ARE LEGAL FEES IN PERSONAL INJURY RECOVERIES TAX DEDUCTIBLE TO THE PLAINTIFF?

by Thomas D. Begley, Jr., Esquire, CELA

[Article originally published in The Barrister, Jan 2020] As a general rule, personal legal fees are not tax deductible, but legal fees in connection with business are deductible.  So, if a client gets divorced, this is personal and the legal fees are non-deductible.  If legal fees are paid in connection with incorporating a business or representing a business in litigation, the legal fees should be deductible to the business.

Contingent Fees

The general rule articulated by the United State Supreme Court in 2005 in Commissioner v. Banks^[1]is that in contingent fee cases the plaintiff must generally recognize gross income equal to 100% of the recovery.  If the contingent fee is 40% and the plaintiff recovers $1,000,000 and pays the lawyer $400,000, the plaintiff must, nevertheless, pay income tax on the $1,000,000.  This seems to be a form of double taxation in that both the plaintiff and the lawyer pay income tax on the same recovery.

Above & Below the Line Deductions

There are two types of tax deductions.  One is known as an above-the-line deduction.  An above-the-line deduction is almost like not receiving the income at all.  The legal fees are deducted in the calculation of the income.  Conversely, a below-the-line deduction is much less valuable.  Since passage of the Tax Cuts and Job Act of 2017, below-the-line deductions have been severely curtailed.  Under the new law, there is no below-the-line deduction for legal fees. 

Exceptions

However, there are certain exceptions.  Shortly prior to Banks, Congress enacted an above-the-line deduction for employment claims and certain whistleblower claims.  

• Employment Claims.  If a plaintiff retains counsel in an employment claim case on a contingent basis, the fee is tax deductible because it is an above the line deduction.  There is no alternative minimum tax (AMT) and no other limitations.  The fee of the defense counsel is deductible to the business.  However, in certain sexual harassment cases this exception may not apply.  
• Personal Injury.  There is no concern about deducting legal fees in a personal injury case involving physical harm or physical sickness, because the recovery is 100% tax free if the damages are limited to compensatory damages.  There is no deduction for attorney’s fees, but there is no need to deduct those fees.  
• Court Order.  If the recovery comes as a result of a class action where lawyers are paid separately under a court order, they are not taxed to the plaintiff and, again, the deduction does not matter.

Sexual Harassment

Notwithstanding the exception for employment cases, if the case involved sexual harassment and the settlement includes a non-disclosure agreement, the legal fees are not deductible to the plaintiff.  In these cases if there are separate claims for sexual harassment aside from other employment claims, it might be wise to allocate to each claim in a written settlement agreement.

Tax Advice

Legal fees for tax advice are deductible whether the advice is related to income, estate, gift, property or other taxes.  Even fees for purely personal tax advice qualify as miscellaneous itemized deductions.  However, fees in connection with estate planning, including preparation of Wills, are not deductible, unless the attorney can specify the portion of the fees that relate to tax planning.

Discrimination

There is special tax treatment for attorney’s fees in connection with discrimination cases.  Legal fees in these cases do not need to be deducted as miscellaneous itemized expenses.  They are an above the line deduction.

Payment of Plaintiff’s Fees by Defendant

Some defendants will agree to pay the plaintiff’s legal fees separately.  The question then arises:  do two checks solve the problem?  At this point, this strategy would seem questionable.  Also, in employment cases the defendant is required to issue a Form 1099 and the Form 1099 would include the full amount of the settlement.

Court Awarded Fees

What about court-awarded fees?  If the court awards the attorney a fee in excess of the agreed upon contingent fee, is the separate fee taxable to the plaintiff?  Again, the answer is not clear.

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^[1] 543 U.S. 426 (2005).