Not all employment plaintiffs can deduct fees

Can a plaintiff ever be taxed on more money than they receive? To anyone but a tax lawyer, it sounds like a crazy question. Surely the most you can be taxed on is your net recovery after expenses and legal fees, right? Well, starting in 2018, many legal fees became nondeductible, so some plaintiffs pay tax on their gross recoveries if they are not very creative.

Fortunately, employment cases still qualify for a gold-plated, above-the-line tax deduction. As a result, everyone seems to assume -- plaintiffs, lawyers and even defendants -- that there is never a tax problem for employment plaintiffs. If the case settles for $1M with a 40% fee, the most the plaintiff could be taxed on is $600,000, right? Well, does it matter when the legal fees are paid?

You bet. If the case is a contingent fee case, it all shakes out fine. But what if the client paid out the $400,000 in legal fees on an hourly basis during the two years before the settlement? That is rare, but it happens. Can you claim the same above-the-line deduction for your legal fees as the plaintiff who uses a contingent fee lawyer?

Nope. The client has $1M of gross income -- including the legal fees -- and cannot deduct the $400k paid in prior years, even though they were not deducted in the past. Somehow capitalizing the fees seems logical, but the wording in the tax code doesn't seem to allow it.

Suppose that you paid $50,000 in legal fees in 2018, $50,000 of fees in 2019, and another $50,000 of fees in 2020, when many legal fee deductions were suspended under Section 67(g) of the Internal Revenue Code. You settle your case for $600,000 in 2020. You can clearly deduct the $50,000 of fees you paid in 2020, since they occur in the same tax year as your recovery, and they are obviously less than the $600,000 of gross income you are recognizing.

But how about the $100,000 you paid in the past? There is no easy path. Since you could not deduct either of those $50,000 amounts when you paid them, can't you claim them in 2020? Understandably, many people may want to argue that you sort of "capitalized" them, holding them like you would if they were fees relating to a capital transaction. However, the language of Section 62(a)(20) suggests that you actually must pay the fees in the year you settle to be able to deduct them.

Refund, Then Repay?

What if your lawyer repays you the fees you paid in the past, and then you pay your lawyer again? This may sound flaky, but some plaintiff's lawyers do it as a way to at least give their client an argument. The flow of funds might work something like this. Lawyer and client amend their fee agreement to call for a kind of hybrid fee arrangement. The amendment is signed now, but probably says it is clarifying their original fee agreement, effective as of the date of the original agreement.

As amended, it calls for hourly fees converting to contingent fees, which just happens to work out mathematically the way the hourly fees did. As part of the amendment, the lawyer agrees to rebate the $100,000 paid in the past, and to charge all fees at settlement time, the total of $150,000. Based on the amendment, the lawyer hands back a check for $100,000 to the client. Then, when the case settles, the attorney retains all $150,000 from the settlement payment, like a vanilla contingent fee.

On the surface, the client has "paid" the full amount in 2020, right? So, shouldn't that offset the $600,000 settlement, leaving the net taxable amount at $450,000? There is certainly an argument, and given the not very good choices in this dilemma, perhaps it is the best the client can do. Properly documented, and not missing any of the steps or formality, the client might even have a decent case.

The client in some sense did pay the fees in 2020, so might feel good claiming the above the line deduction. Even in an audit, the client might be able to show the settlement document and even show the 2020 legal fee payment. If you think too hard about both sides of the transaction, though, you might be more skeptical. After all, it is a circular transaction that is fairly transparent in its motive and intended effect.

The lawyer surely took the fees into income when they were actually paid in past years. Thus, on the lawyer's side of the ledger, the lawyer is probably not going to be amending his tax return and reversing that out. For the lawyer, it is just a kind of check-swapping in the year of the settlement, to accommodate the plaintiff and a seemingly unfair tax result.

That does not necessarily mean the plan is doomed to fail, but it isn't exactly a strong tax position either. You aren't supposed to play audit lottery, but everyone thinks about the odds. Despite seeing very large numbers of employment case legal fee deductions claimed every year since 2004, I have personally seen almost no audits, or even IRS queries on the legal fee issue. Of course, that could change now that so many legal fees cannot be deducted.

So how does our circular repayment-payment of legal fees stand up to this test, assuming it is documented as well as one can? There is no direct authority on the legal fee issue of which I am aware. But the IRS could certainly trot out a number of cases and tax doctrines relating to circular transactions that the IRS might label as a sham. We will see whether this is ever tested.

In the meantime, it would certainly be nice to have an easy way to deduct legal fees in all cases. The pending Bill S.3913, the "End Double Taxation of Successful Consumer Claims Act," would expand the above the line deduction for legal fees to any civil case. But even it would not address the timing question. 