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Claimants' Attorneys' Fees and Costs in Judgments and Settlements Are Deductible Under New Tax Code Provision

By K. Joy Chin and Bruce H. Schwartz
  • November 10, 2004

New amendments to the Internal Revenue Code under the American Jobs Creation Act of 2004 change the tax treatment of attorneys' fees and costs paid to claimants in connection with judgments and settlements of unlawful discrimination and other employment-based claims. The law applies only to judgments and settlements occurring after October 22, 2004, and does not affect the current state of the law regarding whether attorneys' fees and costs must be included in a claimant's gross income. Rather, the AJCA amends the tax code to provide that where attorneys' fees and costs are includible in a claimant's income, the amount is 100% deductible in all cases.

Prior Law Allowed Only Partial Deductions in Certain Circumstances

Prior to the enactment of the AJCA, an award of attorneys' fees and costs from an employment-related judgment or settlement that was includible in income was treated as a miscellaneous itemized deduction ("below-the-line" deduction) subject to the 2% of adjusted gross income floor on such deductions. Consequently, a taxpayer who itemized deductions could deduct only a portion of such fees and costs. A taxpayer who did not itemize deductions could not deduct any portion of such fees and costs. Attorneys' fees were not deductible at all for alternative minimum tax purposes.

New Law Amends Tax Code to Allow Full Deduction

The AJCA added Section 62(a)(19) to the Internal Revenue Code. This new section allows a full deduction from gross income (an "above-the-line" deduction) for attorneys' fees and costs paid by or on behalf of a claimant for (1) claims of "unlawful discrimination," (2) certain claims against the federal government, and (3) certain claims against an employer based on group health plan payments subject to the Medicare secondary payor rules. Under new I.R.C. Section 62(e), "unlawful discrimination" is defined as an act that is unlawful under any of the following:

  • Section 302 of the Civil Rights Act of 1991 (2 U.S.C. § 1202);
  • Sections 201-207 of the Congressional Accountability Act of 1995 (2 U.S.C. §§ 1311-1317);
  • The National Labor Relations Act (29 U.S.C. § 151 et seq.);
  • The Fair Labor Standards Act of 1938 (28 U.S.C. § 201 et seq.);
  • Section 4 or 15 of the Age Discrimination in Employment Act of 1967 (29 U.S.C. § 623 or 633a);
  • Section 501 or 504 of the Rehabilitation Act of 1973 (29 U.S.C. § 791 or 794);
  • Section 510 of the Employee Retirement Income Security Act of 1974 (29 U.S.C. § 1140);
  • Title IX of the Education Amendments Act of 1972 (29 U.S.C. § 1681 et seq.);
  • The Employee Polygraph Protection Act of 1988 (29 U.S.C. § 201 et seq.);
  • The Worker Adjustment and Retraining Notification Act (29 U.S.C. § 2102 et seq.);
  • Section 105 of the Family and Medical Leave Act of 1993 (29 U.S.C. § 2615); 38 U.S.C. Chapter 43 (Employment and Reemployment Rights of Members of the Uniformed Services);
  • Section 1977, 1979, or 1980 of the Revised Statutes (42 U.S.C. § 1981, 1983, or 1985);
  • Section 703, 704, or 717 of the Civil Rights Act of 1964 (42 U.S.C. § 2000e-2, 2000e-3, or 2000e-16);
  • Section 804-806, 808, or 818 of the Fair Housing Act (42 U.S.C. § 3604-3606, 3608, or 3617);
  • Section 102, 202, 302, or 503 of the Americans with Disabilities Act of 1990 (42 U.S.C. § 12112, 12132, 12182, or 12203);
  • Any federal law prohibiting discharge, discrimination, or other forms of retaliation or reprisal against an employee for asserting rights or taking actions permitted under federal law (popularly known as whistleblower protection laws); and
  • Any provision of federal, state, or local law or common law claims permitted under federal, state, or local law (1) providing for the enforcement of civil rights, or (2) regulating any aspect of the employment relationship, including claims for wages, compensation, or benefits, or (3) prohibiting discharge of an employee or discrimination or any other form of retaliation or reprisal against an employee for asserting rights or taking other actions permitted by law.

Taxability of Attorneys' Fees Remains Unchanged

The AJCA does not alter the current state of the law regarding the underlying taxability of awards of attorneys' fees and costs paid in connection with judgments or settlements of unlawful discrimination and other employment- related claims.

Contingent Attorneys' Fees

The courts are split on whether contingent attorneys' fees paid directly to attorneys out of a judgment or settlement are excludable from a claimant's gross income or are includible in income but potentially deductible as an expense. The First, Second, Third, Fourth, Seventh, Ninth (in Alaska and California) and Tenth Circuit Courts of Appeals, the U.S. Tax Court and the Internal Revenue Service have ruled that contingent attorneys' fees and costs are taxable income and must be reported on IRS Form 1099-MISC provided to the claimant.

However, the Fifth, Sixth, Ninth (in Oregon), and Eleventh Circuit Courts of Appeals have ruled that contingent attorneys' fees and costs are neither taxable nor reportable.

The U.S. Supreme Court has agreed to decide the issue as to whether contingent attorneys' fees are taxable. See related discussion on the Supreme Court in this issue.

Non-contingent Attorneys' Fees and Costs

In all circuits, non-contingent attorneys' fees and costs are taxable income to a claimant and must be reported on IRS Form 1099-MISC, regardless of whether the fees are paid to the claimant or paid directly to the attorney. The case pending before the Supreme Court will not affect the tax treatment of non-contingent attorneys' fees and costs.

©2004 Jackson Lewis P.C. This material is provided for informational purposes only. It is not intended to constitute legal advice nor does it create a client-lawyer relationship between Jackson Lewis and any recipient. Recipients should consult with counsel before taking any actions based on the information contained within this material. This material may be considered attorney advertising in some jurisdictions. Prior results do not guarantee a similar outcome.

Reproduction of this material in whole or in part is prohibited without the express prior written consent of Jackson Lewis P.C., a law firm that built its reputation on providing workplace law representation to management. Founded in 1958, the firm has grown to more than 900 attorneys in major cities nationwide serving clients across a wide range of practices and industries including government relations, healthcare and sports law. More information about Jackson Lewis can be found at www.jacksonlewis.com.

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