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A victim of defamation, intentional infliction of emotional distress, and invasion of privacy asks for your advice on whether she should pursue legal action. You determine that she has a good chance of success through settlement or trial. But you realize that if she is required to include the entire damage award in her gross income (including amounts she will never receive because they will be used to pay attorney fees under a contingent fee agreement), federal income taxes could equal, or even exceed, her portion of the damage award. How should you advise her? In 2004, Congress let plaintiffs exclude attorney fees and court costs from gross income. But this is only for certain types of lawsuits (not including the claims in this scenario), and even then, the exclusion is only for damages and settlements occurring and paid after Oct. 22, 2004. Last year the Supreme Court held that a plaintiff cannot exclude legal fees on the basis that the attorney has an equitable interest in the award, because doing so would be an improper assignment of the plaintiff’s income to the attorney. But the Supreme Court did not address the taxpayers’ other arguments supporting exclusion of the attorney fees from the plaintiff’s income because those arguments were not raised in the lower courts. Thus, despite the recent legislative and Supreme Court consideration, significant uncertainty remains over whether a plaintiff must include her entire damage award in gross income. That’s something to remember, not just for tax lawyers but also for plaintiffs lawyers and for defense counsel and in-house lawyers who are evaluating the settlement value of claims. Because the Supreme Court did not address all of the taxpayers’ arguments supporting exclusion of legal fees, it is probable that some taxpayers will exclude attorney fees from their gross income. As a result, resolution of the issue might involve a dispute with the Internal Revenue Service. THE TAX CONUNDRUM The perverse tax result of a successful plaintiff owing more in tax than she received in damages can happen when she is required to include her entire damage award in her gross income. This occurs because, even though she can deduct attorney fees and other litigation costs, three provisions of the tax law can eliminate this deduction entirely. First, it is the IRS’s view that attorney fees and litigation costs are deductible as miscellaneous itemized deductions. Miscellaneous itemized deductions are initially reduced by 2 percent of adjusted gross income (which will already be high because the entire damage award is included in gross income). Second, all itemized deductions are reduced for taxpayers with adjusted gross income above a threshold amount (which the damage award often exceeds). Third, and most significant, miscellaneous itemized deductions are not deductible for purposes of the alternative minimum tax. Again, including the damage award in gross income usually triggers the alternative minimum tax. The combination of these three factors can result in little, if any, deduction for attorney fees and other litigation costs. THE JOBS ACT After sharp criticism in the national press and in the 2002 report of the National Taxpayer Advocate, Congress provided a partial solution when it passed the American Jobs Creation Act of 2004. The Jobs Act lets a plaintiff exclude attorney fees and court costs from gross income in certain cases. As an exclusion from gross income, the exclusion is not subject to the alternative minimum tax, the phaseout of itemized deductions, or the 2 percent limitation. Unfortunately, the exclusion is only for specified types of lawsuits and only for damages and settlements occurring and paid after Oct. 22, 2004. The new provision applies to federal civil rights actions, federal actions based upon violations of specific federal laws governing discrimination (including whistle-blower protection provisions), claims against the United States, and private causes of action under the Medicare secondary-payer laws. Also covered are claims for unlawful employment-related discrimination based upon violations of federal, state, and local laws providing for the enforcement of civil rights or regulating any aspect of the employment relationship — a potentially broad category of lawsuit. Though the exclusion solves the deduction problem for the covered situations, the problem still exists for all other situations. For example, the Jobs Act exclusion does not cover common-law tort actions based on nonphysical personal injury, such as defamation, negligent or intentional infliction of emotional distress, false imprisonment, and invasion of privacy. The Jobs Act also does not cover claims based on interference with contractual relations and claims for investment losses from negligent or careless brokers. Though the Jobs Act covers relator actions under the federal False Claims Act, the status of relator actions under state and local false claims act and other nonfederal whistle-blower statutes remains unclear. False claims statutes, which are also known as private attorney general statutes, empower private citizens to sue on behalf of the government for certain forms of fraud and false claims by persons and entities doing business with the government. Even for covered situations, thorny issues remain. Where there are multiple causes of action in a single complaint, some that are covered and others that are not, how should plaintiffs apportion litigation costs? Should plaintiffs dismiss or drop certain claims before settlement? Or should plaintiffs and plaintiffs attorneys avoid bringing potentially meritorious claims because of possible tax implications? THE SUPREME COURT WEIGHS IN Since 1996 the federal courts have been divided on how to treat legal fees. Some federal courts found that legal fees are excludable from gross income because state law provided the attorney with an equitable interest in the cause of action to the extent of the contingency fee. The attorney effectively had an ownership right or lien on part of that award, and, therefore, the plaintiff should not include that portion of the award in his gross income. Other federal courts, however, have held that attorney fees in nonphysical personal injury cases must be included in the plaintiff’s income. These courts reached this conclusion by following the assignment of income doctrine, which prevents a taxpayer from avoiding tax on income by simply assigning it to another person. After denying certiorari four times, the Supreme Court finally took up the issue in Commissioner v. Banks and its companion case, Commissioner v. Banaitis. The 2005 decision in Banks applies to situations not covered by the Jobs Act. The Supreme Court reviewed arguments on whether the assignment of income doctrine requires inclusion in gross income or whether the attorney interest in the final award permits exclusion from gross income. Concluding that the attorney fee is includable in the plaintiff’s gross income, the Court agreed with the government’s position that the contingent fee arrangement was an anticipatory assignment of the plaintiff’s income. The Supreme Court did not find any state statute creating an ownership interest in the litigation outcome for the attorney. The taxpayers also presented other arguments, including the following: (1) that the contingent fee arrangement established a partnership for tax purposes, (2) that the litigation recovery is proceeds from disposition of property, and the attorney fee is a deductible capital expense, and (3) that the attorney fee is a deductible reimbursed employee expense. Refusing to consider those arguments, the Supreme Court stated: “We are especially reluctant to entertain novel propositions of law with broad implications for the tax system that were not advanced in earlier stages of the litigation and not examined by the Courts of Appeals. We decline comment on these supplementary theories.” The Supreme Court also refused to consider the treatment of False Claims Act and qui tam litigation under prior law because these issues were not presented by the facts of the case before the Court. When confronted with arguments that treating the fee award as income to the plaintiff can lead to the perverse result of the plaintiff losing money by winning the suit, and treating statutory fee awards as income to plaintiffs can undermine the effectiveness of fee-shifting statutes, the Court refused to address those claims on the grounds that they were not presented by the facts. WHERE WE ARE NOW Although the Jobs Act solves the problem caused by the limited deductibility of attorney fees in the specified situations, many other situations are left in the uncertainty of the prior law. Furthermore, although the Supreme Court resolved the prior law and the prior circuit split with regard to the arguments considered, the debate continues with respect to the validity of the arguments not considered. The circuit courts could again split on the tax treatment of attorney fees based on the legal arguments not yet addressed by the Supreme Court. As a result, significant uncertainty surrounds how a plaintiff should treat attorney fees. So how might you advise your potential client? Given that the tax treatment of any award could determine whether a successful claim could cost her money, she should determine before proceeding whether she properly can exclude the attorney fees from her gross income. This will require her to analyze the strength of the arguments not considered by the Supreme Court, the strength of any arguments the IRS could raise, and her willingness to resolve any controversy with the IRS. Furthermore, if she had any additional claims that could be covered by the Jobs Act, she should carefully review any settlement documents to remove, to the extent possible, any ambiguity about what claims the settlement payment covers. Undertaking this analysis may not always be simple. But until the uncertainty dissipates, it remains the most reasonable option in an unclear situation.
Dwight Mersereau is counsel and Justin C. Miller is an associate in the D.C. firm of Miller & Chevalier. They specialize in tax law.

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