Understanding the Intricacies of the Plaintiff Double Taxation and Commissioner v. Banks

The taxation of plaintiff litigation recoveries often induces confusion, yet understanding it is indispensable. Especially significant are the implications of the “double tax” issues. This article explores this intricate topic, focusing on the landmark case of Commissioner v. Banks.

1. Decoding the Complexities of Plaintiff Litigation Recoveries

1.1. Taxation of Personal Injury Plaintiff Litigation Recoveries

The tax implications are not always straightforward when dealing with litigation recoveries. While compensatory and related emotional distress damages for physical injuries are tax-free, other related non-personal injury components, including punitive damages and interest, are taxable.

1.2. Tax Implications for Other Types of Recoveries

In many other plaintiff recoveries, the situation becomes more complicated. These include (but are not limited to) non-physical injuries such as emotional distress, defamation, breach of contract, malpractice, fraud, and intellectual property violations. In these instances, the recoveries are typically taxable.

1.3. Deductions and Legal Fees

Surprisingly, many individual plaintiffs receiving taxable recoveries cannot deduct their legal fees. These fees are considered “miscellaneous itemized deductions,” which are nondeductible according to the Internal Revenue Code §67(g). Only limited exceptions exist, making it crucial for plaintiffs to understand whether the IRS permits deducting their attorney fees.

2. The Double Tax Phenomenon: Commissioner v. Banks

2.1. Overview of the Case

The double tax issue arises from the 2004 U.S. Supreme Court ruling in Commissioner v. Banks. (Commissioner v. Banks, 543 U.S. 426 (2005)). This case established that plaintiffs must include the attorney fee portion of their taxable recovery in income, resulting in a “double tax.” As a result of Commissioner v. Banks, in contingent fee cases, plaintiffs must generally recognize gross income equal to one hundred percent (100%) of their recoveries, even if the attorney is paid directly by the defendant and the plaintiff receives only a settlement payment net of the attorney fees. This strict tax rule generally requires plaintiffs to devise a method for deducting their 40 percent (or other) contingency fee and other attorney costs.

2.2. The Implications of the Ruling

In taxable cases where the attorney fee is not deductible, the plaintiff and the attorney pay tax on the attorney fee portion of the recovery. This double taxation can significantly reduce plaintiffs' recovery, especially those in high-tax jurisdictions. In extreme cases, such as high-tax states like New Jersey, New York, and California, plaintiffs may end up with little or nothing (sometimes less than 15% of the gross settlement) after paying their lawyer and offsetting case expenses and taxes.

3. The Role of Defendants and Plaintiff Lawyers

3.1. The Responsibilities of Defendants

Defendants in taxable cases are also subject to significant penalties if they fail to issue a 1099 or exclude the attorney fee portion. The penalty could be 10% of the unreported amount, without limit, according to IRS Regulation 1.6041-1(f) and IRC §6722(e). This point is critical and frequently misunderstood or ignored, as the plaintiff should expect the defendant to be unwilling to ignore or “fudge” any tax treatment reporting.

3.2. Ethical Guidelines for Plaintiff Lawyers

The American Bar Association advises that competent representation of plaintiffs requires considering the tax implications of the settlement. It’s an ethical obligation for personal injury lawyers to inform clients about the taxation of the litigation proceeds and the consequences of not addressing taxes properly or seeking competent tax advice.

4. Potential Pitfalls in Reducing Plaintiff Recovery Taxes

Many suggested ways of minimizing plaintiff recovery taxes are ineffective. These include reporting only the portion of the recovery received by the plaintiff to the IRS, treating the attorney-client relationship as a partnership or business, excluding the structured part of the attorney’s fees, or improperly treating the claims as “civil rights” violations. These strategies fail to work and expose the plaintiff to severe penalties and interest and the possibility of tax fraud allegations if discovered by the IRS.

There is a deduction in the Internal Revenue Code that allows plaintiffs in employment and civil rights lawsuits to be taxed on their net recoveries (i.e., the attorney fees and costs for these types of cases are deductible). The limit results in no problem where all legal fees are paid in the same tax year as the recovery. However, the issue remains if the plaintiff paid hourly legal fees over more than one year. In such an event, there is no income to offset, so one cannot deduct the legal fees above the line. An aggressive approach – unlikely to withstand review - would have the lawyer pay back the prior fees and have the lawyer charge them once again in the tax year of the settlement.

This above-the-line deduction only applies to attorney fees paid because of “unlawful discrimination” claims as defined by Code §62(e). The definition of “unlawful discrimination” only includes claims brought under the following federal statutes:

• Civil Rights Act of 1991;
  
• Congressional Accountability Act of 1995;
  
• National Labor Relations Act;
  
• Fair Labor Standards Act of 1938;
  
• Age Discrimination in Employment Act of 1967;
  
• Rehabilitation Act of 1973;
  
• Employee Retirement Income Security Act of 1974;
  
• Education Amendments of 1972;
  
• Employee Polygraph Protection Act of 1988;
  
• Worker Adjustment and Retraining Notification Act;
  
• Family and Medical Leave Act of 1993;
  
• Chapter 43 of Title 38
  
• Section 1981, Section 1983, and Section 1985;
  
• Civil Rights Act of 1964;
  
• Fair Housing Act; and
  
• Americans with Disabilities Act of 1990.
  

If the pleadings in the case do not explicitly cite a violation of at least one of these statutes or an employment-based claim, one should consider carefully the risk of asserting unlawful discrimination to avail the taxpayer of the above-the-line deduction. It has been suggested by numerous tax professionals that taking an above-the-line deduction may well be a major IRS audit flag and may result in substantial underpayment penalties.

5. Proactive Measures to Increase After-Tax Recovery

Drafting the complaint or settlement agreement to consider the taxes is a strategy to avoid the double tax when the facts and circumstances allow. Another method involves contributing the claim to a Plaintiff Recovery Trust (PRT), a  charitable trust planning arrangement adapted for litigation. A plaintiff may also consider selling the claim to reduce taxes associated with a taxable recovery, but the sale must be valid and have substance.

6. The Difficulty of Addressing Taxes After Settlement

Tax planning to reduce plaintiff taxes on recoveries is possible while the case is ongoing and unresolved. However, opportunities are limited once the claim is resolved. Few accountants are familiar with plaintiff recovery taxation issues, and they often get involved only after the recovery when it’s too late.  There are post-settlement planning opportunities, but they aren’t as effective as addressing the tax issues before the case is resolved.

7. Key Takeaways: The Impact and Implications of the Double Tax Issue

The complexities of plaintiff recovery taxation, particularly the controversial double tax issue, have profound implications that affect plaintiffs, attorneys, and defendants alike. While the tax treatment of plaintiff recoveries remains a contested area, understanding the intricacies of these issues is crucial.

In conclusion, while the taxation of plaintiff recoveries and the double tax phenomena can be daunting, understanding these aspects is crucial for all parties involved in litigation. The Commissioner v. Banks case is a critical reference point in this complex tax landscape, highlighting the need for experienced advisors early in the process and well before settlement or adjudication.

The Commissioner v. Banks case underscores the importance of competent legal and tax advice for plaintiffs embarking on litigation.

To learn more about Commissioner v. Banks, its impacts, and solutions like the Plaintiff Recovery Trust, visit the Eastern Point Trust Company Resource Library of articles on various topics associated with Commissioner v. Banks.