Monsanto weed killer verdict highlights unfair tax rules, again

Trials can be seesaws of emotion. In August, jurors awarded $289 million to a man they say got cancer from Monsanto's Roundup weed killer. Plaintiff Dewayne Johnson was awarded $39 million in compensatory damages, and $250 million in punitive damages. Monsanto cried foul.

And shortly thereafter, it looked as if the judge might throw out the verdict entirely. In the end, though, the judge denied Monsanto's new trial motion. However, the judge did take a weed wacker to the jury's award of $250 million in punitive damages. With the stroke of a pen, the judge reduced the $250 million punitive verdict to just under $40 million.

Now, Johnson is slated to collect $78.5 million, about half compensatory and half punitive damages. Johnson still can't count on the money, of course, since nothing is really over until it's over. Monsanto faces hundreds of other claims, and may fight hard. But even if Monsanto were to fork over the money right away, Johnson will have to contend with new tax rules that make how legal settlements are taxed even trickier than in the past.

Under President Donald Trump's tax bill passed in late 2017, there is a new tax on litigation settlements: no deduction for legal fees. Amazingly, many legal fees simply can't be deducted. That means Johnson must pay tax even on monies his attorney collects. That is so even though the attorney must also pay tax on the same money.

If you are a plaintiff with a contingent fee lawyer, the IRS treats you as receiving 100 percent of the money, even if the defendant pays your lawyer directly. If your case is fully nontaxable, say a physical injury case that settles before trial, that causes no tax problems. If the recovery is all tax-free for physical injuries, the legal fees are not income to the plaintiff, so the plaintiff does not need to worry about trying to deduct them.

However, if your recovery is taxable, all or in part, you could be taxed on more money that you actually collect. Up until the end of 2017, you could claim a tax deduction for your legal fees. In 2018 and thereafter, there is often no deduction for these legal fees. But not all lawyers' fees face this terrible tax treatment.

If the lawsuit concerns the plaintiffs' trade or business, the legal fees are a business expense. Similarly, if your case involves claims against your employer, or certain whistleblower claims, those legal fees are also protected. By protected, I mean taxed to the plaintiff as gross income, but then immediately subtracted above the line.

The net result of an above the line deduction -- if you can manage to claim the tricky above the line tax deduction properly on your tax return -- is that you have a wash. If you recover $1 million and your lawyer takes 40 percent, you net $600,000. And you are taxed on $600,000. That seems fair, but that is only if you qualify for the above the line deduction.

Johnson in the Roundup case won't qualify. He can try to work around the rules. And sometimes advice on the taxation of damage awards before the case settles can make a difference. But you need to be creative, to document it, and the IRS may not agree.

Awards of pre- or post-judgment interest can produce the same tax problems as punitive damages, with no deduction for legal fees. Meanwhile, defendants like Monsanto can write off the whole verdict, even the punitive damages. If the reduced $78 million verdict is upheld, how much tax will Johnson pay?

Let's assume that the combined contingent fees and costs Johnson pays might total 50 percent. If so, he gets to keep half of his $39 million compensatory award. His lawyer gets the other half. So Johnson should collect $19.5 million that should be tax free.

What about the punitive damages? He should get half of that too, another $19.5 million. But here's where taxes get strange. The plaintiff would be taxed on the whole $39 million of punitive damages. And even though he only actually gets to keep $19.5 million of the punitive damages (his lawyer gets the other half), Johnson will pay tax on the entire $39 million, with no deduction for legal fees.

If you add it up, he gets cash of $39 million, and he pays tax on $39 million, even though part of the award is supposed to be tax-free for his physical injuries/sickness. Between state and federal, he loses about half. So he probably nets less than $20 million. That seems small from a $78 million verdict, let alone from one that just two months ago was $289 million.

Take home pay of something in the neighborhood of $19 million is nothing to sneeze at. However, the taxes are made much worse as a result of the 2017 tax law that killed off tax deductions for many legal fees. For many types of cases involving significant recoveries and attorney fees, the lack of tax deductions for legal fees may be catastrophic.

For plaintiffs who are stuck with the gross income, we should expect some to go to new lengths to try to deduct or offset the fees. Some of these efforts may be sophisticated and well thought out. Others may be clumsy, if not downright desperate. But few plaintiffs receiving a $100,000 recovery will think it is fair to pay taxes on the full amount if legal fees have consumed a third or more of their recovery.

Multiply the figures into bigger numbers, and the situation will be worse. Add a higher contingent fee percentage and high case costs, and the situation could be worse still. All in all, settlement time for legal disputes may become even more stressful. And for some, tax return time may bring unpleasant surprises.