Academic journal article Journal of Legal Economics

Neutralizing the Adverse Effect of State and Federal Income Taxes on Lump Sum Awards in Employment Cases

Academic journal article Journal of Legal Economics

Neutralizing the Adverse Effect of State and Federal Income Taxes on Lump Sum Awards in Employment Cases

Article excerpt

I.Introduction

The adverse effect of federal income taxes in employment cases has received considerable attention in the forensic economics literature (Goodwill and Paul 1988; Benich, 1991, 1996; Markowski and Cross 1991a, 1991b; Bowles and Lewis 1996; Lewis and Bowles 1996; BenZion 2000; Rodgers 2003; Ireland (2010; 2012); Roney 2012, 2016; Macpherson and Stephenson 2016; Schap 2016). The ambiguity existing prior to 1996 in the treatment of taxes in litigation involving employment law was clarified by the Small Business Job Protection Act of 1996 (Public Law No. 104-88, Sec. 1605 (REPEAL OF EXCLUSION FOR PUNITIVE DAMAGES AND FOR DAMAGES NOT ATTRIBUTABLE TO PHYSICAL INJURIES OR SICKNESS); 26 U.S.C. ?104(a)(2)). This law codified that damages not resulting from a personal physical injury are subject to federal income taxes.1 This means taxes are levied on awards for back pay and front pay in employment cases. An award lacking an accounting for these tax consequences will undercompensate a plaintiff for the presumed tort. Rodgers (2003) addressed this issue in two respects. First, he noted that if the award is presented in after tax dollars, the taxation of the award causes the income to be taxed twice. Second, he noted that because federal tax rates are progressive, taxing the award of back pay and front pay when received as a lump sum in one tax year causes the plaintiff to pay higher taxes on the lost income than they would have paid if the plaintiff had received the income yearly. Ben-Zion (2000) termed this increase in federal tax liability an "adverse tax consequence."

Besides the usual loss estimation issues2 involved in personal injury cases, employment cases require the expert to address any adverse tax consequence. This means calculating an award amount such that after deducting federal and state income taxes and payroll taxes the resultant difference is the estimated loss amount. This calculation has been referred to as an award "gross-up" to account for, or neutralize, an adverse tax consequence of an award in employment cases or other non-physical injury cases (Ben-Zion 2000; Ireland 2010).

A "gross-up" calculation is not straightforward. The calculation must consider both federal and state (if applicable) income taxes and their progressive rate structure; the deductibility of state income taxes in some state jurisdictions; payroll taxes; and investment income. The "gross-up" calculation becomes more cumbersome when the forensic economist estimates alternative loss scenarios.

This paper provides an innovative method to perform "gross-up" calculations to determine an award amount when estimated losses are taxable income and extends the literature in two ways. First, it incorporates several real-world tax calculation issues (using the Tax Cuts & Jobs Act of 2017) when addressing adverse tax consequences of an award including investment income, Social Security and Medicare taxes and NIIT. Second, the paper presents a tax "gross-up" using readily available spreadsheet functions3 to iterate a user-friendly "gross-up" tax calculation.

Section II outlines the conceptual framework for the "gross-up" calculation. Section III uses an example to demonstrate the use of spreadsheet internal routines to solve for a tax-adjusted award amount for back pay. Section IV demonstrates the use of the model for grossup calculations for varying years of possible future lost earnings. Section V compares the accuracy of an approximation "gross-up" formula to the correct results for a range of annual earnings and years of losses. Section VI provides our conclusions.

II.Conceptual Framework

The following provides the conceptual framework for our grossup model.

GUA = ATL þ SITGU þ FITGU þ PTGU

Where:

GUA = the "grossed-up" award amount

ATL = the estimated after-tax loss amount

SITGU= the incremental state income tax on the "grossed-up" award amount (if applicable)

FITGU = the incremental federal income tax on the "grossed-up" award

PTGU= the incremental payroll (i. …

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