Legal Fees
Posted on June 12, 2008
Filed Under Deductions, Federal Income Tax
At first glance, the topic of deductions for legal fees (attorneys’ fees) would appear to be simple, or so one would think. In Commissioner v. Banks, a consolidated Supreme Court case dealing with the deductibility of legal fees in two separate employment discrimination lawsuits filed and won by complainants Banks and Banaitis, the Court affirmed the decision rendered by the United States Courts of Appeals in the Sixth and Ninth Circuits that legal fees under a contingency fee arrangement are includible in gross income and deductible only as an itemized (below the line) deduction. Because the facts are similar, I will focus on the tax issues in complainant Banaitis’ case.
To pay his attorneys, Banaitis signed a contingency fee agreement (pdf file). After winning the discrimination action, the entire judgment, including contingent attorneys’ fees, was included in Banaitis’ gross income. Banaitis was able to take a deduction for legal fees but only as a miscellaneous itemized deduction. At issue is the fact that itemized or below the line deductions are treated unfavorably when compared to above the line deductions: unlike their above the line cousins, many miscellaneous itemized deductions, including legal fees, are deductible only to the extent they exceed a 2% of adjusted gross income (AGI) floor. But of greater significance for Banaitis, below the line deductions for legal fees paid to attorneys under a contingency fee arrangement are added back to income when calculating the alternative minimum tax (AMT). In short, these restrictions negated the deductibility of Banaitis’ legal fees. Banaitis’ share of the discrimination judgment was about $4.9 million but after adding back to income the miscellaneous itemized deduction for legal fees in order to calculate the AMT, the judgment on which he would be taxed grew to $8.4 million.
In an attempt to fix the arguably faulty tax logic in Banks v. Commissioner, Congress, in the American Jobs Creation Act of 2004 (pdf file), now allows taxpayers to take an above the line deduction for contingent attorneys’ fees in employment discrimination lawsuits and other causes of action related to, for example, the Employee Polygraph Protection Act of 1988, section 105 of the Family and Medical Leave Act of 1993, various sections of the Fair Housing Act, the Americans with Disabilities Act of 1990, and section 510 of the Employee Retirement Income Security Act of 1974 (the list could continue; consult the American Jobs Creation Act for additional details). It is important to note that this new law does not apply to noncontingent (viz., hourly or fixed) attorneys’ fees. Several sources of secondary authority on taxation law suggest that in the type of employment discrimination action pursued by Banks and Banaitis, attorneys’ fees, contingent or noncontingent, are in substance a cost of producing taxable income and should be allowed as an above the line deduction. That is to say, the origin and nature of the claim should determine deductibility, not the type of billing arrangement negotiated with attorneys.
Although the federal income tax is a tax on net income and not gross income, above the line deductions, with several exceptions (a nonexhaustive list including alimony, qualified higher education expenses and interest on qualified education loans, retirement plan payments, and medical and health savings accounts), are allowed only for expenses incurred while producing nonexempt (taxable) income in a trade or business or managing income-producing property. In other words, as a general rule, deductions are allowed only if the related income is taxable. In addition, deductions for personal, living, or family expenses are not allowed but Congress, through legislative grace, has granted several exceptions, many of which are below the line deductions and subject to a 2% of AGI floor: home mortgage interest and state and local taxes on the home (not subject to the 2% of AGI floor), medical and dental expenses (but subject to a higher 7.5% of AGI floor), bad debts and worthless securities, expenses related to tax advice and litigation, nonbusiness or personal casualty losses (each loss most be over $100 and is subject to a higher 10% of AGI floor), state and local taxes, charitable contributions (not subject to the 2% floor but restricted nonetheless), and, of course, legal fees to protect future employment or produce income.
In Banks and similar cases, complainant’s cause of action is based on employer’s violation of employment discrimination law; because of wrongful discharge, complainant incurs attorneys’ fees in suing for the production of current and future income. In Francis Lawrence and Kathryn Tenopir Remkiewicz v. Commissioner (Tax Court Memorandum Ruling 2001-01), petitioners Lawrence and Remkiewicz asked, and the Tax Court granted, an allocation and deduction for legal fees related to the production of nonexempt income (salaries and wages). In brief, taxpayers contesting termination of employment or pursuing an employment discrimination action may deduct that portion of attorneys’ fees associated with the production or recovery of nonexempt income (in the case of Lawrence, current and future compensation from employment).
Additional writings on the legal fees deduction are detailed below:
- Commissioner v. Banks
- Legal fees: How do attorneys charge?
- Miscellaneous Deductions (pdf file)
- Discussion: Legal Fees Paid for Ongoing Settlement Negotiations
- New Rules, New Ruling
Many happy returns, Roger
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