There is a compelling tax reason to specify the amount of the recovery going for attorneys’ fees and expenses, in cases not involving personal injury. In other words, taking the position that “it’s none of the other side’s business” can be expensive for both sides.
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In preparing a paper for Bob Fitzpatrick’s showcase ALI-CLE program in Santa Fe July 24-26, 2014, I looked at a lot of tax questions and was forcefully reminded of a critical practice tip that applies ONLY where the client’s award is taxable to the client. This is largely taken from one of my papers for the program that I just finished.
Background: In those cases, the amount of the award that goes for attorneys’ fees and expenses has to be included in the claimant’s taxable income. In civil rights or employment or whistleblower cases, the claimant can take an above-the line deduction for the full amount of the fees and expenses up to the extent of the claimant’s recovery, without the exclusion of 2% of adjusted gross income and without triggering the Alternative Minimum Tax. In other cases not covered by 26 U.S.C. §§ 62(a)(20) and –(21), the client can deduct the fees and expenses up to the extent of the claimant’s recovery, subject to the exclusion and the possible triggering of the alternative minimum tax. In both instances, the deductibility of the fees and expenses is capped by the claimant’s taxable recovery.
Important Practice Tip: There has been recent discussion on plaintiffs-attorney list-serves as to whether the amount of attorneys’ fees and expenses paid by the defendant (or entity defending the claim, if it is pre-suit) should be specified in settlement agreements. Some plaintiffs’ attorneys say it is no business of the other side. However, the IRS takes the position that where the amount is specified in the judgment, court order, or settlement, F.I.C.A. and Medicare taxes on the amount of fees and expenses will not apply as to either the client or the payor, and the payor (if an employer) will not have to pay unemployment taxes on the amount. Where the amount is not specified in the judgment, court order, or settlement, F.I.C.A., Medicare, and FUTA taxes will be applied. It makes no difference if the fees are contingent or not.
IRS Rev. Rul. 80-364, 1980-52 I.R.B. 15, 1980-2 C.B. 294, 1980 WL 130164, “Legal Fees and Interest Awarded with Back Pay,” describes three situations and states the different tax treatment of each:
Situation 1. After termination of employment by a company, an individual filed a complaint against the company for back pay owed to the individual. The court awarded the individual 8x dollars as back pay, and also awarded interest of 1x dollars and an attorney’s fee of 1x dollars.
Situation 2. An individual sued the individual’s employer for 15x dollars for back pay. Pursuant to a court order the employer made a payment to the employee of 10x dollars. The court order did not indicate that a portion of the award was attorney’s fees or interest. The employee paid 1x dollars for an attorney’s fee which was paid out of the award.
Situation 3. Due to a breach of a collective bargaining agreement a union filed claims on behalf of its members against a company. Subsequently, the union and the company entered into a settlement agreement, later approved by a federal district court, that provided that the company would pay the union 40x dollars in full settlement of all claims. The union paid 6x dollars of the settlement for attorney’s fees and returned 34x dollars to the employees for back pay owed to them. The back pay was distributed among the employees in proportion to their claims.
The IRS’s resolution of these situations is as follows:
In Situation 1, while the full amount of the award is income to the employee and must be included in the employee’s gross income, only the back pay award of 8x dollars is wages for federal employment tax purposes. The payments for interest and the attorney’s fee are not wages, because they are not remuneration for employment.
In Situation 2, the full amount of the award is income to the employee and it is also wages for federal employment tax purposes, notwithstanding that a portion of it was spent on attorney’s fees.
In Situation 3, the amount of the settlement paid by the union for attorney’s fees is not remuneration to the individual employees and, therefore, is not wages for purposes of the federal employment taxes. The attorney’s fees portion of the settlement is a reimbursement for expenses incurred by the union to enforce the collective bargaining agreement. The amount allocated to attorney’s fees is not includible in the gross income of the individual employees and the individual employees may not deduct the attorney’s fees as a business expense. Compare Rev. Rul. 58-301, 1958-1 C.B. 23.
The IRS Chief Counsel Memorandum, Release Number 20133501F, released August 30, 2013, which also comes with a disclaimer, states that the same reasoning applies to settlements:
Although Rev. Rul. 80-364 addresses court awards in the back pay context and not settlements of claims outside of court, the reasoning in the ruling can be extended to settlement payments. When an employment-related claim brought under a fee-shifting statute is settled outside of court and the settlement agreement clearly allocates a reasonable amount of the settlement proceeds as attorney’s fees, the amount allocated to attorney’s fees, while includable in income, is not wages for employment tax purposes. On the other hand, if the settlement agreement does not clearly allocate an amount for attorney’s fees, and/or the claim is brought under a statute that does not provide for fee-shifting, the entire amount paid to the claimant-employee is wages for employment tax purposes.
F.I.C.A. taxes are 6.2% on the employee and on the employer for the first $117,000 of pay, and Medicare taxes are an additional 1.45% of payroll. The Federal Unemployment Tax is 6% of the first $7,000 of payroll, payable only by the employer. As a result, failure to specify the amount of fees and expenses in a judgment, court order, or settlement will cost the employee 7.65% of that amount up to $117,000, and will cost the employer an additional 7.65% of that amount up to $117,000, plus up to $420 in FUTA taxes.
Since the employer will likely be negotiating with the total cost (including taxes) in mind, bringing up this saving may enable a little more money on the table and a modest increase in the amount the employee recovers, in addition to the employee’s tax saving. In difficult negotiations, this may help bridge the gap.
Mediators and arbitrators in employment and civil rights cases need to keep this tax question in mind.
Richard T. Seymour
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I represent the dispossessed of the Earth, and executives recently shown the door.
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