"Double
Tax" on Contingency Fees Eliminated
On
October 22, 2004, President Bush signed the American Jobs Creation Act of
2004, which contains a section ending the "double taxation" of
attorneys' fees in employment discrimination cases. Previously, the
attorneys' fees portion of an employment discrimination award or settlement
has been taxable to the plaintiff and to the attorney.
The
Internal Revenue Service has favored double taxation, as have most courts.
The issue is also the subject of two cases before the Supreme Court on
their 2004-2005 docket.
Prior Law Allowed Double Tax
Section
703 of the new law signed by President Bush is called the Civil Rights Tax
Relief Act ("CRTRA"). Under the CRTRA, the attorneys' fees
portion of a settlement or judgment will be taxable only to the attorney
making settlements more attractive to plaintiffs.
Prior
to this law, the IRS and most courts had found the attorneys' fees taxable
both to the plaintiffs and their attorneys. The IRS took the position that
a plaintiff's attorneys' fees paid as part of a judgment or settlement
constituted income to the plaintiff. Thus, if a plaintiff won a $100,000
award, he/she would be required to pay taxes on the entire amount, even
though $30,000 of it went to the plaintiff's attorney under a contingency
fee arrangement and even thought the attorney would also pay taxes on that
amount. The government concluded that the entire award went to the
plaintiff and should be taxed to the plaintiff, no matter where a portion
of the award ended up.
A
1995 United States Supreme Court decision, Commissioner of Internal
Revenue v. Schleier, 515 U.S. 323 (1995),
held that a plaintiff's recovery in a discrimination case did not
constitute "damages for personal injuries" within the meaning of
26 U.S.C. section 104(a)(2) and thus were not exempt from income tax under
that provision.
New Law Provides Relief from Double Tax
The
CRTRA allows the taxpayer to reduce his/her adjusted gross income by the
amount of the attorneys' fees. The new deduction is allowed regardless of
whether the plaintiff's attorneys' fees are paid by the employer under a
statutory fee shifting provision, or by the plaintiff, or as part of a
settlement. The bill is prospective and applies to judgments and
settlements after the date of enactment.
The
bill will impact discrimination and retaliation claims brought under the
following laws, among others:
- Title VII;
- The Age
Discrimination in Employment Act;
- 42 U.S.C. section
1981;
- The National Labor
Relations Act;
- The Fair Labor
Standards Act;
- The Americans With
Disabilities Act;
- The Family and
Medical Leave Act;
- The Employee
Retirement Income Security Act;
- Federal
whistleblower protections.
New Law Received Wide Support
Pro-employer
groups and civil rights groups alike supported the Civil Rights Tax Relief Act.
The U.S. Chamber of Commerce, Society for Human Resources Management both
supported the bill, as did the AARP, the National Employment Lawyers,
Association, and the National
Whistleblower Center. Business groups did not like
the double taxation policy because it would increase the cost of settling
suits to compensate for the extra tax payment. A bill to fix the problem
has sat in Congress for five years before this year's ultimate success.
Supreme Court Cases Still Raise Issue
On November 1, 2004, the Supreme Court will hear oral argument
in two consolidated cases regarding the issue of whether the attorneys'
fees portion of a settlement or judgment is taxable as income to both the
plaintiff and the plaintiff's attorney.
The
pair of cases now before the Supreme Court involved employment disputes
where the plaintiffs challenged tax bills that were based on the full
amount of the award, including the attorneys' fees portion: Commissioner
of Internal Revenue v. Banks and Commissioner of Internal Revenue v.
Banaitis, Case Nos. 03-892 and 03-907.
The
plaintiffs in both cases were successful in the appellate court.
Banaitis is a decision from the Ninth Circuit
Court of Appeals interpreting Oregon
law and finding that the attorneys' fees portion of the award would not be
taxable to the plaintiff because the attorney had an ownership interest in
it. Banaitis had been taxed on an $8.7
million settlement he obtained in an employment dispute, even though $3.8
million went to his attorneys for fees. Banks is a Sixth Circuit
decision reaching the same conclusion on different grounds. The federal
circuit courts have been divided on the issue.
Even
with the signing of the CRTRA, the Supreme Court cases are important for
those settlements or awards that took place before October 22, 2004.
Moreover, the new law only affects contingency fees in litigation under
those laws specified in the statute.
While
waiting for the Supreme Court decisions, it is at least clear that for
future settlements, employers are able to use the non-taxation of
attorneys' fees to the plaintiff to their advantage in coming to a proper
settlement amount.
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