Taxability of Attorney’s Fees
On October 22, 2004 President Bush signed the American Jobs Creation Act of 2004 (the “Act”) into law. A key provision of the Act permits employees to fully deduct attorney fees and court costs paid by, or on behalf of, the employee in connection with any action involving a claim of unlawful discrimination. “Unlawful discrimination” is defined as an unlawful act under a myriad of laws commonly used by employees when suing their employers. These include: the CRA; ADEA; ADA; Rehabilitation Act; FMLA; FLSA; NLRA; ERISA; WARN; Federal laws governing members of the uniformed services; Federal Whistleblower Protection laws; and any “Federal, State, or local law, or common law claims permitted under Federal, State, or local law (i) providing for the enforcement of civil rights, or (ii) regulating any aspect of the employment relationship, including claims for wages, compensation, or benefits, or prohibiting the discharge of any employee, the discrimination against an employee, or any other form of retaliation or reprisal against an employee for asserting rights or taking other actions permitted by law.” 118 Stat. 1418, 1547-48 (2004). The Act only applies to attorney fees and costs paid after October 22, 2004, in connection with any judgment or settlement occurring after that date.
Law Prior to the Act’s Passage
Prior to the Act’s passage, plaintiffs were generally required to report as taxable income attorney fees and court costs awarded in discrimination cases. Although reportable, plaintiffs were permitted a “below the line” miscellaneous deduction for those expenses. Some federal circuit courts, however, held that a plaintiff entering into a contingency fee arrangement with an attorney was not required to report the recovery of attorney fees and costs as taxable income. These circuits were at odds with other courts, and the IRS, who took the position that a plaintiff must always report the recovery of any attorney fees and costs, even when paid directly to the plaintiff’s attorney by the losing defendant.
The Supreme Court Steps In
To resolve whether contingency arrangements absolved plaintiffs from reporting the recovery of fees and costs, the United States Supreme Court reviewed the issue and upheld the IRS’ position. Commissioner of Internal Revenue v. Banks, consolidated with Commissioner of Internal Revenue v. Banaitis, 125 S. Ct. 826 (2005). The Court’s decision effectively treats all recoveries of fees and costs as income, regardless of whether the fees were paid to the attorney through a contingency arrangement.
Current Status of the Law
The Act, which was passed prior to the Court’s decision, is consistent with the Court’s ruling, as it too requires all recoveries of fees and costs to be reported as income by the plaintiff. The Act, however, now permits an “above the line” deduction for all attorney fees and costs, regardless of whether the plaintiff itemizes, or is subject to the alternative minimum tax.
The new legislation has wide support from advocates for both plaintiffs and defendants. In pressing for the Act’s passage, employers argued that the tax liability on fee and cost awards encouraged plaintiffs to seek higher settlements to compensate them for the taxes they needed to pay following receipt of their award. On the other side, employee groups stressed that where plaintiffs only sought injunctive relief, or had small actual damages, the tax liability on their recovered attorney fees could exceed their damage award. Both sides believe the Act will reduce settlement costs and compensate plaintiffs more fairly.
