Sometimes attorneys will charge clients contingent fees based on the outcome of a case, rather than billing a flat or hourly fee for services rendered. However, the federal income tax treatment of contingent fees paid to an attorney out of a taxable nonbusiness judgment or settlement has historically been a source of confusion and litigation between taxpayers and the IRS.
Deducting Business-Related Attorneys’ Fees
Taxpayers are allowed to deduct all ordinary and necessary expenses incurred in carrying on an active business. Legal expenses constitute such ordinary and necessary expenses when they arise from an active business venture. However, legal fees to acquire a business asset, such as real estate or a patent, must be capitalized as part of the cost of the asset and then generally depreciated or amortized over a number of years.
For example, in a 2015 Private Letter Ruling, the IRS was asked to opine on the proper tax treatment of three types of fees paid to the taxpayer’s attorneys to resolve business-related litigation:
1. Legal and related expenses incurred by the taxpayer to unsuccessfully defend himself against a lawsuit,
2. Expenses to unsuccessfully appeal the adverse court decision against him, and
3. Payments by the taxpayer to his legal adversary to cover court-awarded compensatory and punitive damages and the adversary’s legal expenses.
The taxpayer had experience in managing closely held companies. He had agreed to serve as the managing shareholder of a newly formed corporation in exchange for a management fee. After another shareholder became dissatisfied with the corporation’s performance, the taxpayer was sued for alleged breach of contract, breach of fiduciary duty and fraud. He incurred legal fees to unsuccessfully defend himself against these charges and unsuccessfully appeal the initial court decision against him. He also paid fees to accounting consultants and an expert witness. To add insult to injury, the taxpayer had to pay court-ordered compensatory and punitive damages to his legal adversary, as well as the adversary’s legal fees.
These expenditures clearly had their origin in the conduct of the taxpayer’s business as the managing shareholder of the troubled corporation. Therefore, the IRS concluded that his payments to satisfy the final judgment against him were deductible business expenses.
Opposing Legal Theories
Over the years, some court decisions have concluded that an individual claimant must do two things:
1. Include 100% of the taxable portion of a legal judgment or settlement in gross income, and
2. Treat the related contingent attorneys’ fees as a miscellaneous itemized deduction.
Under this treatment, a winning claimant can effectively be forced to pay federal income tax on most or all of the contingent attorneys’ fees, even though that fee is subtracted from the amount received by the claimant.
This unfavorable tax result is caused by:
- The Tax Cuts and Jobs Act’s suspension of most miscellaneous itemized deductions under the regular federal income tax rules for 2018 through 2025, and
- The complete and permanent disallowance of miscellaneous itemized deductions under the alternative minimum tax (AMT) rules, which means no deduction for contingent fees if you’re subject to the AMT.
In contrast, other decisions have concluded that contingent fees can simply be excluded from the claimant’s gross income because the fees are actually “owned” by the attorney rather than the claimant. That way, the claimant doesn’t pay any federal income tax on the portion of a judgment or settlement that goes to the attorney. This favorable view is consistent with the fact that the contingent attorneys’ fees never pass through the claimant’s hands. The amount goes straight to the law firm.
Supreme Court Decision
In Commissioner v. Banks (125 S. Ct. 826, 2005), the U.S. Supreme Court ruled that an individual taxpayer must include in gross income the portion of a taxable judgment or settlement that goes to the taxpayer’s attorney under a contingent-fee arrangement. The decision was based on the Supreme Court’s review of Banks (345 F.3d 373, 6th Cir. 2003) and Banaitis (340 F.3d 1074, 9th Cir. 2003). In both decisions, the federal appeals courts had reversed the U.S. Tax Court, concluding that the taxpayers could exclude from their gross income amounts paid to their attorneys under contingent-fee arrangements.
The Supreme Court disagreed. It ruled that, even though the value of a taxpayer’s legal claim is speculative at the time a contingent-fee arrangement is entered into with an attorney, that factor doesn’t cause the arrangement to be properly characterized for tax purposes as a partnership or joint venture between taxpayer and attorney. Instead, the Court said the attorney-client relationship is properly characterized as a principal-agent relationship. As such, the principal (the taxpayer claimant) must include the entire taxable amount earned from the legal action in gross income and then hope to somehow be able to claim a deduction for the agent’s share of the pot (the amount paid to the attorney under the contingent-fee arrangement).
In essence, the Supreme Court’s decision reaffirmed one of the oldest principles in federal income taxation: Taxpayers can’t assign taxable income to someone else, even though the attempt to do so may happen before the income is earned. Instead, taxpayers must include the income on their returns when it’s earned, and then hope to be able to deduct amounts that go to other parties (such as the taxpayer’s attorney in this context). The fact that the tax code can limit or prevent deductions for contingent fees — through the conspiracy of the TCJA’s current-law suspension of miscellaneous itemized deductions and the complete disallowance of those deductions under the AMT rules — is unfortunate.
The Supreme Court’s decision in Banks seemed to close the door on any argument that contingent attorneys’ fees paid out of a taxable nonbusiness judgment or settlement can be excluded from a claimant’s gross income. However, there are limited circumstances where contingent fees can be deducted.
Specifically, the tax code permits so-called “above-the-line” deductions for attorneys’ fees and court costs paid in legal actions involving certain claims of unlawful discrimination, certain claims against the federal government and private causes of action under the Medicare Secondary Payer statute. Above-the-line deduction treatment means you don’t need to itemize to benefit from the deduction.
Examples of legal actions that are defined to be for unlawful discrimination include claims of violations of:
- The Age Discrimination in Employment Act of 1967,
- The Civil Rights Acts of 1964 and 1991,
- The Congressional Accountability Act of 1995,
- The National Labor Relations Act,
- The Family and Medical Leave Act of 1993,
- The Fair Housing Act,
- The Americans with Disabilities Act of 1990, and
- Any provision of federal law, popularly known as whistleblower protection provisions, that prohibit 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 other actions permitted under federal law.
Important: Above-the-line deduction treatment for qualifying contingent legal fees and related costs effectively allows you to subtract these expenses from the amount of the judgment or settlement. So, you only pay federal income tax on the amount you keep.
Contingent Fees Taken Out of Tax-Free Judgments or Settlements
Injured parties can’t deduct attorneys’ fees incurred to collect a tax-free judgment or settlement, such as one for physical injuries or sickness. In other words, no deductions are allowed for fees to collect tax-free compensation.
Generally, payments for punitive damages (amounts paid for the specific purpose of punishing the wrongdoer) and payments of interest are taxable even if they’re paid as part of the compensation for physical injuries or sickness. Therefore, contingent attorneys’ fees allocable to the collection of punitive damages and/or interest will fall under unfavorable tax treatment for personal legal expenses.
Noncontingent Attorneys’ Fees
Attorneys’ fees that aren’t contingent on the outcome of the case are treated in the same fashion as contingent fees. For example, hourly fees paid to collect a taxable nonbusiness judgment or settlement are subject to the unfavorable rules for personal legal expenses unless the above-the-line exception applies. And noncontingent fees paid to collect a tax-free judgment or settlement are nondeductible.
Get It Right
Determining the proper tax treatment of an individual’s attorneys’ fees can be tricky. Your tax advisor can help you navigate the rules. Seek tax advice early in the litigation process because better results can sometimes be achieved with advance planning.