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.
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.
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
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. …