Applying the above-the-line deduction for certain legal fees.

• Author: Klemens, Andrew D.

Controversy over the tax treatment of contingent legal fees (not deductible as a trade or business expense) incurred in the recovery of taxable legal damages is not a new issue. Recent cases addressed whether an award should be reported on a (1) gross basis and the related legal fees deducted under Sec. 212 (subject to the 2%-of-adjusted-gross-income (AGI) limit), or (2) net basis (after deducting the legal fees).

Cases

This dispute created a split among the circuits: the Fifth, Sixth and Eleventh Circuits approved the netting approach, the Ninth Circuit split in its holdings, based on property rights created under state law, and six other courts said the entire recovery is income; see the discussion of these cases in Banks, II, 125 S.Ct. 826 (2005). The Supreme Court reviewed the issues in Banks, II, and ruled that the portion of the award attributable to contingent legal fees may not be excluded from gross income.

The reason for the decision in Banks, II was that allowing the taxpayer to avoid taking the portion of the settlement relating to legal fees into gross income would be equivalent to an anticipatory assignment of income. The Court required the gross settlement to be included in income, allowing an itemized deduction under Sec. 212 for any legal fees. This treatment creates many undesirable repercussions for taxpayers receiving such awards.

Due to AGI-based phaseouts, some taxpayers may not benefit from a miscellaneous itemized deduction, because of the increase in AGI that results from the settlement. For small settlements, the legal fees may not exceed the individual's standard deduction. In other cases, an individual may benefit from the itemized deduction of legal fees for regular tax purposes; however, the alternative minimum tax (AMT) may significantly reduce that benefit, by adding back the miscellaneous itemized deductions as a tax preference, resulting in a significant AMT liability.

In most instances, this treatment subjects an individual to tax on a portion of a settlement that will never be received, sometimes resulting in a tax liability that exceeds the settlement net of legal fees; for a discussion, see Wood, "Should Taxes Be Included in Damage Calculations?" TEA, October 2005, p. 614. The Banks, II decision, while keeping with the Sec. 61 definition of gross income, produces inequitable results to many taxpayers, which Congress has attempted to alleviate.

See. 62(a)(20)

Congress addressed this inequity in American...