Tax Treatment of Contingent Legal Fees

Article excerpt

Suppose Peter Plaintiff wins $1 million in an age discrimination suit against his former employer. On his behalf, Libby Lawyer collects the million and deposits it in a lawyer's trust fund account. Under their 40 percent contingent fee agreement, Libby gives Peter $600,000 and keeps the remaining $400,000. Peter reports $600,000 of income.

Right?

Wrong!

The Internal Revenue Service (IRS) takes the position that Peter must report the entire $1 million as income.

But he's allowed to take a deduction for the $400,000 legal fee he paid Libby, so he still only pays tax on a $600,000 income. Right?

Wrong! Several tax provisions interact to limit Peter's ability to deduct the full $400,000 that Libby Lawyer kept. The net effect is that the IRS will make Peter pay tax on more than the $600,000 that he actually received.

And several courts have agreed with the IRS.

Here's how it works.

At the outset, Peter will have to include the $1 million damage award in income. Current law allows individuals to exclude the amount of any damages that they receive in a car accident or other physical injury, but damages received on account of a nonphysical injury like age discrimination are taxable.

At the same time, however, the tax code generally permits individuals to deduct business expenses and other expenses incurred to generate income. So Peter is allowed to claim an itemized deduction for the $400,000 legal fee that he paid Libby Lawyer.

Unfortunately, however, section 67 of the tax code treats that $400,000 expense as a so-called "miscellaneous itemized deduction" - - deductible only to the extent it exceeds 2 percent of Peter's income. So right off the bat, Peter's legal-fee deduction will be cut to just $380,000 ($400,000 -- 2 percent x $1 million).

Peter's legal-fee deduction will be trimmed again, this time by section 68 of the tax code. In the year 2000, this provision will reduce Peter's otherwise allowable $380,000 deduction by 3 percent of the excess of his income over $128,950. So Peter will lose another $26,131.50 of his legal-fee deduction (3 percent x [$1 million - $128,950), leaving him with an allowable itemized deduction of just $353,868.50 ($400,000 - $20,000 - $26,131.50).

Consequently, Peter will have to pay federal income tax on $646,131.50 ($1 million - 353,868.50), even though he actually received just $600,000.

If Peter is single, he would owe $233,538 in federal income tax on a $646,131.50 taxable income ($91,857 + 39.6 percent x [$646,131.50 - $288,350]). If Peter instead had a taxable income of just $600,000, he would owe Uncle Sam just $215,270 in federal income taxes ($91,857 + 39.6 percent x [$600,000 - $288,350]). In short, the disallowance rules of tax sections 67 and 68 will increase Peter's income tax liability by about $18,000.

Worse still, Peter will be zapped by the alternative minimum tax (AMT). The AMT was added to the tax code in the 1970s in order to ensure that rich people actually paid some income tax no matter how cleverly they sheltered their income. The AMT imposes a tax of up to 28 percent on individuals with more than $33,750 of income (and on couples with more than $45,000 of income). Affected taxpayers must compute their tax liability under both the regular income tax and the AMT and pay the larger amount.

As more fully explained below, Peter's alternative minimum tax liability will be $276,500. As that's more than his regular income tax liability of $233,538, Peter will owe Uncle Sam the full $276,500.

Here's how Peter will compute his alternative minimum tax liability. At the outset, Peter's alternative minimum taxable income will be $1 million.

That's because miscellaneous itemized deductions (including Peter's legal-fee deduction) must be added back into the AMT tax base. Single individuals like Peter are generally allowed an exemption of $33,750, but this exemption is phased out after the taxpayer's income reaches $112,500. …