New Rules, New Ruling: The Tax Treatment of Litigation Proceeds and Legal Fees

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EXECUTIVE SUMMARY

* The tax treatment of damages and legal fees and costs varies according to the type of underlying claim, Congressional action providing an above-the-line deduction for legal fees for discrimination claims and a recent Supreme Court decision in Commissioner v. Banks have contributed to making the treatment of damage awards somewhat more manageable.

* Damages for personal injury or sickness and the related legal fees and costs are excludable from gross income, but the punitive or interest components are not. Taxpayers must allocate legal fees according to the rules in IRC section 104(a)(2). Damages for discrimination and employment-related claims are included in gross income net of the legal fees and costs, but not less than zero under IRC section 62(a)(20).

* Only the net amount of damages received from qualified settlement funds is included in gross income. Essentially, the legal fees and costs are afforded an above-the-line deduction.

* All other damages received are included in gross income in full, including the amounts that may have been paid directly to the attorneys. Legal fees and costs are deductible only as miscellaneous deductions under IRC section 212 and are subject to both the 2% of AGI limit and the 3% overall limitation on itemized deductions and are disallowed under the AMT.

Within the past two years two major developments--new legislation and a court decision--have changed the federal tax treatment of legal fees incurred in connection with personal damage awards. As a result, the taxability of litigation proceeds and the deductibility of related legal fees and court costs have become somewhat clearer. This article breaks litigation awards into four categories and summarizes the tax treatment afforded to each.

FINALLY, NEW GUIDANCE

In October 2004 Congress enacted the American Jobs Creation Act. Included in it was new IRC section 62(a)(20) which provides an above-the-line deduction for legal fees and court costs incurred in connection with discrimination awards. This provision allows individuals, who previously were entitled to only a miscellaneous itemized deduction, to deduct their legal fees and court costs in arriving at adjusted gross income. The deduction cannot exceed the amount reported as gross income from the litigation. This provision was effective for all covered claims settled or awarded after October 22, 2004.

In January 2005 the U.S. Supreme Court rendered its decision in the consolidated cases of Commissioner v. Banks and Commissioner v. Banaitis, 543 US 426 (2005). The ruling eliminated an existing division in the circuit courts and required taxpayers to include in gross income all litigation proceeds, including any amount that went to the lawyers under a contingent fee arrangement.

THE FOUR CATEGORIES OF LITIGATION CLAIMS

Litigation proceeds and the related legal fees generally fall into four categories:

* Personal injury claims where the proceeds are excluded from gross income under IRC section 104(a)(2).

* Discrimination claims that qualify for the new deduction for AGI under section 62(a)(20).

* Claims where only the net proceeds of the litigation are reportable as gross income.

* Claims that remain fully includible in gross income, but where the related legal fees and court costs are not eligible for the above-the-line deduction outlined in section 62(a)(20).

Personal injury exclusion. Proceeds from personal injury or sickness-only claims are excluded from income under section 104(a)(2). The legal fees litigants pay for claims that fall fully under this exclusion are not at issue, since the exclusion of any income renders the legal fee deduction question irrelevant.

Personal injury awards can include both compensatory and punitive portions. An example would be when an individual sues a pharmaceutical company for drug-related injuries and is awarded both compensatory and punitive damages because the company failed to adequately warn doctors and consumers of the risks. …