Neutralizing the Adverse Tax Consequences of a Lump-Sum Award in Employment Cases

By Ben-Zion, Barry | Journal of Forensic Economics, Fall 2000 | Go to article overview

Neutralizing the Adverse Tax Consequences of a Lump-Sum Award in Employment Cases


Ben-Zion, Barry, Journal of Forensic Economics


I. Introduction

The lump-sum award for a stream of lost earnings in employment cases is subject to income taxes in the year it is received by the plaintiff. Given the progressive nature of income taxes, the lump-sum award will typically be subject to a much higher tax rate than the rates applicable to the stream of lost annual earnings. The difference between the higher tax paid on the lump sum and the lower tax that would have been paid on the lost annual income that would have been earned sequentially can be referred to as the "adverse tax consequence of a lump-sum award," or more simply the "adverse tax consequence."

An additional sum of money is needed to neutralize this adverse tax consequence. The "tax neutralization" is that amount of money that would compensate the plaintiff for the adverse tax consequence. Since any additional award designed to compensate for the adverse tax consequence would also be subject to taxation at high rates (since it is an addition to the lump-sum award for lost earnings) the tax neutralization amount needs to be larger than the adverse tax consequence. In other words, awarding an amount of money, which is just equal to the adverse tax consequence, would not make the plaintiff whole.

This paper demonstrates the adverse tax consequence of the lump-sum award and suggests a methodology for the computation of the correct tax neutralization amount. It proceeds to describe some of the complexities that may arise in actual calculations.

II. The Legal Setting

Following the Supreme Court decision in the Schleier case,(1) Congress enacted HR 3448, known as the Small Business Job Protection Act of 1996.(2) The act clearly states that damages received for non-physical injury or sickness are taxable under the Internal Revenue Ruling Code.(3) Thus, any award for damages for wrongful termination, age and sex discrimination, or other employment cases, are clearly taxable under the Code. Many states would likewise subject the award to their own state income taxes. Thus, unlike personal injury and wrongful death awards that are generally not subject to taxation, the lump-sum award for lost earnings in employment cases is subject to taxation when received by the plaintiff.(4)

III. The Adverse Tax Consequence

A simple example of a wrongful termination case demonstrates the adverse tax consequence of the lump-sum award. Assume the following:

1. Mr. Jones is a single male.

2. Mr. Jones was wrongfully terminated from employment in California on 1/01/1995.

3. The position that Mr. Jones held commanded an annual wage of $16,000 in 1995.

4. The annual wage in the position that Mr. Jones held was increased by $1,000 per year subsequent to 1995, so that it was $17,000 in 1996, $18,000 in 1997, etc.

5. Mr. Jones was not earning any fringe benefits from his employment.

6. The actions of the employer who terminated Mr. Jones prevented him from securing any employment for a period of exactly five years.

7. Mr. Jones retrained himself with new skills and secured new employment starting on 1/01/2000, earning $21,000 per year. This wage level is exactly the same as that which he would have earned with the prior defendant employer but for his termination. It is assumed that he would have no future loss of earnings subsequent to 1/01/2000.

8. The economist testified in trial that the loss of wages from 1995 through 1999 was $90,000 (the sum of $16,000 plus $17,000 plus $18,000 plus $19,000 plus $20,000). The economist did not add pre-trial interest on the past wage loss.(5)

9. The jury awarded a lump sum of $90,000 for the past wage loss, which was paid by defendant in the year 2000.

10. No attorney's fees and costs were paid by Mr. Jones.(6)

A. Taxes on the Lump-sum Award

Having received the entire lump sum of $90,000 in the year 2000, Mr. …

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