Kenneth Economy v. Sutter East Bay Hospitals, et al. was a California wrongful termination case in which the trial court found a hospital liable for restricting a physician’s privileges without providing notice and a hearing. The hospital was ordered to pay damages for lost income, future lost income and tax neutralization. On appeal, the hospital only challenged the trial court’s damage award for tax neutralization. The Court of Appeal opinion filed on February 4, 2019 confirmed the lower court did not err in awarding an additional amount of damages intended to offset the tax consequences of a lump- sum award for lost earnings. The opinion further indicated there were no reported California decisions regarding the concept of tax neutralization and that federal appellate courts had endorsed it. The Court held that a tax neutralization award was consistent with Civil Code section 3333 which provides for damages to include “the amount which will compensate for all the detriment proximately caused by the wrongful conduct.”

The purpose of a tax neutralization calculation as stated in the appeal was “to offset the increased tax burden on plaintiff resulting from a lump sum award of damages as compared to what plaintiff would have owed in taxes if the earnings had been received sequentially each year.” This tax neutralization award will neutralize the adverse tax consequences a plaintiff will face from having to pay taxes on a lump sum award in a single year instead of paying taxes at a lower rate over several years. Additionally, it will account for any changes in tax burden resulting from changes in income in both the past and future periods. I will illustrate this point with a simple example.

In this example, Mr. Brown was terminated from his job as a supervisor at Common Industries and filed a wrongful termination lawsuit against his former employer. At the time of his termination, Mr. Brown received $85,000 per year in earnings and an additional $15,000 per year in benefits, for a total of $100,000 annually. At the time of his termination, he had a remaining statistical work-life expectancy of 20 years. If he had worked for the company for an additional 20 years, he would have received a total of $2,000,000 in earnings and benefits ($100,000 per year times 20 years). Mr. Brown prevailed in his litigation against Common Industries and received a total judgment of $2,000,000. The award is taxable; therefore, Mr. Brown will pay taxes on $2,000,000 in the year the award is paid. Total federal and state taxes are estimated to be 50%, or $1,000,000.

If Mr. Brown had not been terminated from Common Industries and earned $2,000,000 in earnings and benefits over 20 years, the total amount he would have paid in taxes would have been less. His total earnings were $85,000 per year and the remaining $15,000 was the value of the benefits he received. He would have only paid taxes on the $85,000 per year. Mr. Brown would have been in a lower tax bracket earning $85,000 per year than he was in the year he received $2,000,000. If total federal and state taxes are estimated to be 30%, Mr. Brown will pay $25,500 each year for 20 years for a total of $510,000. In this simplified example, Mr. Brown should receive not only his lost earnings and benefits of $2,000,000 but also an additional $490,000 to account for the additional taxes he will now have to pay. However, this conclusion does not take into consideration several other factors which affect a tax neutralization calculation.

One factor that needs to be considered is the time value of money. In the example, Mr. Brown will have to pay $1,000,000 in taxes in the present day compared to $510,000 in taxes over 20 years. Due to the time value of money, the $510,000 Mr. Brown would have paid over 20 years should be discounted to present value. This is the same type of calculation which would have been performed when analyzing his loss of earnings and benefits and any offset earnings and benefits. All future amounts are discounted to present day dollars. This present value adjustment will decrease the value of the taxes paid over 20 years—thereby increasing the amount necessary to compensate him for his additional tax burden. For example, $25,500 per year for 20 years discounted at a 4.0% net discount rate is $346,554, instead of $510,000 prior to discounting. Once the time value of money is taken into consideration, the difference between taxes Mr. Brown would have paid had he not been terminated and the lump sum taxes he will now pay is $653,446, a 28% increase in the original tax neutralization amount of $510,000.

A second consideration is what additional amounts comprise Mr. Brown’s taxable earnings in any given year. The previous example assumes the only data necessary to determine Mr. Brown’s annual taxable income is his earnings from employment. However, in most instances this is not accurate. There are multiple other types of income which need to be considered when determining one’s total taxable income. Examples are spouse’s income, dividends, interest, Schedule C income, capital gains and losses and rental income. These amounts can be considerable and drastically alter an individual’s tax burden. Additionally, one should consider the plaintiff’s tax filing status, the type of deductions the plaintiff would have claimed and any changes in the status of dependents. A review of historical tax returns is helpful in determining how each of these items should be accounted for in a tax neutralization calculation.

In a wrongful termination matter, post-termination or offset earnings are subtracted from the but-for earnings to determine a plaintiff’s economic loss prior to consideration of any tax neutralization amount. These post-termination earnings are also a factor when analyzing a change to a plaintiff’s tax burden. If the plaintiff is earning more or less than they had been prior to their termination, this will affect their tax burden. Taxes on this stream of income are considered along with taxes on the lump sum award when calculating the total taxes that will be paid by the plaintiff in his or her current situation. The same additional considerations are relevant for this income stream when calculating the total taxes that will now be owed: income to be included in taxable income, deductions, filing status and status of dependents.

Once the initial tax neutralization calculation has been performed, this is not the end of the analysis. I will illustrate this with a continuation of the previous example in which Mr. Brown was awarded $2,000,000. Assuming the economic expert calculated a tax neutralization amount of $650,000, the result is total damages of $2,650,000. Therefore, the lump sum award is no longer $2,000,000 but instead is $2,650,000. The tax neutralization calculation now needs to be based on this updated award amount, which results in an increase to the tax neutralization amount. Each increase to the total lump sum amount awarded needs to be taken into consideration in the tax neutralization calculation.

In conclusion, a tax neutralization calculation can be a considerable component of damages in a wrongful termination matter. As the total amount of damages increases, so too does the tax neutralization amount. Depending on the specific facts of a case, this additional calculation can increase a total award by 50% or more. As illustrated with the Brown v. Common Industries example, a multitude of factors need to be considered when performing this type of calculation. It is a detailed and complex calculation with multiple inputs. Considering the complexities and possible economic magnitude of this type of calculation, one will want to ensure they engage an economic expert who is familiar with this type of calculation and the nuances involved.