New Taxes on Plaintiff Gross Recoveries, Not Net After Legal Fees

Imagine that you are a plaintiff in a lawsuit, and you just settled your case for $1,000,000. Your lawyer takes 40 percent ($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, the Supreme Court held that plaintiffs in contingent-fee cases must generally recognize income equal to 100 percent 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.

Until 2018, there were two ways to deduct: above the line or below the line. Below-the-line (also called miscellaneous itemized) deductions, where plaintiffs historically deducted most legal fees, were disallowed for 2018 through 2025. Thus, beginning in 2018, above the line is the only remaining choice, if you qualify. The above-the-line tax deduction is for employment, civil rights, and whistleblower legal fees, and is more important than ever. Qualifying for it means that in our example, at most you are taxed on $600,000.

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. 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 compensatory for physical injuries and 50 percent punitive damages. There is a 40-percent contingent fee. That means you net $1.2 million. However, 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.

“Unlawful Discrimination” Recoveries

The above-the-line deduction applies to attorney’s fees paid in “unlawful discrimination” cases. The tax code defines a claim of unlawful discrimination with a long list of claims brought under:

• The Civil Rights Act of 1991
• The Congressional Accountability Act of 1995
• The National Labor Relations Act
• The Fair Labor Standards Act of 1938
• The Age Discrimination in Employment Act of 1967
• The Rehabilitation Act of 1973
• The Employee Retirement Income Security Act of 1974
• The Education Amendments of 1972
• The Employee Polygraph Protection Act of 1988
• The Worker Adjustment and Retraining Notification Act
• The Family and Medical Leave Act of 1993
• The Civil Rights Act of 1964
• The Fair Housing Act
• The Americans With Disabilities Act of 1990

Whistleblower Cases

The above-the-line deduction applies to whistleblowers who were fired or retaliated against at work. However, 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. It applies to IRS tax whistleblowers and in 2018 was extended to SEC and Commodities Futures Trading Commission whistleblowers.

Catchall Employment Claims

Arguably the most important item in this list is a catchall provision for claims under:

[a]ny 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.

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

Civil Rights Claims

The catchall language in section 62(e)(18) also provides for 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? You might think of civil rights cases as those brought under section 1983. However, the above-the-line deduction extends to any claim for the enforcement of civil rights under federal, state, local, or common law. Civil rights is not defined for the purposes of the above-the-line deduction, nor do the legislative history or committee reports help. Some general definitions 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.

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 that it “believe[s] that the scope of the term ‘human and civil rights secured by law’ should be construed quite broadly.” Could invasion of privacy cases, defamation, debt collection, and other such cases 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 are compensatory damages for personal physical injuries, then the section 104 exclusion should protect them, making attorney’s fee deductions irrelevant.

However, what about punitive damages? In that context, plaintiffs may once again be on the hunt for an avenue to deduct their legal fees. Reconsidering civil rights broadly might be one way to consider fees in the new environment. In any event, the scope of the civil rights category for potential legal fee deductions merits separate treatment in a forthcoming article.

Business Expenses

If sections 62(a)(20) and 62(e) are not fertile grounds for legal fee deductions, is anything else available? Can legal fees be a business expense? Of course they can. Business expense deductions were largely unaffected by the 2017 tax changes, other than the Weinstein provision restricting deductions in confidential sexual harassment cases.

In a corporation, LLC, partnership, or sole proprietorship, business expenses are above-the-line deductions. Of course, one must ask whether one’s activities are sufficient to be considered really in business, and whether the lawsuit really is related to that business. If one can answer both of these questions in the affirmative, all is well.

However, a plaintiff filing his or her first Schedule C as a proprietor for a lawsuit recovery probably may not be convincing. Before the above-the-line deduction was enacted in 2004, some plaintiffs argued their lawsuits were business ventures. Plaintiffs usually lost these tax cases. The repeal of miscellaneous itemized deductions until 2026 may revive such attempts.

Some may push the envelope about what is a trade or business and how their lawsuit is inextricably connected to it. Some plaintiffs may consider filing a Schedule C even if they have never done so before. Schedule C is historically more likely to be audited and draws self-employment taxes.

Capital Gain Recoveries

If your recovery is capital gain, you arguably could capitalize your legal fees and offset them against your recovery. You might regard the legal fees as capitalized or as a selling expense to produce the income. Thus, the new “no deduction” rule for attorney’s fees may encourage some plaintiffs to claim that their recoveries are capital gain, just (or primarily) to deduct or offset their attorney’s fees.

Exceptions to Banks

The remaining ideas in this article address attempting to keep attorney’s fees out of the plaintiff’s income in the first place. Technically, falling within one of the exceptions to the Banks case is not a way of deducting legal fees, but of avoiding the fees as income. In Banks, the Supreme Court laid down the general rule that plaintiffs have gross income on contingent legal fees. General rules have exceptions, however, and the court alluded to situations in which this general 100-percent gross income rule might not apply.

Separately Paying Lawyer Fees

Some defendants agree to pay the lawyer and client separately. Do two checks obviate the income to plaintiff? According to Banks, they do not. Still, separate payments cannot hurt, and perhaps Forms 1099 can be negated in the settlement agreement.

The Form 1099 regulations generally require defendants to issue a Form 1099 to the plaintiff for the full amount of a settlement, even if part of the money is paid to the plaintiff’s lawyer. Even so, a defendant might agree to issue a Form 1099 only to the plaintiff for the net payment. Banks seems to dictate there is gross income anyway, but the plaintiff might feel comfortable reporting only the net.

Fees for Injunctive Relief

The Supreme Court suggested that legal fees for injunctive relief may not be income to the client. If the plaintiff receives only injunctive relief, but plaintiffs’ counsel is awarded large fees, should the plaintiff be taxed on those fees? Arguably not. However, if there is a big damage award with small injunctive relief, will that take all the lawyer’s fees from the client’s tax return? That seems unlikely, although the documents might help finesse it.

Court-Awarded Fees

Court-awarded fees may also provide relief, depending on how the award is made and the nature of the fee agreement. Suppose that a lawyer and client sign a 40-percent contingent-fee agreement providing that the lawyer is also entitled to any court-awarded fees. A verdict for plaintiff yields $500,000, split 60/40. The client has $500,000 in income and cannot deduct the $200,000 paid to his or her lawyer. However, if the court separately awards another $300,000 to the lawyer alone, that should not have to go on the plaintiff’s tax return. What if the court sets aside the fee agreement and separately awards all fees to the lawyer?

Class-Action Fees

There has long been confusion about how legal fees in class actions should be taxed. Historically, there was a difference between the tax treatment of opt-in cases and opt-out cases. In more recent years, however, the trend appears to be away from taxing plaintiffs on legal fees in class actions of both types.

That is fortunate because the legal fees in class actions generally dwarf the amounts plaintiffs take home. It is an over-generalization, but most plaintiffs in most class actions generally assume that they will not be taxed on the gross amount (or even their pro rata amount) of the legal fees paid to class counsel. Optimally, the lawyers will be paid separately under court order.

Statutory Attorney’s Fees

If a statute provides for attorney’s fees, can this be income to the lawyer only, bypassing the client? Perhaps in some cases, although contingent-fee agreements may have to be customized. In Banks, the court reasoned that the attorney’s fees were generally taxable to plaintiffs because the payment of the fees discharged a liability of the plaintiffs to pay their counsel under their fee agreements. In statutory fee cases, a statute (rather than a fee agreement) creates an independent liability on the defendant to pay the attorney’s fees. If the statutory fees were not awarded, the plaintiff may not be obligated to pay any additional amount to his or her attorney.

Accordingly, some attorneys seem to assume that if a statute calls for attorney’s fees, the general rule of Banks can never apply. Arguably, though, more may be needed. If the contingent-fee agreement is plain vanilla, the fact that the fees can be awarded by statute may not be enough to distance the client from the fees. As the Banks decision notes, the relationship between lawyer and client is that of principal and agent. The fee agreement and the settlement agreement may need to address the payment of statutory fees.

Lawyer-Client Partnerships

A partnership of lawyer and client arguably should allow each partner to pay tax only on that partner’s share of the profits. The tax theory of a lawyer-client joint venture was around long before the Supreme Court decided Banks in 2005. Despite numerous amicus briefs, however, the Supreme Court expressly declined to address this long-discussed topic and whether it would sidestep the holding of Banks.

A mere fee agreement is surely not enough to suggest a partnership, but with appropriate documentation, one can argue that the lawyer contributes legal acumen and services, whereas the client contributes the legal claims. Lawyer purists will note the ethical rules that suggest this cannot be a true partnership because lawyers are generally not allowed to be partners with their clients. Yet, tax law is unique and sometimes at odds with other areas of law.

Could a lawyer-client partnership agreement provide that it is a partnership to the maximum extent permitted by law? Partnership nomenclature and formalities matter, and lawyer-client partnerships rarely seem to be attempted with conviction. A partnership tax return with Forms K-1 to lawyer and client might be difficult for the IRS to ignore. So far, however, lawyer-client partnerships do not look terribly promising.

Conclusion

Returning to our $1,000,000 recovery with $400,000 in fees, no plaintiff will think it is fair to pay taxes on $400,000 paid directly to his or her lawyer. Increase these numbers, and emotions may run higher still. In the old days, alternative minimum tax and phased-out deductions often limited the efficacy of legal-fee deductions. There was plenty of grousing about those rules, but it was relatively rare for them to result in truly catastrophic tax positions. Nevertheless, there were a few cases in which plaintiffs lost money after tax. Today, entirely disallowed legal fee deductions are less likely to be easily endured. Some plaintiffs may aggressively plan or report around this unjust landmine. They may try to gerrymander their settlement agreements to avoid receiving gross income on their legal fees. If plaintiffs cannot credibly argue that they avoided the gross income, they may go to new lengths to try to deduct or offset the fees. The bigger the numbers and the higher the contingent-fee percentage, the more creative and assertive the plaintiff may be. Good luck out there!