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 Seattle, 124 Wn.App. 716, 103 P.3d 827 (2004)).

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,  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 ADA and similar civil-rights employment laws is to make the plaintiff whole, the Third Circuit upheld the additional award for tax consequences. “Without this type of equitable relief in appropriate cases, it would not be possible to restore the employee to the economic status quo that would exist but for the employer’s conduct,” the court wrote (quoting In re Continental Airlines, 125 F.3d at 557.)

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 inNeill 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.

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This article originally appeared in Employment Law Strategist, Vol. 17, No. 7, November 2009. Reprinted with permission of ALM Properties Inc.

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