New Litigation Settlements Tax, Legal Fees No Longer Deductible

Beginning with January 1st, 2018, some changes to the tax code have changed how settlements are taxed and many plaintiffs will now be taxed on their gross recoveries, while attorney fees will no longer be deductible. For example, a plaintiff who settles for $100,000 will be taxed on that amount, regardless if they pay their lawyers $40,000 or more. In cases with bigger recoveries, the situation can look a lot worse. These changes will not only affect plaintiffs and their lawyers, but likely also defendants, who may be forced to pay more to resolve cases.

Gross Income

A part of the problem that triggered the tax reform bill is historical: in Commissioner v. Banks, 543 U.S. 426 (2005), the U.S. Supreme Court stated that plaintiffs in contingent fee cases are generally obligated to recognize gross income to the amount of 100% of their recoveries. This means that plaintiffs will have to figure out a way to deduct their 40% (or other) fee.

A few months before Commissioner v. Banks, Congress enacted an above-the-line deduction for some whistleblower claims, as well as employment claims. That’s almost like not even having the income to start with. It subtracts the fees before you even reach page 2 of the tax return.

Plaintiffs in employment cases won’t find themselves affected by the new GOP tax law, unless sexual harassment is involved, because the above-the-line deduction for legal fees remains in the law. This generally ensures that employment claim plaintiffs will be taxed on their net recoveries, not their gross.

There are, however, nagging problems even for employment plaintiffs. For example, the above-the-line deduction for fees in employment and whistleblower cases that qualify cannot exceed the income received by the plaintiff from the litigation in the same tax year. However, so long as all the legal fees are paid during the same tax year as the recovery, this might not be an issue.

If the plaintiff has been paying legal fees on an hourly rate over several years, there are some possible workarounds, although none are foolproof. There are some cases in which plaintiffs might be unable to deduct their legal fees even in employment cases.

It’s worth mentioning that only employment and some whistleblower claims qualify for the above-the-line deduction. There has always been some concern that the IRS might limit deductions for legal fees by attributing them to particular claims, but now the danger that the IRS might start to allocate legal fees between employment claims and other claims seems greater now.

What’s more, plaintiffs in employment claims are now obligated to content with the “Harvey Weinstein” provision for sexual harassment claims and releases. This can disallow all settlement and legal fee deductions, perhaps even plaintiffs’ deductions.

Affected Plaintiffs

It’s likely that if you are not an employment plaintiff or one of the few qualifying types of whistleblowers and your claim does not involve your trade or business, you may be unable to deduct legal fees above the line. Up until this point, that meant deducting your legal fees below the line, which was more limited, but nonetheless, it was still a deduction.

The limits were as follows:

  1. You could only deduct fees that were greater than 2% of your adjusted gross income.
  2. You could be subject to a phaseout of deductions, depending on your income.
  3. Legal fees were non-deductible for purposes of the alternative minimum tax.

Presently, there is no below-the-line deduction for any legal fees for tax years 2018 all the way through 2025. Unless you are an employment or qualified whistleblower plaintiff and you cannot position your claim as a trade or business expense or capitalize fees into the tax basis of damaged assets, you are unable to get a deduction. This means you will be taxed on 100% of your recovery.

Some examples of when you will be affected as a plaintiff include recoveries from:

  • a financial advisor or stock broker for poor investment advice, if you can’t capitalize your fees;
  • your former spouse for anything related to your divorce or children;
  • your insurance company for bad faith;
  • the police for wrongful arrest or even imprisonment;
  • a website for defamation or invasion of privacy;
  • anyone for intentionally inflicting emotional distress;
  • neighbors for encroachment, trespassing, or anything else;
  • truck drivers who injure you, provided you recover punitive damages;
  • your lawyer for legal malpractice;
  • your tax advisor for bad tax advice.

The list of lawsuits where this will be an issue goes on forever. On the other hand, the list of cases where you should typically not face this double tax is much shorter:

  • your recovery relates to your trade or your business and you can deduct the legal fees as a business expense;
  • your employment recovery qualifies for an above-the-line deduction;
  • your recovery comes via a class action where lawyers are paid separately under court order;
  • your recovery qualifies for the above-the-line deduction if it is in a federal False Claims Act or IRS whistleblower case;
  • your recovery is completely tax free, as would be the case in a physical injury case with no interest and no punitive damages. You can’t deduct attorney fees if the recovery is fully excludable from your income, but you don’t need to.

Eliminating some miscellaneous itemized deductions means that many plaintiffs won’t benefit from any legal fee deductions at all. They will have to pay taxes on their gross recoveries with no deduction for their fees.

SEC Whistleblowers

Initially, SEC whistleblowers also suffered under the new law. An amendment had proposed that they receive above-the-line deduction for legal fees, which would match the treatment that IRS whistleblowers and Federal False Claims act whistleblowers enjoy. However, when the final tax law was passed at Christmas, the amendment was not included.

Later, when the massive budget bill was passed in February 2018, things changed for the better. It allows above-the-line deductions of legal fees for whistleblower recoveries under section 21F of the

Securities Exchange Act of 1934 (15 U.S.C. 78u-6), recoveries under state false claims acts, and those under section 23 of the Commodity Exchange Act (7 U.S.C. 26). The new provision if available for any recoveries after December 31st, 2017.

Sexual Harassment

The Weinstein tax is also included in the new law. It denies tax deductions for settlement payments made in sexual harassment or abuse cases, provided there is a nondisclosure agreement. This deduction applies both to the lawyers’ fees, as well as to the settlement payments.

Most settlement agreements have some sort of confidentiality or nondisclosure provision, and many employment cases also have a mixture of facts and claims, as well as a comprehensive settlement agreement. This means that lawyers will have to worry about whether this no-deduction rule applies.

If it does, there may be some consequences. It could even cover legal fees that a plaintiff pays in a confidential sexual harassment settlement. The new provision was added to section 162, which relates to business expenses. The Congressional Research Service’s summary of the legislation states that the provision prohibits tax deductions for trade or business expenses in certain cases of sexual harassment and sexual abuse.

Congress’s intent was to simply limit defendants’ trade or business deductions for settlement payments and other related legal fees, but the language enacted into the tax code is actually much broader. The provision states that “no deduction shall be allowed under this chapter,” where “this chapter” would appear to include every section of the tax code between section 1 and 1400Z-2, covering most of the sections that taxpayers use to calculate taxes each year.

It could therefore disallow above-the-line deductions for plaintiffs’ employment and qualifying whistleblower claims. One way to preserve the availability of deductions for other claims might be small allocations to the sexual harassment portion of settlement agreements, but it’s unclear whether the IRS would actually respect them.

What Now?

The lack of deductions for attorney fees may seem confiscatory in many types of cases that involve significant recoveries and attorney fees, and plaintiffs, as well as their lawyers, are unlikely to just take it lying down. Let’s look at some ideas that might address the new rules.

  1. Lawyer Fees Paid Separately

In some cases, defendants will agree to pay lawyers and clients separately, but this might not obviate the income to the plaintiff and the Form 1099 regulations may not be of any help. These regulations generally require defendants to issue plaintiffs a Form 1099 for the full amount of the settlement, even if part of that money is actually paid to the plaintiffs’ lawyers. There are, however, some taxpayers that may still claim reporting positions on these facts.

  1. Business Expenses

One way of deducting legal fees might be a business expense deduction. Businesses fared well in the new tax bill and business expense deductions, with the exception of the Weinstein provision, have been unaffected. You need to make sure, though, that your activities are such that you really are in business and that the lawsuit relates to that business.

Otherwise, could the lawsuit itself be seen as a business? A plaintiff that files his first Schedule C as a proprietor for a lawsuit recovery will probably not look very convincing. In 2004, before the above-the-line deduction for employment claims was enacted, there were some plaintiffs who argued that their lawsuits represented business ventures so that they could deduct legal fees.

Unsurprisingly, they usually lost these tax cases; just suing your employer doesn’t seem like a business. It could be considered an investment or an income-producing activity, but not a business, and under tax reform, investment expenses don’t qualify for tax deductions.

However, a plaintiff who does business as a proprietor and regularly files for Schedule C could claim a deduction there for legal fees regarding the trade or business, and it seems inevitable that in the future there will be more and more arguments based on Schedule C from plaintiffs.

  1. Capital Gain Recoveries

Another possible way to deduct legal fees is capital recoveries. Provided that your recovery is capital gain, you can capitalize the legal fees and offset them. You might consider your legal fees as capitalized or as a selling expense in order to produce the income, but at least you shouldn’t have to pay any tax on the attorney fees. The new no-deduction rule for attorney fees may actually lead to some plaintiffs claiming their recoveries as capital gain just so they can “deduct” their attorney fees.

Exceptions to Commissioner v. Banks

There will be new efforts in the future to explore the exceptions to the Supreme Court’s holding in Commissioner v. Banks. The Supreme Court set a general rule that plaintiffs have gross income on contingent legal fees, but general rules have exceptions and the Court made allusions to certain situations where this 100% gross income rule may not apply.

  1. Injunctive Relief

Any legal fees for injunctive relief may not represent income to the client. While it may present a way out on some facts, the bounds of this exception aren’t very clear. It seems unlikely that all the lawyer’s fees will be taken from the client’s tax return if there is a big damage award with small injunctive relief, for example.

  1. Court-Awarded Fees

In some cases, depending on how the award is made and the particular nature of the fee agreement, court-awarded fees may provide some relief. For example, let’s suppose that a lawyer and their client sign a 40% contingent fee agreement, and the agreement provides that the lawyer is also entitled to any fees awarded by the court. A verdict in favor of the plaintiff yields $500,000, which are split 60/40. The client gets $500,000 in income, but he cannot deduct the $200,000 paid to their lawyer.

However, if the lawyer alone is awarded another $300,000, that sum should not have to go on the plaintiff’s tax return. However, the court could set aside the fee agreement and separately award all fees to the lawyer. It’s unclear if this means that the IRS should not be able to tax the plaintiff on the fees, but the IRS will have an incentive to scrutinize such an attempt.

  1. Statutory Attorney Fees

These fees can be another potential battleground. If a statute provides for attorney fees, can this represent income to the lawyer only, thus bypassing the client? This may be true in some cases, but contingent fee agreements may need to be customized in particular ways. Relationships between lawyers and clients is that of principal and agent, meaning it may take quite a lot of effort to distance a plaintiff from the fees their lawyer is due.

  1. Lawyer-Client Partnerships

Partnerships between lawyers and their clients fared well in the tax reform bill and the tax theory of a lawyer-client joint venture (another term for partnership) was around for a long time before the Supreme Court decided the Commissioner v. Banks case. However, the Supreme Court declined to address it.

The lawyer offers legal acumen and services, while the client contributes the legal claims. If the fee agreement says it is a 60/40 partnership, can’t the partnership actually report 60/40? Some legal purists will cite ethical rules that suggest that a true partnership is impossible, because lawyers are usually not supposed to partner with their clients.

Tax law, however, is unique and it can sometimes be at odds with other areas of the law. Shouldn’t partnership agreements between lawyers and their clients state that it is an actual partnership, to the full extent permitted by law? It’s not clear whether or not ethics rule will control the tax treatment of the arrangement.

In order to be sure, some key factors in how these partnerships would fare with the IRS would be optics and consistency. The partnership nomenclature and formalities would matter, and the IRS might find it hard to ignore a partnership tax return with Schedules K-1 to lawyer and client. Partnerships between lawyers and their clients at least deserve to be brought back. There is no doubt that some are in the works right now.

Conclusion

In some types of cases that involve significant recoveries and attorney fees, the impossibility to deduct taxes for legal fees can very well be catastrophic. It would at least be expected of plaintiffs to be more aggressive in trying to avoid receiving any gross income on their legal fees, and for those who are stuck with the gross income, it would be expected of them to try and go to new lengths to try and deduct them or at least offset the fees.

While some efforts may be sophisticated and well planned, others may be quite clumsy attempts. There are probably very few plaintiffs receiving a $100,000 recovery who think that it is fair to pay taxes on the full amount if the legal fees they have to pay amount to a third or more of their recovery.

If you multiply the figures into bigger numbers and add a higher contingent fee percentage and high case costs, the situation becomes much worse. Contingent fee attorneys may sometimes be sympathetic and try to help plaintiffs if possible, but all in all, settling legal disputes may well become more stressful in the coming years.