Employer Bankruptcy and Lawsuits

Yes. The tax system starts with the basic premise that “All income is taxable, unless specifically excluded.” This includes settlements and damages from employment cases. Due to the way the tax laws are structured, however, you may pay higher taxes on money you receive in an employment case than you would if you had continued working for your employer and paid taxes on your wages.

There are two ways that you may pay higher taxes in settling or winning your employment case. If you receive damages for noneconomic harm (also called “compensatory damages”) such as the pain and suffering and emotional distress that employees suffer as a result of egregious, international harassment, retaliation, or similar workplace wrongs, you will be taxed on those damages, even though those who receive noneconomic damages in other types of cases, such as personal injury cases, do not pay taxes on these cases.

In a case rejected for review by the Supreme Court, Murphy v. IRS, the DC Circuit Court of Appeals upheld the constitutionality of taxing non-economic damages in employment cases, even though these damages are not taxed in other types of cases. As this is one of the only rulings on this subject, it will most likely be necessary to pass new legislation to undo the previous change to the law.

Yes. Back wages are taxable as income, since if they were earned as wages during your employment, you would be taxed on them. Also, since you are required to pay taxes on the entire amount of your income in any given year, if you receive a lump-sum award for several years of lost back pay, you often will pay taxes at a higher rate than if you had earned that pay over a several year period. There currently is no way to average out your award so that you only pay taxes at the rate you would have paid had you still been employed.

Yes. Over the years there has been bipartisan legislation introduced that would end the unfair taxation of recoveries in these cases by excluding non-economic damages received in employment cases from gross income. This legislation has gone by the names of the “Civil Rights Tax Relief Act” and the “Civil Rights Tax Fairness Act.” The most recent legislation, introduced in the 114th Congress by George Democrat John Lewis and Wisconsin Republican Jim Sensenbrenner, is called the Civil Justice Tax Fairness Act. Along with excluding non-economic damages, the CJTFA also attempts to counter the negative impact of receiving a multiple back pay and/or front pay award in a single year by providing incoming averaging for those recoveries. With income averaging, employees will pay taxes at the same amount they would have if they had received the income over several years of employment.

Passing the CJTFA helps ensure that employees receive the full compensation due them for the harm they suffered, which is the central purpose of the civil rights laws.

Passing the CJTFA will help employers as well. The excessive taxes paid in employment cases drive up the cost of settlement of workplace-related cases for America’s businesses, while at the same time reducing recoveries for victims of discrimination. Instead of settling more quickly, more cases go to trial, as employees hope that they will receive a higher award from a jury, rather than settling for a lesser amount that is inadequate to cover their excessive tax burden. A number of employer groups and attorneys who represent employers support the CJTFA as well, to reduce the costs of litigating employment cases.

Yes. In October 2004, a provision ending double taxation of attorneys’ fees in employment discrimination, civil rights and other cases regulating employment was passed as part of the America Jobs Creation Act of 2004. The law allows employees who have received a settlement or award to deduct the portion of the award paid to the attorney as attorneys’ fees as an above-the-line deduction of attorneys’ fees This means that payments will not be subject to the Alternative Minimum Tax or to the 2% floor on miscellaneous deductions, which caused employees to pay taxes on portions of the award that they did not receive – which went to their attorneys instead. It applies to settlements and awards made, and fees and costs paid, after the date of enactment.

The recent ruling holds the IRS can continue to tax compensatory damages awarded to victims of whistleblower retaliation and other civil rights violations. These damage awards, which are intended to make the victim “whole” again, include payments for loss of reputation and emotional distress.

The case was brought by Marrita Murphy, an environmental whistleblower who won her case before the Department of Labor, and was awarded compensatory damages to vindicate her rights under six federal environmental whistleblower statutes. Murphy filed suit when the IRS demanded that she pay taxes on the “make-whole” award as if it were income. After having her case dismissed, Murphy filed an appeal.

After full briefing and oral argument, the Appeals court initially held that Murphy’s award was not income and the tax on her damages violated the U.S. Constitution. Then, under pressure from the Bush Administration, the judges decided to rehear the case. In this ruling, Murphy II, the D.C. Circuit reversed its own previous decision, declaring that non-physical compensatory damages are taxable as gross income. The Supreme Court recently declined to hear this case.

If you receive a lump sum amount as a settlement of an employment law claim, then you must decide how to allocate the amounts, and which forms to use. You have two choices, Form W-2 and Form 1099-MISC. Within Form 1099-MISC, you have two further choices: Box 3 or Box 7. Box 3 is for “other income,” including taxable damage awards. Box 7 is for “non-employee compensation” over $600. For example, suppose you settle your case for $100,000. You pay your attorney $30,000 as agreed in your retainer. Of the remaining $70,000, you and your accountant or tax adviser decide to allocate $25,000 to wage loss and $45,000 to emotional distress. Only the wage loss allocation will be subject to the normal withholdings if you choose the W-2 form option.

Tax law is very complicated, and the lawyer representing you in your employment case, who may be very knowledgeable about employment law, may not fully understand the tax implications either. Many employment attorneys recommend that their clients get independent tax advice from someone who specializes in tax law, such as an accountant, tax adviser or tax attorney. If your attorney makes this recommendation, or if you don’t understand what your attorney has recommended regarding the tax implications of your settlement or award, you should definitely talk to someone who has specific expertise in tax law.

Now that you have concluded your lawsuit and received money from your employer, the last thing you probably want is an audit or further litigation. It is worth the relatively minimal investment to get sound tax advice, especially compared to the alternative of losing even more of your award to taxes and penalties.