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Settling Employment Cases Just Got Easier: New Tax Law Excludes Attorneys Fees’ Portion Of Recovery From Income To Plaintiff

If there is anything that the typical clever lawyer does right, it is to shy away from offering tax advice to his clients. For years, the question of taxability of the attorney’s fee earned on an employment case has been particularly perplexing for two reasons: first, because the fee may be a substantial portion of the recovery, especially if it’s awarded under statute or as a contingency fee in a huge award; and second, because settlement of employment cases is otherwise taxed as earnings to the Plaintiff, unlike other personal injury actions. Few employment litigators, and even fewer employment mediators truly understand the workings of these tax laws.

The following is a previewed synopsis of the latest developments in tax law affecting settlement and judgments in employment cases:

Pre-Jobs Act Tax Law re: Deductibility of Attorneys Fees and Court Costs:

Under the law, prior to October 22, 2004, any judgment or settlement related to a taxpayer’s employment was subject to tax as income. Attorney’s fees and costs were treated as miscellaneous itemized deductions (“below the line deductions”). Accordingly, a taxpayer could not deduct the full amount of the fees and costs, and the fees were not deductible for taxpayers choosing the “alternative minimum tax” method.

The 2004 Jobs Act

On October 22, 2004, President Bush signed into law the American Jobs Creation Act of 2004, which included a Section on “Civil Rights Tax Relief”. That bill was designed to eliminate the double taxation which the IRS contended resulted when an unlawful discrimination claim was settled by the payment of any amount to the Plaintiff. Accordingly, the Plaintiff in an unfair discrimination claim need now report as income only the income she receives after she has paid her attorney his fees and litigation costs.

The effect of the new legislation will be to make it easier to arrive at a settlement because Plaintiff is now permitted to pay taxes only on the net recovery, after attorneys fees are paid. Plaintiffs can take advantage of this deduction in Title VII, ADEA, ADA, NLRB, FLSA, ERISA, WARN and FMLA cases, and the deduction applies equally to settlements or judgments, paving the way for creative allocation of damages in order to minimize the tax consequences as well as to minimize the pay-out by the employer, because Plaintiff’s no longer need to inflate their demands in order to cover the anticipated tax bite.

The legislation, however, only applies to cases settled prospectively, after the adoption of the Jobs Creation Act last October. All mediators working in the field of employment should be aware of this benefit and clarification in crafting a comprehensive settlement of these sophisticated cases.

The Supreme Court’s Recent Decision on Taxability of Attorney’s Fees in Employment Cases:

Then came the much awaited decision in Banks and Banaitis, handed down on January 24, 2005 (get cite): in Commissioner of Internal Revenue v. John W. Banks, II and Commissioner of Internal Revenue v. Sigitas J. Banaitis, (need cite). This decision reversed the Ninth Circuit case which held that attorney’s fees must be included as income to the Plaintiff in an employment case, and then taken as a “below the line” deduction. Under the Supreme Court decision, the Plaintiff may take an “above-the-line” deduction, rather than including all of his legal recovery as straight income, and then deducting the costs of getting the result “below the line”. This brought about an official end to double taxation under Federal tax law going forward only from January, 2005. Because it was decided after the Federal Jobs Act was instituted, it did not really change the law as it is applied to cases retroactively, as many in the legal community had hoped and anticipated.

Creative Use of Tax Implications Make Settlements More Appealing to Both Sides

The way in which the claims are made, and the terms of the ultimate settlement can save or cost the Plaintiff and her attorney thousands of dollars. A savvy mediator should be aware of these issues and be armed with the right questions to raise in order to maximize the satisfaction of the parties with their ultimate resolution.

Some of the questions that arise, include: whether emotional distress damages are taxable in an employment case, whether the taxation issue is the same in both Federal and State cases, which causes of action are covered by recent legislation and which remain non-taxable. Other issues come up as a consequence of the pleadings falling within or outside of FEHA claims, whether the settlement is comprised of salary or penalties, or both and in what allocation, whether there are non-employment related tort claims (such as defamation, assault and battery, negligent or intentional infliction of emotional distress outside the employment context and invasion of privacy, for example).

Many cases are settled on the basis that none of the lawyers really understand the tax treatment, and therefore the Defendant employer will demand a “hold harmless” from the Plaintiffs, and Plaintiffs will be directed to seek tax advice from their accountant. This is a dangerous route because the employer’s tax counsel may later insist that withholding be made and reported to the IRS, and the claimant’s counsel will refuse the deal, after all withholdings are accounted for, on grounds that it is no longer adequate compensation for the alleged wrongdoing.

It is beyond the scope of this article to address precisely which types of damages are taxable and which are “tax free”, which should be paid out as wages (with a W-2) and which are non-wage income (1099), which are characterized as “wages” and which are not wages, but still reportable, and how the parties can best allocate between wages and non-wages to maximize the recovery, and minimize the tax liability. Certain key factors must be considered in allocating emotional distress damages, for example.


Jan Frankel Schau

Attorney Jan Frankel Schau is a highly skilled neutral, engaged in full-time dispute resolution. Following a successful career spanning two decades in litigation, she has mediated over 700 cases for satisfied clients. Ms. Schau understands the nuances of trial and settlement practice as well as client relations and balancing the… MORE >

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