Kelly A. Knight is an attorney and mediator based in Los Angeles, CAlifornia. He handles matters throughout California.

Court of Appeal affirms tax-neutralization award as a component of economic loss, including on future-lost-income amounts

Recall Clemens v. Centurylink, Inc., 874 F.3d 1113 (9th Cir. Nov. 3, 2017) (link to my writeup here). In that case, the Ninth Circuit held that "tax adjustments" to back-pay awards to neutralize the effect of a lump-sum taxable judgment are an equitable form of relief in Title VII cases.

There hadn’t been a California appellate authority affirming a tax gross-up. Until now. And this one goes one step further.

In Economy v. Sutter East Bay Hospitals (Cal. Ct. App. 1st Dist. Feb. 4, 2019) (slip opinion linked here), after a doctor prevailed in a court trial alleging improper loss of hospital privileges, he was awarded monetary damages for past and future lost income, plus an additional amount on top of his economic loss to neutralize the tax effect of receiving a large lump sum, to the tune of $650,910.

The defense objected to the admissibility of the plaintiff’s expert’s testimony on the subject of tax consequences of an award under Kelly-Frye (see People v. Kelly, 17 Cal. 3d 24 (1976); Frye v. United States, 293 F. 1013 (D.C. Cir. 1923)), lack of foundation, speculation, and improper expert testimony under Evidence Code sections 801 and 802. See slip op. at 15. The trial court noted that “while there are no reported decisions in California on the concept of tax neutralization, the concept has been endorsed by . . . federal appellate courts,” citing several cases including the Ninth Circuit’s Clemens case, above. Slip op. at 16. Citing those cases and admitting the plaintiff’s expert testimony over objection on the subject of the different tax consequences of a lump-sum award versus payments over time, the trial court allowed the testimony and ultimately issued the tax-neutralization award.

On appeal, the Court of Appeal noted while any award based on what might happen in the future is “inherently speculative,” there was no error because the expert testimony provided was sufficient to establish foundation for admissibility:

Although an award to compensate for an income-tax disparity for lost future wages is inherently speculative, as is any award for lost future income, we see no reason why this factor cannot be established with sufficient certainty. As the trial court noted, plaintiff’s expert provided “detailed testimony regarding his calculations of (i) plaintiff’s total tax liability had plaintiff not been terminated and had he continued to earn income, (ii) the amount plaintiff would have to pay in taxes if awarded the computed loss of earnings (back and front pay), and (iii) the tax neutralization amount, i.e., the amount of money needed to generate a net amount equal to the adverse tax consequence.” We agree with the trial court that the foundational information relied on by the expert, including the applicable tax rates, provided a reasonable basis for his opinions.

Slip op. at 16-17.

The Court of Appeal distinguished the defendant-appellant’s cited authority (that tax awards are inappropriate because they are so highly speculative regarding the tax laws of the future) by noting that the cited authority involved tax consequences in the future—yet the tax-neutralization award in this case was about the tax consequences of the present lump-sum award:

The hospital’s reliance on Canavin v. Pacific Southwest Airlines (1983) 148 Cal.App.3d 512 is misplaced. In that case, that court held that in a wrongful death action it is “error to compute a survivor’s lost support based upon the decedent's projected net income which would have been available for support except for the wrongful death.” (Id. at p. 522, italics added.) The court explained, “Numerous California decisions as well as rulings of the courts of other jurisdictions exclude income tax projections from the jury’s consideration.” (Id. at p. 539 (conc. & dis. opn. of Staniforth, J. & Brown, J.).) This is because, among other reasons, “tax consequences are collateral, speculative and conjectural.” (Id. at p. 541.) In that case, however, the court was concerned with reducing the amount of damages to account for the income taxes that might otherwise have been paid in the future. (See id. at p. 542 [A “negligent defendant should not benefit by the fortuitous event the person injured may be subject (or not subject), in a totally unknown and unpredictable amount, to income tax.”].) In contrast, the purpose of the award in the present case is to ensure that plaintiff is fully compensated for his losses. We agree that the expert here laid a sufficient foundation to establish the probability and reasonableness of the tax neutrality projections to justify reliance on those projections.

Id. at 17. (Importantly, note that the award in this case included an amount for lost future income. See slip op. at 12 (“The judgment orders the hospital to pay damages in the following amounts: $1,136,906 in lost income, $1,159,354 in future lost income, $650,910 for tax neutralization, $19,000 for the cost of the PACE program, $650,000 for emotional distress and $250,952 in prejudgment interest.”).

So there you have it. A California Court of Appeal has authorized tax-neutralization/tax-consequence/tax-gross-up awards for lost income.

And remember, the Ninth Circuit’s Clemens opinion was about tax-gross-up amounts on back-pay awards in Title VII cases. The Court of Appeal has gone one step further, authorizing a tax-neutralization award on not just past lost income, but also future lost income. If this rule holds, it affects the damages calculations in many cases alleging lost income.

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