How is a successful plaintiff taxed for attorney’s fees - the Plaintiff pays from the recovery?

The Internal Revenue Service and the 9th U.S. Circuit Court of Appeals take the position in a contingency case a successful plaintiff owes income taxes not only on the portion of the recovery actually received after the deduction of attorney fees but also on the portion of the recovery received by the lawyer under the contingency fee agreement.

Recoveries relating to physical injuries are not taxable.

This is the way it works. On a $100,000 taxable damage recovery with a 40% contingency fee, the plaintiff is required to report as income the entire $100,000 instead of just the $60,000 net recovery that he or she receives.

The client takes the taxpayers deduction of $40,000 of attorney fees as a miscellaneous itemized deduction on Schedule “A”.

Unfortunately, the taxpayer does not always receive a deduction for that amount. Tax law requires that the taxpayer compute his or her tax liability under the regular tax system and the Alternative Minimum Tax or income phase outs. Only $35,400 of the $40,000 of legal fees in this example would be allowed as a deduction under the regular tax system. No portion of the legal fees can be deducted for Alternative Minimum Tax purposes. In this example, the disallowed legal fees for Alternative Minimum Tax purposes results in a higher tax.

The taxpayer is taxed differently when reporting a $100,000 recovery and $40,000 of legal fees (“gross reporting”) and reporting a net recovery of $60,000 (“net reporting”). If the tax return reflects gross reporting and these items are the only items on the return, the client can expect to pay almost $10,000 more in taxes than would result from the net reporting. Under that scenario, gross reporting would create tax of $35,000 resulting in an effective tax rate of 58%. However, net reporting would create tax of $25,000 and a 42% effective tax rate.

The client’s reporting the same $40,000 of income as the attorney represents a form of double taxation. This result is based on the tax rule that provides that the entire amount received is the “property” of the prevailing party; i.e., the client. Even if the fees paid to the attorney are secured by an attorney’s lien, the lien does not convert the fees to a property interest held by the attorney. Similarly, preparing a separate check for the attorney does not change how the recovery will be taxed to the plaintiff.

Federal Tax law looks to property rights under applicable state law.

In Coady v. Commissioner of Internal Revenue, 213 F.3d 1187 (9th Cir. 2000), the Court reviewed the issue of whether a plaintiff could exclude from gross income costs and contingent legal fees incurred in securing a judgment in connection with a wrongful termination claim. The Court held that under Alaska’s attorney lien statute, the lawyer did not have a superior lien or an ownership interest in the cause of action and, as a result, 100% of the proceeds of the judgment had to be included in the client’s gross income.

Coady declined to follow cases from other circuits because the Court in Coady found that Alaska’s attorney lien statute did not create an ownership interest in the cause of action, as did the statutes in those other circuits.

The 9th Circuit reached the same result in Benci-Woodward v. Commissioner of Internal Revenue, 219 F.3d 941 (9th Cir. 2000), as it did in Coady. In Benci-Woodward, the Court, citing various authorities including Coady, concluded that in California, a contingency fee agreement does not confer an ownership interest in the client’s claim but only operates to give the lawyer a lien upon the client’s recovery. As a result, the entire amount of the recovery was includable in income.

In California, absent agreement, an award of attorney fees under the Fair Employment and Housing Act belongs to the lawyer and not to the client. Flannery v. Prentice, 26 Cal.4th 572 (2001).