The Supreme Court Rules: Contingent Attorney Fees are Taxable

Should plaintiffs pay taxes on attorney fees recovered in employment actions through settlement or judgment? This has been a recurrent issue in employment litigation, and one that on occasion impacts the resolution of the case. This eAlert discusses two important recent developments in the area: first, a United States Supreme Court decision that resolves a conflict among the circuits and holds that attorney fees are not excludable from plaintiff's gross income; and, second, federal legislation, applicable to amounts received after October 22, 2004, that in effect relieves plaintiffs in employment cases of tax liability on attorney fee recovery.

Summary

The Federal Circuit Courts of Appeal had been in conflict about the excludability of contingent fees paid to a plaintiff's attorney out of a taxable damage award or settlement. A minority of Federal Circuits had determined that these fees are excludable from the plaintiff's gross income. A majority, however, determined that they are includable in gross income and can be deductible only as Schedule A miscellaneous itemized deductions. On January 24, 2005, the United States Supreme Court resolved the conflict among the courts by holding with the majority rule, that contingent fees paid to a plaintiff's attorney out of a taxable damage award or settlement are not excludable from the plaintiff's gross income.

On October 22, 2004, President George W. Bush signed into law the American Jobs Creation Act of 2004 (the Jobs Act). Section 708 of the Jobs Act, entitled Civil Rights Tax Relief, creates an above-the-line deduction for attorneys' fees which should result in a plaintiff paying income tax on only the net amount received (after paying attorney fees) pursuant to an employment-related lawsuit. The new law, however, applies only to judgments and settlements occurring after the October 22, 2004, date of enactment. Because the new law (the Jobs Act) does not generally provide relief in non-employment related lawsuits (i.e., business litigation lawsuits), the Supreme Court's ruling results in the taxation of attorney fees in cases not involving an employment relationship, both before and after the date of the new law's enactment.

This article will briefly discuss the background regarding the taxation of attorneys' fees; the Jobs Act's provisions (such as Civil Rights Tax Relief); and the Supreme Court's recent ruling regarding the taxation of attorneys' fees in contingency fee-type cases.

Background

Damages received (whether by judgment or settlement) by an individual on account of personal physical injuries are generally not included in gross income. Expenses related to the recovery of such non-taxable damages are generally not deductible. Conversely, other types of damages are generally included in gross income, and the expenses related to the recovery of such taxable damages, including attorneys' fees, are generally deductible only as Schedule A itemized deductions. However, there are disadvantages to a Schedule A deduction for attorneys' fees. First, the attorneys' fees are classified as a miscellaneous itemized deduction and therefore are only deductible to the extent the plaintiff's total miscellaneous itemized deductions exceed 2 percent of the plaintiff's adjusted gross income (AGI). Second, any amount allowable as a deduction is subject to reduction if the plaintiff's AGI exceeds a threshold amount ($145,950 in 2005). Third, attorneys' fees are not deductible for alternative minimum tax (AMT) purposes. Because of such limitations, plaintiffs generally pay income tax on their gross award or settlement with no reduction for fees paid to their attorney.

American Jobs Creation Act of 2004

The Jobs Act allows individuals who win or settle any case involving a claim for "unlawful discrimination" (as defined below) to deduct the fees paid to their attorneys as an above-the-line deduction (i.e., no longer...