When one is in a position to bring a claim against another, attorneys are often hired to provide representation on a contingent-fee basis. In such a case, the attorney only gets paid if they are successful in pursuing one’s claim; otherwise, they receive no compensation for their services.
If the case ends favorably for the taxpayer, resulting in a judgement where their attorney’s fees have been deducted from the proceeds, they are often under the impression that they are only required to pay tax on the net proceeds of their settlement (settlement less contingent attorney fee). However, this is not always the case.
Until 2005, courts were divided on how to handle this situation. Some courts ruled that 100% of the settlement had to be included in the taxpayer’s income, with the contingent attorney fee being taken as a miscellaneous itemized deduction. Other courts concluded that contingent fees were completely excluded from gross income because those amounts were actually owned by the attorney, rather than the taxpayer.
In 2005, the Supreme Court settled the debate when it ruled that all income recovered in litigation is considered taxable, including the portion paid to the attorney. The Court’s decision was based on a rule in tax law known as the Fruit and Tree Doctrine, which states that income is taxable to the person who earned it and that it cannot be reassigned so someone else, to avoid taxation.
Fortunately, for some taxpayers, the American Jobs Creation Act of 2004 established a loophole that permits an above-the-line deduction for attorney fees and related court costs in certain limited cases. To be eligible to take an above-the-line deduction, the claim must have only been for unlawful discrimination, certain claims against the federal government, or private causes of action under the Medicare Secondary Payer statute. This is a very narrow focus, indeed.
As helpful as it would be if Congress would take the next step and allow taxpayers to exclude contingent attorney fees from gross income in all circumstances, the chances of this happening any time soon are, unfortunately, minute. It is, therefore, extremely important for taxpayers to consider and understand the tax ramifications of any settlement they are offered, along with the related contingent attorney fees, prior to entering into such an agreement.
To learn more about the tax treatement of contingency fees or if you have questions regarding business or personal tax concerns, contact me at dalger@zinnerco.com or any of our tax professionals at 216-831-0733.