Properly Calculating Earnings Capacity
By David B. Singal
When an injury, accident, wrongful termination, or other event
occurs affecting an individual’s ability to earn income, too often a
general estimate for lost wages is figured into a settlement. However, in doing
justice for one’s client you need to consider a lost earnings calculation.
In defining earnings capacity Black’s Law Dictionary
explains that earnings loss does not necessarily mean actual earnings one was
making at the time an injury occurred, but refers to what an individual is
capable of earning based on training, experience and business acumen. In other
words, quantification of earnings capacity attempts to measure what the individual
was earning or potentially could have been earning whether or not the individual
was actually engaged in such employment. To make a proper determination certain
factors must be considered. Such factors include, but are not limited to, education,
training, experience, intelligence, health, age and employment history.
There have been numerous court cases that have used this
concept, including, for example, Sarah Beth Clingan Overstreet v. Shoney’s
Inc., Court of Appeals of Tennessee, 1999. Overstreet, an intelligent,
motivated person received a graduate nursing degree and had minimal job experience
prior to her injury. The injury caused her to lose eyesight in one eye and
greatly affect her permanent psychological disposition. Nevertheless, the jury
based her future earnings on her future education plans. Due to her professors’ encouragement,
Overstreet had plans to pursue an advanced nursing degree.
Obviously, each case is based on its particular factors.
The idea to bring to light is that earnings capacity represents what a person
could have been capable of earning but for the impairing incident. However,
the desire alone of attaining a particular employment without any specific
evidence would likely be mere speculation.
To some, this may seem unfair restitution. However, visualizing
the entire picture, this concept is just a specific application of the purpose
of tort damages in law: to restore to as whole as possible the economic loss
sustained by the injured.
Are Damage Awards Taxable?
Based on Internal Revenue Code (IRC) Section 61, damages are normally taxable
to the recipient. However, under IRC Section 104 (a), certain damages may be
excluded. These include physical injuries or physical sickness. The Code added
specific language to exclude emotional distress from physical injury or sickness.
However, this is only true when the origin of distress is from a nonphysical
injury, like injury to reputation or employment injury. This is in contrast
to emotional distress stemming from a physical injury or sickness claim, which
would not be taxable.
Punitive damages do not come under Section 104 income exclusion
and are therefore taxable even if arising out of a personal physical injury.
However, punitive damages may be excluded from income taxation under certain
Medical expenses from emotional distress arising from non-physical
injury are taxable awards. This is only true for amounts received above those
paid out. Awards received that are not in excess of amounts paid for medical
care are not taxable.
Award amounts attributable to medical expenses actually deducted
on prior tax returns will not be excluded from income. For example: Nancy was
injured in 1999 and incurred $10,000 of medical expenses that year. She deducts
the $10,000 of expenses on her tax return but only gets the benefit of a $4,500
deduction due to the itemized deduction limitation on medical expenses. In
2001, Nancy receives a settlement award which includes $10,000 specifically
allocated to 1999 medical expenses. Of the settlement, $4,500 will not meet
the exclusion provision and will be taxable.
When a person receives a lump settlement for general, physical,
medical and punitive damages it is necessary to allocate the amounts to each
type of damage because of the differing tax consequences. Failure to apportion
properly may result in none of the settlement excludable from income by the
IRS. The question is how to apportion such awards.
IRS Revenue Ruling 85-98 sets forth that the complaint is
the most persuasive evidence for characterizing damages (this means the basis
on which the plaintiff filed suit).
Settlement agreements are relevant but may not carry much
weight depending on their nature. Plaintiffs have attempted to be very creative
in allocating as much of the award as possible to nontaxable awards. The IRS
advises its agents in IRS Field Service Advice 200146008 to consider the following
three points as to settlement agreements:
a) the settlement agreement be a bona fide and adversarial
settlement as to the allocation of payments between claims;
b) the terms are consistent with the true substance of
the plaintiff’s claims;
c) the allocation was not entirely tax-motivated.
For this reason alone, it is important for a lawyer to seek
input throughout every stage of the litigation process. From the drafting of
the complaint to the negotiations, deposition, trial and settlement agreement,
a certified public accountant can be an invaluable source in effective client
David B. Singal, CPA, CVA, is a business consultant for the accounting
firm BBC Company. He concentrates his practice in economic damage calculations
and business valuations.