Workarounds for Plaintiffs & Lawyers Under New Tax Law

• Publication year: 2020
• Author: Robert W. Wood

Workarounds for Plaintiffs & Lawyers Under New Tax Law

Robert W. Wood

Robert W. Wood practices law with Wood LLP (www.WoodLLP.com) and is the author of Taxation of Damage Awards and Settlement Payments and other books available at www.TaxInstitute.com. This discussion is not intended as legal advice.

You are a plaintiff in a lawsuit and just settled your case for $1,000,000. Your lawyer takes 40%, $400,000, leaving you the balance. Most plaintiffs assume their worst-case tax exposure would be paying tax on $600,000. But today, you could pay taxes on the full $1,000,000. Welcome to the crazy way legal fees are taxed.

In Commissioner v. Banks,¹ the Supreme Court held that plaintiffs in contingent fee cases must generally recognize income equal to 100% of their recoveries. This is so even if the lawyer is paid directly by the defendant, and even if the plaintiff receives only a net settlement after fees. This harsh tax rule usually means plaintiffs must figure a way to deduct those fees.²

Until 2018, there were two ways to deduct legal fees: above the line or below the line.³ Under the new tax law, however (which took effect January 1, 2018), below-the-line (also called miscellaneous itemized) deductions, where plaintiffs historically deducted most legal fees, have been disallowed for 2018 through 2025.⁴

Starting in 2018, therefore, above-the-line became the only remaining choice—for those who qualify.⁵ The above-the-line tax deduction, which is the topic of this article, is for employment, civil rights, and whistleblower legal fees, and is more important than ever. Qualifying for it means, at most, you are taxed on $600,000 of the hypothetical settlement above.

Physical Injury Recoveries?

You might think there would be no tax issues in physical injury cases, where damages should be tax-free. But section 104 (the tax exclusion section for physical injury recoveries) applies only to compensatory damages, not to punitive damages or interest.⁶

What if a case has some of each?

Example: You are injured in a car crash, and sue the other driver. Your case settles for $2 million; 50 percent is awarded as compensatory damages for physical injuries, and 50 percent for punitive damages. There is a 40 percent contingent fee. That means you net $1.2 million. But the IRS divides the $2 million recovery in two, and allocates legal fees pro rata. You claim $600,000 as tax-free for physical injuries. But you are taxed on $1 million, and cannot deduct any of your $800,000 in legal fees.

1. "Unlawful Discrimination" Recoveries

The above-the-line deduction applies to attorney fees paid in "unlawful discrimination" cases. The tax code defines a claim of unlawful discrimination as one arising out of any of a long list of claims brought under:

1. The Civil Rights Act of 1991;
2. The Congressional Accountability Act of 1995;
3. The National Labor Relations Act;
4. The Fair Labor Standards Act of 1938;
5. The Age Discrimination in Employment Act of 1967;
6. The Rehabilitation Act of 1973;
7. The Employee Retirement Income Security Act of 1974;
8. The Education Amendments of 1972;
9. The Employee Polygraph Protection Act of 1988;
10. The Worker Adjustment and Retraining Notification Act;
11. The Family and Medical Leave Act of 1993;
12. The Chapter 43 of Title 38 (relating to employment rights of uniformed service personnel);
13. Section 1981, 1983, and 1985 cases;
14. The Civil Rights Act of 1964;
15. The Fair Housing Act; and
16. The Americans With Disabilities Act of 1990.⁷

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2. Whistleblower Cases

The above-the-line deduction applies to whistleblowers who were fired or retaliated against at work.⁸ But what about whistleblowers who obtain awards outside this context? The deduction applies to federal False Claims Act cases, and was later amended to cover state whistleblower statutes, as well.⁹ It also applies to IRS tax whistleblowers, and in 2018 was extended to SEC and Commodities Futures Trading Commission whistleblowers.¹⁰

3. Catchall Employment Claims

Arguably the most important item in this list is the catchall provision for claims under section 62(e)(18):

Any provision of federal, state or local law, or common law claims permitted under federal, state or local law, that provides for the enforcement of civil rights, or regulates any aspect of the employment relationship, including claims for wages, compensation, or benefits, or prohibiting the discharge of an employee, discrimination against an employee, or any other form of retaliation or reprisal against an employee for asserting rights or taking other actions permitted by law.¹¹

This is a broad provision, and should cover employment contract disputes even where no discrimination is alleged.

4. Civil Rights Claims

The catchall language in section 62(e)(18) also provides a deduction for legal fees to enforce civil rights. This unlawful discrimination deduction is arguably even more important than the deduction for fees relating to employment cases.

What exactly are civil rights, anyway, though? You might think of civil rights cases as only those brought under section 1983, which provides a right of action to victims of discrimination under color of law.¹² However, the above-the-line deduction extends to any claim for the enforcement of civil rights under federal, state, local, or common law,¹³ and "civil rights" is not defined for purposes of the above-the-line deduction. Neither the legislative history nor the committee reports addressing section 62(e)(18) help.

Some general definitions of the term are broad, indeed, including:

[A] privilege accorded to an individual, as well as a right due from one individual to another, the trespassing upon which is a civil injury for which redress may be sought in a civil action.... Thus, a civil right is a legally enforceable claim of one person against another.¹⁴

In an admittedly different context (charitable organizations), the IRS itself has generally preferred a broad definition of civil rights. In a General Counsel Memorandum, the IRS stated, "[w]e believe that the scope of the term 'human and civil rights secured by law' should be construed quite broadly.15 Could invasion of privacy, defamation, debt collection, and other similar cases therefore be called "civil rights" cases? Possibly.

What about credit reporting cases? Don't those laws arguably implicate civil rights as well? Might wrongful death, wrongful birth, or wrongful life cases also be viewed in this way? Of course, if all damages in any of these cases...