The “Tax Cut Act” actually increased the tax on consumer recoveries. Under the new tax law, most damage awards a consumer recovers stand to go, in large part, to the IRS.
So even if you are successful in vindicating your legal rights, the expenses of getting the award aren’t deductible from the gross award. The taxing authorities end up getting a large hunk of the total recovery.
Welcome to tax “reform”.
Consumers get shafted
It isn’t that way for every plaintiff, and it wasn’t that way before tax “reform”.
If you operate a business and hire an attorney to assist you with business issues, your legal fees will typically be fully deductible under IRC Section 162 as ordinary and necessary business expenses.
Recoveries for personal physical injuries or physical sickness are non-taxable and the change in the law won’t affect you.
But the vast bulk of all other legal recoveries ARE taxable under IRS Section 104 . However, you used to be able to deduct the costs to obtain the award under the miscellaneous expense deduction.
But now, under the new tax law, the attorney fees you pay to obtain these recoveries are not deductible in ANY amount.
How did this happen
The Tax Cuts and Jobs Act (TCJA) removed the miscellaneous itemized deduction. It was completely removed. This deduction formerly resided at Section 67 of the Internal Revenue Code. Its passing wasn’t mourned or even noticed by most.
Often overlooked but quite valuable, these miscellaneous itemized deductions include odds & ends of taxpayer expenses such as: Unreimbursed employee expenses, job education, safe deposit, tax preparation, and among other things – Attorney’s Fees paid by individuals.
The TCJA rests, at least in part, on the rationale that only about one-third of all taxpayers itemize. The reverse of that statement being two-thirds of all taxpayers don’t itemize.
Those who drafted the TCJA apparently looked at the raw percentage of 1/3 versus 2/3 and concluded relatively few would be significantly impacted.
But this conclusion is faulty. The vast majority of people who don’t itemize have chosen not to do so because the standard deduction benefits them more. Thus, year by year these taxpayers do what they need to do in terms of taking or not taking the standard deduction.
Tax and destroy
The “one-third” who itemize includes an ever-changing group of non-itemizers in previous tax years whose current year tax situation makes itemization important. Typically, these are lower-middle to middle-class taxpayers who for one reason or another have a “bump” in their income that makes itemization much preferable, or in the case of certain taxable activities, critical.
For taxpayers bringing a lawsuit because they were financially harmed, were injured and suffered emotional distress, and/or nearly every other type of claim, it will result in owing CONFISCATORY and in some cases RUINOUS income taxes. Now, the ability to deduct legal fees paid to obtain the award, settlement or jury verdict is gone. The fact that the individual paid the attorney fees to the attorney is completely ignored.
Imagine an individual being awarded punitive damages of $1,000,000. Further, imagine that the agreement with their attorney is that the attorney receives 50%. Under the TCJA the individual now will be required to include the full $1,000,000 as THEIR income. They will have to pay taxes on that full $1,000,000 even though half of it went to their attorney! The attorney who is paid $500,000 will also be required to include that money as their income.
Double taxation? You bet!
Consumers, who often bring federal and state cases actually enacted to protect their rights, will be decimated by the taxes owed on any recovery.
Under the new tax law, THEIR “CIVIL” RIGHTS ARE EFFECTIVELY GONE. The vast majority of the American taxpayers will not be able to “afford” to sue anyone. There are no hardship provisions and no relief whatsoever.
The law before “reform”
The law before the TCJA was lousy but at least it provided some deduction for legal fees.
Under the old rules, since personal legal fees you pay were classified as a miscellaneous itemized deduction – they were limited by the “two percent rule”: Fees were deductible only if, and to the extent, they (along with all your other miscellaneous deductions) exceed 2% of your adjusted gross income (AGI).
What’s Adjusted Gross Income? Put simply, it’s all your income from working, investments, retirement accounts, rental property, etc. minus all the expenses considered “above the line” such as IRA contributions, student loan interest, and HSA deposits.
To utilize the convoluted deduction under Section 67 you actually had to do FOUR things:
1. Establish your Adjusted Gross Income; and
2. Calculate two percent (2%) of that figure; and
3. Establish the total amount of your miscellaneous itemized deductions; and
4. Calculate the excess if any of your total miscellaneous itemized deductions over the 2% figure.
Example: Hapless, a single taxpayer has an adjusted gross income of $50,000. Under the old tax law, he may deduct his miscellaneous itemized deductions only to the extent that they exceed 2% of $50,000, or $1,000. This year he had $100 in tax preparation fees and $1,100 in personal attorney fees. Therefore of the $1200 in miscellaneous itemized deductible items subject to the 2% floor, only $200 is tax deductible. (It ain’t great but it was better than nothing.)
Welcome to “reformed” tax hell
Picture Hapless in 2018: He files a lawsuit filed under a state consumer protection statute and obtains a statutory award of $5,000 from Disreputable Debt Collection Agency who sued him in court over a debt they were legally blocked from ever collecting under the state’s statute of limitations.
Imagine Disreputable actually takes Hapless to court, sues and loses, and appeals. Imagine Hapless finally wins on appeal. Imagine the court piously and magnanimously awards Hapless $5,000 and awards him his attorney’s fees of $70,000.
Under the TCJA the full $75,000 ($5000 to Hapless plus $70,000 in attorneys fees) goes into Hapless’ income ON TOP of his other taxable income, with no deduction for the attorney’s fees incurred to get the recovery. Keep in mind that the $70,000 was paid to Hapless’ attorneys. The $70,000 will be taxed to Hapless’ attorneys. But Hapless will also be taxed on the $70,000!
In federal income taxation classes, students learn to recognize this situation as a Fresh Slice of Tax Hell.
Figure in classic consumer cases the attorney contingent fees runs anywhere from 35% to 50% of the recovery. Assume that 100% of these fees are non-deductible.
Sizeable punitive damages awards will be virtually catastrophic for victims as they are 100% income taxable and 100% nondeductible to the victim. Many plaintiffs in ordinary consumer litigation will owe far more in taxes than they actually received in money.
Having won the lawsuit, they will have no way to pay the income taxes. The IRS will besiege them, filing tax liens and levying their bank accounts and wages. (You don’t want to think about what the California Franchise Tax Board will do.)
All the while these tax agencies will pretend as though they don’t understand the problem the tax law itself has caused.
And don’t forget: Attorneys who receive the fees are paying taxes on those fees themselves.
What’s the solution
One of the most fundamental tenets of the income tax system has always been that income should be matched and offset by very basic costs necessary to produce it. When attorney’s fees are included in the client’s income, that tenet just went out the window completely.
The TCJA, as it relates to this issue, and the IRS’s position absolutely violates the fundamental income taxation principles of income/expense matching as well as the tried and true rule of income tax congruence.
Given the IRS and existing tax law sensibly mandates that there would be NO deduction for attorney’s fees that generate nontaxable income, it is utterly asymmetric to impose full bore taxation on both the recovery and the attorney’s fees with no deduction for these fees when they are absolutely integral to the creation of that taxable income. It violates the most basic rules of the income tax system. It always has, and it always will.
When you pay your attorney, they pay tax on that money. Why should you have to pay tax on it too?
The only answer from bureaucrats and politicians: “The law is the law.”
If you’re thinking that this problem could easily be fixed by making attorney’s fees an above the line deduction, you’re right. That could work with a little tinkering.
If your objection is that people will engage in outrageously frivolous attorney fee driven litigation if their attorney’s fees were fully deductible above the line, that can be fixed by providing such fees are deductible to the extent said fees are includable in the gross income of the client. No recovery, no deduction.
It isn’t hard to make the system fairer than it is now. This alone should give you an idea of how illogical and indefensible the current change in the law is for anyone, let alone the tens of millions of lower and middle-income taxpayers who can least afford it.
The law in this area was lousy and foolish before 2018. It’s indefensible now.
Cathy adds: Consider the extent to which this tax change stands to undermine consumer protection laws, without Congress ever having to take a roll call vote on consumer law.
More Bill Purdy
This post has been slightly revised on 3/21/18.