Deduction Of Attorneys' Fees Paid By Individuals (Commissioner v. Banks, 125 S.Ct. 826 (2005)"04.04.2005
The recent decision of the Supreme Court in Commissioner v. Banks, 125 S.Ct. 826 (2005), resolves a very narrow but most important issue pertaining to the tax treatment of attorneys' fees [FN1] payable by plaintiffs in connection with settlements and judicial awards. The Banks decision presents an opportunity to explain the deduction of attorneys' fees broadly to you. Deductibility is important not only to our clients who are paying our fees but also to attorneys in weighing the effect on opposing parties who incur attorneys' fees in pursuing claims against our clients or defending against claims brought by our clients. As will be seen from the discussion below, even though a recovery by a plaintiff on a claim as a result of a judgment or settlement may be included in full in taxable income, the attorneys' fees incurred in pursuing the action may not be fully deductible in determining the normal income tax and may not be deductible at all in determining the alternative minimum tax.
To appreciate the tax consequences of attorneys' fees in calculating taxable income for federal and California income tax purposes you need to be aware of not only the regime used in computing the normal income tax but also the regime used in computing the alternative minimum income tax.
From this point on, it will be assumed that (1) the amount paid to the plaintiff pursuant to a settlement or judgment is not excluded from taxable income under section 104 of the Internal Revenue Code as a recovery in compensation of personal physical injuries or physical sickness, [FN2] (2) the parties incurring the attorneys' fees are individuals, and (3) because they are not incurred in the acquisition of property, defending or perfecting title to property, developing or improving property or disposing of property the attorneys' fees are not required to be capitalized.
I will cover what I consider to be the important points of law. In doing so I will avoid discussing some complexities.
LAW PRIOR TO 2004 LEGISLATION
In determining an individual's income tax liability, the first step is to compute "gross income" which consists of the various items of income realized by a taxpayer. Next, "adjusted gross income" is computed by deducting certain business expenses from gross income. Finally, "taxable income" is determined by subtracting certain "itemized deductions" from adjusted gross income. The normal tax rates are applied to taxable income.
Legal fees incurred in the course of an individual's own trade or business are deducted in determining gross income. However, unreimbursed legal fees incurred by an employee in the course of the business affairs of his or her employer and legal fees incurred in the production of income or the management or maintenance of investment properties are deductible in determining adjusted gross income to the extent that such expenses, when aggregated with certain other itemized deductions,[FN3] exceed 2% of adjusted gross income. In addition, all itemized deductions (other than medical expenses, investment interest, and casualty, theft and gambling losses) are reduced by an amount equal to 3% of adjusted gross income in excess of $145,900 for 2005 ($72,975 for a married individual filing a separate return).[FN4] However, this reduction may not exceed 80% of such deductions. For example, if these deductions amounted to a total of $100,000, the 3% reduction could not exceed $80,000. The 3% reduction is to be phased out over a five-year period beginning in 2006.
The alternative minimum tax is a separate tax regime intended to require taxpayers to pay a minimum amount of taxes. It applies in lieu of the normal tax when the minimum tax exceeds the normal tax. The minimum tax is applied against alternative minimum taxable income ("AMTI") which is taxable income computed in determining the normal tax plus itemized deductions that were allowed in computing such taxable income to the extent that the aggregate of those deductions exceed exclusions for 2005 of $58,000 for married individuals filing a joint return, $40,250 for a single person, and $29,000 for a married individual filing a separate return. These exclusions, however, are phased out based on the amount of a taxpayer's AMTI. The phase out is at the rate of 25 cents for each dollar of AMTI in excess of $150,000 for married persons filing a joint return, $112,500 for single individuals, and $75,000 for married individuals filing separate returns. Ignoring a special alternative minimum tax rate imposed on capital gains, a 26% rate is imposed on the first $175,000 of AMTI ($87,500 for married persons filing separate returns) and 28% is imposed on any amounts in excess of $175,000 ($87,500). The result of the inclusion of itemized deductions in AMTI is that they are not allowed as deductions in determining AMTI.
Therefore, prior to the changes in the Internal Revenue Code discussed below, an individual plaintiff's recovery in a judgment or settlement in a lawsuit would be included in taxable income, but the deduction for the legal fees paid to obtain the taxable recovery would be limited by the 2% floor and 3% ceiling in determining the normal tax and would be completely eliminated in determining the alternative minimum tax.[FN5] In fact, it is possible that a successful plaintiff could pay a combination of taxes and legal fees in excess of the amount of the recovery less legal fees.
THE BANKS CASE
The Banks case consisted of two cases which the Supreme Court agreed to hear because of a disagreement between Circuit Courts of Appeals about whether and when a taxpayer may offset contingent legal fees against judgment or settlement recoveries in determining his or her tax liability. Various Circuit Courts had held that (1) gross income is determined by offsetting legal fees, (2) the legal fees could only be offset in those few states that give attorneys a statutory lien against the judgment or settlement, or (3) the legal fees must be deducted from adjusted gross income in accordance with the normal tax and alternative minimum tax regimes discussed above. In a relatively brief opinion, Justice Kennedy speaking for a unanimous Court held that the fees cannot be offset and may only be deducted as itemized deductions from adjusted gross income in determining taxable income and may not be deducted in computing the alternative minimum tax. The door was left open to the proposition that court-awarded attorneys' fees or statutory fees might be allowed as an offset in determining gross income.
The Banks decision addressed the issue of whether the portion of a money judgment or settlement paid directly by the defendant to a plaintiff's attorney pursuant to a contingent fee arrangement was income to the plaintiff. The Court unanimously concluded that it was income. A striking feature was that the contingent fees were paid directly to the attorneys so that the plaintiffs never had possession of the funds. However, the tax effect is the same whether the fee is contingent, by the hour, or set on some other basis and is paid directly by the defendant to the plaintiff's attorney or is paid directly by the plaintiff to his or her attorney.
THE LEGISLATION IN 2004
Section 703 of the American Jobs Creation Act of 2004 (118 Stat. 1418) amended the Internal Revenue Code by adding thereto new section 62(a)(19).[FN7] This provision provides that legal expenses paid after October 22, 2004 in lawsuits for "unlawful discrimination" (defined in section 62(e) to include 18 categories of discrimination type lawsuits brought under specified federal or state laws)[FN8] , a claim against the federal government under subchapter III of chapter 37 of 31 U.S.C. or a private claim under the Medicare Secondary Payor laws (42 U.S.C. 1395, (b)(3)(A)) will be deductible in determining gross income (and thus will not be subject to either the 2% floor or 3% ceiling) and will not increase income subject to the alternative minimum tax. This deduction, however, may not exceed the amount of any judgment or settlement amount included in taxable income for the taxable year in which the legal fees are paid. Moreover, the rules discussed above continue to apply to other suits such as defamation, consumer fraud, and other actions. No doubt plaintiffs will include in complaints claims under one or more of these 18 categories and will attempt to negotiate settlements allocating payments against such claims. Also, where appropriate they might seek a statement that fees are in lieu of statutory fees.
FN1 Herein the terms "legal fees" and "attorneys' fees" will include other costs incurred in pursuing a legal claim.
FN2 Legal fees incurred in recovering income so excluded are not deductible. IRC § 265(a)(1). Punitive damages are not excluded. Therefore, legal fees relating to recovery of punitive damages may be deductible subject to the rules discussed herein.
FN3 These other deductions do not include, among other things, deductions for interest, taxes, casualty losses, charitable contributions, and medical expenses.
FN4 These figures are adjusted annually to reflect inflation. The amount for 2005 is projected.
FN5 Generally, the California income tax and the California alternative minimum tax are computed in the same manner as the corresponding federal taxes, but California has a 6% floor on itemized deductions and a 7% alternative minimum tax rate.
FN6 Chief Justice Rehnquist did not participate in the decision.
FN7 California law has not yet conformed with federal law by recognizing this new provision.
FN8 See below for a list of these 18 categories.
1. Section 302 of the Civil Rights Act of 1991;
2. Sections 201, 202, 203, 204, 205, 206 or 207 of the Congressional Accountability Act of 1995;
3. The national Labor Relations Act;
4. The Fair Labor Standards Act of 1938;
5. Sections 4 or 15 of the Age Discrimination in Employment Act of 1967;
6. Sections 501 or 504 of the Rehabilitation Act of 1973;
7. Sections 510 of the Employee Retirement Income Security Act of 1974 (P.L. 93-406);
8. Title IX of the Education Amendments of 1972;
9. The Employee Polygraph Protection Act of 1988;
10. The Worker Adjustment and Retraining Notification Act;
11. Section 105 of the Family and Medical Leave Act of 1993;
12. Chapter 43 of Title 38 of the United States Code;
13. Sections 1977, 1979 or 1980 of the Revised Statutes;
14. Sections 703, 704 or 717 of the Civil Rights Act of 1964;
15. Sections 804, 805, 806, 808 or 818 of the Fair Housing Act;
16. Sections 102, 202, 302 or 503 of the Americans with Disabilities Act of 1990;
17. Any provision of federal law prohibiting discharge or any other form of retaliation or reprisal against an employee for asserting rights or taking other actions permitted under federal law (often referred to as whistle-blower protection); or
18. Any provision of federal, state or local law, or common law claims permitted under federal, state, or local law providing for the enforcement of civil rights or regulating any aspect of the employment relationship (including claims for wages, compensation, or benefits), or prohibiting discharge, discrimination, or any other forms of retaliation or reprisal against an employee for asserting rights or taking other actions permitted by law.