Taxes on Civil Rights Damages Need Adjustment

A recent ruling can have a positive financial impact for winning employees in discrimination cases and both plaintiffs and their counsel should know about it. The Third Circuit decision in Eshelman v. Agere Systems addresses a long term tax problem the employment bar has been struggling with for years. 

Here’s the explanation. Awards in discrimination cases usually entail an amount called “backpay” which compensates the victim for wages lost as a result of the discriminatory conduct. So, for example, if a person was wrongfully discharged because of his race and it took him three years to find a new job, the jury is entitled to award three years of “backpay.”

The problem is that when awarded in a lump sum, the taxes owed are more than they would have been had the employee paid the taxes in three consecutive years of work or in the normal course of employment. This result doesn’t jive with the law which entitles the employee to be restored to the economic position he would have been in but for the employer’s conduct.

The lawyer representing Joan Eshelman, who won this important disability discrimination case discussed  here on February 18th, asked the judge in a post-trial motion for an amount to compensate Eshelman for the negative tax consequences of the lump sum back pay award.

The judge granted the request and the Third Circuit Court of Appeals agreed:

We hold that a district court may, pursuant to its broad equitable powers granted by the ADA, award a prevailing employee an additional sum of money to compensate for the increased tax burden a back pay award may create. Our conclusion is driven by the “make whole” remedial purpose of the anti-discrimination statutes. 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.'

In order to obtain the additional award, employees must be prepared to prove the loss. In Eshelman, the plaintiff provided an affidavit from an economic expert who calculated the amount of tax effect, the applicable tax rates, and Eshelman’s tax returns for the years in question, a method of proof which was approved by the court.

Several years ago, as reported in Lawyers Weekly USA, we got the trial court  in one of our cases to instruct the jury on this issue. In other words, the jury charge included language informing them that the award to the plaintiff would be taxed at a higher rate as a result of the lump sum award than if the plaintiff employee had collected the same amount in income over several years. We provided economic testimony on the issue so that the jury had the appropriate calculations.

Groups advocating for both employers and employees have been trying to address this tax problem for years. We now have precedent to address this issue on a case by case basis. When the Civil Rights Tax Relief Act is reintroduced, Congress should pass it and rectify this situation once and for all.