Recent Developments in the Tax Treatment of Attorney Fees - Tax Tips
| Publication year | 2005 |
| Pages | 79 |
| Citation | Vol. 34 No. 5 Pg. 79 |
2005, May, Pg. 79. Recent Developments in the Tax Treatment of Attorney Fees - Tax Tips
May 2005
Vol. 34, No. 5 [Page 79]
Tax Tips
Recent Developments in the Tax Treatment of Attorney Fees
by James Serven
This column is sponsored by the CBA Taxation Law Section to provide timely updates and practical advice on federal, state, and local tax matters of interest to Colorado practitioners.
Column Editors:
Larry Nemirow, Denver, of Davis, Graham & Stubbs LLP, (303) 892-7443, larry.nemirow@dgslaw.com; and John Warnick, Denver, of Holme Roberts & Owen llp - (303) 861-7000, warnicj@hro.com
This month's article was written by James Serven, Denver, special counsel at Moye Giles LLP and an adjunct faculty member at the University of Denver College of Law and University of Denver School of Accountancy, Daniels College of Business. He can be reached at (303) 292-2900, jim.serven@moyegiles.com.
This article addresses two recent developments regarding tax consequences for individuals paying legal fees. It discusses the American Jobs Creation Act of 2004 and the consolidated cases of Commissioner v. Banks and Commissioner v. Banaitis, which the U.S. Supreme Court decided in January 2005.
Two recent developments have important consequences for the federal income tax treatment of attorney fees paid by an individual. The first is the passage of the American Jobs Creation Act of 2004 ("AJCA"),1 which amended the Internal Revenue Code ("IRC") by adding new IRC §§ 62(a)(20) and 62(e).2 These provisions allow individual taxpayers to claim certain types of legal fees as "above-the-line" deductions.
The second development is the U.S. Supreme Court's January 2005 decision in the consolidated cases of Commissioner v. Banks and Commissioner v. Banaitis (collectively, "Banks").3 In Banks, the Court concluded that contingent legal fees incurred by a taxpayer in obtaining a taxable recovery cannot simply be netted against the taxpayer's recovery. Instead, the recovery must be reported on a gross basis, and the legal fees must be separately deducted. The Supreme Court's decision has important implications for legal fees not covered by the AJCA.
This article discusses both of these developments. It provides an overview of the tax treatment of attorney fees, describes the relevant provisions of the AJCA, and summarizes the Supreme Court's decision in Banks.
Tax Treatment of Attorney Fees: Overview
An individual who obtains a taxable recovery,4 either through settlement or judgment, faces considerable tax questions in determining the manner in which associated legal fees may be properly deducted, if at all.5 An individual taxpayer, such as a sole proprietor, generally is entitled to claim "trade or business" expenses as deductions under IRC § 162. As a computational matter, such expenses, including deductible legal fees and costs, will be taken as above-the-line deductions. That is, they are deductions that reduce adjusted gross income ("AGI").
However, many individuals will be eligible to claim legal fees only as "below-the-line" miscellaneous itemized deductions. This result occurs either because the expenses did not arise in the context of a trade or business or because they related to the taxpayer's activities as an employee or ex-employee (for example, legal fees incurred in a wrongful discharge civil rights case).6 These deductions do not reduce AGI, although they reduce taxable income.
It might seem that the ability to deduct legal fees below the line brings the same tax result as either claiming them above the line or simply netting them against the taxpayer's reported recovery. However, there are potentially adverse tax consequences to having deductions relegated to below-the-line status. Such deductions are subject to the 2 percent floor of IRC § 67,7 as well as the overall itemized deduction limitation of IRC § 68.8
Moreover, miscellaneous itemized deductions are simply not deductible for the purposes of the alternative minimum tax ("AMT") under IRC § 55.9 This can be devastating, particularly when the legal fees represent a large percentage of the recovery. In fact, if that percentage is large enough, it is possible that a victorious claimant may actually wind up being out-of-pocket for having pursued his or her action, after taking account of legal fees and income taxes on the recovery.
Unlawful Discrimination Claims Definition
The phrase "unlawful discrimination" is defined in new IRC § 62(e) as an act that is unlawful under any of the following:
1) Civil Rights Act of 1991 § 302 (2 U.S.C. § 1202)
2) Congressional Accountability Act of 1995 §§ 201, 202, 203, 204, 205, 206, and 207 (2 U.S.C. §§ 1311, 1312, 1313, 1314, 1315, 1316, and 1317)
3) National Labor Relations Act (29 U.S.C. §§ 151 et seq.)
4) Fair Labor Standards Act of 1938 (29 U.S.C. §§ 201 et seq.)
5) Age Discrimination in Employment Act of 1967 §§ 4 and 15 (29 U.S.C. §§ 623 and 633a)
6) Rehabilitation Act of 1973 §§ 501 and 504 (29 U.S.C. §§ 791 and 794)
7) Employee Retirement Income Security Act of 1974 § 510 (29 U.S.C. § 1140)
8) Title IX of the Education Amendments of 1972 (20 U.S.C. §§ 1681 et seq.)
9) Employee Polygraph Protection Act of 1988 (29 U.S.C. §§ 2001 et seq.)
10) Worker Adjustment and Retraining Notification Act (29 U.S.C. §§ 2102 et seq.)
11) Family and Medical Leave Act of 1993 § 105 (29 U.S.C. § 2615)
12) Chapter 43 of Title 38, United States Code (relating to employment and reemployment rights of members of the uniformed services)
13) 42 U.S.C. §§ 1981, 1983, and 1985
14) Civil Rights Act of 1964 §§ 703, 704, and 717 (42 U.S.C. §§ 2000e-2, 2000e-3, and 2000e-16)
15) Fair Housing Act §§ 804, 805, 806, 808, and 818 (42 U.S.C. §§ 3604, 3605, 3606, 3608, and 3617)
16) Americans with Disabilities Act of 1990 §§ 102, 202, 302, and 503 (42 U.S.C. §§ 12112, 12132, 12182, and 12203)
17) Popularly known as "whistleblower protection provisions," any provisions of federal law prohibiting the discharge, discrimination, or any other form of retaliation or reprisal against an employee for asserting rights or taking other actions permitted under federal law
18) Any provision of federal, state, or local law or common law claims permitted under federal, state, or local law: (a) providing for the enforcement of civil rights; or (b) regulating any aspect of the employment relationship, including claims for wages, compensation, or benefits, or prohibiting the discharge, discrimination, or any other form of retaliation or reprisal against an employee for asserting rights or taking other actions permitted by law.
American Jobs Creation Act of 2004
New IRC § 62(a)(20) partially alleviates the problems by allowing individual taxpayers an above-the-line deduction for attorney fees and costs paid in the context of certain enumerated actions. The listed actions include:10 (1) those involving a claim of "unlawful discrimination" (see accompanying box); and (2) violations of the False Claims...
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