Proper characterization of deductible legal fees.

The proper characterization of deductible legal fees can have a significant effect on the related tax benefit, if any. For example, legal fees incurred for the recovery of royalty income may be fully deductible regardless of the treatment of miscellaneous deductions under the alternative minimum tax (AMT).

IRS Position

The IRS issued a Market Segment Specialization Program (MSSP) internal training module on Lawsuits Awards and Settlements in November 2000. The MSSP guide explicitly directs Service agents to verify that the taxpayer reported taxable amounts at gross, rather than reporting them net of legal fees paid. Further:

* Allowable legal fees should be deducted on Schedule A as miscellaneous itemized deductions, unless the origin of the claim litigated is related to a Schedule C (independent contractor) or a capital transaction.

* The legal fees deducted on Schedule A are a tax preference item for A/MT purposes.

* For purposes of the AMT credit, the legal fees that created AMT do not generate the credit. They are an "exclusion" item.

The MSSP guide contains a section captioned "Amount To Be Included in Income" It states:

In cases involving contingent fee arrangements, the gross award/settlement, without diminution for attorneys' fees or costs, should be included in the taxpayer's income. This treatment is in accord with IRC section 61 and the long established principle, `the fruit of the tree' theory, that income is taxable to the person who earns it and cannot be assigned to someone else.

The guide states that taxing the gross amount from lawsuit proceeds has been upheld in Tax Court, as well as in various circuits. Citing Kenseth, 114 TC 399 (2000), the guide states that the Tax Court held that anticipatory assignment principles require a taxpayer to include in gross income the entire amount of judgment/settlement proceeds undiminished by any contingent fee, regardless of the state in which a fee arrangement is signed. The Tax Court expressly rejected the principles enunciated in cases holding to the contrary. The IRS cautions that examiners handling cases involving payments of attorneys' fees in lawsuits in Alabama, Michigan and Texas should be aware that there is contrary authority based on an interpretation of applicable state law.

Until the issue is resolved, the IRS position is that taxpayers should not be allowed to net the proceeds of the direct payment of attorneys' fees in all cases arising under any law other than Alabama, Michigan and Texas. Further, except in rare cases, such as a compensatory recovery of self-employment (SE) income (e.g., commissions reported on Schedule C) or capital gain income, legal fees will be a Schedule A miscellaneous itemized deduction, subject to the two-percent floor and AMT.

Under a section captioned "Penalties," the IRS observes that lawsuit settlement cases usually result in significant adjustments to income. As in other cases in which there are large amounts of unreported income, the accuracy-related and fraud penalties must be considered. Among factors to consider in determining whether penalties are warranted include what advice, if any, the taxpayer's attorney provided on the taxability of the settlement amount. If interest income was received and not reported, more consideration should be given to assessing the accuracy-related penalty on the interest income.

AMT Treatment

Attorneys' fees are not deductible for purposes of the AMT, if reported as miscellaneous itemized deductions. However, if they are deductible against royalty income, the AMT is not an issue; AMT calculations provide no specific adjustment for business or investment expenses deducted or netted against royalty income.

Return Reporting

There are other alternatives to be considered (and dismissed) in favor of Schedule E royalty reporting. (References to specific lines and schedules of Form 1040 are based on the 2000 version.)

Line 21, Other Income. The instructions state that line 21 should be used to report any other income not reported on the return or other schedules. Schedule E is the proper schedule to report royalty income.

Schedule C, Profit or Loss From Business (Sole Proprietorship). The instructions state that Schedule C is used to report income or loss from a business operated or a profession practiced as a sole proprietor. The instructions for Schedule C note that Schedule E is used to report royalty income not subject to SE tax.

Independent contractors recovering awards related to their businesses can deduct attorneys' fees directly from gross income (Sec. 62(a)(1)).

Schedule A, Itemized Deductions. The instructions cite examples of expenses to include on line 22, including certain legal and accounting fees.

A two-percent floor on miscellaneous itemized deductions applies (Sec. 67). Generally, miscellaneous itemized deductions are disallowed to the extent of two percent of adjusted gross income (AGI). The tax regulations provide examples of otherwise deductible expenses subject to the two-percent floor, including expenses for the production or collection of income, such as certain attorneys' fees (Temp. Regs. Sec. 1.67-1T(a)(ii)).

For individuals, royalty income is reported on Schedule E of Form 1040 for Federal income tax purposes. If the royalties were reported gross before payment of attorneys' fees, the gross amount would be reported on line 4 and an offsetting subtraction would be reported on Schedule E, line 10, or as part of depreciation expense on line 20 (if the legal fees are capitalized into the basis of the underlying intangible property rights). The tax law and regulations support this filing position on Schedule E. AGI means gross income minus deductions, including deductions attributable to property held for the production of royalties (Sec. 62(a)(4) and Temp. Regs. Sec. 1.62-IT(c)(5)).

A deduction is allowed for expenses incurred for the production or collection of income, for the management, conservation or maintenance of property held for the production of income, or in connection with the determination, collection or refund of any tax (Sec. 212). Under Regs. Sec. 1.212-1(k), attorneys' fees paid to collect accrued rents are deductible.

Case Law

Case law primarily addresses the payment of attorneys' fees in the context of personal injury settlements or compensation for services, Royalty income has been distinguished from either of these two categories of gross income. The courts are split on the treatment of contingent attorneys' fees. The Tax Court and the First, Third, Fourth, Ninth and Federal Circuits have agreed with the IRS that an assignment of income is not effective to transfer proceeds net of attorneys' fees. The Fifth, Sixth and Eleventh Circuits have each determined that a contingent fee arrangement effectively transfers a portion of the claimant's rights to the attorney.

The courts have split on whether the gross amount of a nonphysical injury award is taxable to an individual taxpayer. The assignment-of-income doctrine is the prevailing rationale for the courts that follow taxability of the gross award. This is regardless of whether the award is subject to contingent attorneys' fees, and regardless of attorneys' fees paid directly to the attorney by the defendant or the taxpayer. A contrary view is the fact that specific state law may give attorneys equity in a cause of action or division of income sufficient to negate the assignment-of-income doctrine. This scenario has been found to exist in Alabama, Michigan and Texas.

Substantial Authority Protection from Penalties

If there is substantial authority for a tax position, the item is treated is if it were shown properly on the return, and any tax ultimately assessed is not treated as an understatement for penalty purposes (Regs. Sec. 1.6662-4(d)(1)). The "substantial authority" standard is an objective standard involving an analysis of the law and application of the law to relevant facts. It is less stringent than the "more likely than not" standard, but more stringent than the reasonable-basis standard (Regs. Sec. 1.6662-4(d)(2)). Reasonable basis is a relatively high standard of tax reporting, significantly higher than "not frivolous" or "not patently improper" (Regs. Sec. 1.6662-3(b)(3)).

Based on the tax law and regulations with respect to royalty income, there is substantial authority for the position that legal fees will be a deductible or amortizable expense against royalty income rather than a miscellaneous itemized deduction.

No 20% accuracy-related penalty is imposed if a taxpayer can show that there was reasonable cause for the position and that the taxpayer acted in good faith with respect to the position (Regs. Sec. 1.6664-4(a)). The determination of whether a taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all pertinent facts and circumstances. Generally, the most important factor is the extent of the taxpayer's effort to assess the proper tax liability. Reliance on an information return or on the advice of a professional tax adviser does not necessarily demonstrate reasonable cause and good faith. It does, however, constitute reasonable cause and good faith if, under all the circumstances, such reliance was reasonable and the taxpayer acted in good faith (Regs. Sec. 1.6664-4(b)(1)(c)).

Conclusion

As noted in the MSSP internal training module, an analysis of the origin of the claim giving rise to deductible legal fees is critical to properly characterizing them.

FROM MARK A. SELLNER, CPA, J.D., LL.M., LARSON, ALLEN, WEISHAIR & CO., LLP, ST. PAUL, MN