Congress Revises Internal Revenue Code To Eliminate Double Tax On Attorneys’ Fees In Employment Cases

On October 22, 2004, President Bush signed the American Jobs Creation Act. Tucked away in the corporate tax bill is the Civil Rights Tax Relief Act, a significant piece of legislation eliminating the double taxation of attorneys’ fees awarded to plaintiffs in discrimination lawsuits. A diverse coalition of business and civil rights groups backed the legislation to remedy inequities in the tax treatment of employment awards.

Under federal income tax law, attorneys’ fees and damages recovered in an employment discrimination case, not involving an actual physical injury, are considered income. A plaintiff is taxed on the award even though the monies earmarked for attorneys’ fees are merely passed on to his counsel. Consequently, the attorney also pays a tax on the award as income. As a result, the award is taxed twice and the plaintiff may take home less money than was decided in the settlement or litigation. Consequently, the plaintiff requests more money from the employer to make up the potential loss created by the tax laws.

In some instances, a successful plaintiff may be able to take a miscellaneous itemized deduction for the attorneys’ fees; however, these below-the-line deductions are allowable only to the extent that their total exceeds two percent of adjusted gross income. Unfortunately, the size of the deduction frequently triggers the Alternative Minimum Tax ("AMT"); thereby requiring the plaintiff to pay taxes equal to either 26 or 28 percent of the award. Indeed, the AMT does not allow taxpayers to deduct attorneys’ fees from income. Accordingly, a plaintiff can receive a tax bill from the Internal Revenue Service which exceeds the award. This is especially problematic for plaintiffs pursuing only injunctive or declaratory relief, as they may be faced with a net loss. Proponents of the Civil Rights Tax Relief Act argued that these potential tax consequences could deter plaintiffs from bringing valid claims, thereby frustrating the ideals of civil rights legislation.

The Civil Rights Tax Relief Act is applicable to most civil rights and employment statutes, as well as any Federal, State or local law enforcing civil rights or regulating the employment relationship. The Act remedies the variable tax consequences facing plaintiffs by permitting taxpayers to take an above-the-line deduction for attorneys’ fees and costs, without subjecting the payment to the AMT or the two percent floor on itemized deductions. The Civil Rights Tax Relief Act does not change the tax implications for attorneys. Although some members of Congress lobbied for a retroactive application of the Act, the final bill applies prospectively to judgments or settlements occurring after October 22, 2004.

Due to the Act’s prospective application, observers wondered whether recent challenges to the tax code would provide relief to plaintiffs who received awards before the legislation’ passage. The United States Supreme Court’s recent decision in two companion cases, confirms that those precluded from the Act’s protection are still subject to the double taxation laws which spurred the legislation’s creation. In Commissioner of Internal Revenue v. Banaitis, 125 S.Ct. 826 (2005), the Court held that monies received by a litigant through judgment or settlement, including the funds paid to an attorney under a contingent-fee agreement, are subject to taxation.

The Court’s recent decision involved two plaintiffs who won awards in employment discrimination cases and subsequently disputed the tax bills premised on the amount of the award. The Court, in a unanimous decision,¹ held that the plaintiffs’ awards met the definition of gross income under the tax code. Moreover, the Court held that contingent-fee agreements should be viewed as anticipatory assignments of the client’s income to an attorney. Under the anticipatory assignment of income doctrine, gains should be taxed to those who earn them. Finding that the attorney-client relationship functions as a principal-agency relationship, with the attorney acting in the interests of his client and the client ultimately deciding whether to pursue or settle the lawsuit, the Court held that any gains made in the litigation should be treated as income to the client. Notably, the Court mentioned that had the Civil Rights Tax Relief Act applied retroactively, it was likely that these cases would not have arisen.

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