Workarounds for Plaintiffs & Lawyers Under New Tax Law
Robert W. Wood
Robert W. Wood practices law with Wood LLP (www.WoodLLP.com) and is the author of Taxation of Damage Awards and Settlement Payments and other books available at www.TaxInstitute.com. This discussion is not intended as legal advice.
You are a plaintiff in a lawsuit and just settled your case for $1,000,000. Your lawyer takes 40%, $400,000, leaving you the balance. Most plaintiffs assume their worst-case tax exposure would be paying tax on $600,000. But today, you could pay taxes on the full $1,000,000. Welcome to the crazy way legal fees are taxed.
In Commissioner v. Banks,1 the Supreme Court held that plaintiffs in contingent fee cases must generally recognize income equal to 100% of their recoveries. This is so even if the lawyer is paid directly by the defendant, and even if the plaintiff receives only a net settlement after fees. This harsh tax rule usually means plaintiffs must figure a way to deduct those fees.2