However, these provisions do not explicitly include SEC whistleblower claims. Indeed, there are at least some indications that when Dodd-Frank was being considered, some senate staff working on the bill specifically acknowledged that Dodd-Frank did not qualify for an above-the-line deduction. See Letter by Harold R. Burke to Mary Schapiro, Chairwoman, Securities and Exchange Commission (Sept. 14, 2010). Moreover, a former SEC Senior Counsel similarly suggested in 2013 that Dodd-Frank does not qualify under this above-the-line deduction. See Gary Aguirre, “Unfair Tax Liability for Whistleblower Awards under Dodd-Frank,” Government Accountability Project (Apr. 11, 2013).
To an SEC whistleblower, this may not be conclusive, but it is sure worrisome. Of course, there can sometimes be an overlap. For example, whistleblower claims often arise out of employment. In my experience, many SEC whistleblowers were employed by the firms whose conduct they reported.
There is also an awfully broad “catch-all” provision of I.R.C. Section 62(e)(18). That provision provides that a claim of unlawful discrimination includes a claim under any provision of state law “regulating any aspect of the employment relationship including . . . [any provision] prohibiting the discharge of an employee, the 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.” I.R.C. § 62(e)(18)(ii) (emphasis added); see Robert W. Wood, Tax Aspects of Settlements and Judgments, 522 T.M., Part V.G.1., A-63 (2015).
This language in I.R.C. Section 62(e)(18) is nearly identical to the language in I.R.C. Section 62(e)(17). I.R.C. Section 62(e)(17) provides that legal fees for suits involving claims of retaliation against whistleblowers in violation of any federal whistleblower protection laws can qualify for the above-the-line deduction. The SEC whistleblower rules contain robust whistleblower protections against employment retaliation. See Dodd-Frank Act § 922(h), codified as 15 U.S.C. § 78u-6(h).
The SEC whistleblower protections created by the Dodd-Frank Act allow SEC whistleblowers who have been retaliated against other remedies, too. They may be entitled to reinstatement; double back-pay, with interest; and compensation for their legal expenses and attorney’s fees. In fact, if an SEC whistleblower has been retaliated against, there is a strong argument that they can deduct their legal fees above the line.
However, it is less clear whether an SEC whistleblower who has not been retaliated against can qualify for the above-the-line deduction. If such a line can be drawn, the public-policy implications seem odd. After all, Congress surely hoped to create every incentive possible for SEC whistleblowers to come forward.
Indeed, retaliation is expressly discouraged. It seems perverse to create incentives for whistleblowers to try to prompt retaliation against them (or to allege retaliation that did not occur) to qualify for an above-the-line deduction. Nevertheless, under the current law, whistleblowers bringing suit might understandably cross their fingers in hopes of at least some measure of retaliation. Paradoxically, retaliation might be good if it is the ticket to claiming an above-the-line tax deduction.
Allocating Among Claims
The above-the-line deduction is available for any action “involving a claim of unlawful discrimination.” Of course, many complaints allege multiple claims. Read literally, this language suggests that if one claim in a lawsuit qualifies as a claim of unlawful discrimination, then all of the legal fees may be deducted under I.R.C. Section 62(a)(20). One might make the same observation about an SEC whistleblower’s claim of retaliation, however minor that retaliation might be.
However, knowing the IRS, you might reasonably assume that there be some kind of allocation—that is, if only 10 percent of the case is about “unlawful discrimination,” perhaps only 10 percent of the fees would be covered. For example, assume you have a tax-free, physical injury recovery, but 50 percent of the damages are punitive. With damages that are 50 percent tax-free and 50 percent taxable, the legal fees must be divided, too. One generally treats 50 percent of the legal fees as attributable to each part of the case. If 50 percent of the damages are tax-free, 50 percent of the legal fees are, too. That means there is no need to include the tax-free portion in income and try to deduct it. The punitive damages are taxable, and the 50 percent of the legal fees attributable to those damages are also income to the plaintiff. So, the plaintiff must report the gross amount of punitive damages (including the legal fees), and then deduct the fees.
That usually means a miscellaneous itemized deduction, which is treated unfavorably. One potential answer is a non-pro-rata allocation of legal fees. The IRS says that the presumptive allocation of fees is pro-rata, but you can have another allocation if you can support it. For example, suppose that 90 percent of the lawyer’s time in the case was devoted to compensatory damages, with only 10 percent to punitive damages. If lawyer bills and declarations support that, it could mean large tax savings. Anything better than 50/50 might help.
Allocating SEC Claims
With this background, should legal fees in SEC and other whistleblower recoveries be allocated in some way? Assume an SEC whistleblower collects $10 million, allocated as follows: 90 percent from the target’s bad conduct exposed in the claim, and 10 percent for relation against the employee-whistleblower. Does this suggest an above-the-line deduction for 10 percent of the legal fees, and a miscellaneous itemized deduction for 90 percent of the fees?
It should not, in my opinion. I worried about this issue in 2004 when the above-the-line deduction was enacted. See Robert W. Wood, “Jobs Act Attorney Fee Provision: Is it Enough?,” 105 Tax Notes 8, 961 (Nov. 15, 2004). However, I have seen no suggestion since then that the IRS would require it. I have also not encountered other practitioners who seem worried about it. Where one claim qualifies for an above-the-line deduction under I.R.C. Section 62(a)(20), I think it is likely that all legal fees allocable to taxable recoveries can be deducted above the line. See also Robert W. Wood, Tax Aspects of Settlements and Judgments, 522 T.M, Part V.G.2., A-64 (2015).
The IRS has provided at least one indication that it might agree. In Chief Counsel Memorandum 20133501F (Aug. 30, 2013), the IRS described I.R.C. Section 62(e)(18) as providing “an above-the-line deduction for attorney’s fees and costs incurred in an action or proceeding involving any aspect of the employment relationship.” (Emphasis added.) At the very least, this language seems to suggest a liberal application of I.R.C. Section 62(e)(18) for actions where at least one claim involves the employment relationship.
More generally, 13 years have elapsed since the above-the-line deduction was enacted. In that time, I have seen large numbers of legal-fee deductions claimed, audited, and disputed. In my experience, the IRS in the field interprets the above-the-line liberally, which seems to me to be entirely appropriate.
Moreover, I have not seen a single case in which the IRS has tried to allocate legal fees between above-the-line qualifying fees (such as employment) and other legal fees. I have seen cases in which the issue could have been raised, but was not. It is true that SEC whistleblower claims might be viewed differently, given the statute, but hopefully they will not be.
One detail of the above-the-line deduction that is easy to miss relates to gross income. Normally, a cash-basis taxpayer is eligible to claim a deduction in the year the underlying payment was made. See I.R.C. § 461(a); Treas. Reg. § 1.461-1(a)(1). However, I.R.C. Section 62(a)(20) limits the available deduction to the income derived from the underlying claim in the same tax year. As a result, a deduction allowable under section 62(a)(20) cannot offset income derived from any other source or received in any other year. This is usually not a problem, but occasionally it can be. For example, where there is a mixture of hourly and contingent fees, the issues can be thorny and may require professional help.
Trade or Business
Before leaving above-the-line versus below-the-line deductions, it is appropriate to consider an additional way that taxpayers may qualify for above-the-line deductions. A taxpayer operating a trade or business and incurring legal fees—contingent or otherwise—need not worry about these issues. In a corporation, LLC, partnership, or even a proprietorship, business expenses are above-the-line deductions.
Some plaintiffs have even argued that they were in the business of suing people. This may sound silly in the case of plaintiffs in employment cases. That is where the argument first appears to have surfaced (long before the above-the-line deduction was enacted in 2004). See, e.g., Alexander v. Comm’r, 72 F.3d 938 (1st Cir. 1995). However, it is quite credible in the case of some serial whistleblowers.
Some file multiple claims, and some go on the lecture circuit, especially after their claims bear fruit. Thus, there is a distinct possibility that a whistleblower can, in a very real sense, be operating a business. A proprietor—a taxpayer operating a business without a legal entity—reports income and loss on Schedule C to his or her Form 1040.
To be sure, you are not likely to want to make a Schedule C argument if you have a good argument for a statutory above-the-line deduction. Schedule C to a Form 1040 tax return is historically more likely to be audited than virtually any other return, or portion of a return. In part, this is due to the hobby-loss phenomenon, with expenses usually exceeding income. It is also due to self-employment taxes. Placing income on a Schedule C normally means self-employment income, and the extra tax hit on that alone can be 15.3 percent. Over the wage base, of course, the rate drops to 2.9 percent.
Even so, most whistleblowers and plaintiffs do not want to add self-employment tax to the taxes they are already paying. Still, when it comes to deducting legal fees, the Schedule C at least deserves a mention. Plaintiffs or whistleblowers who have been regularly filing Schedule C for business activities in the past stand a better chance of prevailing with their Schedule C.
Long before and shortly after the Supreme Court’s Banks case in 2005, there was considerable discussion about the tax treatment of legal fees. Plaintiffs’ employment lawyers were especially vocal in the years leading up to 2004, and they were particularly effective in lobbying Congress. That led to the statutory change in 2004, which ended up covering some whistleblower claims, too.
In part, the statutory changes in late 2004 blunted the impact of the Banks case, which even the Supreme Court itself noted in its opinion. Yet vast number of plaintiffs—and some whistleblowers—are still stuck with the dilemma of how to deduct their legal fees. In the case of SEC whistleblower claims, some people seem to assume that the above-the-line deduction surely must apply. Some people say it does not—not technically. Some seem to ignore the issue entirely. Given the dollars that are often involved, however, it would be wise to consider the income and deduction side of legal fees and costs. A large number of successful plaintiffs and some whistleblowers end up surprised at tax time. As more SEC whistleblower claims are paid, there will hopefully be no successful whistleblowers surprised by their tax preparer, or worse still, by the IRS.