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.
Less Attorney Fees
Less Federal Tax
Less State Tax
After Tax Recovery
Less Attorney Fees
Amount to Plaintiff
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 (1st Cir. 1995) where the tax liability was greater than the taxpayer's recovery.