Long over due tax reform on legal fee deductibility.

Earlier this month, Senator Arlen Spector, Republican of Pennsylvania, introduced S.B. 813, and a companion bill S.B. 814, that are intended to address one of the biggest tax inequities in the legal arena, and that is the non-deductibility of legal fee's on taxable damage cases.

A full copy of the bill and the thinking behind it is available by clicking on the Senators web site here.  

The first bill, 813, changes the code to allow for the above the line deduction of contingency fees portion of an award of  damages. The second bill changes the code to allow the deduction as an ordinary and necessary business expense of attorney advance expenses and court costs in contingency fee cases.

The importance of this bill in the legal and settlement community can not be understated and I am hopeful that both Republicans and Democrats, defendants and plaintiffs, can agree that the current situation is horribly inequitable and is essentially double taxation of injury victims.

The Banks and Banatis Supreme Court cases, the Murphy vs IRS, and other judicial remedies have attempted to address this inequity in different ways, and while Congress has had over 12 years to correct this situation, it is a happy day that a bill has actually been introduced that will fix this mess.

For some back ground, it's important to note that we are primarily talking about taxable damage cases or portions of cases considered taxable, such as punitive damages, wrongful termination, employment discrimination, wrongful imprisonment, etc. In those cases plaintiffs are almost always working on a contingent fee basis with their attorney in trying to address their legal claim. When the case is settled or tried to a conclusion that favors the plaintiff, a portion of the recovery goes to the attorney as their contingency fee, typically between 20% and 40% depending on the type of case. With certain narrow exceptions, the IRS and Treasury take the position that the entire recovery is includible in the income of the plaintiff, and that the attorney fee paid is not deductible in most cases, but if deductible, are characterized as miscellaneous itemized deductions. S.813 is seeking to correct the larger issue, which is that the fee needs to be universally deductible so the plaintiff isn't taxed on money they don't receive, i.e. the legal fee, while the attorney is also taxed on their fee as well. This is double taxation and patently unfair. Further, the change of the classification of payments away from being miscellaneous deductions allows for a reclassification that helps to minimize the unintended impact of creating an AMT issue as well. Basically the current situation is a mess, totally unfair and needs to be reformed in this fashion. I can't think of any good reason anyone would be against this bill.

 The second bill, S.814 is equally important for trial lawyers in that it amends the IRC to permit attorneys to deduct payments of litigation expenses on behalf of contingency fee clients as an ordinary and necessary business expense. Currently such expenses are deemed to be loans, so the attorney cannot deduct litigation related payments when they are made. Under the legislation being proposed by Senator Specter the payments would be treated as ordinary and necessary business expenses, thus allowing the attorney to receive the benefit of the tax deduction of the expenses as they are incurred, and further to recognize the income associated with those expenses later on, if and when damages are recovered. This bill should definitely assist and encourage lawyers to represent individuals who may not be able to afford an attorney or to front these costs, as well as eliminate the ethical issue of advances expenses as loans, which it typically forbidden activity for trial lawyers.

Hopefully NSSTA and SSP, not to mention every trial lawyers group in the US gets behind this bill and move it forward. There is not one single good reason why it shouldn't be the law, and that these litigants should no longer be subjected to double taxation.  

Posted on March 20, 2007 .