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 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?
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.
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.
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!