Tax relief for employment plaintiffs: it used to be that winning a job discrimination case was actually a losing proposition for many plaintiffs after factoring in the income tax costs. Recent changes in the law may help some clients.

One would think that paying income taxes on a recovery would be better than receiving no recovery at all. But for some plaintiffs, these taxes--the calculation of which often prohibits taking into account a deduction for attorney fees--can entirely consume and even exceed the amount that they received. (1)

Recent developments have significantly changed the taxation of some types of recoveries and the fees plaintiffs pay to their attorneys. Still true, however, is this basic principle: All income is taxable, unless specifically excluded. (2) If you win the lottery, plan to give a big chunk back because it's taxable income. Find buffed treasure in your backyard, it's taxable income. Sue your boss for sexual harassment and obtain a judgment or settlement, that too is taxable income.

But there are exceptions to this general rule, and plaintiff attorneys would be wise to secure professional tax advice to help ensure the best possible tax outcomes for their clients.

Under this basic rule, plaintiffs' settlement proceeds and damages awards are generally taxable, and attorney fees related to securing the recovery are generally deductible as expenses for the production of income. (3) Taxable income (or "gross income" as it is called under the Internal Revenue Code) does not include the amount of any damages, other than punitive damages, received (whether by suit or agreement and whether as lump sums or as periodic payments) on "account of personal physical injury or physical sickness." (4) Attorney fees paid from these recoveries are not deductible--under the theory that all the income was tax free to begin with. (5)

The requirement of a physical injury or physical sickness is key. Before passage of the Small Business Job Protection Act of 1996, the income exclusion applied to recoveries for "personal" injuries, which included nonphysical injuries like purely mental pain and suffering. (6) Now, the exclusion applies only to recoveries for claims made on account of a "physical" injury or sickness. (7) Consequently, damages awarded for an emotional distress claim are tax free only if the claim was made on account of a physical injury or sickness. (8)

This is true even if the recipient of the recovery is not the physically injured party. For example, loss-of-consortium damages based on a spouse's physical injury are tax free. (9)

Another interesting policy twist is the treatment of recoveries for lost wages. Ordinarily, a settlement or award for lost wages is considered taxable income. Remember the general rule: All recoveries are taxable unless specifically excluded. However, even though the wages would have been taxable when earned, if the compensation for lost wages was on account of a physical injury or physical sickness, the recovery is excluded from taxable income. (10)

What to deduct?

Until recently, the circuits were split over whether a fee award paid directly to an attorney must be included in a plaintiff's income. Some circuits treated the entire amount of any recovery as income. Other circuits excluded attorney fees. (11)

Under the regular federal income tax scheme, plaintiffs could deduct fees and other litigation-related costs as expenses for the production of income. But because they were miscellaneous itemized deductions, they were subject to a deduction floor: Like all such deductions, the fees and costs could be "written off" only to the extent that all the miscellaneous itemized deductions exceeded 2 percent of the taxpayer's adjusted gross income (AGI).

The amount that could be deducted was also subject to a phase-out for taxpayers whose AGI exceeded a certain amount, adjusted for inflation. (12) In 2004, the threshold was generally $139,500. As a result, most plaintiffs who received awards or settlements that put them over that income level could not deduct any attorney fees.

For some plaintiffs, deductions were further limited by the alternative minimum tax (AMT), a parallel tax system that is meant to ensure that all taxpayers pay at least a minimum amount of tax. When it was enacted in 1969, Congress intended that the AMT apply to fewer than 1,000 taxpayers. However, by 2013, 42 million taxpayers are expected to be subject to it. (13)

All miscellaneous itemized deductions as well as nearly all other itemized deductions are disallowed if the taxpayer is subject to the AMT. (14) As a result, most plaintiffs who lived in circuits that treated all of the proceeds in a lawsuit as income (including any portion paid to an attorney) were subject to the 2-percent-of-AGI floor for deductions, the itemized deduction phase-out, and the AMT. In some cases, this meant a plaintiff had to pay out more in taxes than he or she recovered.

Two recent developments radically changed the taxation of claimants' recoveries and attorney fees in employment discrimination cases. With the American Jobs Creation Act of 2004 (Jobs Act), Congress added a new "above-the-line" (that is, before AGI) deduction for fees, including attorney fees, incurred by plaintiffs who filed "unlawful discrimination" claims. (15) And this year, the U.S. Supreme Court in Commissioner v. Banks unanimously resolved the circuit split on the taxation of contingent attorney fees, holding that successful claimants must include contingent fees in taxable income and then deduct them subject to the limitations on deductions. (16)

Jobs Act. AS a before-AGI deduction, attorney fees and litigation-related costs involving a claim of unlawful discrimination are no longer subject to the 2-percent-of-AGI floor or the phase-out of itemized deductions. The deductions may also be used when computing the AMT.

The Jobs Act defines unlawful discrimination broadly as violations of an array of statutes, including the Civil Rights Act, the Age Discrimination in Employment Act, and the Americans with Disabilities Act. (17) The definition also includes conduct that violates federal whistleblower protection laws and

   any provision of federal, state, or local law,
   or common law claims permitted under federal,
   state, or local law (i) providing for the
   enforcement of civil rights, or (ii) regulating
   any aspect of the employment relationship,
   including claims for wages, compensation,
   or benefits, or prohibiting 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 by law. (18)

But not all discrimination is targeted: It must relate to employment. And, as some practitioners have noted, the act does not apply to claims for punitive damages, emotional distress, or defamation. (19)

Commissioner v. Banks. Since Banks, all taxpayers must declare fees paid directly to their attorneys, including contingent fees, as income. (20) But in light of the Jobs Act, if the plaintiff's recovery is for a claim of unlawful discrimination, he or she can deduct the attorney fees as a before-AGI deduction. The tax result is the same as if the fees had been excluded from income in the first place.

The facts of the two consolidated cases in Banks provide good illustrations of the decision's tax consequences. In one case, John Banks was fired from his job as an educational consultant with the California Department of Education, and he filed suit alleging employment discrimination. After trial, the parties settled, and Banks paid a portion of the award to his attorney under their contingent fee agreement. (21)

In the other case, Sigitas Banaitis alleged that he was fired from his position as a bank's vice president and loan officer after refusing to breach his fiduciary duties to bank customers as urged by the bank. Banaitis won a jury verdict, and part of the award was paid directly to his counsel according to a formula in their contingent fee agreement. (22)

Neither Banks nor Banaitis reported as income the portion of their recoveries that was paid to their attorneys, and the IRS issued them both notices of tax deficiencies. They challenged the notices, and in both cases the tax court ruled for the IRS, finding that the attorney fees should have been reported as income. (23)

Banks and Banaitis appealed to their respective circuit courts, the Sixth and the Ninth. Both courts reversed, holding that the part of the taxpayers' awards that represented contingent attorney fees was not taxable income. (24)

The U.S. Supreme Court reversed again, finding that contingent fee arrangements should be viewed as anticipatory assignments of income by plaintiffs, who retain dominion and control over the income-generating asset (that is, the cause of action). (25)

Under the anticipatory-assignment-of-income doctrine, a taxpayer cannot avoid tax from income on an asset the taxpayer controls simply by assigning the income to another person. The Banks Court noted that income must be taxed to those who earn it, even if the person who earns it does not receive it. (26) For example, a father who wants to give money to his son cannot reduce his taxes by simply assigning a portion of his earned income to the son. While such an assignment might be valid under state law, the father would be required to pay federal income tax on the assigned income, perhaps as well as gift tax on the transfer to the son.

The Supreme Court rejected the argument that the doctrine applied only in a family context. It also declined to consider several arguments--raised by the taxpayers and in amicus briefs--that were not considered by the lower courts:

* that the contingent fee arrangement establishes a partnership between the plaintiff and the attorney, requiring an allocation of income from any recovery among the partners

* that causes of action should be treated as capital assets and attorney fees as capital expenditures to be deducted from the amount realized upon the sale or disposition of a capital asset, such as when a cause of action is settled

* that attorney fees are deductible employee business expenses that are not subject to the limitations on miscellaneous itemized deductions. (27)

These arguments may still have merit in other contexts, but the decision in Banks essentially leaves plaintiffs with a three-part tax scheme for recoveries:

* Damages, other than punitive damages, received by plaintiffs on account of "personal physical injury" or "physical sickness" are excluded from their gross income.

* Damages received in connection with any action involving a claim of unlawful discrimination must generally be included within income because they usually don't arise from a physical injury or sickness; however, the attorney fees and court costs paid by, or on behalf of, the plaintiff are now above-the-line, before-AGI deductions.

* All other damages are generally included within income, including the portion of any recovery paid to the plaintiff attorneys, and the plaintiff must deduct the attorney fees and other costs subject to the 2-percent-of-AGI floor for miscellaneous itemized deductions, the phase-out of itemized deductions, and the AMT.

Planning pointers

Interestingly, the language of the above-the-line deduction added by the American Jobs Creation Act merely allows the taxpayer to deduct attorney fees or litigation-related costs "in connection with" an action "involving a claim of unlawful discrimination." The "in connection with" language appears to be much broader than the "on account of" requirement for the exclusion of attorney fees in cases involving personal physical injuries or physical sickness.

Therefore, under the plain language of the Jobs Act, all attorney fees and costs associated with a lawsuit in which a claim of unlawful discrimination is made, even if it is later dropped, would be a before-AGI deduction. At this point, the courts have offered no guidance on how broadly to interpret the "in connection with" language or whether it is subject to any restrictions. Nevertheless, when an unlawful discrimination claim is viable, it is probably in the client's best interest to assert it.

If a plaintiff's claim is "on account of' personal physical injury or physical sickness, this allegation should be made (keeping in mind that determining whether a claim meets the "on account of" requirement is akin to making a "but for" analysis). If the lawsuit settles, the settlement agreement should be drafted carefully, stating clearly what part of the recovery applies to claims made on account of physical injury or sickness. This allocation should be supported by the pleadings, facts developed in the course of litigation, and the parties' settlement negotiations.

When it is clear that neither the exclusion for personal physical injury or sickness nor the before-AGI deduction for claims of unlawful discrimination will apply, plaintiffs anticipating large recoveries may wish to consider pursuing some of the alternative arguments raised by the taxpayers and amici in Banks. Under the right circumstances, other strategies may have merit as well, such as the formation of a formal partnership to which the plaintiff would contribute the cause of action and the attorney would contribute his or her services.

Another option might be for the plaintiff to consider a structured settlement. There is some authority for the argument that these settlements may be used to defer income for recoveries for nonphysical injuries and sickness. (28) If so, the plaintiff would be able to defer income taxes on the recovery until he or she actually receives the payments. (29)

Plaintiff attorneys also must be mindful of the withholding and information-reporting requirements associated with certain recoveries. To the extent that a recovery is for lost wages or other employee compensation, the payment is subject to income tax withholding and must be reported on Form W-2.

On the other hand, severance payments may or may not be characterized as wages, depending on the language of the employment agreement. Generally, they must be reported on a Form 1099 issued to the person or entity receiving the payment. Other taxable recoveries, including the portion paid to the attorney, are not usually subject to withholding but must be reported on a Form 1099 issued to the plaintiff and sometimes the attorney as well.

Taxation of plaintiff recoveries is complex, and it is always a good idea to consult a tax attorney. Navigating these waters may be too treacherous for many--meaning, as a practical matter, that some potential plaintiffs, without the proper tax planning, could wind up at the bottom of the briny deep, mired in unnecessary taxes.

Notes

(1.) See DAVID CAY JOHNSTON, PERFECTLY LEGAL, THE COVERT CAMPAIGN TO RIG OUR TAX SYSTEM TO BENEFIT THE SUPER RICH--AND CHEAT EVERYBODY ELSE 97-98 (2003).

(2.) I.R.C. [section] 61 (2000).

(3.) I.R.C. [section] 212 (2000).

(4.) I.R.C. [section] 104(a) (2000).

(5.) I.R.C. [section] 265(a)(1) (2000).

(6.) See Robert W. Wood, The Case for Excluding Discrimination, Harassment Recoveries under Section 104, Daily Tax Rep. (BNA), Apr. 25, 2005, at 78.

(7.) I.R.C. [section] 104(a) (2) (2000); see also Wood, supra note 6 (citing H.R. CONE REP. NO. 104-737, at 3001 (1996)); see also Priv. Ltr. Rul. 2001-21-031 (Feb. 16, 2001) (ruling that damages awarded to a spouse as a result of her husband's death from lung cancer caused by inhalation of asbestos was not taxable income). Although Field Service Advice, Private Letter Rulings, Technical Advice Memoranda, and Revenue Procedures may not be used or cited as precedent pursuant to I.R.C. [section] 6110(k)(3), they do indicate the position of the IRS on certain issues and may, in some situations, be helpful. See Treas. Reg. [section] 1.6662-4(d)(3)(iii) (2003).

(8.) Priv. Ltr. Rul. 2000-41-022 (Oct. 17, 2000).

(9.) Wood, supra note 6.

(10.) BORIS I. BITTKER & LAWRENCE LOKKEN, FEDERAL TAXATION OF INCOME, ESTATES AND GIFTS [paragraph] 13.1.4, at 13-10 (3d ed. 2001) (citing O'Gilvie v. United States, 519 U.S. 79 (1996)).

(11.) Compare, e.g., Banks v. Comm'r, 345 F.3d 373 (6th Cir. 2003), rev'd, 125 S. Ct. 826 (2005), and Cotnam v. Comm'r, 263 F.2d 119 (5th Cir. 1959) (excluding contingent fees from income) with Young v. Comm'r, 240 F.3d 369 (4th Cir. 2001) (including within income the entire recovery, including any portion paid to the plaintiff attorney).

(12.) I.R.C. [section] 68 (2000).

(13.) David Cay Johnston, Your Taxes; Talking Simplicity, Building a Maze, N.Y. TIMES, Feb. 15, 2004, [section] 3, at 11 (citing calculations by Leonard E. Burman of the Urban Institute and William G. Gale of the Brookings Institution).

(14.) I.R.C. [section] 56(b)(1)(A)(i) (2000); Raymond v. United States, 355 F.3d 107, 115 (2d Cir. 2004), cert. denied, 125 S. Ct. 1292 (2005).

(15.) American Jobs Creation Act of 2004, [section] 703 (a), Pub. L. No. 108-357, 118 Stat.1418 (codified as amended in scattered sections of 26 U.S.C.).

(16.) 125 S. Ct. 826.

(17.) I.R.C. [section] 62(e) (2000). The definition includes any conduct that is unlawful under scores of statutes, including the National Labor Relations Act (29 U.S.C. [section] 151 (2000)); the Fair Labor Standards Act of 1938 (29 U.S.C. [section] 201); the Age Discrimination in Employment Act of 1967 (29 U.S.C. [section] 623 or [section] 633a); [subsection] 703, 704, or 717 of the Civil Rights Act of 1964 (42 U.S.C. [subsection] 2000e-2, 2000e-3, or 2000e-16); and [subsection] 102, 202,302, or503 of the Americans with Disabilities Act of 1990 (42 U.S.C. [subsection] 12112, 12132, 12182, or 12203).

(18.) I.R.C. [section] 62(e)(18) (2000).

(19.) See, e.g., Mark A. Luscombe, Tax Trends, Taxation of Attorneys' Fees After Banks Decision and the JOBS Act, TAXES, Apr. 1, 2005, at 3.

(20.) 125 S. Ct. 826.

(21.) Id. at 829.

(22.) Id. at 830.

(23.) Id. at 829, 830.

(24.) Banaitis v. Comm'r, 340 F.3d 1074 (9th Cir. 2003), rev'd, 125 S. Ct. 826; Banks, 345 F.3d 373, rev'd, 125 S. Ct. 826.

(25.) Banks, 125 S. Ct. 826, 832-33.

(26.) Id. at 831.

(27.) Id. at 833.

(28.) See, e.g., Treas. Reg. [section] 1.83-3(e) (2003) (excluding unfunded and unsecured promises to pay from the definition of property that can be included in income for services rendered).

(29.) The other possible treatment of structured settlements with respect to nonphysical injuries and sickness is that the plaintiff would be taxed on the present value of the deferred annuity when the agreement is signed--a very bad outcome if the plaintiff does not have other assets with which to pay the tax.

JASON ROY FLAHERTY and PATRICK L. O'DANIEL are tax attorneys with Jenkens & Gilch