Attorneys' Fees In Employment Disputes Now Taxed As Claimants' Income

Paying attorney’s fees is never easy, but paying the fees of someone who’s suing you can be downright painful.

Until recently, this pain was exacerbated in employment settlements due to ambiguity regarding the proper tax treatment of attorney’s fees associated with employment claims, and pressure from the plaintiffs’ bar to take aggressive tax reporting and withholding positions.

While these aggressive reporting positions could expose an employer (and certain directors, officers and employees) to liability and penalties for unpaid employment and payroll taxes, overly conservative reporting positions could produce inflated settlement amounts or derail settlement altogether.

Recent action by Congress and the U.S. Supreme Court has eliminated much of the ambiguity in the tax treatment of attorney’s fees in these cases, but issues do remain that in-house counsel should be aware of when resolving employment claims.

Representation Without Taxation

The underlying question to the controversy concerns whether attorney’s fees paid under an award or settlement in an employment dispute are includible in the gross income of either the employee-claimant, the claimant’s attorney, or both?

Here’s an example. A former employee sues your company alleging he was fired in violation of Title VII. After trial commences, you settle the case for $464,000, from which the plaintiff pays $150,000 to his attorney pursuant to a contingency fee agreement.

The plaintiff’s attorney asks you to exclude the $150,000 from the Form W-2 report issued to the claimant.1 Can you do so without exposing your company – and the persons responsible for withholding and filing taxes – to liability to the IRS?

Claimants have argued for years that, in effect, you may because attorney’s fees are not includible in their income. Their incentive for doing so was compelling.

Until recently, attorney’s fees associated with employment claims were not treated as “above-the-line” deductions. Instead, they were treated as miscellaneous itemized deductions and were allowed only to the extent that they, along with other such deductions, exceeded two percent of the claimant’s adjusted gross income (AGI) for the tax year in which the settlement or award was received.

In addition, these expenses were subject to a deduction reduction if the claimant had AGI in excess of the Tax Code Section 68(b) amount ($145,950 in 2005), and could not be claimed at all for purposes of the alternative minimum tax (AMT).

For most individuals, the AMT regime imposes a two-tiered minimum tax equal to 26 percent of taxable annual income up to $175,000, and 28 percent of taxable annual income in excess of $175,000.

In effect, including attorney’s fees in claimants’ income deprived the claimants of much of the benefit of the award or settlement, and prompted claimants to ask employers to treat the fees as income solely of the claimant’s attorney. Employers were often amenable to this position since it tended to lower settlement demands by increasing the net recovery to the claimant. A division in the U.S. Circuit Courts on the issue provided a basis for accepting this position in appropriate cases.

One-Two Punch To Fee Exclusion

The Jobs Creation Act, enacted in October 2004, and the Supreme Court’s January 2005 decision in Commissioner v. Banks have gone a long way toward barring the position that attorney’s fees in employment cases are excludable from the claimant’s income, attacking it from both the expense side and the income side.

On the expense side, the Jobs Creation Act amended the tax code to create an “above-the-line” deduction for attorney’s fees incurred in connection with a wide range of specifically-designed employment actions. As a result, these attorney’s fees are no longer subject to the deduction reduction for individuals with AGI above the Section 68(b) amount and can be claimed for AMT purposes.

On the income side, in Banks, the Supreme Court considered the scenario described above in which a Title VII claimant sought to have $150,000 in attorney’s fees excluded from his income. The court refused, holding that “as a general rule, when a litigant’s recovery constitutes income,2 the litigant’s income includes the portion of the recovery paid to the attorney as a contingent fee.”

A number of arguments asserted by the appellants in Banks were not addressed by the court and will likely provide fodder for further controversy and aggressive tax reporting requests from the plaintiffs’ bar, including an unanswered argument that contingency fee arrangements establish Subchapter K partnerships, under which the attorney’s fees are allocable to the attorney only.

Of particular note, the court declined to address Banks’ argument that fees should be excluded if paid under a federal statute that authorizes fee awards to prevailing plaintiffs’ attorneys. The court explained that, since Banks settled his case and paid his attorney’s fees pursuant to a contingency agreement, there was no “court-ordered fee award, nor was there any indication in Banks’ contract with his attorney, or in the settlement with the defendant, that the contingency fee paid to Banks’ attorney was in lieu of statutory fees Banks might otherwise have been entitled to recover.”

We are left to speculate as to whether the court would have accepted the claimant’s argument had the facts been different on any of these three points.

Conclusion

The deduction relief afforded by the Jobs Creation Act should significantly reduce pressure from the plaintiffs’ bar to exclude attorney’s fees from claimants’ reported income in employment cases.

Nevertheless, it is likely that claimants will continue to prefer to have these fees excluded from income, and that some will request employers to remove these amounts from settlement payments reported on Form W-2. As noted above, the Banks decision leaves the door open for arguments in support of this position.

But employer’s counsel should be wary of these requests, particularly since the IRS – the prevailing party in Banks – does not currently accept the fee exclusion argument, and may seek to impose personal liability for unpaid employment taxes on the company representatives who are responsible for reporting and transmitting those taxes.

1 The scenario could be further complicated by converting the request to report some or all of the income on a Form 1099 issued to the claimant and treating that income as exempt from withholding and payroll tax.

2 Recoveries for certain employment-related claims, e.g., claims for personal physical injuries, are generally excludable from income. 26 U.S.C. ��(a)(2).