Tax Time -- Employment Lawsuit Attorneys' Fees Payments

Tax issues are complicated.  As an employment lawyer, one of the issues that arises in virtually every case (pre or post suit) is whether the payment of attorneys' fees by the employer-defendant directly to the employee-plaintiff's lawyer is income to the employee-plaintiff and, if so, whether the employee may treat such a payment as a below or above the line deduction. 

The IRC and case law, while opaque, seem to provide that: (1) the payment of attorneys' fees directly to employee-plaintiff's lawyer is income to the employee-plaintiff; and (2) the payment, however, may be treated as a dollar-for-dollar above the line deduction. 

While I am not a tax lawyer and don't provide tax advice to my clients, I encourage my clients to consult with their tax advisor and to ask their tax advisor about the 2004 American Job Creations Act of 2004.  Specifically, while attorneys' fees may be included in gross income (and memorialized through a Form 1099), 29 USC § 62(a)(20) and 29 USC § 62(e)(18)(ii) appear to provide a dollar-for-dollar above-the-line deduction for attorneys' fees paid in connection with a claim involving a violation of law: "regulating any aspect of the employment relationship, including claims for wages, compensation, or benefits . . .."   See http://codes.lp.findlaw.com/uscode/26/A/1/B/I/62. 

The November 2006 Journal of Accountancy, discussing the aforementioned provisions provided:

Discrimination claim. Section 62(a)(20) covers many claims. Section 62(e) defines 'discrimination,' but goes beyond traditional discrimination. It applies to any civil rights claim as well as to a broad spectrum of employment-related claims, including any employment-related legal claim under federal, state, common or local law. This includes cases of age, gender or racial discrimination. Section 62(e)(18)(ii) says it includes any actions 'regulating any aspect of the employment relationship, including claims for wages, compensation, or benefits... any other form of retaliation or reprisal against an employee for asserting rights or taking other actions permitted by law.' On its face the statute seems to cover almost any employee vs. employer litigation.

See http://www.journalofaccountancy.com/Issues/2006/Nov/NewRulesNewRuling.htm. 

At least one IRS Revenue Ruling appears to have interpreted this dollar-for-dollar above-the-line deduction as broadly as this author and as contemplated by the Journal of Accountancy and applied the deduction to attorneys' fees incurred in obtaining pension benefits.  See http://www.irs.gov/pub/irs-wd/0550004.pdf.

Well regarded and oft-published tax lawyers have opined that 62(e)(18)(ii) provides a "catchall" for all true employment claims arising out of the employment context.  http://woodporter.com/Publications/Articles/pdf/Attorney_Fee_Deduction_Problems_Remain.pdf. 

With all of this said, we believe that a tax advisor should be utilized in connection with the treatment of income taxes when attorneys' fees are paid in connection with a lawsuit settlement.