Experts on Damages, Valuation & Accounting Experts on Damages, Valuation & Accounting

Avoiding A Contingency Fee Tax Trap

January 17th, 2010

In re: Commissioner vs. Banks and Commissioner vs. Banaitis, the Supreme Court ruled (8-0) that contingency attorney fees paid by an individual must be included in the taxpayer’s income and then deducted.  This has the following adverse outcomes:

  • Once included in gross income, the legal fee is deducted as an itemized deduction, causing:
      i. the standard deduction to be missed if the individual is not otherwise itemizing expenses, and ii. more importantly, a portion of the deduction is lost because the legal fee is a “miscellaneous deduction” which has a 2% floor that must first be reached.
  • When the alternative minimum tax (AMT) applies (which will likely occur with larger awards), the attorney fee cannot be deducted at all.

A Southern California lawyer unfamiliar with these rules was successfully sued for malpractice, even though all involved acknowledged that the lawyer achieved an outstanding result for the plaintiff (see Jalali v. Root).  Mercifully, the malpractice claim was reversed on appeal, although only because the Appellate Court concluded that the plaintiff failed to put on the correct type of damages evidence.

Employment cases are an exception because of the 2004 Tax Act.  See Tax Relief for Employment-Law Plaintiffs.

In a business setting, an entirely different result is obtained.  When a business is involved, legal expenses are deductible as business expenses, with none of the above limitations.  Therefore, an opportunity may exist to treat the income as a business matter by using a partnership structure.  Under this plan, the plaintiff and his attorney form a partnership or LLC.  The amount of the attorney’s contingent fee equals the attorney’s share of the partnership.  The plaintiff hires the partnership, and the partnership hires the attorney.  The attorney’s reporting of income is effectively unchanged from what would occur without this arrangement.  The plaintiff pays additional self-employment taxes because he is a general partner in a partnership, but these taxes will usually be less than the adverse tax consequences that would otherwise occur.  The plaintiff can perhaps avoid these self-employment taxes if classified as a limited partner.  However, classification as a limited partner is probably not appropriate in light of the client’s ability to (i) select legal counsel and (ii) settle the case.

Importantly, for this structuring to work, the business entity must be established at the beginning of the case.  Even if established early, this structure is risky and unsettled.  You should consult a tax advisor before proceeding with this type of tax planning.

Fulcrum Inquiry is a financial consulting firm that regularly assists lawyers.  We do this through: