3rd Circuit decision illustrates need for the Civil Rights Tax Relief Act

Damages in discrimination cases come is several shapes – economic damages for lost wages (back pay and front pay), compensatory damages, emotional distress damages, punitive damages, and attorneys’ fees. Because back pay and front pay represents lost wages, no one disputes whether the government should receive its fair share via income tax on those amounts.

There are two major sources of other taxes that apply in these cases:  taxation of damages for noneconomic harm; and taxation of lump-sum settlements or awards in one year. Critics argue that the former should not be taxed because it does not represent “wages.” Moreover, if the IRS does not tax noneconomic damages received on account of physical injury, why does it differentiate noneconomic damages received in discrimination cases. The latter greatly increases one’s tax liability by placing the employee in a higher-than-normal tax bracket based on the lump sum.

For employers, this tax treatment makes the settlement of discrimination disputes significantly more difficult. Because employees take tax liability into account when settling cases, the anticipated amount of tax to be paid drives up the cost of settlement. Often, this added cost is a serious impediment to the resolution of cases. Settlements that fall apart costs employers even more, through additional defense costs and the payments of judgments or even higher settlements down the road.

Eshelman v. Agere Systems (3d Cir. Jan. 30, 2009) illustrates this problem in action. In Eshelman, the Third Circuit grossed-up an employee’s back pay award to ensure that the employee did not face any added tax liability as a result of the lump sum award:

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 antidiscrimination 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.” …

[A]n award to compensate a prevailing employee for her increased tax burden as a result of a lump sum award will, in the appropriate case, help to make a victim whole. This type of an award … represents a recognition that the harm to a prevailing employee’s pecuniary interest may be broader in scope than just a loss of back pay.

The Civil Rights Tax Relief Act, which had been introduced in both the House and Senate in 2007 but went nowhere, goes a long way to curing the problem of the IRS’s current treatment of discrimination awards, which Eshelman partly illustrates. The CRTRA would amend the Internal Revenue Code to:

1. exclude from gross income non-economic damages in discrimination cases (back pay, front pay, and punitive damages would still be taxable); and

2. allow income averaging for back pay and front pay received from such claims, limiting an employee’s tax liability for the year in which the money is received to the total amount received divided by the number of years it represents.

There has been lots of talk by lots of people about lots of different pieces of employment legislation that will be passed in the coming years. The Civil Rights Tax Relief Act is one change that makes sense for employees and businesses. By lowering employee’s potential tax liability, it decreases settlement values of discrimination cases. It makes cases easier for employers to settle. If Congress is going to focus on passing pro-employee legislation during these trying times for businesses, it should focus on pro-employee legislation that makes some sense for employers as well.

[Hat tip: Daily Developments in EEO Law]