Your new client comes to you after being terminated from a middle-management position he held for 15 years. He is convinced his termination was age related, as the company explained his lay off as a “reduction in force,” but he and one other 50+ employee were the only two employees let go. Your client had a solid history of earnings increases, complete with health benefits and matching 401(k) contributions. He has been unable to find employment with comparable earnings/benefits. After a lengthy discovery and trial schedule, you prevail on your age discrimination claim and the jury awards your client $1.5 million in back and front pay damages. Everyone, save perhaps the Defendant, is happy. However, your client calls after receiving his net proceeds from the damage award (for purposes of this example, you took this case pro bono so we can ignore fees) and complains that the Feds and the State took a sizeable portion of his award. He explains that, in fact, he paid much more in taxes due to his lawsuit than he would have had he not been terminated. Your client just experienced the “adverse tax consequences of a lump sum damage award.”
This phrase, first coined by Barry Ben-Zion in a 2000 article on the phenomenon, describes the tax effects of receiving a large lump-sum damage award as a replacement to the flow of income over time.[1] Because of the progressive nature of our tax code, your client just paid an incrementally higher tax bill than he would have had he never suffered from his ex-employer’s termination.
While economists have long recognized the negative impacts of taxing damage awards when such awards result in an incremental tax bill, the courts have only recently accepted adjusting damage awards to compensate the Plaintiff for that bill. A 2019 California Appellate Court decision denied a defendant’s motion to reverse a lower court’s approval of a damage award adjustment to account for the incremental taxes the Plaintiff would pay on his award.[2] Subsequent to this decision, more and more economists are applying a “tax neutralization” calculation to their analyses of damages in employment matters.
The calculation is relatively straightforward. The first step it to calculate the present value of the likely Federal and State taxes he would have paid had the termination never occurred (TNT). To the extent your client will have alternative earnings during his remaining work life, a calculation of the present value of his likely taxes on those earnings is also necessary (TWT). Finally, the taxes on the damage award are determined (TD). The difference between the present values of your client’s total tax bill on his alternative earnings plus the taxes on the damage award and the taxes he otherwise would have paid but-for his termination is the adverse tax effect of the lump sum damage award (ATE = TWT + TD – TNT). Using the example from above, let’s assume the present value of your client’s taxes on earnings without termination are $260,000, while the combination of the taxes on his alternative earnings and damage award sum to $900,000. The adverse tax effect is $640,000 and if left unadjusted, would reduce your clients damage award to $860,000, net of the tax effect. Since the amount of the damage award put your client in the highest tax bracket (close to 50% when combining Federal and California state tax rates), it is easy to see that to eliminate the negative effect of the taxes on his award, the Court should award your client an additional $1,280,000 in damages. To see how this makes your client whole, consider that the additional $1.28 million will be taxed at 50%, leaving your client with $640,000 in additional award, which is how much extra he will pay in taxes due to the award.
While the calculation of tax neutralization adjustments is typically more complicated than this simple example, economic experts can, and do, perform them regularly. As can be seen, tax neutralization can have a dramatic impact on the ultimate award Plaintiff’s receive as compensation for their harm.
[1] Barry Ben-Zion, “Neutralizing the Adverse Tax Consequences of a Lump-Sum Award in Employment Cases,” Journal of Forensic Economics, 13(3), 2000, pp. 233-244.
[2] Economy v. Sutter East Bay Hospitals, 31 Cal. App. 5th 1147 – -Cal: Court of Appeal, 1st Appellate Dist., 4th Div. 2019.