TAXING LITIGATION: FEDERAL TAX CONCERNS OF PERSONAL INJURY PLAINTIFFS AND THEIR LAWYERS.

• Author: Polsky, Gregg D.

INTRODUCTION I. TAX CONSEQUENCES TO PERSONAL INJURY PLAINTIFFS A. Foundational Tax Concepts B. Is the Recovery Included in Plaintiff's Gross Income? 1. Broad Exclusionary Rule in Physical Injury Cases 2. Three Specific Exceptions 3. Wrongful Death, Consortium Claims, and Bystander Claims 4. Recoveries of Legal Fees and Costs from the Defendant 5. Allocations of Settlements 6. Broad Inclusionary Rule in Nonphysical Injury Cases 7. Distinguishing Between Physical Sickness and Symptoms of Emotional Distress 8. Specific Exclusion for Wrongful Incarceration C. Is the Recovery Subject to Wage Taxes? D. Deduction for Attorney's Fees and Costs E. Potential Denial of Deductions for Sexual Harassment/Abuse Claimants? F. Structured Settlements II. REPORTING OBLIGATIONS OF DEFENDANTS AND INSURANCE COMPANIES III. TAX CONSEQUENCES FOR DEFENDANTS IV. ADMISSIBILITY OF TAX EVIDENCE A. Tax Evidence Sought To Be Introduced by Defendants B. Tax Evidence Sought To Be Introduced by Plaintiffs 1. Adverse Tax Consequences of Recovery 2. Defendant's Tax Benefits from Paying Punitive Damages V. PERSONAL TAX ISSUES OF TRIAL LAWYERS A. Structured Attorney Fees B. Tax Treatment of Litigation Costs VI. THE 2017 TAX ACT A. The 20% Pass-Through Deduction 1. In General 2. Potential Pass-Through Deduction Strategies for Lawyers a. Strategies for Lawyers Below the Income Thresholds b. "Cracking" Legal Services Businesses B. Drastically Reduced Corporate Rates C. Enlarged Expensing VII. CONCLUSION INTRODUCTION

This Article addresses the federal tax concerns of personal injury plaintiffs and the lawyers who represent them, typically on a contingency-fee basis. Plaintiffs need to know whether their recoveries are taxable and whether their attorney's fees are deductible. Plaintiffs' lawyers need to understand their client's tax concerns and how payments made by defendants or insurance companies will be reported to the Internal Revenue Service (IRS). In addition, litigants may seek to introduce tax evidence to influence the factfinder's calculation of damages. Plaintiffs' lawyers also face their personal tax issues in managing their own legal practices.

While this Article covers all of this ground, it pays particular attention to three important developments stemming from the Tax Cuts and Jobs Act of 2017 (2017 Tax Act). First, certain plaintiffs will no longer be able to deduct their attorney's fees and costs, which can result in extremely high effective tax rates in contingent fee situations. Second, under the so-called "Harvey Weinstein" rule, payments of damages for sexual abuse or harassment accompanied by a nondisclosure agreement are now nondeductible, as are payments of attorney's fees in these cases. Finally, the new tax law created a significant new deduction, known as the pass-through deduction, which may be helpful to some lawyers.

The Article proceeds as follows. Part I addresses the tax concerns of plaintiffs. Part II addresses the tax reporting and withholding requirements imposed on defendants and insurance companies. Part III explains the tax consequences to defendants when they pay settlements or judgments. Part IV discusses the situations where tax evidence may be taken into account by juries or judges in setting the amount of damages. Parts V and VI turn the attention to the tax concerns of plaintiffs' lawyers. Part V analyzes the unique tax issues faced by plaintiffs' lawyers, while Part VI discusses the impact of the 2017 Tax Act on these lawyers.

1. TAX CONSEQUENCES TO PERSONAL INJURY PLAINTIFFS

   1. Foundational Tax Concepts

      Most taxpayers face two types of annual federal taxes: the income tax and the employment tax. The income tax taxes a taxpayer's net income from any source, while the employment tax generally taxes a taxpayer's wages. A taxpayer's net income is equal to the excess of the taxpayer's gross income over the taxpayer's deductions. Gross income generally includes all accessions to wealth, (1) which includes cash receipts that are not offset by any cost (or "tax basis"). Thus, if a taxpayer earns $100 of wages or fees, the taxpayer realizes $100 of gross income. But if the taxpayer sells stock, which was previously purchased for $80 (giving her a tax basis of $80 in the stock), for $100, she realizes only $20 of gross income. Some items of gross income, such as certain damages received on account of personal physical injuries, are specifically excluded from gross income. (2)

      A taxpayer has no tax basis in her body or in her physical or emotional well-being, so personal injury victims would realize gross income equal to the entire amount of the recovery, unless the exclusion mentioned above applies. (3) Thus, for personal injury plaintiffs, a critical threshold issue is whether and to what extent the exclusion applies. If the exclusion does not apply, the award is included gross income. In those cases, a key issue is whether the plaintiff can deduct her attorney's fees. In addition, where the exclusion does not apply, an important issue is whether any portion of the recovery is also subject to wage taxes.

   2. Is the Recovery Included in Plaintiff's Gross Income?

      1. Broad Exclusionary Rule in Physical Injury Cases

         Section 104(a)(2) provides a significant exclusion from gross income for damages "on account of personal physical injuries or physical sickness." (4) Subject to only a few exceptions detailed below, if a claim originates in a physical injury or sickness, the resulting damages are excluded from gross income and therefore tax-free. Thus, in claims involving car accidents, medical malpractice, slips-and-falls, products liability, and batteries, recoveries that represent pain and suffering, mental anguish, disfigurement, physical disability or impairment, inconvenience, loss of capacity for the enjoyment of life, lost wages (past or future), and medical expenses (past or future) are generally excluded from gross income. (5)

      2. Three Specific Exceptions

         While most categories of damages received in a physical injury case are excluded, there are three exceptions. First, punitive damages are included in gross income and therefore taxable. (6) Likewise, any portion of the award that represents pre- or post-judgment interest is taxable. (7) Finally, any recovery of prior out-of-pocket medical expenses that were previously claimed as a deduction is taxable. (8)

         The inclusionary rule for previously deducted medical expenses is typically of little significance. First, due to private insurance, Medicare, Medicaid, or the fact that they lack the financial ability to pay, plaintiffs often do not pay large amounts of medical expenses out of pocket. Second, medical expenses are only deductible to the extent that the aggregate amount of out-of-pocket medical expenses paid during the year exceeds 7.5 or 10% (9) of the taxpayer's adjusted gross income for that year. (10) Third, only taxpayers who itemize their deductions (in lieu of claiming the standard deduction) can deduct medical expenses. Historically, about one-third of taxpayers itemized their deductions, but the 2017 Tax Act will dramatically reduce this percentage because it nearly doubled the standard deduction while limiting or eliminating a host of itemized deductions. (11) The bottom line is that few plaintiffs will have received a tax benefit from previously deducted medical expenses, which means that any recovery of those expenses will not be taxed. (12)

         On the other hand, the inclusions in gross income of punitive damages and interest can be significant in certain cases. In a case involving egregious conduct by a defendant in a physical injury case, the IRS could assert that a significant portion of the plaintiff's recovery represents taxable punitive damages. And in a physical injury case involving a lengthy appeal, a large portion of the plaintiff's recovery may constitute taxable post-judgment interest.

      3. Wrongful Death, Consortium Claims, and Bystander Claims

         In wrongful death and loss of consortium claims, the plaintiff (the estate or spouse) is not the direct victim of the physical injury or sickness. Nevertheless, the legislative history makes clear that these recoveries were intended to be covered by the section 104(a)(2) exclusion:

         If an action has its origin in a physical injury or physical sickness, then all damages (other than punitive damages) that flow therefrom are treated as payments received on account of physical injury or physical sickness whether or not the recipient of the damages is the injured party. For example, damages (other than punitive damages) received by an individual on account of a claim for loss of consortium due to the physical injury or physical sickness of such individual's spouse are excludable from gross income. (13) This approach has been followed by the IRS in private letter rulings involving wrongful death and consortium claims. (14)

         It is not clear whether damages would be excluded in bystander claims where the link between the damages and the physical injury is more tenuous. For example, in California a plaintiff may recover for the emotional disturbance of witnessing an accident that causes physical harm to a close relative. (15) Arguably, such a claim is "an action [that] has its origin in a physical injury" and the damages "flow therefrom," as required by the legislative history quoted above. However, there are no tax cases or rulings that address this specific situation.

      4. Recoveries of Legal Fees and Costs from the Defendant

         If a claim is fully covered by section 104(a)(2) so that all damages are excluded from gross income, any recovery of legal fees or court costs from the defendant is likewise excluded. (16) If a claim is only partially covered by section 104(a)(2) because, for example, a portion of the recovery represents interest or punitive damages, then the recovered fees must be allocated between the taxable and tax-free portions of the award, and courts and the IRS typically use a pro rata...