United States: New Law Eliminates "Double Taxation" of Attorneys´ Fees

Among the silent flurry of tax benefits enacted into law by President George W. Bush on October 22, 2004, is one noteworthy provision that eliminates the "double taxation" of attorneys' fee awards in certain employment-related lawsuits and settlements. The Civil Rights Tax Relief Act (the Act), which is Section 703 of the larger American Jobs Creation Act of 2004, eliminates the double taxation of attorneys' fees awarded to a plaintiff in a judgment or obtained through settlement. In several jurisdictions, attorneys' fees awarded to a plaintiff in a judgment or obtained through settlement were taxed as income to both the employee and her attorney. This double taxation was often a stumbling block to reaching a settlement in employment-related lawsuits. Plaintiffs and their attorneys would insist on substantial monetary settlements to account for the double taxation of the attorney's contingent fee so that the plaintiff would net a higher settlement payment. As a result, the amount of a plaintiff's attorneys' fees frequently became the focus of settlement.

Before the Act, the federal circuit courts of appeal were split on the issue of whether contingency fees paid to a plaintiff as part of a judgment or settlement must be included in the individual's gross income for tax reporting purposes. The IRS's position was that contingency fees had to be included in gross income based on the Assignment of Income Doctrine, which holds that the taxpayer who earns and creates the right to receive and enjoy the benefit of income is subject to taxation on the entire income even if she assigned her income to another taxpayer. On this theory, some circuit courts, including the Tenth Circuit Court of Appeals, which interprets federal law in Colorado, have held that contingent attorneys' fees must be included in gross income. Other circuit courts have held that contingency fees are excluded from gross income for federal income tax purposes based on the manner in which the applicable state's attorneys' lien law defines the attorney's rights in her client's cause of action.

While a plaintiff could deduct attorneys' fees and costs on her taxes before the Act, she could do so only if she itemized her deductions, identifying her attorneys' fees and costs as a miscellaneous itemized deduction, and then only if the sum of each miscellaneous itemized deduction exceeded 2% of her gross income for the applicable tax year. As adjusted gross income increased, the total amount of miscellaneous itemized deductions was reduced. Attorneys' fees and costs could not be itemized as a miscellaneous deduction for individuals subject to the alternative minimum tax. Those subject to the alternative minimum tax risked exposure to increased tax liability if they received a substantial attorneys' fee judgment or settlement.

As a result of the new law, it may now be easier to settle discrimination and other related claims for sensible amounts. The new law provides that attorneys' fees and costs paid to a plaintiff because of a judgment or settlement in a discrimination, retaliation, or other employment-related claim are taxed as income to the plaintiff, but the plaintiff is allowed a full deduction for these attorneys' fees and costs. In other words, the plaintiff is given a tax deduction equal to the amount of attorneys' fees and costs reported as income. The Act allows plaintiffs to deduct attorneys' fees and costs paid to them in connection with claims brought under the following federal statutes:

• Title VII of the Civil Rights Act of 1964
• Americans with Disabilities Act
• Age Discrimination in Employment Act
• Family and Medical Leave Act
• Fair Labor Standards Act
• Employee Retirement Income Security Act
• Worker Adjustment and Retraining Notification Act
• National Labor Relations Act
• Rehabilitation Act
• Employee Polygraph Protection Act
• Uniformed Services Employment and Reemployment Rights Act
• Any federal law providing whistleblower protection? Any federal, state, local, or common law claim "providing for the enforcement of civil rights" or "regulating any aspect of the employment relationship, including claims for wages, compensation or benefits, or prohibiting the discharge of an employee, the discrimination against an employee, or any other form of retaliation or reprisal against an employee for asserting rights or taking actions permitted by law."

The Civil Rights Tax Relief Act appears to be a win-win for employers and their employees in discrimination and other similar employment-related causes of action, especially when it comes to negotiating settlements. Employees no longer have to insist on excessive settlements in order to cover the double taxation of their lawyer's contingent fee, and employers may demand more temperate monetary settlements.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.