INTRODUCTION

Under the 2017 tax act, it is possible that a plaintiff who prevails in litigation or receives settlement proceeds might receive less than 20 percent of the recovery, depending on the contingency fee rate and the applicable federal and state income tax rates.

Successful plaintiffs must pay both their attorneys and the Internal Revenue Service. However, as a result of a 2005 U.S. Supreme Court decision, these plaintiffs must report as taxable income (where the recovery is taxable) their entire recovery, including the attorneys’ fees. In the past, plaintiffs could deduct the attorneys’ fees—subject to a number of limitations—that prevented a full income tax deduction on their Form 1040. The inability to fully deduct attorneys’ fees already was seen as unfair. Now, after enactment of the 2017 Tax Cut and Jobs Act (2017 tax act), the situation is even worse because now attorneys’ fees are not deductible at all, including attorneys’ fees that were previously deductible “above the line.” This means that a successful plaintiff pays income taxes on amounts he or she never sees. This is the “Contingency Fee Tax Trap.”

Fortunately, for contingency fee cases, there is now a solution.

BACKGROUND

In Commissioner v. Banks, the Supreme Court addressed whether the portion of a money judgment or settlement paid to a taxpayer’s attorney under a contingency fee agreement is income to the taxpayer for federal income tax purposes. The Supreme Court held that when a taxpayer’s recovery constitutes taxable income, the taxpayer’s income includes the portion of the recovery paid to the attorney as a contingent fee. That is, a plaintiff may not report his recovery “net” of the attorneys’ fees.

As a very simple example, where a plaintiff receives a taxable money judgment for $100,000, and there is a 40 percent contingent attorney fee, the plaintiff must report $100,000 of taxable income, even though she actually received only $60,000.

Until 2018, the plaintiff could deduct the attorneys’ fees portion of the recovery. However, there were a “trifecta” of limitations that prevented the plaintiff from being able to fully deduct the cost of the attorneys’ fees. First, only “miscellaneous itemized deductions” in excess of 2 percent of the plaintiff’s adjusted gross income could be deducted. (Tax code Section 67.) Litigation attorneys’ fees count as a miscellaneous itemized deduction. Second, there was an overall phase-out limitation on itemized deductions, including miscellaneous itemized deductions. (Section 68.) Finally, when determining the plaintiff’s alternative minimum tax, miscellaneous itemized deductions were not permitted. (Section 56(b)(1)(A)(i).) As a result, much of attorneys’ fees were not deductible. Thus, even prior to 2018, the Contingency Fee Tax Trap was a problem.

But the situation got much worse beginning in 2018. This is because under the 2017 tax act, miscellaneous itemized deductions are not deductible at all for the 2018 through 2025 tax years. (Section 67(g), as added by Pub. L. No. 115-97 (the Tax Cuts and Jobs Act), Section 11045(a).) At the time this article was written, there are discussions about making the 2017 tax act changes permanent, including the full disallowance of miscellaneous itemized deductions.

Take the example above. Assuming the plaintiff had a combined 40 percent federal and state income tax rate, her income taxes on the recovery would be $40,000. The result would be that this participant would net only $20,000 from her $100,000 recovery ($100,000 less $40,000 in attorneys’ fees, less $40,000 in federal and state income taxes). Looked at another way, the plaintiff’s income tax equals two-thirds of his or her actual recovery ($40,000 taxes divided by $60,000 in actual income).

The combination of the Banks Supreme Court ruling and the tax law, including the 2017 tax act changes, is very adverse for plaintiffs. By having to include the attorney portion of the recovery in gross income without any corresponding deduction, the result to a successful plaintiff is substantially higher federal and state income taxes, because the attorneys’ fees portion of the settlement cannot be “written off.” In short, for plaintiffs who must pay contingency fees, this is not only a Contingency Fee Tax Trap—it can be a Contingency Fee Tax Trap disaster. It does not matter if the recovery comes from a judgment or a settlement—the Contingency Fee Tax Trap still applies.

CASES IMPACTED

Now that attorneys’ fees are entirely nondeductible, many contingency fee cases involving a taxable recovery are affected by the Contingency Fee Tax Trap. These include—but are not limited to—cases involving:

  • payments of punitive damages and interest;
  • another’s fraud, negligence, or breach of contract (e.g., by insurance companies or finance companies);
  • intentional infliction of emotional distress;
  • interference with property or contract rights;
  • employment issues;
  • amounts recoverable from an ex-spouse regarding alimony or child support;
  • wrongful arrest or imprisonment;
  • reputational damage or defamation;
  • privacy matters;
  • incorrect tax return preparation or advice;
  • investor fraud;
  • whistleblowers, other than certain whistleblower cases involving the Internal Revenue Service, the Securities Exchange Commission (SEC), the False Claims Act, and the Commodity Exchange Act, Section 23;
  • legal malpractice; and
  • “opt-in” class action cases. (These are class action cases where the plaintiff affirmatively elects to be included in the class of litigants and agrees to be bound by the resulting settlement or judgment. Because a class action plaintiff’s share of a contingency fee can exceed the amount that the plaintiff is entitled to as a share of the recovery, the need for a solution to the Contingency Fee Tax Trap is particularly necessary for opt-in class actions.)

ARE ABOVE THE LINE DEDUCTIONS SAFE?—MAYBE NOT

Also, through 2017, employment discrimination, False Claim Act, and IRS whistleblower cases were not subject to the deduction limitations that give rise to the Contingency Fee Tax Trap. This is because the attorneys’ fees related to those types of litigation were treated as an “above the line” deduction, i.e., not a miscellaneous itemized deduction to which the limitations apply. (Section 62(a)(20), Section 62(a)(21).) However, in 2018, after the 2017 Tax Cuts and Jobs Act, is it quite possible, based on the literal language in the tax code, that attorneys’ fees related to these cases are also not deductible, including contingent fee cases. This would subject those plaintiffs to the Contingency Fee Tax Trap as well. The reason for this result is that the statutory language that authorizes these “above the line” deductions starts with the phrase “any deduction allowable under this chapter.” Because attorneys’ fees are fundamentally miscellaneous itemized deductions under Section 212, which are no longer tax deductible as a result of the 2017 Tax Cuts and Jobs Act, it is possible that the required condition for the above the line deduction no longer exists, resulting in no deductible attorneys’ fees. It is not clear whether this result was intended.

Some contingency fee cases are not subject to the Contingency Fee Tax Trap. These include:

  • Section 104(a)(2) physical injury cases, which are income tax-free (except for the punitive damage award portion of the recovery, and interest, which is taxable income).
  • Where the plaintiff’s legal fees may be treated as a Section 162 trade or business expense.
  • “Opt-out” class actions. These are class action cases where an individual is not required to take any action to be included in the class and where the attorneys are paid separately under a court order.
  • Where the plaintiff’s legal fees may be capitalized under Section 263.

Finally, it is important to note that structuring the attorneys’ fees or the plaintiff portion so that payments are made over time does not eliminate the requirement to include the attorneys’ fees in the plaintiff’s taxable income.

Purported Solutions—No Go

Various solutions have been presented to address the Contingency Fee Tax Trap. There are three approaches that are frequently suggested (there are others as well). We believe that none of them work, as explained below. In our view, a plaintiff that seeks to avoid reporting the attorneys’ fees portion of the recovery on any of these bases runs a significant risk of tax penalties, which of course would make the Contingency Fee Tax Trap outcome even worse.

Separate Checks to Plaintiff and the Attorney

This approach does not work because it runs right into the “Banks Buzzsaw.” The Supreme Court is explicit that the attorneys’ fees portion of the recovery is includible in the plaintiff’s income. This tax result cannot be avoided simply by paying part of the plaintiff’s recovery to someone else (the attorney). Just as having part of a parent’s wages paid to a child would not avoid the parent having to include the diverted wages in his or her income, the result is the same if part of a plaintiff’s income is diverted to the attorney. That dodge is too easy for the IRS to overcome.

Also, as a practical matter, when the defendant sends a Form 1099 with respect to the payment, the Form 1099 should report the entire amount of the recovery (including the attorneys’ fees portion) as income. The IRS would immediately identify and challenge any discrepancy between what is reported on a Form 1099 and what is reported on the tax return.

Forming a Partnership Between the Plaintiff and the Attorney

Some have suggested that a partnership may be formed between the plaintiff and the attorney, where the plaintiff receives his or her share of the recovery, and the attorney receives the contingency fee, each in their capacity as a partner.

The theory is that the plaintiff contributes the case to the partnership, and the attorney brings the skill and expertise necessary to generate a recovery. Unfortunately, this approach will not work for three reasons. First, it fails to recognize that there is a principal-agent relationship between the plaintiff and the attorney. That is, the attorney acts for and represents the plaintiff. As a result, there is no separate identity between the plaintiff and the attorney as relates to the claim. Second, lawyer ethics requirements generally preclude an attorney from acting as a partner with a plaintiff. Third, the Banks case specifically rejected this argument, stating that “the relationship between client and attorney, regardless of the variations in particular compensation agreements or the amount of skill and effort the attorney contributes, is a quintessential principal-agent relationship…”

Treating the Lawsuit as a Trade or Business

A plaintiff may seek to treat a lawsuit as a trade or business, so that the attorneys’ fees may be treated as an offsetting business expense. This approach will most likely fail, because the plaintiff would somehow have to be in the business of bringing litigation. There is a difference between a lawsuit arising in connection with a trade or business (where the attorneys’ fees may be a deductible expense), and a lawsuit being the trade or business, which the IRS is most likely to view as not legitimate.

Of course, it is always worthwhile to try to allocate a recovery between the non-taxable portion (e.g., physical injuries) and the taxable portion (e.g., punitive damages) in order to minimize the effects of the Contingency Fee Tax Trap. In addition, where the litigation involves capital assets, consider whether the recovery may be taxed as a long-term capital gain (which, under current tax law would result in a lower tax rate on the income).

A SOLUTION

There is a solution to the Contingency Fee Tax Trap. But to understand the solution, some more background is necessary.

In the Banks case, the Supreme Court explained that a litigation claim is an asset, which may be income generating only if there is a successful judgment or recovery. This is in contrast to the litigation being considered a right to receive income, with the amount not yet known (which, under Banks, it is not). This is an important distinction, because assets may be assigned without generating current taxable income. In contrast, the assignment of income that is certain to be paid results in current taxation to the person assigning the income.

It follows that because the litigation claim is an asset, it can be given away. For instance, it is possible to donate the litigation claim to charity. While uncommon, this does occur. Such donations are uncommon because most public charities are unwilling or unable to accept an asset that is unusual or which has a complex structure or mechanics (such as a litigation claim). Also, most plaintiffs would like to derive some personal benefit from the litigation, which may be difficult when the claim is fully donated to a charity. Although there are practical aspects to consider, such as how to value the litigation claim for income tax deduction purposes, these do not change the fundamental point that there is an asset to give away.

Accordingly, the solution is for the plaintiff to transfer his or her litigation claim to a specially designed split-interest charitable trust that has a separate legal identity from the plaintiff. The plaintiff (or someone the plaintiff designates) would be one of the beneficiaries of this split-interest trust. Properly structured, the plaintiff no longer owns or controls the litigation claim. That ownership and control is now with the trust. As a result, the trust would receive any recovery that becomes due, and is formally obligated to pay any attorney’s fees that are owed in connection with a successful outcome. If there is a successful outcome, then the trust would allocate the net recovery between the trust beneficiaries, including the charity and the original plaintiff, in the manner specified in the trust. Because the plaintiff gave away his or her interest in the litigation, his or her only entitlement is that of a trust beneficiary, and his or her taxable income will reflect only what is received in that capacity, i.e., not including the amount payable to the attorney (and as such a “net” recovery). As the example below will demonstrate, this can substantially increase the plaintiff’s after-tax settlement proceeds.

The principal reason this solution works is because the miscellaneous itemized deduction prohibition applies to individuals. A properly structured trust is not an individual, and assigns the attorney fee obligation in a manner where it is not treated as an obligation of the plaintiff, thereby avoiding the limitation on miscellaneous itemized deductions.

There are some trust-based fees and other expenditures that apply in connection with this trust-based solution, but the result is still better than would be the case if the solution were not implemented. That is because what the plaintiff would have to report as taxable income does not include the attorney fee portion of the recovery (i.e., is “net”), and the resulting tax savings far exceeds these fees and expenditures.

For this solution to work, there are several important conditions that must be satisfied:

The plaintiff must fully relinquish his or her ownership of the litigation claim in favor of the trust. Because of the way the trust is structured, even though a charity is a beneficiary of the trust, there would be no charitable deduction associated with the transfer.

The transfer must occur before it is certain that the litigation would result in a recovery, i.e., before there is a definitely determinable settlement. This is to avoid the assignment of income doctrine, which would result in the plaintiff being taxed on the recovery (including on the attorney fee portion). It therefore is critical to transfer the litigation claim to the trust as early in the litigation process as possible, while the outcome of the litigation and the recovery is still in doubt.

The attorneys representing the original plaintiff should transfer their representation to the trust that receives the litigation claim. This is to avoid an assertion by the IRS that the trust assumed a liability of the plaintiff (which at the time the claim was donated was only a contingent liability), which assumption may be taxable income to the donating plaintiff.

An Example

The following contains a simple example showing the effect of the Contingency Fee Trap and the suggested solution. In this example, the recovery is $400,000 and the contingent attorney fee rate is 40 percent.

As the example demonstrates, the suggested solution is highly advantageous to the plaintiff and imposes no restrictions or adverse economic effect on the attorney.

CONCLUSION

The combination of the Banks Supreme Court case and onerous tax law provisions results in the Contingency Fee Tax Trap. This can have a devastating effect on a successful plaintiff’s net recovery. Fortunately, there is a solution. Contingent fee attorneys who already achieve extraordinary results for their clients can take their efforts one step further by helping clients understand that the tax law will significantly and adversely affect their recovery, and letting them know that a solution exists.

Lawrence J. Eisenberg, Esquire is principal and founder of Lawrence J. Eisenberg, P.C. He was materially involved with the development of the Contingency Fee Tax Trap solution described in this article.