Accounting and Tax Articles

Attorneys’ Fees and Income Taxes: Is the issue finally resolved?

For years, the federal appellate courts split over whether contingent fees paid out of judgments or settlements in employment discrimination cases were taxable to the plaintiff. The American Jobs Creation Act eases the tax burden on most discrimination plaintiffs by providing an “above-the-line” deduction for these fees. But a recent Supreme Court ruling mandates a different result for cases arising before the act’s effective date.

For years, the federal appellate courts split over the appropriate tax treatment of attorneys’ fees in employment discrimination cases. The debate centered on whether contingent fees paid out of a judgment or settlement were taxable to the plaintiff.

Earlier this year, the Supreme Court settled the issue, ruling that plaintiffs must include these fees in their taxable gross income (Commissioner v. Banks, No. 03-892).

The decision came on the heels of the American Jobs Creation Act (AJCA), which created a new tax code provision that resolves the issue differently for most discrimination claims. AJCA wasn’t considered in Banks, however, because the tax code change isn’t retroactive. It only applies to fees and costs paid after the date of enactment, Oct. 22, 2004, with respect to any judgment or settlement occurring after the enactment date.

Settling the conflict

In Banks, the Supreme Court held that the anticipatory assignment of income doctrine, which prevents one from avoiding tax on an economic gain by assigning it in advance to another party, applies to contingent-fee arrangements. Thus, the attorneys’ fee portion of a judgment or settlement constitutes taxable income to the taxpayer, whether paid to the claimant or directly to the attorney.

The Court declined to address whether the anticipatory assignment principle conflicts with the purpose of fee-shifting provisions in some civil rights statutes, none of which were implicated in Banks. But it noted that AJCA redresses the concern for many, perhaps most, claims governed by fee-shifting statutes.

Pre-AJCA dilemma: The deduction reduction

Before AJCA, plaintiffs who were required to include contingent attorneys’ fees in their income were entitled to deduct those fees on their income tax returns, but the deduction was of limited value.

Attorneys’ fees are generally categorized as miscellaneous itemized deductions, which are deductible only to the extent they exceed 2% of a taxpayer’s adjusted gross income (AGI). In addition, itemized deductions are reduced when a taxpayer’s AGI, including the taxable share of a judgment or settlement, exceeds a specified threshold.

In 2005, for example, itemized deductions are reduced by 3% of the amount by which AGI exceeds $145,950 ($72,975 for married persons filing separate returns), up to a maximum reduction of 80%.

If these limitations weren’t bad enough, the large sums often involved in employment discrimination lawsuits could wipe out the deduction altogether because miscellaneous itemized deductions are disregarded in determining alternative minimum tax (AMT) liability.

Once considered largely irrelevant for most taxpayers, AMT now affects substantial numbers of middle-income taxpayers. Absent a change of law, it will affect more than 30 million taxpayers by 2010.

AJCA to the rescue

AJCA eases the tax burden on most discrimination plaintiffs by providing an “above-the-line” deduction for court costs and attorneys’ fees paid in connection with most unlawful discrimination claims. The deduction is applied directly against gross income, so plaintiffs avoid the limitations on miscellaneous itemized deductions.

Bear in mind, though, that the deduction is limited to amounts includible in a plaintiff’s gross income resulting from a judgment or settlement — in other words, the plaintiff can’t claim the deduction before actually receiving the award.

Lower settlement costs

AJCA should lower the cost of settling discrimination cases by providing certainty about the after-tax value of settlements. The Supreme Court’s decision in Banks, however, may have a negative tax impact on plaintiffs whose awards predate AJCA.