New law provides favorable tax treatment for successful plaintiffs of unlawful discrimination cases

Beth L. Fowler
Counsel, Tax Department
January 1, 2000

Tax treatment of litigation awards to successful plaintiffs have been of great interest to Congress and the courts in the past few months.

As part of the American Jobs Creation Act of 2004, Congress passed a law affecting the taxation of proceeds paid to litigants from a successful claim of unlawful discrimination. Age discrimination, family medical leave act and civil rights actions are examples of unlawful discrimination actions. As a result of the new law, plaintiffs with favorable judgments after October 22, 2004 will now be able to deduct attorney fees and costs, which can be sizable percentages of their awards, in determining their adjusted taxable gross income. A plaintiff will include the entire judgment as income, and then subtract attorney’s fees (be they on a contingency – flat fee- or other basis) on line 35 of his or her income tax return.

On January 24, 2005, the United States Supreme Court also addressed the issue of taxation of settlements issuing an opinion in Commissioner v. Banks holding that a plaintiff is required to treat an entire judgment in a non-personal injury case as income. The plaintiff is then allowed to deduct attorney’s fees and other costs as itemized deductions. Thus, the gross amount of a judgment in non-personal injury cases is to be reported by the plaintiff as income. In its opinion, the Court acknowledged that Congress’ action in changing the law will lead to different tax results for settlements and awards in unlawful discrimination cases and other non-personal injury cases.

Until now, the tax treatment of contingency payments has been uncertain. Courts in several Circuits had historically treated the entire award as income with fees being taken as an itemized deduction. In contrast, courts in other Circuits held that the plaintiff was only required to report the net judgment, after payment of contingency fees. The First Circuit had not issued an opinion on this issue. The difference in treatment is important. Itemized deductions are reduced when a taxpayer exceeds a specified amount of adjusted gross income, and are reversed for alternative minimum tax calculations. A plaintiff who reports the net judgment receives the benefit of all fees paid under both regular and alternative minimum tax calculations, while a plaintiff who was required to treat the entire judgment as income will potentially receive no benefit from the fees paid.

A defendant’s tax reporting obligations under the revised law have not changed. The defendant is required to report amounts paid to the plaintiff and to the plaintiff’s attorney. After the end of the year, the defendant is required to include the entire judgment on the Form W-2 or Form 1099 it issues the plaintiff and to withhold based on this amount. If the defendant knows the amount of attorney’s fees to be paid, it will issue a Form 1099 to the plaintiff’s attorney reporting the amount to be paid to the attorney. If the defendant does not know the amount that will be paid as attorney’s fees, it is required to include the entire judgment on the Form 1099 it issues to the plaintiff’s attorney.

Rules dictating the tax reporting of proceeds from personal injury cases have not been changed. A plaintiff who receives compensation for physical injury does not include any portion of the payment in his or her income, nor deduct any of the related expenses. The defendant does report the amounts paid to the plaintiff to the Internal Revenue Service. The defendant is also required to report any amounts paid on behalf of the plaintiff to the plaintiff’s attorney. If the exact amount of attorney’s fees is known, at the end of the year the defendant issues the attorney a Form 1099 for that amount. If the defendant does not know the amount of attorney’s fees, the defendant is required to issue the attorney a Form 1099 showing the entire amount of the judgment paid.