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Winning Plaintiffs May Lose Tax Battle over Attorneys Fees Reprinted with permission from the BWB Monthly Newsletter It’s not far wrong to say that the hottest tax issue before the courts – one courts can’t agree on – is the proper tax treatment of attorneys’ contingent fees in personal damage awards. Assuming the damages are taxable, as they usually are, the IRS wants the successful plaintiff to include the total award in income and then deduct the attorney’s fee – usually a third or more of the award. The plaintiff would rather skip the deduction and report the amount he or she gets, net of the attorney’s fee. Under the IRS approach, the income tax deduction is cut down by the 2% floor on itemized deductions (and by the itemized deduction phase-out for high incomes). Much worse, from the taxpayer’s standpoint, is the fact that the fee isn’t deductible at all for alternative minimum tax (AMT) purposes. This means many thousands of dollars in AMT on money the taxpayer never sees. More than half the federal circuit courts have ruled on the issue, with the IRS in the lead. But there is hope…
Attorney fees in damage awards connected with the taxpayer’s business are business deductions, not subject to AMT or reduction as itemized deductions. Banaitis v. Comm., CA 9, 8/27/03
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Where taxpayers win, it’s because the court is willing to
find that the attorney “owns” the contingent fee share
of the damages under state law, so it’s not includible in
the plaintiff’s income. This finding doesn’t hurt the
attorney, who is taxed on the fee collected in any case, whatever
tax rule applies to the client plaintiff. The attorney
may therefore try to write the engagement agreement with the client
so as to
support the client’s future claim that the attorney owned
the fee portion of the award. The latest appellate case on the
subject had such an agreement, leading to a taxpayer victory.
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