When a jury awards compensatory damages to a successful discrimination plaintiff, should the plaintiff have to pay federal tax on that income? How big of a tax bite should the IRS get when an employee successfully sues his employer and is awarded several years of back pay. These issues about the tax consequences of payments received to resolve discrimination complaints are the subject of proposed new federal laws and a recent decision from a federal appeals court.

In Washington, bi-partisan bills under consideration in the House and Senate would amend federal tax law by excluding from gross income some payments received because of claims of unlawful discrimination. The draft legislation, called the Civil Rights Tax Relief Act of 2009, would exclude compensatory damages from income, but would not exclude front pay, back pay, or punitive damages. However, the bill would allow recipients of lump sum front pay or back pay awards covering several years to average their income over those years. The excluded income would include amounts not only resulting from court and administrative agency judgments, but also payments received through settlements.

As introduced, the bill would define “unlawful discrimination” broadly. It would include, e.g., claims of race, color, sex, religion, or national origin discrimination under Title VII of the Civil Rights Act of 1964. “Unlawful discrimination” also would encompass various other federal, state, and local laws prohibiting discrimination on the basis of age, disability, and whistleblowing, among other things.

The House of Representatives’ version, if passed, would affect amounts received in taxable years beginning after December 31, 2008. The Senate version would address income earned after December 31, 2009.

A federal appeals court in Philadelphia recently took a different approach to ameliorate the negative income tax consequences for a successful plaintiff in a discrimination case.¹ At trial, Joan Eshelman convinced a jury that her former employer dismissed her in violation of the Americans with Disabilities Act (ADA). The jury awarded compensatory damages and back pay in the total amount of $200,000.

Following trial, Ms. Eschelman’s attorney asked the court to increase the back pay portion of the verdict to make up for the increased tax burden that the lump sum award would impose upon her. She submitted an affidavit from a financial expert who expressed his opinion that the lump sum award would require Eshelman to pay $6,893.00 in additional income taxes.² The defendant-employer did not attempt to rebut the testimony, but argued that a court was without authority to increase a jury verdict to account for tax implications.

The Third Circuit Court of Appeals stated that a chief remedial purpose of the ADA was to make victims of disability discrimination “whole,” i.e., to restore the status quo that would have existed had no discrimination occurred. The court next pointed out that prior cases established that awards of back pay are taxable in the year in which they are paid, adding that “receipt of a lump sum back pay award could lift an employee into a higher tax bracket for that year, meaning the employee would have a greater tax burden than if she were to have received that same pay in the normal course.”³

The court further noted that two other federal appellate courts that had addressed the issue reached opposite results. The Tenth Circuit Court of Appeals awarded extra compensation to a prevailing Title VII plaintiff following a verdict that included a lump sum payment of 17 years of back pay.⁴ In contrast, the Court of Appeals for the District of Columbia rejected that approach,⁵ and concluded, “[a]bsent an arrangement by voluntary settlement of the parties, the general rule that victims of discrimination should be made whole does not support ‘gross ups’ of backpay to cover tax liability. …Given the complete lack of support in existing case law for tax gross-ups, we decline to extend the law in this case.”⁶

The Eshelman court, following the Tenth Circuit, drew an analogy with pre-judgment interest, which courts have consistently awarded to successful plaintiffs in discrimination cases to compensate them for the lost use of their money. The court concluded that the pro-offset approach was consistent with the remedial nature of discrimination law and increased the back pay award to compensate for the plaintiff’s higher tax liability.

Notably, neither the U.S. Supreme Court nor the Sixth Circuit Court of Appeals, which makes federal law in Ohio in the absence of a Supreme Court ruling, has weighed in on the “gross up” issue. However, the Employment Law Section will be monitoring court decisions and the pending legislation on these matters, as they could affect clients’ potential exposure to liability in civil rights cases.

Michael C. McPhillips
Section Chief

¹ Eshelman v. Agere Systems, Inc., 554 F.3d 426 (3rd Cir. 2009)
² In a case cited in Eshelman, the court held it had authority to increase a verdict to offset tax liability, but would not do when the plaintiff failed to provide competent
foundation evidence to make the necessary calculations. EEOC v. Joe’s Stone Crab, Inc., 15 F. Supp.2d 1364, 1380 (S.D. Fla. 1998).
³ 554 F.3d at 441.
⁴ Sears v. Atchison, Topeka & Santa Fe Ry. Co., 749 F.2d 1451 (10th Cir. 1984).
⁵ Dashnaw v. Pena, 304 U.S. App. D.C. 247, 12 F.3d 1112 (D.C. Cir. 1994).
⁶ 12. F.3d at 1116.