Applying the above-the-line deduction for certain legal fees.

Controversy over the tax treatment of contingent legal fees (not deductible as a trade or business expense) incurred in the recovery of taxable legal damages is not a new issue. Recent cases addressed whether an award should be reported on a (1) gross basis and the related legal fees deducted under Sec. 212 (subject to the 2%-of-adjusted-gross-income (AGI) limit), or (2) net basis (after deducting the legal fees).

Cases

This dispute created a split among the circuits: the Fifth, Sixth and Eleventh Circuits approved the netting approach, the Ninth Circuit split in its holdings, based on property rights created under state law, and six other courts said the entire recovery is income; see the discussion of these cases in Banks, II, 125 S.Ct. 826 (2005). The Supreme Court reviewed the issues in Banks, II, and ruled that the portion of the award attributable to contingent legal fees may not be excluded from gross income.

The reason for the decision in Banks, II was that allowing the taxpayer to avoid taking the portion of the settlement relating to legal fees into gross income would be equivalent to an anticipatory assignment of income. The Court required the gross settlement to be included in income, allowing an itemized deduction under Sec. 212 for any legal fees. This treatment creates many undesirable repercussions for taxpayers receiving such awards.

Due to AGI-based phaseouts, some taxpayers may not benefit from a miscellaneous itemized deduction, because of the increase in AGI that results from the settlement. For small settlements, the legal fees may not exceed the individual's standard deduction. In other cases, an individual may benefit from the itemized deduction of legal fees for regular tax purposes; however, the alternative minimum tax (AMT) may significantly reduce that benefit, by adding back the miscellaneous itemized deductions as a tax preference, resulting in a significant AMT liability.

In most instances, this treatment subjects an individual to tax on a portion of a settlement that will never be received, sometimes resulting in a tax liability that exceeds the settlement net of legal fees; for a discussion, see Wood, "Should Taxes Be Included in Damage Calculations?" TEA, October 2005, p. 614. The Banks, II decision, while keeping with the Sec. 61 definition of gross income, produces inequitable results to many taxpayers, which Congress has attempted to alleviate.

See. 62(a)(20)

Congress addressed this inequity in American Jobs Creation Act of 2004 (AJCA) Section 703(a), adding new Sec. 62(a) (20), Costs involving discrimination suits, etc. This provision allows a deduction from gross income, not exceeding a gross judgment or settlement, for legal fees associated with judgments or settlements for a claim:

1. Of "unlawful discrimination"; 2. Against the Federal government of a violation of subchapter III of chapter 37 of title 31 of the U.S. Code; or 3. Made under Section 1862(b)(3)(A) of the Social Security Act (42 USC Section 1395y(b)(3)(A)) resulting from the unlawful exclusion of an employee from coverage under Social Security or Medicare.

Only fees and costs paid after Oct. 22, 2004 (the AJCA's enactment date) are deductible under Sec. 62(a)(20).

Definition: The application of this provision is complicated by the definition of "unlawful discrimination," which is provided in Sec. 62(e). It requires that a claim for unlawful discrimination arise under certain enumerated anti-discrimination laws to warrant a deduction from gross income. Sec. 62(e) lists 16 specific sections of the U.S. Code under which a Sec. 62(a)(20) deduction is warranted. Examples include discrimination based on age, sex, race and religious affiliation, infringement on one's right to participate in labor unions, and exclusion from an educational program that receives Federal funding (i.e., Title IX).

Sec. 62(e)(17) and (18) further provide that legal costs incurred due to discrimination covered by "whistleblower protection provisions" and provisions for the enforcement of civil rights or laws regulating the employment relationship, are also deductible.

Fees incurred to recover awards from claims against the Federal government as set forth in subchapter III of chapter 37 of title 31 of the U.S. Code are deductible if they relate to:

1. Claims of personnel of agencies of the District of Columbia government for personal property damage or loss;

2. Claims of officers and employees at government penal and correctional institutions;

3. Small claims for privately owned property damage or loss;

4. Damages caused by investigative or law enforcement officers of the Department of Justice; or

5. Personal injury or death in a foreign country to non-nationals; see generally, 31 USC Sections 3721-3725.

While these new rules theoretically resolve the issue of which legal fees paid in recovery of damages can be deducted from gross income, the references to the U.S. Code in defining unlawful discrimination make discerning the types of legal fees that qualify for the above-the-line deduction quite cumbersome. Thus, an understanding of the references to the U.S. Code in Sec. 62(a)(20) and (e) is needed to determine the appropriate treatment of legal fees incurred.

Note: Sec. 62(e)(18) is broadly inclusive, allowing legal fees to be deducted from claims arising from violation of Federal, state or local law regulating "any aspect of the employment relationship."

Drastic Difference

If none of the new statutory provisions warrants a deduction from gross income, the taxpayer may deduct the legal fees as an itemized deduction, subject to the 2%-of-AGI threshold, if the fees are deductible under Sec. 212.

Example: In 2006, R and M, married filing jointly with no dependents, have $150,000 in taxable wages and $19,500 in itemized deductions (of which $8,500 relate to taxes). Their Federal liability would be $24,096. However, if in 2006 they receive a $500,000 settlement arising from M's discharge due to unlawful discrimination, and pay $345,000 in legal fees in connection with that settlement, after Banks, II, the following Federal tax liabilities would result:

Regular    $81,057
AMT         94,363

Total     $175,420

The portion of the tax attributable to the settlement is $151,324. The after-tax proceeds of the $500,000 settlement, after payment of legal fees, would be only $3,676.

Treating the legal fees as a deduction from gross income under Sec. 62(a) (20), the regular tax liability would be only $73,968, of which $49,872 relates to the portion of the net settlement included in taxable income; no AMT results from this alternative. Under this method, the taxpayer receives $105,128 after taxes, compared to $3,676 absent Sec. 62(a)(20).

FROM ANDREW D. KLEMENS, MSA, CPA, WOLF & COMPANY LLP, OAK BROOK, IL