This is the eighth in a series of articles on issues surrounding the Taxation of Settlements and Verdicts. The chart below summarizes the taxable nature of a variety of settlements and verdicts.

Damage Award	Taxable?	Exceptions	Relevant Case Law / Statute
Physical Injury / Illness	No	Taxable if not recovered for a tort or tort type right	IRC Section 104(a)(2)
Back Pay	Yes	Not Taxable if qualified under Section 104	Rev. Rul. 96-65
Front Pay	Yes	Not Taxable if qualified under Section 104	Rev. Rul. 96-65
Emotional Distress	Yes	Not Taxable if qualified under Section 104	IRC Section 104(a)(2)
Medical Reimbursement	No	Taxable if already deducted	IRC Section 213
Medical Insurance Reimbursement	No	Taxable if already deducted	IRC Section 213
Pre Judgment Interest	Yes		IRS Section 61(a)(4) Rozpad v. Commissioner 154 F.3d 1 (1st Cir. 1998)
Post Judgment Interest	Yes		IRS Section 61(a)(4) Rozpad v. Commissioner 154 F.3d 1 (1st Cir. 1998)
Wrongful Refusal to Hire	Yes		IRC Section 61
Balance of Contract	Yes		IRC Section 61
Liquidated Damages	Yes		IRC Section 61
Reimbursement for Deductible for Losses	Yes	Not taxable if not previously deducted	IRC Section 61
Punitive	Yes		Ogilivie v. United States, 519 U.S. 79 (1996); IRC Section 104(a)(2)
Discrimination	Yes		Commissioner v. Schleier, 515 U.S. 323 (1995); Rev. Rul. 96-95
Defamation	Yes		IRC Section 104(a)(2)

This is the seventh in a series of articles on issues surrounding the Taxation of Settlements and Verdicts. This article addresses the question of whether the fact that attorney fees are provided for by a statute has any affect on including these fees in plaintiff’s gross income.

United States Supreme Court. The Supreme Court in Commissioner v. Banks, 125 S.Ct. 826 (2005) did not address the contention that application of the anticipatory assignment principle would be inconsistent with the purpose of statutory fee-shifting provisions, such as those applicable in Banks which was brought under 42 U.S.C. Sections 1981, 1983 and 2000(e) et. seq. In Banks, there was no court-ordered fee award or any indication in Banks’ contract with his attorney or the settlement that the contingent fee paid was in lieu of statutory fees that might otherwise have been recovered. The Court noted that the American Jobs Creation Act of 2004 redresses the concern for many, perhaps most, claims governed be fee-shifting statutes.

United States Tax Court. The United State Tax Court has addressed this issue at least twice since the Supreme Court’s decision in Banks.

Vincent v. Commissioner, T.C. Memo, 2005-95. In Vincent, the Petitioner’s contingent fee agreement with her attorney stated that the attorney would be entitled to a defined percentage of any recovery, unless, as occurred in Vincent, the attorney received his fees and costs pursuant to a fee shifting statute. The Tax Court followed the Court of Appeals for the Ninth Circuit which held that a defendant’s payment of a plaintiff/taxpayer’s attorney’s fees and costs pursuant to a fee shifting statute constitutes income to the taxpayer. Sinyard v. Commissioner, 268 F.3d 756 (9th Cir. 2001), affg. T.C. Memo. 1998-364. In Sinyard, the taxpayers and their attorney signed a contingent fee agreement similar to the one in Vincent. The settlement agreement apportioned some of the settlement so as to pay in full the attorney’s fees and costs pursuant to the fee shifting provisions of 29 U.S.C. secs. 216(b) and 626(b). The Court held that the apportioned funds were attributable to the taxpayers, who, in the Court’s words, “bound themselves to pay * * * [their attorneys] one-third of what they received. When * * * [the defendant] satisfied this obligation, the Sinyards were so much the richer. That they never laid hands on the money paid to the lawyers does not obliterate their constructive receipt.” Id. at 759.Green v. Commissioner, T.C. Memo. 2007-39. The United States Tax Court again addressed this question in Green V. Commissioner. It stated: A litigant generally may not exclude the portion of a recovery paid to his or her attorney where, as here, the litigant’s recovery constitutes income. Commissioner v. Banks, 543 U.S. 426, 436-437 (2005). This is true whether the attorney’s fee was paid on a contingent fee basis or under a fee-shifting statute. Sinyard v. Commissioner, 268 F.3d 756 (9th Cir. 2001), affg. T.C. Memo. 1998-364; Vincent v. Commissioner, T.C. Memo. 2005-95.

This is the sixth in a series of articles on issues surrounding the Taxation of Settlements and Verdicts. This article explains when and how the cost of attorneys fees may be deducted “below the line.”

For cases not covered by IRC Section 62(a)(20) the United States Supreme Court determined, in Commissioner v. Banks, 125 S.Ct. 826 (2005), that when a litigant’s recovery constitutes income, the litigant’s income includes the portion of the recovery paid to the attorney as a contingent fee. Therefore, the deduction for attorneys fees must be made “below the line” as an itemized deduction, subject to the 2% AGI limitation and the AMT rules.

Character of Award as Taxable or Non-Taxable Affects Deductibility. When only a portion of the award is taxable, then only a portion of the attorneys fees are deductible. Legal fees and court costs that are related to the taxable portion of the award are allowed as a miscellaneous itemized deduction subject to the 2-percent AGI limitation on Schedule A. The deductible fees and costs are determined by using the ratio of the taxable award to total award and multiplying the total fees and costs by this ratio. For example, assuming an award of $100,000, of which 80% was taxable, only 80% ($41,600) of the attorneys fees and costs of $52,000 would be deductible and even that would be subject to the 2% AGI limit.

Losing the Deduction Through the AMT. If the taxpayer’s income is too high, she may be exposed to the Alternative Minimum Tax (“AMT”) and thereby receive no deduction for the attorneys’ fees.

How the AMT Works. The AMT operates by adding back to a taxpayer’s income certain, but not all, deductions that, at a lower income level, would otherwise be available. The taxpayer is then taxed on this larger amount of income. The AMT operates on both the federal and state levels. Below the line legal fees are one of the deductions that is added back to calculate tax.

Example. The following is not a precise representation of the AMT calculations, but it shows the general impact of the AMT on awards. The calculation assumes the taxpayer had other income equal to or above the AMT exemption amount, not related to the damage award, and paid Minnesota Alternative Minimum Tax.

	Above the Line		Below the Line
Award Received	$210,000.00		$210,000.00
Less Attorney Fees	($70,000.00)		$0.00
Taxable Award	$140,000.00		$210,000.00
Less Federal Tax	($36,400.00)		($55,300.00)
Less State Tax	($11,134.38)		($17,062.50)
After Tax Recovery	$92,465.62		$137,637.50
Less Attorney Fees	$0.00		($70,000.00)
Amount to Plaintiff	$92,465.62		$67,637.50

Impact. After federal taxes, state taxes and effectively nondeductible attorneys fees, the client is left with less than 33% of the damage award. If the attorney charges 40% plus costs, the plaintiff’s share could easily be less than 25% of the total award. See Alexander v. Commissioner 72 F.3d 938 (1^st Cir. 1995) where the tax liability was greater than the taxpayer’s recovery.

This is the fifth in a series of articles on issues surrounding the Taxation of Settlements and Verdicts. This article presents situations when the the expense of attorneys fees may be deducted “above the line.”

Deducting Attorney Fees “Above the Line.” The American Jobs Creation Act of 2004, Section 703, amended Internal Revenue Code, Section 62(a)(20), to allow a taxpayer to take an above-the-line deduction for attorney fees and costs incurred by an individual in connection with a claim of unlawful discrimination, a claim of a violation of subchapter III of chapter 37 of Title 31, United States Code (certain claims against the government), or a claim made under section 1862(b)(3)(A) of the Social Security Act. However, the taxpayer cannot deduct more than the amount he or she received from the claim that was included in gross income for the tax year. This treatment as an above-the-line deduction is available for fees and costs paid after October 22, 2004, with respect to any judgment or settlement occurring after that date. For more information, see IRS Publication 525, Taxable and Nontaxable Income.

Unlawful Discrimination Defined. For purposes of subsection IRC Section 62 (a)(20), the term “unlawful discrimination” means an act that is unlawful under any of the following:Section 302 of the Civil Rights Act of 1991 (2 U.S.C. 1202).

Section 201, 202, 203, 204, 205, 206, or 207 of the Congressional Accountability Act of 1995 (2 U.S.C. 1311, 1312, 1313, 1314, 1315, 1316, or 1317).

The National Labor Relations Act (29 U.S.C. 201 et seq.).

The Fair Labor Standards Act of 1938 (29 U.S.C. 201 et seq.).

Section 4 or 15 of the Age Discrimination in Employment Act of 1967 (29 U.S.C. 623 or 633a).

Section 501 or 504 of the Rehabilitation Act of 1973 (29 U.S.C. 791 or 794).

Section 510 of the Employee Retirement Income Security Act of 1974 (29 U.S.C. 1140).

Title IX of the Education Amendments of 1972 (29 U.S.C. 1681 et seq.).

The Employee Polygraph Protection Act of 1988 (29 U.S.C. 2001 et seq.).

The Worker Adjustment and Retraining Notification Act (29 U.S.C. 2102 et seq.).

Section 105 of the Family and Medical Leave Act of 1993 (29 U.S.C. 2615).

Chapter 43 of title 38, United States Code (relating to employment and re-employment rights of members of the uniformed services).

Section 1977, 1979, or 1980 of the Revised Statutes (42 U.S.C. 1981, 1983, or 1985).

Section 703, 704, or 717 of the Civil Rights Act of 1964 (42 U.S.C. 2000e-2, 2000e-3, or 2000e-16).

Section 804, 805, 806, 808, or 818 of the Fair Housing Act (42 U.S.C. 3604, 3605, 3606, 3608, or 3617).

Section 102, 202, 302, or 503 of the Americans with Disabilities Act of 1990 (42 U.S.C. 12112, 12132, 12182, or 12203).

Any provision of Federal law (popularly known as whistle blower protection provisions) prohibiting the discharge of an employee, the discrimination against an employee, or any other form of retaliation or reprisal against an employee for asserting rights or taking other actions permitted under Federal law.

Any provision of State or local law, or common law claims permitted under Federal, State, or local law -providing for the enforcement of civil rights, or regulating any aspect of the employment relationship, including prohibiting the discharge of an employee, the 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.

This is the fourth in a series of articles on issues surrounding the Taxation of Settlements and Verdicts. This article explains why an award of attorneys fees is included in a taxpayer’s gross income.

Gross Income and Anticipatory Assignment. The Internal Revenue Code defines “gross income” broadly to include all economic gains not otherwise exempted. Under the anticipatory assignment of income doctrine, a taxpayer cannot exclude an economic gain from gross income by assigning the gain in advance to another party, e.g., Lucas v. Earl, 281 U.S. 111(1930), because gains should be taxed “to those who earn them” id., at 114. The doctrine is meant to prevent taxpayers from avoiding taxation through arrangements and contracts devised to prevent income from vesting in the one who earned it. Id., at 115.

Contingent Fee Agreement – Anticipatory Assignment. The U.S. Supreme Court and U.S. Tax Court view a contingent-fee agreement as an anticipatory assignment to the attorney of a portion of the client’s income from any litigation recovery. In an ordinary case, attribution of income is resolved by asking whether a taxpayer exercises complete dominion over the income in question. However, in the context of anticipatory assignments, where the assignor may not have dominion over the income at the moment of receipt, the question is whether the assignor retained dominion over the income-generating asset. In the case of a litigation recovery, the income-generating asset is the cause of action derived from the plaintiff’s legal injury. See Commissioner v. Banks, 125 S.Ct. 826 (2005).

Principal-Agent Relationship. The attorney-client relationship is a principal-agent relationship. The client retains ultimate dominion and control over the underlying claim. The attorney can make tactical decisions without consulting the client, but the client still must determine whether to settle or proceed to judgment and make other critical decisions. The attorney is an agent who is duty bound to act in the principal’s interests, and so it is appropriate to treat the full recovery amount as income to the principal. This rule applies regardless of whether the attorney-client contract or state law confers any special rights or protections on the attorney, so long as such protections do not alter the relationship’s fundamental principal-agent character. See Commissioner v. Banks, 125 S.Ct. 826 (2005).