The Tax Cost of Litigation Part I

When a plaintiff wins a judgment or reaches a settlement, the tax man will be lurking to get his share.  There are two main issues in the taxation of litigation.  This blog will focus on a plaintiff in a non-business litigation situation, such as personal injury or discrimination.  The first issue is the tax treatment of any amounts received in a judgment or settlement with a defendant.  The second issue is what costs of the litigation, primarily attorney fees, are deductable to the plaintiff.  A plaintiff in the process of finalizing a settlement would be wise to consult with a qualified tax attorney to determine how the settlement should be structured to avoid unnecessary taxation.

 Recoveries

In general, only physical personal injury recoveries are nontaxable under the income tax laws. The rationale behind this result is that a taxpayer should not be taxed on the receipt of money damages, which are merely intended to make him whole from physical injury.  Where the underlying claim (basis of lawsuit) may be based on a tort or tort-like rights, the crucial inquiry is whether the amount received by the plaintiff was paid on account of the physical injury or physical sickness. To ascertain the basis of the lawsuit, the IRS and courts will usually look to the underlying complaint.

If the amount is paid on account of the physical injury or physical sickness, all damages (other than punitive damages) flowing from that injury or sickness (e.g., lost wages, pain and suffering, emotional distress) are excludable from gross income.  If a plaintiff asserts that the recovery or settlement was compensation for a personal injury claim when the basis of the underlying complaint is solely in contract, the taxpayer will probably be unsuccessful in having the amount received treated as tax-free.

The simplest way to characterize a settlement or judgment payment for tax purposes is to specify in the appropriate documents the precise allocation of the payments. Although The IRS is not bound by such an allocation, and may look behind the documents to the evidence introduced at trial or the information elicited and disclosed during recovery and develop its own allocation, typically the IRS gives deference to the allocation.  In addition, absent any allocation, a court will be bound to accept the IRS’s allocation (which is presumptively correct), unless the taxpayer can provide evidence to the contrary.  Therefore, a plaintiff, when appropriate, must be sure to include physical damages in any complaint filed and properly allocate any physical damages in the final settlement.

Costs

Litigation is expensive with attorney fees usually the main expense.  Unfortunately, for non business litigation, the plaintiff is only entitled to deduct legal fees as a miscellaneous itemized deduction limited by the 2% of adjusted gross income floor. This rule is exacerbated when a plaintiff pays his attorney fees under a contingency basis, because under California law, contingent attorney’s fees are includable in the plaintiff’s gross income. The reasoning is that contingent legal fees are effectively paid by the plaintiff to the attorney after the plaintiff has received, and included in gross income, the settlement or judgment.  Therefore, we can have a situation where a plaintiff reached a settlement of $1,000,000 and under a contingency fee agreement his attorney is entitled to 50% of the settlement, or $500,000.  In this case the plaintiff is taxed on the full $1,000,000 and not the $500,000 he is allocated under the contingency fee agreement.  Taking into account both federal and California tax rates, the plaintiff will owe $300,000 in taxes.  In addition, there is no withholding on the settlement; therefore the plaintiff may have a nasty surprise come filing time.

Plaintiffs in a class action lawsuit usually are exempt from of these harsh income tax rules.  The rationale is that, in class action lawsuits, it is a single class representative who hires the class attorney and the other class members may receive a benefit from the litigation, but no express contractual liability for a fee exists between them and litigating counsel. Therefore, in such opt-out class action lawsuits, the attorneys’ fees generally are not includable in a class member’s gross income.

Given these potential harsh tax rules of litigation, it is very important to consult a tax attorney who understands these rules and can minimize the plaintiff tax liability.  After all, litigation is ultimately about money and proper tax planning can make a lot of difference for the plaintiff’s bottom line.