The taxation of plaintiff litigation recoveries is confusing. But it’s important to know the right answers. This is because the income tax consequences are so significant, especially where there are “double tax” issues.
1. Recoveries in connection with personal injuries are not always tax-free.
2. Many other types of individual plaintiff recoveries are taxable.
Compensatory and emotional distress damages for physical injuries are tax-free, but the related punitive damages and interest are taxable.
These include non-physical injuries and related emotional distress, mental anguish, defamation, breach of contract, malpractice, fraud, securities law violations, intellectual property and more.
3. Many individual plaintiffs receiving taxable recoveries CANNOT DEDUCT their legal fees.
Personal attorney fees are “miscellaneous itemized deductions,” which are nondeductible. IRC §67(g). There are limited exceptions (e.g., employment discrimination, whistleblower). It’s important to know whether the IRC permits the deduction of your attorney fee.
4. The U.S. Supreme Court held that plaintiffs must include the attorney fee portion of their taxable recovery in income – creating the double tax.
This is the 2004 ruling in Commissioner v. Banks. As a result, in taxable cases where the attorney fee is not deductible, both the plaintiff and lawyer pay tax on the attorney fee portion of the recovery – hence the “double tax.”
5. In “double tax” situations, plaintiffs in high-tax jurisdictions end up with little or nothing.
A plaintiff might keep 10% after paying 40% to their lawyer and 50% in taxes. (Looking at you California!) And if their lawyer had significant expenses that are not covered by the contingent fee, the plaintiff may end up with nothing.
6. Defendants are subject to huge 1099 penalties in taxable cases if they don’t issue a 1099, or if they exclude the attorney fee portion.
The penalty can be 10% of the unreported amount, without limit. IRS Regulation 1.6041-1(f); IRC §6722(e).
7. Plaintiff lawyers must consider client tax issues.
American Bar Association (ABA) materials advise that “competent representation” of plaintiffs requires “considering the tax implications of the settlement.” ABA, Ethical Guidelines for Settlement Negotiations (August, 2002). Ethics rules require that personal injury lawyers tell clients the consequences of not addressing taxes or seeking competent tax advice.
8. Many suggested ways of reducing plaintiff recovery taxes don’t work.
These include reporting to the IRS only the portion of the recovery received by the plaintiff (excluding the attorney fee portion), treating the attorney-client relationship as a partnership or business, or excluding the structured portion of the attorney’s fees. Not only do these not work, they subject the plaintiff to massive penalties and interest if the IRS finds out.
9. Plaintiffs with taxable recoveries can increase their after-tax recovery if they act before a final resolution of the claim.
One way to do so is to draft the complaint or settlement agreement to consider the taxes (to the extent the facts allow). Another way to avoid taxation on the attorney fee portion of the recovery is to contribute the claim to a Plaintiff Recovery Trust (PRT). A PRT uses a traditional charitable trust planning arrangement, modified to the litigation context to achieve this result. There are other methods to reduce the taxes associated with a taxable recovery, such as selling the claim.
10. Addressing taxes after settlement is hard.
Tax planning to reduce plaintiff taxes on their recoveries is possible while the case is contingent and doubtful, i.e., not finally resolved. Careful planning is required. There are limited opportunities once the claim resolves. In this regard, few accountants are familiar with plaintiff recovery taxation matters and they tend to get involved only after the recovery, when it’s too late.
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