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Tax Tenets for Trial Lawyers

By Robert W. Wood

Just in time for tax season, here are some rules every litigator should observe about tax issues.

Taxes matter in drafting settlement agreements. Most lawyers know the maxim that once a settlement agreement is signed, there is no incentive for the parties to cooperate. So, if you want tax provisions in a settlement agreement, ask for them as part of your other comments.

What tax provisions should you ask for? Litigation recoveries (whether by settlement or judgment) take their tax character from the origin and nature of the claim. This tax rule seems more logical than most of the rest of the tax code. If your client is suing for lost wages, the recovery will probably be treated as wages for tax purposes. If your client is suing for lost profits, lost profit tax treatment will apply. If your client is suing for diminution in value to his stock portfolio, capital gain treatment (or even recovery of basis tax treatment) may be appropriate. Ask for tax language in the settlement agreement that is consistent with your theory of the case.

Tax language in the settlement agreement will not bind the Internal Revenue Service (IRS) or the courts in any subsequent tax dispute. However, such language is often respected by the IRS and the courts. Besides, if you don’t even attempt to provide tax language in a settlement agreement, you may miss out entirely.

Beware the personal physical injury exclusion. One critical statutory exclusion that confuses many lawyers relates to personal physical injuries. Section 104 of the Internal Revenue Code excludes from income recoveries (by settlement or judgment) for personal physical injuries. Up until 1996, this exclusion applied to any personal injury recovery, including defamation, intentional or negligent infliction of emotional distress, and many others.

In 1996, Congress amended Section 104 to require physical injuries. Although this statutory change is now 13 years old, there are no regulations explaining just what “physical” means. The IRS says a recovery must be for physical injuries you can see (such as broken bones or bruises). The statute also excludes damages for physical sickness, but there is virtually no authority on what physical sickness means.

However, if you have a legitimate physical injury or physical sickness, emotional distress damages flowing from that injury or sickness are also excludable. In contrast, emotional distress damages that occur outside the context of physical injuries or physical sickness are taxable. If you find this confusing, you are not alone. You may need a tax specialist to help you and your client before the settlement agreement is finalized.

Clients usually have income when their contingent fee lawyer is paid. To untangle the mess of tax rules concerning attorney fees, let’s start with the question whether the client has gross income when the lawyer is paid. For example, assume a client receives $100,000 to settle an employment discrimination case. The lawyer receives 40 percent of that $100,000. Does the client have $100,000 of income or only $60,000?

The IRS will generally treat the client as having the full $100,000 of income, whether or not the lawyer receives the money directly from the court or the defendant. In Comm’r v. Banks, 543 U.S. 426 (2005), the U.S. Supreme Court held that the client generally has gross income measured by the full amount of the recovery. You might think the client could simply deduct the contingent fee, so the tax treatment would be the same as only having $60,000 of income in the first place. Yet you should keep some things in mind.

Legal fee tax deductions vary. The client can usually deduct the legal fee in one of several ways. We must distinguish between employment lawsuits (and federal False Claims Act suits) and virtually all others. In employment cases, the client gets an above-the-line deduction, so the client will only have to pay tax on $60,000. But in non-employment litigation, most clients will be able to deduct the legal fees only as a miscellaneous itemized deduction. Such deductions are subject to limitations and phase outs, and do not apply for purposes of the alternative minimum tax. The result is that frequently the client will not be able to deduct all (or sometimes any) of the attorney fees.

Apart from employment cases, there is one more type of case in which you should not worry about the deductibility of attorneys’ fees: the pure physical injury case. If your client is injured in a catastrophic accident, the entire recovery ought to be excludable from the client’s income under Section 104. However, if interest or punitive damages are paid, then that interest or punitive damages will be taxable income to the client even in a physical injury case, and determination of the tax treatment of any attorney fees paid or received that are attributable to punitive damages or interest will probably require input from a tax specialist.

Know qualified settlement fund requirements. Enabled by section 468B of the Internal Revenue Code, Qualified Settlement Funds (QSFs or 468B funds) enable defendants to claim tax deductions for settlement payments currently, even though amounts might be tied up among squabbling plaintiffs for months or even years. Under general tax rules, a defendant cannot claim a deduction until the plaintiff receives the funds. QSFs provide a big exception to the normal reciprocity in the tax law between payor and payee.

There are three requirements to form a QSF. First and foremost, the trust must be subject to court supervision. That means you ask a judge to approve a QSF trust document and take jurisdiction over the assets. Second, the trust must exist to resolve or satisfy legal claims. Third, the trust must qualify as a trust under state law.

QSFs are flexible, and while QSFs usually exist for a short time (often a few weeks or a few months), there is no express time limit on their duration. In complex and large class actions, QSFs may exist for several years. The QSF truly operates as a tax-free holding pattern. Moneys are not treated as received by the plaintiffs—or their lawyers—until they are paid out of the QSF. Yet, the defendant is entitled to a tax deduction as soon as the money is put into the QSF.

Both plaintiffs and defense counsel can use a QSF to make the settlement process smoother, more efficient, and more closely tailored to what the plaintiffs (and their counsel) need and want.

Be aware of IRS Form 1099 and withholding rules. The main category of payments subject to withholding is wages in employment cases. If you are handling employee lawsuits, you will be familiar with the notion that the employer must withhold on wage payments. Withholding means the client will receive a net check after payroll tax withholding, and all of the withheld tax will be sent to the federal and state governments.

If your case is outside the employment context, you may not have withholding issues, but you will face Form 1099 reports. You need to be aware what tax forms your client and you will both receive when a case settles. You may be surprised to learn that how you ask for checks to be cut can dramatically influence what Forms 1099 you and your client receive.

Be aware of duplicate Form 1099 reporting. If you settle a case for a traditional joint check (payable to you and your client jointly), the IRS regulations require the defendant to issue one Form 1099 to you and one Form 1099 to your client, each for the full amount! If that sounds like duplicate reporting and potential double taxation, that’s just the way the rules work.

If the defendant issues two checks, one to the lawyer for the lawyer’s share, and the other to the client for the client’s share, then the lawyer will receive a Form 1099 only for the lawyer’s fee. The client is probably still going to receive a Form 1099 for 100 percent (the client’s share plus the lawyer’s fee), but not always

Lawyers need to send Forms 1099 too. Another concern is what Forms 1099 you as a lawyer must send. In general, anyone making payments in connection with a business must issue IRS Forms 1099 for payments of $600 or more. The penalties are not too severe for failing to do so (generally $50 for each form you fail to file), but they are quite severe if you intentionally fail to do so.

The IRS scrutinizes payments to co-counsel. Suppose you are the lead counsel in a case and receive a $1 million fee but are entitled to keep only $400,000, paying the other $600,000 to other lawyers and law firms. You must issue Forms 1099 to all of your co-counsel. If you don’t, you may have trouble deducting the $600,000 you paid out, and you may be subject to penalties. Although most payments to corporations are exempt from Form 1099 rules, incorporated lawyers and law firms must still be issued Forms 1099 for legal fees.

Usually you need not send Form 1099 to clients. The instructions to Form 1099-MISC expressly state that an excludable damage payment is not to be the subject of a Form 1099. It is less clear whether you should issue a Form 1099 in other kinds of cases. Most lawyers do not issue Forms 1099 to clients, on the theory that they are acting merely as an intermediary. The Treasury Department has promulgated some highly complex regulations that in general require you to issue a Form 1099 to your client if you exercised significant management and oversight of the funds before paying them out. Most lawyers in most cases probably do not.

Trial lawyers need to be sensitive to tax issues to know when to call upon tax advisors for guidance. Frequently, you can do a good deal of tax planning as a case is winding up, and even sometimes use the tax rules to settle a case that might not otherwise seem resolvable.

Keywords: tax guidance, settlement agreements, legal fee tax deductions, physical injury exclusion

Robert W. Wood practices law with Wood & Porter, in San Francisco, California.

This article was adapted from a longer one that was published in the Summer 2009 issue of Litigation.

  • March 5, 2010 – Excellent reminders.


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