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10 Things to Know About the Plaintiff Recovery “Double Tax”

A post-it note with Double Taxation printed on it sitting on a stack of papers

The taxation of plaintiff litigation recoveries is confusing. But it’s important to know the right answers. This is because the income tax consequences are so significant, especially where there are “double tax” issues.

10 things to know:

1. Recoveries in connection with personal injuries are not always tax-free.

2. Many other types of individual plaintiff recoveries are taxable.

Compensatory and emotional distress damages for physical injuries are tax-free, but the related punitive damages and interest are taxable.

These include non-physical injuries and related emotional distress, mental anguish, defamation, breach of contract, malpractice, fraud, securities law violations, intellectual property and more.

3. Many individual plaintiffs receiving taxable recoveries CANNOT DEDUCT their legal fees.‍‍

Personal attorney fees are “miscellaneous itemized deductions,” which are nondeductible. IRC §67(g). There are limited exceptions (e.g., employment discrimination, whistleblower). It’s important to know whether the IRC permits the deduction of your attorney fee.

4. The U.S. Supreme Court held that plaintiffs must include the attorney fee portion of their taxable recovery in income – creating the double tax.

This is the 2004 ruling in Commissioner v. Banks. As a result, in taxable cases where the attorney fee is not deductible, both the plaintiff and lawyer pay tax on the attorney fee portion of the recovery – hence the “double tax.”

5. In “double tax” situations, plaintiffs in high-tax jurisdictions end up with little or nothing.

A plaintiff might keep 10% after paying 40% to their lawyer and 50% in taxes. (Looking at you California!) And if their lawyer had significant expenses that are not covered by the contingent fee, the plaintiff may end up with nothing.

6. Defendants are subject to huge 1099 penalties in taxable cases if they don’t issue a 1099, or if they exclude the attorney fee portion.

The penalty can be 10% of the unreported amount, without limit. IRS Regulation 1.6041-1(f); IRC §6722(e).

7. Plaintiff lawyers must consider client tax issues.

American Bar Association (ABA) materials advise that “competent representation” of plaintiffs requires “considering the tax implications of the settlement.” ABA, Ethical Guidelines for Settlement Negotiations (August, 2002). Ethics rules require that personal injury lawyers tell clients the consequences of not addressing taxes or seeking competent tax advice.

8. Many suggested ways of reducing plaintiff recovery taxes don’t work.

These include reporting to the IRS only the portion of the recovery received by the plaintiff (excluding the attorney fee portion), treating the attorney-client relationship as a partnership or business, or excluding the structured portion of the attorney’s fees. Not only do these not work, they subject the plaintiff to massive penalties and interest if the IRS finds out.

9. Plaintiffs with taxable recoveries can increase their after-tax recovery if they act before a final resolution of the claim.

One way to do so is to draft the complaint or settlement agreement to consider the taxes (to the extent the facts allow). Another way to avoid taxation on the attorney fee portion of the recovery is to contribute the claim to a Plaintiff Recovery Trust (PRT). A PRT uses a traditional charitable trust planning arrangement, modified to the litigation context to achieve this result. There are other methods to reduce the taxes associated with a taxable recovery, such as selling the claim.

10. Addressing taxes after settlement is hard.

Tax planning to reduce plaintiff taxes on their recoveries is possible while the case is contingent and doubtful, i.e., not finally resolved. Careful planning is required. There are limited opportunities once the claim resolves. In this regard, few accountants are familiar with plaintiff recovery taxation matters and they tend to get involved only after the recovery, when it’s too late.

Disclosure: This content is an overview. It is not a detailed analysis and offers no legal or tax opinion on which you should solely rely. Always seek the advice of competent legal and tax advisors to review your specific facts and circumstances before making any decisions or relying on the content herein.
Any opinions, views, findings, conclusions, or recommendations expressed in the content contained herein are those of the author(s) and do not necessarily reflect the view of the Eastern Point Trust Company, its Affiliates, or their clients. The mere appearance of content does not constitute an endorsement by Eastern Point Trust Company (“EPTC”) or its Affiliates. The author’s opinions are based upon information they consider reliable, but neither EPTC nor its Affiliates, nor the company with which such author(s) are affiliated, warrant completeness, accuracy or disclosure of opposing interpretations.

EPTC and its Affiliates disclaim all liability to any party for any direct, indirect, implied, special, incidental, or other consequential damages arising directly or indirectly from any use of the content herein, which is expressly provided as is, without warranties.
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