In 2004, Congress enacted the American Jobs Creation Act of 2004, which amended the Internal Revenue Code by allowing a taxpayer, in computing income, to deduct “attorney fees and court costs paid by, or on behalf of, the taxpayer in connection with any action involving a claim of unlawful discrimination.” The Act was not made retroactive, and only applies to fees and costs paid after October 22, 2004, with respect to any judgment or settlement occurring after that date.
Given the October 2004 effective date of the Act, on January 24, 2005, in Commissioner of the Internal Revenue Service vs. Banks, the United States Supreme Court addressed the issue of whether attorney fees and costs, paid from a recovery, pursuant to a contingency agreement, are taxable income to the employee. In many cases, an employee will hire an attorney to represent her pursuant to a “contingency contract.” Such contract typically reads that the employee does not pay for the attorney’s time up front, instead agreeing to provide the attorney with a percentage (typically 1/3) of the recovery, if any. For example, if an employee won or settled her suit for $150,000, the attorney would receive $50,000 and the employee would receive $100,000.
The cases before the Supreme Court resulted from such arrangements. In such cases, the employees argued that the $50,000 paid to their attorneys was not taxable income to them, and the courts of appeals had agreed. Under such theory, using the example above, and assuming a flat 25 percent tax rate, the employee would pay taxes of $25,000 on the $100,000, and have a net gain of $75,000. The Supreme Court reversed the courts of appeals, finding that the total amount of the settlement was taxable income to the employee, including the amount paid to the attorney. Under the court’s ruling, using the same example, the employee would owe a total tax of $37,500 on the full $150,000. Thus, instead of receiving $75,000, she would receive $62,500.
The court did not address one of the more interesting questions before it. What happens if the attorney fees are awarded under a federal statute that authorizes fee awards for prevailing plaintiffs’ attorneys? In many cases, attorneys may take deserving cases, with few economic damages, in order to obtain injunctive relief for the employee, or challenge a discriminatory practice. In such cases, the plaintiff may recover only a few thousand dollars, but the fees could be in the hundreds of thousands of dollars. It was argued to the court that treating fee awards as income to the plaintiff in such cases would lead to the perverse result that the plaintiff would lose money by winning the suit. The court did not address the issue, noting that the plaintiff in the case before it had “settled” his suit, there was no “court-ordered fee award,” and that the Act “redresses the concern for many, perhaps most, claims governed by fee shifting statutes.”
The bottom line is that if you received payment of attorney fees as part of a court judgment or settlement that was entered into prior to October 22, 2004, then the portion of that award or settlement representing attorney fees and costs would be viewed by the IRS as taxable income. Of course, you should speak with your tax preparer for specific advice about your situation.
** This information is provided by the attorneys at Passman & Kaplan, P.C., a law firm dedicated to the representation of federal employees worldwide. For more information on Passman & Kaplan, P.C., go to www.passmanandkaplan.com **
