New way to write off legal fees on your taxes

In recent years, it has become been tougher to deduct legal fees. Some plaintiffs in contingent-fee cases are taxed on their gross recoveries, not net recoveries after deducting legal fees. Being creative is needed in this new age since sometimes the rules seem to say you shouldn't be deducting legal fees at all. Fortunately, the mechanics of deducting legal fees in employment, whistleblower and civil rights cases have been improved, at long last.

The tax code was amended in 2004 to allow legal fee deductions "above the line," almost like not having the income in the first place. But the deduction has been quirky to claim, and many taxpayers and accountants have trouble navigating the rules. Not only was there no proper line for it on the IRS forms, but you had to include a particular code next to your write-in, e.g., entering "UDC" for an unlawful discrimination claim.

Starting with 2021 tax returns, the IRS is made it easier with a new Form 1040 containing a line item for attorney fees. New Schedule 1 to Form 1040 gives you two lines. Line 24 of Part II, Adjustments to Income, allows for:

(h) Attorney fees and court costs for actions involving certain unlawful discrimination claims $XXXX

(i) Attorney fees and court costs you paid in connection with an award from the IRS for information you provided that helped the IRS detect tax law violations $XXXX.

Why worry about deducting legal fees in the first place? Most plaintiffs would rather have the lawyer paid separately and avoid the need for the deduction. Unfortunately, it is not that simple. If the lawyer is entitled to 40%, the plaintiff generally will receive only the net recovery after the fees. Most plaintiffs assume that the biggest tax they could face would be the tax on their net recoveries.

But under Commissioner v. Banks, 543 U.S. 426 (2005), plaintiffs in contingent-fee cases must generally include 100% in income, even if the lawyer is paid directly and even if the plaintiff receives only a net settlement. This harsh tax rule usually means plaintiffs must figure out a way to deduct their lawyer's 40% fee. Fortunately, in 2004, shortly before Banks was decided, Congress enacted an above-the-line deduction for employment claims, civil rights claims, and certain whistleblower claims. That should mean those plaintiffs are taxed on their net recoveries, not their gross.

Even so, many taxpayers and return preparers have had trouble claiming the deduction. There are technical limits, too, since a plaintiff's deduction for fees in qualifying cases cannot exceed the income the plaintiff received from the litigation in the same tax year. That works fine if all the legal fees are paid in the same tax year as the recovery (a typical contingent-fee case). But if the plaintiff has been paying legal fees hourly over several years, there's no easy way.

Even for contingent fees, again, the deduction only covers employment, civil rights, and certain types of whistleblower claims. For employment claims, the tax code says the deduction applies to attorney fees in claims of "unlawful discrimination." The definition of what is a claim of unlawful discrimination refers to claims under a long list of laws, including the Civil Rights Act of 1964, ERISA, ADA, ADEA, Title VII, Title IX, NLRA, FLSA, WARN, FMLA, Sections 1983 and 1981, and any whistleblower protection or civil rights law.

Yet after quite a long list of laws, the tax code adds this catchall that swallows up much more: "Any provision of federal, state or local law, or common law claims permitted under federal, state or local law, that provides for the enforcement of civil rights, or regulates any aspect of the employment relationship, including claims for wages, compensation, or benefits, or prohibiting the discharge of an employee, 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." IRC Section 62(e)(18).

Talk about broad. Some people argue that an employment contract between a company and an executive doesn't involve alleged discrimination, so might not be covered. But an employment contract dispute is an employment matter! Many people have been claiming these deductions since 2004 without incident.

The deduction also covers whistleblowers who were fired or retaliated against at work. Whistleblowers who expended legal fees in qui tam award are also covered, even if there was no retaliation. Originally, the law for non-employment whistleblowers covered only federal False Claims Act cases. But it now covers state cases, IRS cases, SEC and CFTC case, too.

The catchall language in IRC Section 62(e)(18) also covers legal fees to enforce civil rights. You might think of civil rights cases as only those brought under Section 1983. But the deduction extends to any claim for the enforcement of civil rights under federal, state, local or common law. The tax code does not define "civil rights," nor does the legislative history or committee reports. But some authorities suggest they are "a privilege accorded to an individual, as well as a right due from one individual to another, the trespassing upon which is a civil injury for which redress may be sought in a civil action. ... Thus, a civil right is a legally enforceable claim of one person against another." 15 Am. Jur. 2d Civil Rights Section 1.

In the context of charitable organizations, the IRS itself once said, "We believe that the scope of the term 'human and civil rights secured by law' should be construed quite broadly." IRS Gen. Couns. Mem. 38468 (Aug. 12, 1980). Could invasion of privacy cases, defamation, debt collection and other such cases be called civil rights cases? What about credit reporting cases? Don't those laws arguably implicate civil rights as well?

Might wrongful death, wrongful birth, or wrongful life cases also be viewed in this way? Of course, if all damages in any of these cases are compensatory damages for personal physical injuries, then the Section 104 exclusion should protect them, making attorney fee deductions irrelevant. However, if plaintiffs receive punitive damages, they may need an avenue to deduct their legal fees. Reconsidering civil rights broadly may be one way to consider fees in the new environment. (For further discussion, see Robert W. Wood, "Civil Rights Fee Deduction Cuts Tax on Settlements," Vol. 166, No. 9, Tax Notes Federal (March 2, 2020), p. 1481).

The IRS deserves credit for fixing a deduction that's been tough to claim since 2004. Personally, I'm still not used to the Schedule 1 idea for Form 1040, part of the failed effort to make tax returns like postcards. But those issues aside, the IRS change for 2021 returns with a place for attorney fees is a big win. Don't overlook it. 