The tax rules relating to litigation recoveries and costs are complicated. They have been made more so by the Tax Cuts & Jobs Act of 2017. The new tax legislation which applies to recoveries and costs in 2018 and beyond makes it a good time to review the complex labyrinth of tax rules that apply to your clients’ receipt or payment of judgments and settlements, as well as payment of attorney’s fees and costs. Once you understand the tax costs, you will likely recommend that your clients seek the guidance of an experienced tax adviser when considering the most tax efficient approach to your litigation cases or the structure of potential recoveries.
The tax treatment of judgments and settlements, and related attorney’s fees and costs depend on the nature of the claims giving rise to the judgment or settlement. This is generally referred to as the “Origin of the Claim Doctrine.” Typically, the applicable tax result requires an analysis of all relevant facts and circumstances. Issues include whether the claims are personal, business, or for the production of taxable income; whether the claims relate to physical personal injury, divorce, labor law discrimination, harassment, fines or penalties, or property rights; and, whether the claims relate to whistleblowers, or federal or state false claims.
As discussed more fully below, some recoveries are non-taxable and others are taxable or partly taxable. Taxable awards can represent ordinary income, while others may be entitled to preferential capital gain treatment. Amounts paid for judgments and settlements may similarly be either deductible or non-deductible; and not all attorney’s fees or costs are deductible. Some recoveries and payments may be treated as basis adjustments to property. In many cases, where multiple claims or causes of action are involved, the recovery, payment or costs may have varying tax consequences; and settlement agreements may be structured to obtain the best tax treatment, consistent with the varying facts and circumstances of the particular case.
Complicating this tax regime is the new tax law that repeals the deduction of attorney’s fees and costs in certain disputes, disallows the deduction of settlement payments and costs in sexual harassment cases if a non-disclosure agreement is signed, and disallows the family law alimony deduction.
It is even possible under the new tax law that some recoveries could be totally erased by attorney’s fees, costs and taxes. Take the example of a $100,000 fully taxable recovery for personal defamation (not related to a business or income producing activity), for which an attorney takes a 50% contingency, with $10,000 of costs. If the plaintiff is in the maximum 37% federal income tax bracket and 13% California income tax bracket, he or she would pay $50,000 in attorney’s fees, $10,000 for costs, $37,000 of federal income taxes and $13,000 of state income taxes, for a total cost of $110,000. After the recovery, the plaintiff would actually be worse off by $10,000. While this hypothetical may be rare in real life, it is technically possible and the attorney may be uncomfortable explaining that he or she exposed his or her client to the time, expense and emotional distress of trial only to reach this unfortunate and negative outcome. The best course of action is to plan ahead when it comes to taxes in litigation.
Generally, all recoveries for a personal claim (as opposed to a business claim) are taxable to the individual taxpayer as ordinary income, and no deduction is available for attorney’s fees and costs. Also, an individual cannot reduce the amount of the taxable recovery by having the payor separately pay the attorney’s fees and costs to the attorney, thus reducing the net payment to the taxpayer. Whether paid by the payor or the recipient, the attorney’s fees and costs are part of the taxable recovery by the claimant-taxpayer. Unless an exception applies, these rules apply to claims involving personal rights including defamation, invasion of privacy, trespass, harassment, domestic abuse, insurance bad faith, divorce, punitive damages, and emotional distress.
An important exception to these rules applies to claims that derive out of a claimant’s physical personal injury. Any recovery for physical injuries and other injuries (such as pain & suffering and mental & emotional distress) deriving therefrom, are non-taxable. Of course, the attorney’s fees and costs associated with such a non-taxable recovery are similarly, non-deductible.
Another meaningful exception for individual taxpayers concerns recoveries for claims relating to employment harassment, whistle-blower cases, and federal false claims act cases. By statute, attorney’s fees and costs related to such claims are deductible as an “above-the-line” deduction. That is, such deductions can be taken into account in calculating the taxpayer’s adjusted gross income. In other words, while the recovery is taxable as ordinary income (with potential employment taxes as well), the attorney’s fees and costs are deductible in full against such taxable income. Moreover, the new tax law extends such deductibility of attorney’s fees and costs to recoveries for state false claims act cases as well as federal ones. In employment cases, often other related claims and causes of action are alleged, which provide an opportunity to allocate the recovery to those other claims with beneficial tax results. In one such case, a common law partnership was alleged in addition to the employment relationship which allowed an allocation of part of the settlement proceeds to the disposition of the partnership interest, a capital asset, with resulting preferential capital gain treatment afforded that portion of the settlement amount, versus the ordinary income and employment taxes assessed against the back pay portion of the proceeds.
Sometimes claims relate to damaged or lost property, or the ownership of property. In those cases, the receipt or payment of recoveries, or payment of attorney’s fees or costs, may represent an adjustment to the basis of the property, rather than taxable income or deductions. This may apply for example with the receipt of insurance proceeds for damaged business or personal property, or the receipt or payment of recoveries relating to the perfection of ownership rights to tangible or intangible assets. For instance, the payment of a settlement and attorney’s fees or costs to protect the ownership rights to a trademark would be added to the tax basis of the trademark and be amortized (deducted) over 15 years for tax purposes.
Claims related to a trade or business are more straightforward. Typically, a recovery by a business is taxable as ordinary income, unless the recovery relates to the disposition of property, in which case the income may be treated as preferential capital gain income, or a basis adjustment as discussed above for lost or damaged property. Any payments by a business, including attorney’s fees and costs, will typically be treated as ordinary and necessary trade or business expenses, again with the exception applicable to property-related payments, discussed above. An important exception here applies to payments for fines or penalties. Generally, such payments which are punitive in nature are not deductible. On the other hand, some civil penalties which represent compensatory damages or restitution, may be deductible.
Recoveries and payments in connection with a divorce are more complicated. Any attorney’s fees or costs associated with the dissolution of the marital relationship or the determination of child custody or support are non-deductible. Money and property received in connection with the division of marital property are tax-free and the recipient spouse “inherits” the couple’s tax basis in the property received. Attorney’s fees and costs associated with the property division, may become part of the basis of the property received. Under the new law, after 2018, alimony is no longer taxable income for the recipient spouse, or a tax-deduction for the payor spouse. Attorney’s fees and costs related to the determination of alimony under the new tax law is no longer deductible by either spouse.
As mentioned above, payments in connection with the settlement of a sexual harassment claim are not deductible if the parties sign a non-disclosure agreement. Interestingly, while maybe unintentionally, the language of the new law includes even the claimant’s attorney’s fees and costs in the deduction disallowance rule. As discussed above for labor law cases, harassment cases often include related and unrelated claims beyond sexual harassment. In such cases, the settlement amount may be allocated among the various claims. It is not likely that the IRS would apply the new law’s deduction disallowance rule to the non-sexual harassment portion of the settlement proceeds, unless the settlement was structured in bad faith. It should be mentioned here that the IRS is not bound to the parties’ settlement allocation, but typically the Service will be deferential to the parties’ allocation, if it appears to be the product of good faith.
The tax rules applicable to business claims relating to the receipt or payment of judgments, settlements, and related attorney’s fees and costs also generally apply to claims related to rental activities that are carried on for the production of income, even if the rental activity does not rise to the level necessary for treatment as the taxpayer’s trade or business.
As illustrated above, the tax treatment of judgments, settlements, attorney’s fees and costs are complicated, sometimes onerous and even draconian. The new tax law makes the tax rules even more complicated. Astute counsel will suggest that their clients consult tax advisers that are experienced in this area to ensure that the parties are not surprised by unexpected and unintended tax considerations.