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Lawsuit settlements just became more profitable…for the IRS. Under the new tax code, most personal claims are now taxed at 100% with no deduction for legal fees. That’s right: In those cases, the plaintiff will be taxed on the fees paid to the attorney and so will the attorney who receives them!

Here are some points you need to know:

  1. If the plaintiff recovery is considered personal income (not business income), it may be fully taxable with no deductions. This includes any number of situations like marriage and custody disputes, trespassing, wrongful arrest, intentional infliction of emotional distress, bad financial or investment advice, legal malpractice, and defamation.
  2. Two major exceptions to this rule are qualified personal injury cases and complaints against employers (that aren’t related to confidential sexual harassment claims).
  3. The sexual-harassment caveat hinges on whether a nondisclosure agreement is involved (which it usually is). It’s an evolving issue and a burden Congress may have inadvertently placed on plaintiffs when it really meant to take tax benefits away from employer defendants who choose to settle.

The tax deduction began disappearing in 2005 when, in Commissioner v. Banks (543 U.S. 426), the U.S. Supreme Court issued the opinion, “We hold that, as a general rule, when a litigant’s recovery constitutes income, the litigant’s income includes the portion of the recovery paid to the attorney as a contingent fee.”

No longer could plaintiffs whose recoveries qualified as income deduct attorney fees from gross payments before being taxed. After that, those plaintiffs would often deduct attorney fees as a miscellaneous itemized deduction instead. However, under the new tax code, that’s no longer possible in many of the cases listed above. Attorney Robert W. Woods explains more about the evolution of the issue in this Forbes article

The good news: Exceptions are emerging every day as the rule is tested in court. Before entering into a major settlement case, plaintiffs (and their attorneys) are welcome to talk to us about the potential tax implications they may face. After all, the amount the plaintiff is taxed could directly affect both their take-home payment and the fees the attorney recovers.

Image Copyright: aruba2000 / 123RF Stock Photo

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