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Damages: A Tax Break for Plaintiffs Raises Interesting Issues
The Third Circuit recently delivered a significant clarification on economic damages in employment matters. In Eshelman v. Agere Systems Inc., 554 F.3d 426 (2009), the court held that plaintiffs in employment-discrimination suits may recover for the negative tax consequences of receiving a lump-sum award for back pay. (Circuit courts are not in accord on this issue ' the Tenth Circuit upheld an enhancement for tax consequences in Sears v. Atchison, Topeka & Santa Fe Railway Co., 749 F2.d 1451 (1984), while the District of Columbia Court of Appeals categorically refused to do so in Dashnaw v. Pena, 12 F.3d 1112 (1994).)
Successful claimants in wrongful-discharge actions often receive several years' compensation as a lump-sum payment. Since the Internal Revenue Service holds that such awards are taxable in the year that they are received, the awards often put the claimant into a much higher tax bracket for that year. In some extreme cases this has led to awards that, after taxes, leave the prevailing plaintiff poorer than before the award. (See Pham v. City of Seattle, 124 Wn.App. 716, 103 P.3d 827 (2004)).
The negative tax consequences of lump-sum payments are due to the progressive nature of the federal tax code. When a plaintiff receives a lump-sum award representing several years of back pay or front pay, the lump sum may push the plaintiff into a higher marginal tax bracket in the year in which the award is received, and the plaintiff will pay proportionally more tax than if the income had been spread over several years.
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