When to Include Taxes as Financial Damages: Marshall v PwC
By Serena Morones, CPA, ASA, ABV, CFE
In the recent case Marshall v. PwC, an Oregon jury awarded the Marshall family $84.5 million in damages against PricewaterhouseCoopers (PwC) for negligent tax advice. The judge apportioned the damages, attributing 77.5% of the fault to PwC, which resulted in a net award of $66.5 million.
Importantly, nearly half of the $84.5 million — or $40 million — was allocated to cover the Marshalls’ income tax liability on the award. The aim was to ensure that the after-tax amount would be sufficient to fully satisfy the Marshalls’ outstanding tax obligations.
The Marshall case illustrates the critical importance of considering whether a negative tax impact of the alleged harm should be added to the damage claim to make the plaintiff whole.
Tax Considerations in Damage Calculations
The addition of income taxes to a damage award is known as a “tax gross-up” or “tax damage” calculation. This calculation determines the total award necessary so that, after paying taxes, the plaintiff is restored to the same financial position they would have been in had the injury never occurred.
The question of whether a tax gross-up should be applied is crucial for damage experts, yet many experts lack experience in making this determination. The Marshall v. PwC case underscores the importance of this issue, where the $40 million tax gross-up was a significant component of the total award.
This article addresses the financial and tax considerations related to tax damages without exploring legal precedents or case law. While courts have varied in their willingness to award taxes as damages, damage experts should consider the tax implications of a damage award and advise clients on whether the damages should include an adjustment to account for an income tax impact.
Two Key Questions for Tax Damage Claims
When deciding whether a tax gross-up should be applied, damage experts can ask two key questions: 1) Will the damage award trigger tax? 2) Would the expected (non-damaged) scenario have been similarly taxable?
Question 1: Will the Damage Award Trigger Tax?
The first step is determining whether the damage award will be taxable. Under the Internal Revenue Code (IRC) §61, “Except as otherwise provided in this subtitle, gross income means all income from whatever source derived.” This broad definition includes most types of damage awards, but there are a few exceptions, such as:
- Damages for personal physical injury or sickness
- Return of capital or loan principal repayment
The analysis can be complex because the damage award may represent various economic elements, including interest or compensation for lost future earnings. Notably, non-punitive personal injury damages are the most common type of non-taxable award.
Conversely, damages for lost profits or lost earnings are generally taxable. In cases involving damages for non-physical injuries or lost income, the award will likely be subject to taxation.
Question 2: Would the Expected (Non-Damaged) Scenario Have Been Similarly Taxable?
Once the expert determines that the award will be taxable, the next step is to assess whether the original expected scenario — the situation without the injury or damage — would have been similarly taxable.
If both the damage award and the expected scenario would be taxed in the same way at similar tax rates, then a tax gross-up may not be necessary. Lost profit damages are typically viewed as similarly taxable and no tax gross-up is applied.
However, lost wages damages in employment cases can warrant a tax gross-up calculation due to a significant change of timing of compensation received that can substantially change tax brackets.
Example: Suppose an employee expected to earn $100,000 per year for 10 years but lost all of those wages due to a wrongful termination. In this case, the employee might receive a lump-sum award of $1 million (ignoring time value of money and mitigation).
However, if the employee is awarded the $1 million in a lump sum, they would face a much higher effective federal income tax rate on that income than if they had earned $100,000 per year over 10 years due to the U.S. graduated income tax rate structure. This difference in effective tax rates creates potential for a tax gross-up calculation to be added to damages, to compensate the employee for the higher taxes owed and to ensure the employee is made whole.
To calculate the tax gross-up in a lost wages case, the expert must determine the tax rate that applies to both the damage award and the original expected earnings and also consider the time value of money under each scenario.
A Damage Award Can Also Create a Tax Windfall
Certain types of damage calculations can create a tax windfall for the plaintiff, unless the damage expert removes the tax benefit. If a plaintiff loses wages or business income as a result of a physical injury, a damage award that consists of replacement of lost income would be exempt from income taxes.[1] If the damage expert calculates lost income damages without deducting the income taxes that would have been owed on the income but-for the injury, the plaintiff will receive a windfall because the resulting damage award will then not be taxed. To correct for this tax benefit, the theoretically correct calculation of lost earnings resulting from personal injury is on an after-tax basis.
The Marshall Case Example
In the Marshall v. PwC case, the Marshalls sought relief from approximately $50 million in outstanding federal taxes, penalties, and interest that had accumulated over 20 years due to allegedly negligent tax advice from PwC. The Marshalls had already paid millions in taxes and spent decades litigating with the IRS.
To make the Marshalls whole, I explained to the jury that if they awarded $50 million so that the Marshalls could pay their tax bill, the Marshalls would report it as income, leaving them with only around $26 million to pay the IRS. I compared the taxable damage award to the after-tax funds needed to pay off the IRS. The Marshalls needed $50 million of funds on an after-tax basis to pay off the IRS.
The only way to fully resolve their tax liability would be to include additional damages to cover the income tax on the damage award, ensuring that after-tax proceeds would fully pay off the tax bill.
Marshall Tax Damage Calculation
To calculate the necessary tax gross-up, we started with the base damage amount of approximately $50 million and divided it by (1 – tax rate). Using the highest applicable marginal tax rate of 46.9% (federal and state), the gross-up calculation was:
$50,000,000 / (1 – 0.469) = Total Award of $94,161,000
Thus, to ensure the Marshalls could fully pay their tax bill, the jury needed to award approximately $94 million. The actual award was $84.5 million because the jury adjusted it slightly for reasons that are unclear.
Bottom Line: Examine the Tax Implications of a Damage Award
The goal of a damage expert is to ensure that the plaintiff is made whole, restoring their financial position as if the injury had never occurred. In many cases, taxes can significantly reduce the value of a damage award beyond the original expected scenario and in some situations the damage award can create a tax windfall. Therefore, it is critical for damage experts to consider the tax impact of the damage award and make appropriate adjustments.
[1] U.S. Code §104(a)(2)
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Serena Morones, CPA, ASA, ABV, CFE is an independent damages and business valuation expert. Top commercial and IP litigators turn to her again and again to resolve high-stakes disputes through expert testimony or settlement.
503-906-1579 | [email protected]
