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Bar Journal - Spring 2005

Recent Developments in the Taxation of Settlements and Judgments



In recent years, the tax treatment of settlements and judgments has been decidedly unsettled. There has been significant confusion among practitioners regarding the deductibility of attorney’s fees and disagreement among the courts as to the proper tax treatment of contingency fees. Two recent developments in the law, however, have now settled the confusion in both of these areas, at least for cases involving certain types of claims, including unlawful discrimination.

One of the two recent developments arises from federal tax legislation enacted in late 20041 and the other from a United States Supreme Court case decided last January.2 As to the legislation, the American Jobs Creation Act of 2004 changed the tax rules governing how the payment or award of attorney’s fees is deducted in certain types of cases. Under the old rule, attorney’s fees incurred in litigation were deductible only as a miscellaneous itemized deduction and only if the Alternative Minimum Tax (the "AMT") did not apply.3 Under the new rule, the attorney’s fee deduction will be allowed above-the-line for judgments or settlements occurring and paid after October 22, 2004 in cases involving certain types of claims, including unlawful discrimination. The second development is the Supreme Court’s pronouncement that contingent attorney’s fees are fully attributable to the client as income. The decision resolves a long-standing debate among the Courts of Appeals, which, in some cases, excluded these fees from income. Practitioners should take note that for cases not covered by the new legislation, the Supreme Court’s decision eliminates the strategy of claiming that contingency fees are not taxable to the plaintiff as a means of avoiding the miscellaneous itemized deduction and AMT issues.

This article first provides some general background on taxation of settlements and judgments, then describes the recent changes in the area, and finally illustrates how the changes will affect the tax treatment of settlements and judgments in employment discrimination cases covered by the new legislation.


Awards or settlements based on personal physical injury or physical sickness claims are excludable from income.4 Attorney’s fees in these cases are not deductible.5 Damages recovered in connection with economic tort actions, including unlawful discrimination, are taxable.6 Attorney’s fees in these cases are deductible as miscellaneous itemized deductions, unless they are required to be capitalized.7 Unfortunately, this categorization has created major problems for taxpayers.

First, miscellaneous itemized deductions are subject to what is referred to as the two-percent floor.8 Such deductions are only deductible to the extent they exceed two percent of the taxpayer’s adjusted gross income. Second, as a taxpayer moves into higher tax brackets, the Internal Revenue Code gradually lowers the permissible amount of all deductions, including miscellaneous itemized deductions.9 Finally, miscellaneous itemized deductions are lost entirely if a taxpayer is subject to the AMT.10

Applying these rules has had some very distasteful results. While not being able to deduct the entire amount paid to an attorney can be irksome enough, in some cases successful plaintiffs have wound up paying more in tax than they received after winning a case. In Spina v. Forest Preserve Dist.,11 a female police officer won a three million dollar judgment for significant sexual harassment and retaliation. The district court upheld the verdict but reduced the award to $300,00012 plus attorney’s fees and costs of approximately $950,000.13 Spina was taxed on the entire amount, $1.25 million, and because she was subject to the AMT, she was not able to deduct any of her legal costs.14 The net result was that she owed the government more than her recovery. That is, even after winning her civil rights claim she had to pay taxes of $399,000, nearly $100,000 more than she was awarded.15


The American Jobs Creation Act of 2004. One provision of the American Jobs Creation Act of 2004 (the "Act") took a major step in alleviating this problem. Courts had already ruled that attorney’s fees are generally deductible under Section 162 or 212 of the IRC.16 However, Section 730 of the Act created new Section 62(a)(20),17 which expressly grants certain deductible attorney’s fees the more favorable treatment of an above-the-line deduction. A taxpayer’s gross income less above-the-line deductions is referred to as adjusted gross income. Above-the-line deductions also reduce income before itemized deductions. Other examples of above-the-line deductions include the deduction for alimony18 and moving expenses.19

Allowing an above-the-line deduction for fees creates significant benefits for taxpayers. First, such fees are not subject to the two-percent floor applicable to miscellaneous itemized deductions or the gradual decrease in permissible deductions for higher bracket taxpayers. In addition, by moving the deduction above-the-line there is no longer a risk that fees are not deductible because of the AMT. Allowing a taxpayer to deduct attorney’s fees from gross income also has a positive impact on other aspects of a taxpayer’s return. For example, deductions for medical expenses and casualty losses are also subject to floors based on adjusted gross income. Because an above-the-line deduction of attorney’s fees lowers a taxpayer’s adjusted gross income, such floor-determined deductions will be larger.

The new above-the-line deduction for attorney’s fees applies to cases involving (i) "unlawful discrimination,"20 (ii) certain claims against the federal government,21 and (iii) a private cause of action under the Medicare Secondary Payer statute.22

The provision appears to exclude certain types of actions, such as defamation, breach of contract, consumer protection, landlord-tenant, and property claims, provided they do not occur in an employment context. As a result, practitioners need to be aware that attorney’s fees in connection with certain settlements and judgments will still be considered miscellaneous itemized deductions that may be eliminated if the taxpayer is subject to the AMT.

One other limitation on the new rule is that a taxpayer only gets an above-the-line deduction on amounts from a covered judgment or settlement includible in the taxpayer’s gross income for the year.23 This means that when a taxpayer pays an attorney each month through 2005, but does not get a judgment or settlement until 2006, the fees are still only deductible as miscellaneous itemized deductions and are potentially subject to elimination by the AMT.

Commissioner v. Banks. The second recent development in the taxation of settlements and judgments is the United States Supreme Court’s decision in Commissioner v. Banks.24 Banks involved the question whether an attorney contingency fee paid to the plaintiff should be excluded from the plaintiff’s income. The arguments to support this position had been crafted to avoid the problems described above relating to the miscellaneous itemized deduction rules and the AMT. If the attorney’s fees were not included in income in the first place, there would be no need to depend on the deductibility of the fees to keep them from being taxed. By the time the Supreme Court decided the Banks case, all of the federal Courts of Appeals (except the District of Columbia Circuit) had considered the issue and the results were not consistent.25 In a unanimous opinion, the Supreme Court rejected the taxpayer’s arguments and agreed with the IRS that an attorney contingent fee agreement was an anticipatory assignment of income. As such, the entire judgment is income to the plaintiff, i.e. fees paid out pursuant to a contingency agreement are not excludable from income.

The Banks decision simply brings contingent fee awards in line with cases where fees were statutorily provided or where the plaintiff paid the attorney a certain rate. At any rate, new Section 62(a)(20) takes quite a bit of the sting out of the Banks decision for taxpayers because, as discussed above, in many cases, a taxpayer will now be able to deduct his attorney’s fees in full. Banks is still relevant, however, for the class of cases described above that do not come within the new law. Thus, for example, cases involving defamation, consumer protection, or the breach of a covenant-not-to-compete that do not arise in connection with employment but involve contingent fee arrangements will be included in the plaintiff’s income and still subject to the miscellaneous itemized deduction rules and the AMT.


To illustrate how the new rules work and which of the old rules remain the same, assume the following: Employee A sues a former employer for gender discrimination and settles the suit before trial for $200,000. The settlement calls for a payment of past wages (back pay) of $45,000 and future wages of $155,000. Employee A has a contingent fee agreement with her lawyer and will have to pay him $50,000.

Income Taxes. Under the Banks case, it is now clear that Employee A would have to include the full $200,000 settlement amount in income, despite the fact that $50,000 of that amount will go to her attorney to pay a contingency fee. However, due to new Section 62(a)(20) because Employee A’s case is an "unlawful discrimination" case, she will not have to pay income tax on the amount she has to pay to her attorney. Thus, she will include $200,000 in income but be able to deduct $50,000, paying tax on only $150,000 of the total settlement.

Other significant tax aspects of Employee A’s settlement agreement are unaffected by these recent developments, including long-standing rules regarding employment taxes and information reporting.

Employment Taxes. With respect to employment tax, it is still the rule that if a party making a settlement or damage payment pays the attorney fee portion directly to the attorney, the payment is not subject to employment tax withholding.26 If the same payment were made to the plaintiff with the plaintiff then paying her attorney, the employment tax would apply. While this trap for the unwary has been around for a long time, and most practitioners are already aware of it, it is important to note that it is unaffected by the recent changes in the law.

Information Reporting. It is also the case that nothing has changed with respect to information reporting. Before the new legislation, in a case where separate payments were made to the plaintiff and her attorney, the plaintiff received either a Form W-2 (e.g., for back pay)27 or a Form 1099 (e.g., for future pay or other non-wage payments) or both (e.g., where the settlement involved multiple types of payments) in an amount that would total the entire amount paid to both the plaintiff and the attorney. The attorney also received a Form 1099 for the amount paid to her. The duplication of reporting of the attorney fee portion was intentional.28 In the immediate wake of the new legislation there was some confusion as to whether the information reporting rules had been changed because the attorney’s fees would now be fully deductible in most cases. The change in the law, however, does not make the attorney’s fees excludible from gross income. Instead, it merely provides an above-the-line deduction. As a result, the amounts still must be reported to the recipient as income and then the recipient deducts then on her return.


Recent changes in the law have done much to settle the confusion that existed around the deductibility of attorney’s fees. It is now clear that contingent fee payments to attorneys are included in income of the plaintiff. It is also clear that in a case involving "unlawful discrimination," attorney’s fees will now be deductible in full (provided they are not otherwise required to be capitalized). It is important to keep in mind, however, that attorney’s fees in certain cases may still be subject to the miscellaneous itemized deduction requirement and the AMT. Finally, the employment tax and information reporting rules applicable to settlements and judgments have not changed. As a result, the strategy of issuing two checks (one to the attorney and one to the plaintiff) and reporting to both the plaintiff and the attorney the amount paid to the attorney is still in place.


1. American Jobs Creation Act of 2004, P.L. 108-357, 10/22/04, section 703.

2. Commissioner v. Banks, 125 S. Ct. 826 (2005)

3. In addition, sometimes attorney’s fees, rather than being deductible, must be capitalized. See, e.g., Third Nat’l Bank in Nashville v. U.S., 427 F.2d 343 (6th Cir. 1970) (if payment pursuant to judgment or settlement is required to be capitalized, legal fees incurred in the litigation must also be capitalized); Berry Petroleum v. Commissioner, 104 T.C. 584 (1995) (acquiring corporation must capitalize its costs of defending against class action suit brought by shareholders of the acquired corporation as suit had origins in the acquisition; alleged breach occurred within the context of the acquisition); Field Service Advice 200126018 (legal fees paid to defend and settle class action lawsuit relating to taxpayer’s initial public offering must be capitalized because sale of stock was acquisition or disposition of a capital asset). The new legislation does not change this result.

4. Section 104(a)(2). All "Section" and "Sec." references herein are to the corresponding sections of the Internal Revenue Code of 1986, as amended, codified at 26 U.S.C. §§ 1 to 9833, and the final, temporary, and proposed Treasury Regulations promulgated thereunder.

5. IRC § 265(a)(1); McKay v. Commissioner, 102 T.C. 465 (1994), vac’d and rem’d on other grounds, 84 F.3d 433 (5th Cir. 1996) (per curiam) (portion of taxpayer’s legal expenses attributable to a wrongful discharge award not deductible under §265 because expenses related to a nontaxable personal injury award).

6. Damages and settlement payments in such cases are included in income because they are not expressly excluded by Section 104(a) or any other section of the Code.

7. There is no special provision in the Code that permits a deduction for legal fees. However, legal fees may be deductible as business expenses under §162 (where legal fees are incurred in litigation that relates to a trade or business conducted by the taxpayer and the legal fees are ordinary and necessary expenses and reasonable in amount) or as production of income expenses under §212 (where legal fees are incurred in connection with the production of income or the management, conservation, or maintenance of income producing property). Section 67(b) defines miscellaneous itemized deductions as any deductible item not expressly listed therein. Legal fees are not listed in Section 67(b) and, therefore, are miscellaneous deductions. See also supra note 3 (regarding capitalization of legal fees).

8. IRC § 67.

9. IRC § 68.

10. IRC § 56(b)(1)(A)(i).

11. 207 F. Supp. 2d 764 (N.D. Ill. 2002).

12. Id.

13. 2002 U.S. Dist. LEXIS 16005 (N.D. Ill. 2002).

14. Jennifer S. Neumann, Comment, The Discrimination Created by the Tax Treatment of Attorney’s Fees in Federal Civil Rights Cases, 51 Kan. L. Rev. 595, 595-96 (2003).

15. Id.

16. See supra note 7.

17. The Act identifies the new Code section as Section 62(a)(19), but because that section already addresses the deduction for Health Savings Accounts, the legal fees provision is expected to be renumbered as Section 62(a)(20).

18. Section 62(a)(10).

19. Section 62(a)(15).

20. Section 62(e) defines "unlawful discrimination" to mean an act that is unlawful under any of the following:

1. Section 302 of the Civil Rights Act of 1991 (2 U.S.C. § 1202).

2. Section 201, 202, 203, 204, 205, 206, or 207 of the Congressional Accountability Act of 1995 (2 U.S.C. §§ 1311, 1312, 1313, 1314, 1315, 1316, or 1317).

3. The National Labor Relations Act (29 U.S.C. §§ 151 et seq.).

4. The Fair Labor Standards Act of 1938 (29 U.S.C. §§ 201 et seq.).

5. Section 4 or 15 of the Age Discrimination in Employment Act of 1967 (29 U.S.C. §§ 623 or 633a).

6. Section 501 or 504 of the Rehabilitation Act of 1973 (29 U.S.C. §§ 791 or 794).

7. Section 510 of the Employee Retirement Income Security Act of 1974 (29 U.S.C. § 1140).

8. Title IX of the Education Amendments of 1972 (20 U.S.C. §§ 1681 et seq.).

9. The Employee Polygraph Protection Act of 1988 (29 U.S.C. §§ 2001 et seq.).

10. The Worker Adjustment and Retraining Notification Act (29 U.S.C. §§ 2102 et seq.).

11. Section 105 of the Family and Medical Leave Act of 1993 (29 U.S.C. § 2615).

12. Chapter 43 of title 38, United States Code (relating to employment and reemployment rights of members of the uniformed services).

13. Section 1977, 1979, or 1980 of the Revised Statutes (42 U.S.C. §§ 1981, 1983, or 1985).

14. Section 703, 704, or 717 of the Civil Rights Act of 1964 (42 U.S.C. §§ 2000e-2, 2000e-3, or 2000e-16).

15. Section 804, 805, 806, 808, or 818 of the Fair Housing Act (42 U.S.C. §§ 3604, 3605, 3606, 3608, or 3617).

16. Section 102, 202, 302, or 503 of the Americans with Disabilities Act of 1990 (42 U.S.C. §§ 12112, 12132, 12182, or 12203).

17. Any provision of Federal law (popularly known as whistleblower protection provisions) 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 under Federal law.

18. Any provision of Federal, State, or local law, or common law claims permitted under Federal, State, or local law—

a. providing for the enforcement of civil rights, or

b. regulating any aspect of the employment relationship, including claims for wages, compensation, or benefits, or 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.

21. Claims made for a violation of subchapter III of chapter 37 of title 31, United States Code (this subchapter primarily allows recovery against the government for damage to personal property by certain government officials and for personal injuries caused by certain government officials, including, for example, claims of non-nationals for personal injury or death in a foreign country).

22. Claims made under Section 1862(b)(3)(A) of the Social Security Act (42 U.S.C. § 1395y(b)(3)(A)).

23. Section 62(a)(20)(last sentence – "The preceding sentence shall not apply to any deduction in excess of the amount includible in the taxpayer’s gross income for the taxable year on account of a judgment or settlement (whether by suit or agreement and whether as lump sum or periodic payments) resulting from such claim.")

24. 125 S. Ct. 826 (2005).

25. Philip N. Jones, Supreme Court Finally Rules — Against Taxpayers — On Contingent Attorney’s Fees, 102 J. Tax’n 169 (2005)

26. Rev. Rul. 80-364, 1980-2 C.B. 294.

27. Rev. Rul. 96-65, 1996-2 C.B. 6 (back pay is "wages" for all employment tax purposes); see also, Private Letter Ruling 200244004.

28. Treas. Reg. Section 1.6041-1(f)(1) and (2), Example 2, 26 C.F.R. 1.6041-1; Prop. Treas. Reg. Section 1.6045-5, Notice of Proposed Rulemaking 67-96 (Reg – 126024-01, issued on May 17, 2002).


Attorney Peter T. Beach is a member and director of the Manchester law firm of Sheehan Phinney Bass + Green, P.A., and is head of the taxation practice group. His practice covers a broad range of sophisticated tax matters.


Attorney Michael G. Valentine is an associate with Sheehan Phinney Bass + Green, P.A. Since joining the firm in 2004, Michael has worked in the litigation practice group, focusing on tax, employment, and insurance matters.

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