Maryland Bar Bulletin
Publications : Bar Bulletin : August 2005

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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 circumstances.

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 representation.


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.

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Publications : Bar Bulletin: August, 2005

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