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Bar News - February 18, 2015

Tax Law: Taxing Success: Federal Income Tax Applied to Court Judgments


For most plaintiffs, the high of a settlement check or judgment award gets quickly tempered by the sobering come-down of federal income tax liability.

Unless the recovery involves damages for physical injury, the plaintiff generally winds up owing tax on the dollars received. But does this include the portion paid to the plaintiff’s attorney? Except for fee awards in pro bono cases and certain categories of employment cases, the answer is likely to be “mostly, yes.” Thus, pre-claim planning can be important in determining the extent to which a plaintiff benefits from an award.

Under the Internal Revenue Code (IRC), “gross income” means “all income from whatever source derived.” Unless the IRC provides for specific relief, gross income is taxable to the recipient. Relief, in turn, can come under the guise of exclusions, exemptions, deductions, or credits. The two types of relief most relevant to the issue of legal award taxation are exclusions and deductions.

Exclusions refer to economic gain that the IRC excludes from the definition of gross income, in whole or in part. Life insurance proceeds and scholarships are common examples of wholly excludable income. Gifts, Social Security benefits, and gain on the sale of a personal residence, on the other hand, are excludable up to a certain amount.

Another category of pertinent exclusions is awards of damages for physical injury. “[W]hether by suit or agreement,” the entire award is excludable, so long as it is made “on account of personal physical injuries or physical sickness.” Thus, damages for purely emotional distress must be included in the gross income tally, unless the distress connects to physical symptoms.

Accordingly, in non-physical injury cases, the general rule is that an award is includable as gross income. The question then arises whether the portion of the award paid to the plaintiff’s attorney is, nonetheless, excludable from income. After all, the plaintiff never sees this money, and it does not “feel” like income.

Unfortunately for the plaintiff, the portion paid in attorneys’ fees does not generally get excluded from the amount of gross income subject to taxation. In most cases, the whole award is counted as gross income – not the net proceeds after payment of costs and attorneys’ fees.

This is true whether the payment is made directly by the defendant, ordered by the court, paid via settlement, or calculated pursuant to a contingency fee agreement. For instance, in the 2005 case Commissioner v. Banks, the US Supreme Court viewed a contingency-fee arrangement as an attempted anticipatory assignment of income, and held that the portion of the plaintiff’s award paid to the attorney was not excludable from gross income. Similarly, under the doctrine of Old Colony Trust Co. v. Commissioner (1929), direct payment by the defendant makes no difference to the analysis because the taxpayer realizes an economic gain from this type of debt satisfaction.

A notable exception to the includability of award portions paid out in attorneys’ fees occurs when the plaintiff’s representation is pro bono. This is because a pro bono litigant has no obligation to pay attorneys’ fees. The IRS has said as much in a non-binding Private Letter Ruling. Lack of a fee agreement equals lack of responsibility on the plaintiff’s part for payment of attorneys’ fees, or any enforceable relationship between the attorneys’ work and the plaintiff’s recovery. Thus, a court order for defendant to pay attorneys’ fees has no bearing on the plaintiff’s tax liability. It should be noted that no court has yet confirmed the stance taken in this Private Letter Ruling, but the IRS has not advocated a contrary position.

Despite the broad includability of most litigation proceeds in gross income, some classes of plaintiffs can lower the overall tax burden on their awards significantly by claiming certain, targeted deductions.

Thanks to the American Jobs Creation Act of 2004 (PL 108-357), IRC Section 62 now provides an above-the-line deduction for attorneys’ fees and court costs in most employment claims, as well as claims under the False Claims Act, 31 USC §3729. Above-the-line deductions are also known as adjustments to income, because they’re direct subtractions from the gross income you list on page one of your Form 1040. Consequently, they lead to the calculation of adjusted gross income, before you turn the page.

Thus, these “deductions” reduce the amount of adjusted gross income that’s subject to tax, even before application of exemptions, standard or itemized deductions, and credits. In this way, an above-the-line deduction can reduce a plaintiff’s tax burden as much as an exclusion from gross income.

Even if a taxpayer does not qualify for an above-the-line deduction of fees and costs, the taxpayer may benefit from claiming those expenses on Schedule A, although the impact is not as profound. For example, attorneys’ fees incurred while handling a tax issue or while trying to produce or collect taxable income are generally deductible as an itemized miscellaneous deduction. This, however, does not apply to income subject to the Alternative Minimum Tax restrictions. Moreover, fees are deductible only to the extent they exceed 2 percent of the taxpayer’s adjusted gross income.

Because of the varying tax treatment of awards and costs for different types of claims, tax consequences are a critical consideration when determining the types of claims to bring on behalf of a plaintiff. Proper pre-claim planning can be very beneficial for a plaintiff.

Barbara G. Heggie

Barbara G. Heggie is the coordinator for the Low-Income Taxpayer Project, part of the Pro Bono Referral Program at the NH Bar Association. She thanks Krista Atwater and Mary Stewart, independent contract attorneys for the NH Foreclosure Relief Project, for this topic idea, as well as Beth Fowler and Steven Burke, tax attorneys at the McLane firm, for their review of this article.

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