Taxing Settlements and Judgments – Are Attorneys’ fees paid included in income to litigant?

Are attorneys’ fees paid from a settlement included in the gross income to the plaintiff – are they “above-the-line deduction”, merely listed as itemized deductions, “below-the-line deduction” where they may be disregarded in an alternative minimum tax analysis, or not deductible at all?

 

The tax answers depend upon the nature of the legal fees.  For “unlawful discrimination” cases, broadly defined to include civil rights claims, the attorneys’ fees are above-the-line deductions. (see discussion below).   Section 104 excludes physical injury (and emotional injury arising from the physical injury) recoveries for compensatory damages. (This section does not exclude settlement or judgement money collected for lost wages, interest or punitive damages which are not deductible!)  The IRS will allocate the legal fees pro rata and current tax law screws you by not letting you deduct the attorneys fees associated with obtaining the punitive damages. (If you obtain $350,000 in punitive damages and paid the lawyer 40% of that award, you will have netted $210,000 but will be taxed on all $350,000.  Thanks to politicians that voted to increase taxes, based upon 2020 rates, you will pay 35% on $350,000 or $122,500, meaning that of the $350,000 in punitive damages awarded to you, after attorneys’ fees ($140,000) and taxes ($122,500) you will only have $87,500. The big winner, Washington with $49,000+$122,500 = $171,500.  Recap: Net to plaintiff – $87,500, net to attorney – $91,000, net to Washington – $171,500)

 

In 2005, the U.S. Supreme Court held that the portion of a money judgment or settlement paid to a plaintiff’s attorney under a contingent-fee agreement is income to the plaintiff under the Internal Revenue Code, 26 U.S.C. § 1 et seq. (2000 ed. and Supp. I [26 USCS §§ 1 et seq.]. Commissioner v. Banks, 543 U.S. 426, 429, 125 S. Ct. 826, 828 (2005).

 

The distinction between whether it is to be excluded or included in gross income and offset with a deduction to arrive at net income is that for some taxpayers, the Alternative Minimum Tax bites them.  The Supreme Court explained, 

 

For the tax years in question the legal expenses in these cases could have been taken as miscellaneous itemized deductions subject to the ordinary requirements, 26 U.S. C. §§ 67-68 (2000 ed. and Supp. I), but doing so would have been of no help to respondents because of the operation of the Alternative Minimum Tax (AMT). For noncorporate individual taxpayers, the AMT establishes a tax liability floor equal to 26 percent of the taxpayer’s “alternative minimum taxable income” (minus specified exemptions) up to $175,000, plus 28 percent of alternative minimum taxable income over $175,000. §§ 55(a), (b) (2000 ed.). Alternative minimum taxable income, unlike ordinary gross income, does not allow any miscellaneous itemized deductions. § 56(b)(1)(A)(i).

 

Id. at 432.

 

The Supreme Court went on to explain that in 2004 Congress modified the tax law for unlawful discrimination, (which includes civil rights cases under 42 USC § 1983) and federal whistle-blower claims which permits deductions for attorneys’ fees even when the AMT applies:

 

Second, after these cases arose Congress enacted the American Jobs Creation Act of 2004, 118 Stat. 1418. Section 703 of the Act amended the Code by adding § 62(a)(19). Id., at 1546. The amendment allows a taxpayer, in computing adjusted gross income, to deduct “attorney fees and court costs paid by, or on behalf of, the taxpayer in connection with any action involving a claim of unlawful discrimination.” Ibid. The Act defines “unlawful discrimination” to include a number of specific federal statutes, §§ 62(e)(1) to (16), any federal whistle-blower statute, § 62(e)(17), and any federal, state, or local law “providing for the enforcement of civil rights” or “regulating any aspect of the employment relationship … or prohibiting the discharge of an employee, the discrimination against an employee, or any other form of retaliation or reprisal against an employee for asserting rights or taking other actions permitted by law,” § 62(e)(18). Id., at 1547-1548. These deductions are permissible even when the AMT applies.

 

The definition of a civil right under the catchall language of 62(e)(18) for any claim for enforcement of civil rights under federal, state, local or common law, is not defined by the statute.  Civil Rights, 15 Am.Jr. 2d §1 defines a civil right to be a privilege accorded to an individual, as well as a right due from one individual to another, the trespassing upon which is a civil injury for which redress may be sought in a civil action. 

 

The law cuts off at the knees all attempts to circumvent the inclusion of the attorneys’ fees to the client by explaining that in the case of a litigation recovery the income-generating asset is the cause of action that derives from the plaintiff’s legal injury, the plaintiff retains dominion over this asset throughout the litigation, because the client-attorney relationship is “quintessential principal-agent relationship.”  Id. at 434-436. The court explained:

 

The Internal Revenue Code defines “gross income” for federal tax purposes as “all income from whatever source derived.” 26 U.S. C. § 61(a). The definition extends broadly to all economic gains not otherwise exempted. Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 429-430 (1955); Commissioner v. Jacobson, 336 U.S. 28, 49 (1949). A taxpayer cannot exclude an economic gain from gross income by assigning the gain in advance to another party. Lucas v. Earl, 281 U.S. 111 (1930); Commissioner v. Sunnen, 333 U.S. 591, 604 (1948); Helvering v. Horst, 311 U.S. 112, 116-117 (1940). The rationale for the so-called anticipatory assignment of income doctrine is the principle that gains should be taxed “to those who earned them,” Lucas, supra, *434 at 114, a maxim we have called “the first principle of income taxation,” Commissioner v. Culbertson, 337 U.S. 733, 739-740 (1949). The anticipatory assignment doctrine is meant to prevent taxpayers from avoiding taxation through “arrangements and contracts however skillfully devised to prevent [income] when paid from vesting even for a second in the man who earned it.” Lucas, 281 U. S., at 115. The rule is preventative and motivated by administrative as well as substantive concerns, so we do not inquire whether any particular assignment has a discernible tax avoidance purpose. As Lucas explained, “no distinction can be taken according to the motives leading to the arrangement by which the fruits are attributed to a different tree from that on which they grew.” Ibid.

 

Id. at 433-434(emphasis added) 

 

However, it is important to note that the Supreme Court did not address arguments advanced for the first time on the appeal including arguments that the fees constituted a capital expense or a business expense, stating,

 

Respondents and their amici propose other theories to exclude fees from income or permit deductibility. These suggestions include: (1) The contingent-fee agreement establishes a Subchapter K partnership under 26 U.S. C. §§ 702, 704, and 761, Brief for Respondent in No. 03-907, pp. 5-21; (2) litigation recoveries are proceeds from disposition of property, so the attorney’s fee should be subtracted as a capital expense pursuant to §§ 1001, 1012, and 1016, Brief for Association of Trial Lawyers of America as Amicus Curiae 23-28, Brief for Charles Davenport as Amicus Curiae 3-13; and (3) the fees are deductible reimbursed employee business expenses under § 62(a)(2)(A) (2000 ed. and Supp. I), Brief for Stephen B. Cohen as Amicus Curiae. These arguments, it appears, are being presented for the first time to this Court. We are especially reluctant to entertain novel propositions of law with broad implications for the tax system that were not advanced in earlier stages of the litigation and not examined by the Courts of Appeals. We decline comment on these supplementary theories. In addition, we do not reach the instance where a relator pursues a claim on behalf of the United States. Brief for Taxpayers Against Fraud Education Fund as Amicus Curiae 10-20.

 

Id. at 437-438.

 

Additionally, in the Banks case, the Supreme Court did not decide the impact of the fee shifting statutes, because the legal fees were paid based upon the contingency fee without regard to the fee shifting provisions of the civil rights statute and the amendments to the tax laws for future cases prevent a perverse result.  The court stated,

 

Banks brought his claims under federal statutes that authorize fee awards to prevailing plaintiffs’ attorneys. He contends that application of the anticipatory assignment principle would be inconsistent with the purpose of statutory fee-shifting provisions. See Venegas v. Mitchell, 495 U.S. 82, 86 (1990) (observing that statutory fees enable “plaintiffs to employ reasonably competent lawyers without cost to themselves if they prevail”). In the federal system statutory fees are typically awarded by the court under the lodestar approach, Hensley v. Eckerhart, 461 U.S. 424, 433 (1983), and the plaintiff usually has little control over the amount awarded. Sometimes, as when the plaintiff seeks only injunctive relief, or when the statute caps plaintiffs’ recoveries, or when for other reasons damages are substantially less than attorney’s fees, court-awarded attorney’s fees can exceed a plaintiff’s monetary recovery. See, e. g., Riverside v. Rivera, 477 U.S. 561, 564-565 (1986) (compensatory and punitive damages of $33,350; attorney’s fee award of $245,456.25). Treating the fee award as income to the plaintiff in such cases, it is argued, can lead to the perverse result that the plaintiff loses money by winning the suit. Furthermore, it is urged that treating statutory fee awards as income to plaintiffs would undermine the effectiveness of fee-shifting statutes in deputizing plaintiffs and their lawyers to act as private attorneys general.

We need not address these claims. After Banks settled his case, the fee paid to his attorney was calculated solely on the basis of the private contingent-fee contract. There was no court-ordered fee award, nor was there any indication in Banks’ contract with his attorney, or in the settlement agreement with the defendant, that the contingent fee paid to Banks’ attorney was in lieu of statutory fees Banks might otherwise have been entitled to recover. Also, the amendment added by the American Jobs Creation Act redresses the concern for many, perhaps most, claims governed by fee-shifting statutes.

 

Id at 438-439. (emphasis added)

 

Tax Cuts and Jobs Act of 2017 eliminated miscellaneous itemized deductions as part of individual tax reform from 2018 through 2025.  This act precludes deduction of legal fees even if they are greater than 2% of the taxpayer’s adjusted gross income as a miscellaneous expense unless they fit into the unlawful discrimination, whistle-blower or physical injury cases.  

 

Attorneys’ fees in trade or business are deductible under § 61(a)(1), however, under § 162(q), tax deductions for settlement payments in sexual harassment or abuse cases are denied, which includes attorney’s fees, if such settlement or payment is subject to a nondisclosure agreement (“Harvey Weinstein tax”). 

The definition of “adjusted gross income” in 26 U.S. Code § 62 excludes from that term “Any deduction allowable under this chapter for attorney fees and court costs paid by, or on behalf of, the taxpayer in connection with any action involving a claim of unlawful discrimination (as defined in subsection (e)).” 26 U.S. Code § 62(a)(20).

(a)General rule. For purposes of this subtitle, the term “adjusted gross income” means, in the case of an individual, gross income minus the following deductions:

(20)Costs involving discrimination suits, etc.

Any deduction allowable under this chapter for attorney fees and court costs paid by, or on behalf of, the taxpayer in connection with any action involving a claim of unlawful discrimination (as defined in subsection (e)) or a claim of a violation of subchapter III of chapter 37 of title 31, United States Code, or a claim made under section 1862(b)(3)(A) of the Social Security Act (42 U.S.C. 1395y(b)(3)(A)). The preceding sentence shall not apply to any deduction in excess of the amount includible in the taxpayer’s gross income for the taxable year on account of a judgment or settlement (whether by suit or agreement and whether as lump sum or periodic payments) resulting from such claim.

Conclusion:

 

Client and Litigants – Consult your tax professional.

Attorneys – wherever possible in settlements identify settlement proceeds in categories that are “above-the-line” deductions from gross income, discrimination, civil rights and/or whistle-blower claims.  Where a compromise is reached, compromise punitive damages and interest first.

NOTHING HEREIN SHALL BE DEEMED LEGAL ADVICE. 

 

Disclaimer

The materials are prepared for information purposes only.  The materials are not legal advice.  You should not act upon the information without seeking the advice of an attorney.  Nothing herein creates an attorney-client relationship.
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Thomas H. Roberts, Esq.
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