees, arguably, should be
backed out of the award before determining the tax liability faced by
the claimant.
Neither the court
in Eshelman or the
Jobs Creation Act of 2004 addresses the tax implications of attorneys
fees awarded by the court, which are taxable as income to the claimant
in the year they are received. Arguably, using the make-whole reasoning
in Eshelman,
plaintiffs should be reimbursed for any additional tax liability brought
on by court-awarded fees.
Front Pay
The
Eshelman opinion is silent
as to whether successful claimants are entitled to reimbursement for the
negative tax consequences of receiving a front-pay award, as opposed to
back pay awards. However, this issue was addressed in
Neill v. Sears, Roebuck & Co.,
108 F.Supp.2d. 443 (E.D.Pa. 2000), which was cited in
Eshelman. In
Neill, the trial court
agreed to enhance the jury verdict for the negative tax impact of both
the back- and front-pay award. Arguably, in light of
Eshelman, the Third Circuit will allow the enhancement of
awards for front-pay as well as back-pay to counteract negative tax
consequences.
Front-pay awards,
however, present special tax issues distinct from back-pay awards.
First, obviously, future tax rates are not known. Also, front-pay awards
are reduced to present value to reflect the time value of money -- since
the lump-sum award can be invested and earn interest, successful
plaintiffs receive only the amount that, if invested, will yield the
full amount of future damages in the year the damages would have
occurred. The gross-up should be based on any tax due now on the reduced
present value of the award -- presumed future taxes on an award for lost
future income need not be considered.
Testimony
The enhancement for
extra tax liability in Eshelman
was made by the trial court, post-trial, at the request of
the plaintiff. The amount was based on an affidavit submitted to the
court by her expert economist. Was the jury instructed to disregard any
tax issues in arriving at its verdict? If not, the award may have been
enhanced in the jury room, prior to any post-trial adjustments by the
magistrate. If this was the case, the plaintiff has effectively enjoyed
a double recovery. Should experts be allowed to testify to the jury as
to tax consequences?
Taxes on
the Enhancement
Any enhancement to
an award to compensate for negative tax consequences will in itself have
negative tax consequences. Obviously, as a matter of fairness, any
enhancement should be molded to reflect this fact. The award should be
enhanced to compensate for any extra tax liability caused by the award
and the enhancement combined, not just the award. For example, assume
that the excess tax burden on a lump-sum award is determined to be
$5,000. If the plaintiff is in the 33 percent tax bracket, the plaintiff
would need an award of $7,463 in order to be made whole.
These are a few of
the questions and issues that arise when we look at the problem of
making a plaintiff whole in terms of tax liability. We are sure, as
courts further address this issue, more issues will arise. Meanwhile,
plaintiffs making claims, defendants trying to value demands and parties
involved in settlement negotiations now should pay particular attention
to tax issues.
___________________
This article
originally appeared in Employment Law Strategist, Vol. 17, No. 7,
November 2009. Reprinted with permission of ALM Properties Inc.