New Hampshire Bar Journal
2005 Spring, 46.
Recent Developments in the Taxation of Settlements and Judgments
New Hampshire Bar Journal Volume 46, No. 1, Pg. 46 Spring 2005 Recent Developments in the Taxation of Settlements and Judgments Bar Journal Author - Attorneys Peter T. Beach and Michael G. Valentine
In recent years, the tax treatment of settlements and judgments has been decidedly unsettled. There has been significant confusion among practitioners regarding the deductibility of attorney's fees and disagreement among the courts as to the proper tax treatment of contingency fees. Two recent developments in the law, however, have now settled the confusion in both of these areas, at least for cases involving certain types of claims, including unlawful discrimination.
One of the two recent developments arises from federal tax legislation enacted in late 2004(fn1) and the other from a United States Supreme Court case decided last January.(fn2) As to the legislation, the American Jobs Creation Act of 2004 changed the tax rules governing how the payment or award of attorney's fees is deducted in certain types of cases. Under the old rule, attorney's fees incurred in litigation were deductible only as a miscellaneous itemized deduction and only if the Alternative Minimum Tax (the "AMT") did not apply.(fn3) Under the new rule, the attorney's fee deduction will be allowed above-the-line for judgments or settlements occurring and paid after October 22, 2004 in cases involving certain types of claims, including unlawful discrimination. The second development is the Supreme Court's pronouncement that contingent attorney's fees are fully attributable to the client as income. The decision resolves a long-standing debate among the Courts of Appeals, which, in some cases, excluded these fees from income. Practitioners should take note that for cases not covered by the new legislation, the Supreme Court's decision eliminates the strategy of claiming that contingency fees are not taxable to the plaintiff as a means of avoiding the miscellaneous itemized deduction and AMT issues.
This article first provides some general background on taxation of settlements and judgments, then describes the recent changes in the area, and finally illustrates how the changes will affect the tax treatment of settlements and judgments in employment discrimination cases covered by the new legislation.
Awards or settlements based on personal physical injury or physical sickness claims are excludable from income.(fn4) Attorney's fees in these cases are not deductible.(fn5) Damages recovered in connection with economic tort actions, including unlawful discrimination, are taxable.(fn6) Attorney's fees in these cases are deductible as miscellaneous itemized deductions, unless they are required to be capitalized.(fn7) Unfortunately, this categorization has created major problems for taxpayers.
First, miscellaneous itemized deductions are subject to what is referred to as the two-percent floor.(fn8) Such deductions are only deductible to the extent they exceed two percent of the taxpayer's adjusted gross income. Second, as a taxpayer moves into higher tax brackets, the Internal Revenue Code gradually lowers the permissible amount of all deductions, including miscellaneous itemized deductions.(fn9) Finally, miscellaneous itemized deductions are lost entirely if a taxpayer is subject to the AMT.(fn10)
Applying these rules has had some very distasteful results. While not being able to deduct the entire amount paid to an attorney can be irksome enough, in some cases successful plaintiffs have wound up paying more in tax than they received after winning a case. In Spina v. Forest Preserve Dist.,(fn11) a female police officer won a three million dollar judgment for significant sexual harassment and retaliation. The district court upheld the verdict but reduced the award to $300,000(fn12) plus attorney's fees and costs of approximately $950,000.(fn13) Spina was taxed on the entire amount, $1.25 million, and because she was subject to the AMT, she was not able to deduct any of her legal costs.(fn14 )The net result was that she owed the government more than her recovery. That is, even after winning her civil rights claim she had to pay taxes of $399,000, nearly $100,000 more than she was awarded.(fn15)
The American Jobs Creation Act of 2004. One provision of the American Jobs Creation Act of 2004 (the "Act") took a major step in alleviating this problem. Courts had already ruled that attorney's fees are generally deductible under Section 162 or 212 of the IRC.(fn16) However, Section 730 of the Act created new Section 62(a)(20),(fn17) which expressly grants certain deductible attorney's fees the more favorable treatment of an above-the-line deduction. A taxpayer's gross income less above-the-line deductions is referred to as adjusted gross income. Above-the-line deductions also reduce income before itemized deductions. Other examples of above-the-line deductions include the deduction...