Consideration of Taxes in a Lost Earnings Calculation

shutterstock_935684-150x150Considering taxes in a lost earnings calculation related to personal injury matters may materially alter the damages amount.  In the well-known 1980 Supreme Court case, Norfolk & Western Railway Co. v. Liepelt, the Court ruled that courts should consider taxes and calculate lost earnings net of income taxes.  The Court’s rationale was that the damage award is not taxable, but had Plaintiff not been injured and actually earned the calculated “but-for” earnings, these earnings would have been taxed.  Thus, by not taxing lost earnings (nor the damage award), the Plaintiff attains a windfall.

Despite this 1980 Supreme Court ruling, many jurisdictions appear to either exclude any tax consideration on a personal injury lost earnings calculation or remain silent and/or ambiguous.  Only Hawaii, New Jersey, Oregon, and Texas provide relatively clear case law or state law essentially upholding the Supreme Court ruling.  (Note:  Alaska only considers taxes for past lost earnings, not future lost earnings.)  Some of the jurisdictions that exclude tax consideration explain their rationale for excluding taxes generally as follows:  Plaintiff’s lost earnings damages award is discounted to present value.  Plaintiff is expected to invest the award in some risk-free investment that will generate interest.   (See article here in why a risk-free investment may be inappropriate).  In many instances, the earned interest is taxable.  If taxes are ignored both on lost earnings and on interest earned, the tax effects offset each other (i.e., lost earnings (pre-tax) increases present value damages while ignoring taxes on investment income decreases Plaintiff’s investment monies actually received); thus, taxes can be ignored.

However, the tax effects do not necessarily fully offset each other.  Using net earnings (post tax earnings) may lower the damages award depending on Plaintiff’s income levels and projected real wage growth rates.  The amount of monies necessary to cover the taxes owed on interest (increase the damages award) depends on the damage period length and nominal discount rate.   In deciding whether to consider taxes in any lost earnings damages calculation, one should consider the law applicable in the jurisdiction.

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