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Lawsuit Winners Lose the Tax Battle
LA Times ^ | 1-25-2005 | By David G. Savage, Times Staff Writer

Posted on 01/26/2005 9:50:51 AM PST by det dweller too

 

Lawsuit Winners Lose the Tax Battle

·  The Supreme Court rules unanimously that plaintiffs must pay levies on awards without first subtracting legal fees.

 

By David G. Savage, Times Staff Writer

WASHINGTON — The winners of big lawsuits may find themselves losers at tax time, thanks to a Supreme Court ruling Monday.

The justices, agreeing with the Internal Revenue Service, ruled that all the money plaintiffs won in lawsuits must be included in their gross incomes, even if a large portion of it went to lawyers.

(Excerpt) Read more at latimes.com ...


TOPICS: Crime/Corruption; Extended News; Government
KEYWORDS: lawsuits; taxes; tortreform


For the Record
Earlier versions of this story, which also ran in today's newspaper, incorrectly stated that the ruling will affect cases involving auto accidents and medical malpractice. Federal tax law exempts compensation for such "personal injuries." The ruling is likely to affect taxes on money won in lawsuits that result in punitive damages or for claims such as defamation.


To cover the cost of fighting lawsuits — which can drag out for years — lawyers often require clients to agree from the beginning to pay them as much as 40% of any judgment obtained.

But under the court's ruling, all of the final award will be considered as income to the plaintiff — even though he may receive 60% of that amount.

"It is a fundamental rule of taxation that income is to be taxed to the person who earns it, even when it is paid at the person's direction to someone else," the Justice Department and the IRS told the high court.

In a unanimous decision, the justices reversed the rulings of two lower courts, including the U.S. 9th Circuit Court of Appeals, which had held that plaintiffs should pay taxes on the amounts they received after subtracting lawyers' fees.

John W. Banks, fired from his post with the California Department of Education, sued the agency for discrimination. Shortly after the trial began, the two sides settled and the department paid Banks $464,000. His lawyer received $150,000 of it.

However, the IRS said Banks owed income taxes on the entire $464,000, and the Supreme Court agreed in the case of Internal Revenue Service vs. Banks.

In many instances, a plaintiff can take the legal fees as an itemized deduction on his tax form. However, those itemized deductions gradually fade for high-income earners. In addition, as the court noted, taxpayers subject to the alternative minimum tax — the special levy created to make sure wealthy filers could not evade taxation by claiming lots of deductions and credits — are not allowed any miscellaneous itemized deductions.

Beyond that, some lawsuits that drag on for years result in a judge awarding legal fees that far exceed the amount won by the plaintiff. For example, Illinois police Officer Cynthia Spina sued her employer for sex discrimination and harassment and was awarded $300,000 in damages. But a judge awarded her lawyer $1 million in legal fees. The IRS insisted that the total amount of $1.3 million was taxable income to Spina, and she ended up "losing every penny of the award," the court was told in one brief.

In his opinion for the court, Justice Anthony M. Kennedy acknowledged the ruling could "lead to the perverse result that the plaintiff loses money by winning the suit."

Congress can change the tax laws, and while this case was pending, lawmakers did exempt from a taxpayer's gross income "attorney fees and courts costs" that arose from "a claim of unlawful discrimination."

Lawmakers said they wanted to shield from taxes legal fees that arose from federal civil rights and job discrimination claims.

In cases involving auto accidents and medical malpractice. federal tax law exempts compensation for such "personal injuries." The ruling, however, is likely to affect taxes on money won in lawsuits that result in punitive damages or for claims such as defamation.

Chief Justice William H. Rehnquist did not vote in the decision.

 

 

1 posted on 01/26/2005 9:50:52 AM PST by det dweller too
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To: det dweller too

The money is double taxed since the Lawyer has to claim it too.


2 posted on 01/26/2005 9:54:15 AM PST by Semper Paratus
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To: det dweller too

This is a tough one.

Who do I want to profit less from lawsuits, lawyers or the government?


3 posted on 01/26/2005 9:58:00 AM PST by KidGlock (W-1)
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To: Semper Paratus
"The money is double taxed since the Lawyer has to claim it too."

If you use money that was taxed to pay a lawyer to fight a parking ticket you can't deduct his fee. Why should you be able to deduce his fee for any other reason?

4 posted on 01/26/2005 9:59:22 AM PST by norwaypinesavage
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To: Semper Paratus

Correctomundo..the trial lawyers are gonna love this...


5 posted on 01/26/2005 9:59:30 AM PST by ken5050
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To: KidGlock

Who do I want to profit less from lawsuits, lawyers or the government?

What's the difference?


6 posted on 01/26/2005 10:02:11 AM PST by yobid
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To: det dweller too
I've been here. What is an interesting consequence of the gradual elimination of deductions that arises from the action of Alternative Minimum tax calculations is that, while the legal fees paid by the prevailing party in the lawsuit may end up in large part, or in whole, nondeductible, the actual fees aid to the attorney will also be taxable income to him. This can result in a sort of perverse "Double Taxation" of the same money, once by the winner an another time by the attorney.
7 posted on 01/26/2005 10:02:58 AM PST by drt1
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To: det dweller too
So the lawyers have been ruled tax free by another set of lawyers. If the winner of the suit pays the taxes that the lawyer does not have to pay. Really sounds fishy to me. Before you sue incorporate and let the corporation sue then the lawyer fee would be corporate expense.
8 posted on 01/26/2005 10:05:31 AM PST by YOUGOTIT
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To: det dweller too
One way around the potential 'Double Taxation' pitfall would be to somehow have the attorney's fees awarded directly to him by the Court as opposed to having it awarded to the Plaintiff who then remits it to the attorney. I would think this could somehow be worked out in the determination of the final form of the judgment but not sure.
9 posted on 01/26/2005 10:07:14 AM PST by drt1
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To: KidGlock
I have a problem with this, in that if the total is considered income, then the cost of earning that income should be deductible. The cost of earning this income is the lawyer fees...

Just as I would not pay tax on gross receipts of a lawn business (if I had to rent the equipment, or paying an employee - I would get to deduct the cost of doing business),

In this case, the lawyer is my employee. I would send the law firm a 1099, and deduct it as a business expense.
10 posted on 01/26/2005 10:10:11 AM PST by babygene (Viable after 87 trimesters)
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To: Semper Paratus

The money is double taxed since the Lawyer has to claim it too.


True, and I don't see Workman's Compensation anywhere in the article, wonder if it will effect those, though I don't see how it would.


11 posted on 01/26/2005 10:10:51 AM PST by gidget7
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To: YOUGOTIT
"Before you sue incorporate and let the corporation sue then the lawyer fee would be corporate expense."

Don't think that would work. A Corporation formed after the acts forming the basis for the suit would not have standing. A possible way out along those lines though is to claim the act being litigated arises out of the conduct of your own personal business and try to include both income and expenses associated with the suit on Schedule C of your Tax Return.

12 posted on 01/26/2005 10:13:04 AM PST by drt1
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To: drt1

have the attorney's fees awarded directly to him by the Court

They usually are already, in that the lawyer gets the award, and deducts his portion, then issues a check to his client for the remaining amount.

I know a lawyer and this is common practice.


13 posted on 01/26/2005 10:14:24 AM PST by gidget7
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To: det dweller too
...even if a large portion of it went to lawyers.

Then that portion should be a deductible expense.

14 posted on 01/26/2005 10:14:44 AM PST by Bloody Sam Roberts (All I ask from livin' is to have no chains on me. All I ask from dyin' is to go naturally.)
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To: gidget7
While it is true that the Gross amount of the award is often disbursed directly to the attorney, it is not always so and the records of the Court will show the award to the Plaintiff/attorney's client. Also, in cases where subsequent collection action is necessry in executing the judgment the amounts may, or may not, flow in this fashion.

Ex. Court awards 1M$ judgment, Plaintiff hires another collections attorney to effect execution or Plaintiff executes on his own. The originl attorney very probably would not be in the direct flow unless he had filed a lein against the award, for example.

15 posted on 01/26/2005 10:22:38 AM PST by drt1
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To: det dweller too
It is possible, under this scenario, to win a large settlement and owe more in taxes than you net from the judgment.

Voila!

Back door tort reform!

This is almost as good a way to discourage frivolous lawsuits as "loser pays," though I would prefer "loser pays."

16 posted on 01/26/2005 10:25:54 AM PST by E. Pluribus Unum (Drug prohibition laws help fund terrorism.)
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To: Bloody Sam Roberts
Then that portion should be a deductible expense.

We are talking about the IRS here.

Logic does not apply.

17 posted on 01/26/2005 10:27:01 AM PST by E. Pluribus Unum (Drug prohibition laws help fund terrorism.)
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To: det dweller too
One trap I fell into in a previous thread on this case was arguing "what should the law be". However, this should be an arguement about "what is the law". The judges should read the laws and the Constitution and rule on those. If the laws as written are bad, then they should be rewritten by congress not by judges.

I haven't dug deeply enough into the facts of the case to conclude if the Supreme Court did what they should be doing. If they did just rule correctly on a bad law, then the Supreme Court did its job.

18 posted on 01/26/2005 10:33:31 AM PST by KarlInOhio (Blackwell for Governor 2006: hated by the 'Rats, feared by the RINOs.)
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To: E. Pluribus Unum
Logic does not apply.

Sorry. I lost my mind. But only for a minute or two.


19 posted on 01/26/2005 10:34:13 AM PST by Bloody Sam Roberts (All I ask from livin' is to have no chains on me. All I ask from dyin' is to go naturally.)
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To: YOUGOTIT
So the lawyers have been ruled tax free by another set of lawyers

Where did you get that from? Both the Plaintiff and the lawyer must pay taxes. The Plaintiff on the entire amount and the lawyer on the attorney fee portion.

20 posted on 01/26/2005 10:37:43 AM PST by CharacterCounts
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To: babygene
In this case, the lawyer is my employee. I would send the law firm a 1099, and deduct it as a business expense.

Are you in business?

21 posted on 01/26/2005 10:41:53 AM PST by CharacterCounts
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To: det dweller too
I am a bit perplexed.

injury can arise from personal physical harm done to one person by another, such as kicking a person and breaking his or her leg. It can cost the injured person money. Let's say, 10K of hospital expenses.

Another way to harm a person is to accuse him or her of inappropriate behavior which is untrue-- libel or slander. The person winds up losing a job and it costs the person money. Let's say, for example, $10K to move from one locale to a different locale to find another job.

In each case, the out-of-pocket expenses by the injured party is $10K.

Now the SC proposes charging tax on any court-ordered monetary award categorized as defamation/slander?

In the second case, the injured party effectively pays taxes on an *expense*. The award it seems to me should be regarded as *compensation* for *expenses*, not "income."

It sounds overall as if the SC suffers from the impression that the purpose of society is income redistribution-- otherwise why exempt discrimination? Would there be any real doubt that so-called "reverse discrimination" would be effectively removed from this exemption, given the demonstrated bias of the court in this decision?

Likewise, the implicit purpose of taxing defamation seems to be, effectively, to exempt state and companies from any consequences of unintentionally or intentionally harming a person's reputation.

Injury is injury. Compensation is compensation, or should be. This is income redistribution and corporate pandering in the form of yet another wacked-out SC decision.

Maybe I misunderstand some aspect or another of the nature and effects of this decision(?)

22 posted on 01/26/2005 10:45:01 AM PST by SteveH
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To: norwaypinesavage
If you use money that was taxed to pay a lawyer to fight a parking ticket you can't deduct his fee. Why should you be able to deduce his fee for any other reason?

General rule: expenses incurred for the production of income are deductible, fines and penalties are not.

23 posted on 01/26/2005 11:43:13 AM PST by talleyman (E=mc2 (before taxes))
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To: talleyman

Simple answer is make the lawyers fees after taxes in the initial pre-litigation agreement.If this was not done bring action against lawyer for hiding facts in initial negotiations.


24 posted on 01/26/2005 12:04:17 PM PST by Blessed
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To: CharacterCounts

Where did it say the lawyer was to pay taxes on his fee? All I read was that the winner was to pay tax on the total amount.


25 posted on 01/26/2005 12:08:27 PM PST by YOUGOTIT
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To: SteveH

Income is taxable unless specifically exempt.

Among the exemptions are damages paid for personal physical injuries & sickness. The treatment of deductions depends upon the associated income - business income, business deductions, vs personal income, personal deductions.

The essence of a defamation/slander suit presumably is to replace income lost by damage to one's reputation. If the income "lost" would have been taxable, why not its replacement? On the other hand, compensation for a lost body part (don't go there) is replacing one non-taxed asset (I mean it, don't go there) with another. It's all pretty logical, actually.


26 posted on 01/26/2005 12:08:41 PM PST by talleyman (E=mc2 (before taxes))
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To: det dweller too
I can't believe I am saying this, but God bless AMT!

Many of the lowlife professional plaintiffs will end up with far, far less than the shysters promised them. Some will actually OWE huge amounts of money after their "win."

The only downside is that the shysters will walk away with at least as much if not more than the crooked plaintiffs. And there are still no 1099s to the iRS reporting the monies paid to the lawyers.

27 posted on 01/26/2005 12:08:48 PM PST by FormerACLUmember (Honoring Saint Jude's assistance every day.)
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To: talleyman
OK (at least, I can't come up with a ready counterargument at the moment that does not involve stuff classically regarded as "tax protestor" related), but what if the damage suffered is property loss-- for example, poor workmanship in constructing a house, or purchasing faulty equipment (machinery, software, hardware, you-name-it)? Does it make sense to tax those expenditures twice (help, lost in income tax hyperspace ;-)?? Also what about compensation for emotional damage due to loss of reputation, therapy that otherwise would not be needed and thus expenditure not made or taxable, etc.?

Don't want to drag anyone necessarily down another income tax rathole-- NST is the way to go and abolish the intrusive privacy invasion of the IRS altogether IMO.

28 posted on 01/26/2005 4:58:31 PM PST by SteveH
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To: CharacterCounts
"Are you in business?"

You might say... I'm the president of a multi-thousand dollar corporation.
29 posted on 01/26/2005 7:58:01 PM PST by babygene (Viable after 87 trimesters)
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To: YOUGOTIT
Where did it say the lawyer was to pay taxes on his fee? All I read was that the winner was to pay tax on the total amount.

Well, I can see how the IRS can twist it that way. If you won a lawsuit for a $ Million and $ 500K in legal fees, the IRS is saying you got $1.5 Mil and you in turn paid the lawyer $500K.

That is the theory, but the actual way it works is the lawyer gets the money, subtracts their fee and sends/gives the remainder to the plaintiff. Now how about if the ENTIRE amount was able to the lawyer, and then just the result sent to the plaintiff, which is all he ever sees anyway, is also taxable to him. Wow! that would be a shock.

30 posted on 01/26/2005 9:10:37 PM PST by det dweller too
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To: det dweller too
You are correct. If the plaintiff wins $1,000,000 and the fee is 35% then the plaintiff pays tax on the $1 million of approximately $390,000 Federal and $80,000 State. He then gives the lawyer his fee of $350,000 so the plaintiff ends up with $180,000. So who made the money? The lawyer and the tax man.
31 posted on 01/27/2005 4:26:25 AM PST by YOUGOTIT
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To: SteveH
but what if the damage suffered is property loss

Property loss (casualty or theft) is deductible to the extent not reimbursed. If reimbursement exceeds your "basis" in the property, then you have income (possibly capital gain.)

32 posted on 01/28/2005 12:13:12 PM PST by talleyman (E=mc2 (before taxes))
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