Taxing Our Civil Rights

by John Gause, Esq.
Published: Maine LAWYERS REVIEW, May 26, 1999

The Tax Code needs to change. Victims of discrimination are taking home far too little of what they recover in successful civil rights claims. With the 1996 changes to the Code, even compensatory damages are now taxable. For the time being, we have to find thoughtful ways of minimizing the tax consequences of an employment discrimination settlement or award.

A successful civil rights plaintiff can generally recover lost wages, lost benefits, compensatory damages, punitive damages, and attorney’s fees. The Civil Rights Act of 1991 defines compensatory damages as “future pecuniary losses, emotional pain, suffering, inconvenience, mental anguish, loss of enjoyment of life, and other non pecuniary losses.” The plaintiff’s taxable income is determined by calculating her gross income and then making appropriate statutory deductions. All earnings are included in gross income unless there is a specific exclusion. The tax rate increases with the Plaintiff’s taxable income.

Historically, there have been no exclusions or deductions for most elements of damages in employment discrimination claims. Lost wage, such as back and front pay, are understandably included in gross income and subject to tax—they would have been taxed if earned in the ordinary course of employment. Prior to 1996, punitive damages were taxable unless awarded in cases with physical injuries. Now, there are no exclusions or deductions for punitive damages.

The settlement or award attributable to the plaintiff’s attorney fees is included in the plaintiff’s gross income, but the fee can be deducted in arriving at the plaintiff’s taxable income. Attorney’s fees are gross income to the plaintiff regardless of whether the defendant pays them directly to the plaintiff’s attorney or they are taken out as a percentage of the plaintiff’s overall recovery. The generally accepted deduction for attorney fees is a “below the line” miscellaneous itemized deduction. As such, the plaintiff will only be able to deduct attorney fees to the extent they exceed 2% of her adjusted gross income.

One problem with the Code is the fact that no exception is made for the increase in the tax rate when the plaintiff receives a lump sum payment. Most employment awards compensate plaintiffs for losses occurring over a larger span than one year. Yet the plaintiff pays a higher tax rate because her income is substantially increased in the year of the payment. This is so despite the fact that future losses are calculated at present value.

Another problem is the fact that compensatory damages are taxable. Most forms of compensatory damages were excluded from gross income prior to the Code changes in 1996. The former Code contained an exclusion for any damages received “on account of personal injuries or sickness.” The term “on account of personal injuries” was interpreted to mean any damages that resulted from injuries in a tort or tort-type cause of action. The term “injuries” could mean either physical or psychological injuries, and psychological injuries did not need to be tied to physical injuries.

The exclusion of damages for psychological injuries in their own right was particularly signifiant in employment discrimination claims, where physical injuries are rare. With the passage of the Civil Rights Act of 1991, allowing broad compensatory damages in employment discrimination claims, most employment discrimination actions were viewed as tort-type causes of action. Accordingly, civil rights plaintiffs could use the personal injury exclusion to avoid paying taxes on the majority of settlements and verdicts. Not only were recoveries for emotional distress and other intangible losses covered, but lost wages were excluded if they resulted from emotional distress.

This changed with the Job Protection Act of 1996, which amended the personal injury exclusion to cover only personal physical injuries. Excluded from gross income is “the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness.” The amended language also specifically states that, “emotional distress shall not be treated as a physical injury or physical sickness.”

As a result of this change, typical employment discrimination damages for emotional pain suffering, inconvenience, mental anguish, and loss of enjoyment of life are included in gross income. Because there are no deductions for these types of recoveries, they are taxable.

The logic behind the amendment is less than clear, especially when viewed in light of the objective of making employment discrimination victims whole. The remedial scheme is designed to restore the plaintiff to the position she would have been in had the discrimination never occurred. An employment discrimination plaintiff comes up short if she must pay taxes on damages that were intended to put her back to square one. The tax leaves the plaintiff worse off than if she had not been the victim of discrimination.

The amendment also leaves us wondering why it treated psychological injuries differently from physical injuries. In both cases, the jury is asked to determine a monetary figure to compensate for an intangible loss. It is hard to imagine why one recovery is taxable and the other is not.

As a result of the current tax scheme, employment discrimination plaintiffs can expect to pay a sizable chunk of their recovery to taxes. In some cases, plaintiffs may actually have to pay to bring their civil rights cases. In Alexander v. IRS, the plaintiff settled his claim against his former employer for $350,000. Of that amount, he paid his lawyers $258,000 in legal fees (presumable by the hour). He incorrectly deducted the full legal fee “above the line,” and he paid taxes only on the remaining $92,000. The IRS found that the plaintiff miscalculated his taxes, and it imposed a $57,000 deficiency.

Putting aside the current injustices, there are ways we can serve our clients. They will certainly want to know the tax implications at the outset. This will help them to weigh the pros and cons of going forward. There is no question that the client should be warned when thinking about settlement. The defendant also may be willing to put more money on the table if it understand the tax ramifications to the plaintiff.

In some cases, the client may need to be told that she might end up having to pay out more than she receives. The Alternative Minimum Tax (AMT) may come into play if the attorney’s fees greatly exceed the verdict. The AMT is a higher tax that applies if there are excessive deductions compared with the plaintiff’s gross income. In Alexander, the AMT applied because the plaintiff deducted the $258,000 in attorney’s fees from the $350,000 recover. Although a $258,000 attorney’s fee may be exceptional, the AMT is a risk when attorneys accept small employment discrimination cases based on the expectation of recovering fees from the other side.

It is also important not to forget the exclusions from gross income. There are employment discrimination cases that involve physical injuries, for example. Although rare, physical injuries may arise in a sexual harassment case. Under the Americans with Disabilities Act, a physical injury may result if an employer fails to meet its obligation to provide a reasonable accommodation. The failure to prove an accommodation, such as a modified work station, may result in an aggravation of the plaintiff’s physical disability.

There are other exclusions from gross income that may be applicable. These include contributions by an employer to certain benefit plans such as health and accident insurance, qualified group legal services plans, educational assistance programs, and dependent care assistance programs. The loss of an employment benefit such as health insurance coverage is an element of damage that is recoverable in an employment discrimination claim. If the plaintiff loses employer contributions to a benefit plan as a rest of her termination, she should seek these amounts in her employment discrimination claim. If the claim is settled, characterizing the settlement in this manner will minimize the tax consequences to the plaintiff.

The IRS will look at the entire transaction when scrutinizing a characterization of an award or settlement as falling within an exclusion. The complaint should include a claim for the particular type of relief sought. If the case goes to the jury, the jury verdict form should break down the award according to the excludable categories. Release agreements should make appropriate references to the portions of the settlement that will be attributed to an exclusion. Separate checks are appropriate in some cases.

Another consideration is the fact that Worker’ Compensation benefits are excluded from gross income. It often happens that an employer will insist on resolving a Workers’ Compensation claim at the same time that an employment discrimination action is settled. There is a strong tax advantage to characterizing more of the settlement as attributable to the Workers’ Compensation claim. Maine’s Workers’ Compensation Act narrowly restricts attorney’s fees in lump-sum settlements, however. Because contingency-fee agreements are the norm in employment discrimination claims, attributing the settlement to the Workers’ Compensation claim may substantially reduce the allowable fee.

We may also want to ask for a jury instruction or for the court’s permission to inform the jury that the amount received will be taxed. There are few cases that have addressed this issue. If there is a larger settlement, a structured payout beyond a single tax year may avoid a higher tax bracket. The difference in rates may outweigh the advantages to receiving the settlement or award at one time. It is always a good idea to refer the client to a competent tax professional.

What we need more than anything is a legislative response. Taxing compensatory damages and bumping civil rights plaintiffs into higher tax brackets is plainly wrong. Given the relatively recent changes in the opposite direction, however, we may be waiting a while for the necessary corrections to occur.