The Federal Income Tax Treatment of Contingent Legal Fees in Personal Injury Cases

• Publication year: 2001
• Pages: 81

30 Colo.Law. 81 Colorado Lawyer 2001.

2001, March, Pg. 81. The Federal Income Tax Treatment Of Contingent Legal Fees in Personal Injury Cases

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81

Vol. 30, No. 3, Pg. 81

The Colorado Lawyer
March 2001
Vol. 30, No. 3 [Page 81]

Specialty Law Columns
Tax Tips
The Federal Income Tax Treatment Of Contingent Legal Fees in Personal Injury Cases
by James Serven

Recent judicial developments have heightened the controversy surrounding the federal income tax treatment of contingent legal fees payable in the context of personal injury awards and settlements. The basic question is: May recipients of personal injury recoveries simply net their contingent legal fees against the recovery, reporting only the net recovery in gross income, or must they report the gross recovery in full with the legal fees being deducted separately on the recipients' tax return? The answer can have important and surprising tax consequences. This article discusses the use of miscellaneous itemized deductions, the assignment of income doctrine, and emerging case law as it affects the treatment of contingent legal fees

Background

The current controversy over the tax treatment of contingent legal fees in the personal injury arena is a direct outgrowth of major judicial and legislative developments in the 1990s that materially restricted the scope of Internal Revenue Code ("Code") § 104(a)(2). Code § 104(a)(2)—prior to its amendment in 1996—exempted from gross income "the amount of any damages received (whether by suit or agreement . . . ) on account of personal injuries. . . . " The applicable Treasury Regulations noted that the damages excludable under Code § 104(a)(2) were those received through "prosecution of a legal suit or action based on tort or tort type rights."1

These provisions had been construed broadly by the courts to exclude a wide variety of personal injury recoveries sounding in tort, whether arising from physical or nonphysical injury.2 For example, prior to 1996 it was clear that recoveries for personal defamation were excludable from gross income, notwithstanding the nonphysical nature of the underlying tort. Extrapolating from this, many taxpayers took the position that recoveries under civil rights statutes such as Title VII of the Civil Rights Act of 1964 ("Title VII")3 and the Age Discrimination in Employment Act ("ADEA")4 also were excludable, even though those statutes generally limited the available remedies to back pay, front pay, and, in some circumstances, liquidated damages in a prescribed amount. Because taxpayers felt justified in completely excluding recoveries in most personal injury cases, the deductibility of contingent legal fees was rarely an issue—such fees simply would be nondeductible under the "anti-double dipping" provisions of Code § 265.5

However, the tide began to turn in 1992 with the U.S. Supreme Court's decision in Burke v. United States.6 In Burke the taxpayer's gender discrimination recovery under pre-1991 Title VII was held to be fully taxable. Focusing on the limited nature of the remedies available, the Court held that a suit brought under that statute simply did not resemble a traditional "tort or tort type" action. Under this "scope of the remedies" test, a recovery will not be excluded under Code § 104(a)(2) unless the remedies available to the claimant in the underlying action are sufficiently broad in scope that they resemble those available in traditional tort actions, such as compensatory damages, punitive damages, and the like. Therefore, the Burke Court concluded that recoveries under pre-1991 Title VII, which allowed recoveries only for back pay, could not satisfy this test and were deemed taxable.

Three years later, in Schleier v. Commissioner,7 the Court held that recoveries under the ADEA also are fully taxable. The ADEA allows claimants to seek liquidated damages in addition to back and front pay, and some observers believed that this was enough to enable ADEA recoveries to satisfy the "scope of the remedies" test of Burke. However, the Court in Schleier clarified that the key to satisfying that test is the availability of a broad range of damages evocative of the "hallmarks of traditional tort liability" that compensate for "traditional harms associated with personal injury, such as pain and suffering, mental anguish, harm to reputation, or other consequential damages and the like."8 The Court concluded that the remedial scheme of the ADEA did not meet this requirement.

Schleier also explained that, in addition to satisfying the "scope of the remedies" test, a recovery also must be "on account of" the underlying personal injury to be excludable. In other words, the recovery must directly compensate the tort victim for the injury itself. In the Court's view, neither back pay, which is not awarded by reference to the nature or severity of the injury, nor liquidated damages, which are in the nature of punitive damages, are designed to compensate victims directly for their injuries. Therefore, an ADEA recovery also fails this test.

Schleier provided the first real clue as to how the Court would handle a remaining lower court controversy over the excludability of punitive damages under Code § 104(a)(2).9 In view of the additional requirement that a recovery must be "on account of" the underlying personal injury to be excludable, most observers concluded that punitive damages should be considered taxable because they are "smart money" intended to punish the tortfeasor and deter similar conduct by others, not to compensate the victim. This was confirmed in 1996 by the U.S. Supreme Court's decision in O'Gilvie v. United States.10

Notwithstanding the Court's apparent resolution of these issues, in 1996 Congress opted to enter the fray by amending Code § 104(a)(2) to read in its current form.11 Code § 104(a)(2) now provides that recoveries will not be eligible for exclusion unless the personal injury is a physical injury. Additionally, punitive damages are never excludable. These rules are even more stringent than those delineated by the Court, because even damages arising from torts such as personal defamation, invasion of privacy, and the like—which would have survived Burke and Schleier —are now taxable.

After these judicial and legislative developments, many types of previously excludable personal injury recoveries are now clearly taxable. These developments have created issues that did not have to be faced by taxpayers a few years ago, when such recoveries were routinely not reported in gross income by the recipients.12 One of these issues is the income tax treatment of contingent legal fees incurred in obtaining personal injury recoveries.

Miscellaneous Itemized Deductions

If a taxpayer is allowed to net contingent legal fees against the personal injury recovery to which they relate, the fees will effectively be entirely excluded from the taxpayer's gross income and will never find their way into the tax return. On the other hand, if the recovery must be reported in full, the only way that the taxpayer can enjoy a tax benefit from the fees will be to deduct them.

For the most part, legal fees are deductible by a personal injury claimant only as Code § 212 expenses incurred in the production or collection of income or as Code § 162 employee business expenses.13 As such, they must be deducted "below the line," that is, as a deduction from adjusted gross income in deriving taxable income, as a "miscellaneous itemized deduction."14 Such deductions carry with them several disadvantages, including that they are subject to the 2 percent floor of Code § 6715 and the overall itemized deduction limitation of Code § 68.16 Most importantly, miscellaneous itemized deductions are not deductible in computing the alternative minimum tax ("AMT") under Code § 55.17

Taxpayers can be severely whipsawed by the computational repercussions of the AMT. For example, in the widely publicized Paula Jones case,18 Jones reportedly obtained a settlement of $850,000 from President...