We have been fielding many questions about the Supreme Court's decision last week regarding the taxability of attorney fees to clients (Commissioner v. Banks). I hope the information below begins to clarify some of the issues.We now have three broad categories into which cases fall for purposes of the taxability of attorney fees to plaintiffs.
1. Personal physical injury cases as defined by 104(a)(2). Code Section104(a)(2) provides: "IN GENERAL. --...(G)ross income does not include the amount of any damages received (whether by suit or agreement and whether as lump sums or structured settlements) on account of personal injuries or physical sickness." The Banks decision last week only addressed cases where a plaintiff's recovery constitutes income. As 104(a)(2) clearly points out, recoveries for personal physical injuries are statutorily excluded from income. Accordingly, the exclusion from income should continue to apply to all of the personal physical injury damages received by plaintiffs, including that portion of the recovery paid to the attorney.
2. Unlawful discrimination (which includes most employment cases) or certain specified claims against the government (typically brought under the False Claims Act). The American Jobs Creation Act of 2004, signed by President Bush in October, 2004, also includes the Civil Rights Tax Relief Act. The latter act allows an above-the-line deduction for amounts attributable to attorney fees and costs received on account of these claims settled after 10/22/2004. The Act provided much needed relief (in this limited category of claims) by rectifying the Alternative Minimum Tax (AMT) problem that disallowed deductions of attorney fees. Before the Civil Rights Tax Relief Act, it was uncertain whether a plaintiff must pay income taxes on his or her entire recovery, including attorney fees and court costs. For example, if a plaintiff received an award of $100,000 and paid $33,333 in attorney fees, the IRS maintained that the plaintiff was required to pay taxes on the entire $100,000 and that the attorney also was required to pay taxes on the $33,333 fee (i.e. the much despised "double taxation").The types of employment claims getting relief under the new law include those brought pursuant to:
- a) the Civil Rights Act of 1991;
- b) the Congressional Accountability Act of 1995;
- c) the National Labor Relations Act;
- d) the Fair Labor Standards Act of 1938;
- e) the Age Discrimination in Employment Act of 1967;
- f) the Rehabilitation Act of 1973;
- g) the Employee Retirement Income Security Act of 1974;
- h) the Education Amendments of 1972;
- i) the Employee Polygraph Protection Act of 1988;
- j) the Worker Adjustment and Retraining Notification Act;
- k) the Family and Medical Leave Act of 1993;
- l) Chapter 43 of Title 38 (employment rights of uniformed service personnel);
- m) Sections 1981, 1983, and 1985 cases;
- n) the Civil Rights Act of 1964;
- o) the Fair Housing Act;
- p) the Americans With Disabilities Act of 1990;
- q) any provision of federal law (known as whistle-blower protection provisions) that prohibits the discharge of an employee, 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; or
- r) any provision of federal, state, or local law, or common law claims permitted under federal, state, or local law, that provides for the enforcement of civil rights or regulates any aspect of the employment relationship, including claims for wages, compensation, or benefits, or prohibiting the discharge of an employee, 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.
3.Other non physical injury cases (e.g. those not included on the list above). Unfortunately, attorney fees in all other non physical injury cases, past and future, appear to be taxable to the plaintiff and the attorney. Some notable examples of the types of claims absent from the list above (which may be brought outside of the employment context) include: negligent infliction of emotional distress, defamation, invasion of privacy, false imprisonment, interference with contractual relations, and claims for investment losses.
There is a silver lining (albeit slight) in the Supreme Court's Banks decision -- The court rejected the argument that the attorney had a direct property interest in the recovery (rather, the court reasoned, it is a classic principal-agent relationship). This rationale is critical to preserving an attorney's ability to "structure" part of his/her attorney fee. If the court had accepted this "direct property interest" argument, a direct taxable benefit would be triggered for the attorney before a structured fee agreement could be established.
I hope you find this summary helpful.
Leave a Comment