Legal Fees in Many Lawsuit Settlements Are Now Subject to Tax! Rob Wood Explains
The new tax law has taken effect, and it has made a number of changes, all of them widely discussed. One change that has not received as much attention as some others relates to legal fees paid by plaintiffs in lawsuits. As tax lawyer Rob Wood explains in this report, plaintiffs may now be paying taxes on the entire amount of a settlement, including attorney’s fees that may take 40% of the recovery. He also discusses the change in the law in his article, “New Tax On Lawsuit Settlements—Legal Fees Can't Be Deducted.”
Wood says that the key to whether legal fees will be deductible is the nature of the plaintiff’s business. If the lawsuit is not business-related, there may be no write-off for legal fees. “For a lot of people, this change in the law is going to be a very unpleasant surprise.” The change doesn’t represent an effort to single out lawsuits for taxation; the change is related to the rules for itemizing deductions. The problem, according to Wood, is that people may settle lawsuits in 2018 and be unaware of the change in the tax law until 2019, when they sit down to do their tax returns.
As to what has changed, Wood notes that the new law retains and above the line deduction for employment cases. Except for a few types of cases (the “Harvey Weinstein tax,” for example), the deduction remains intact. Also, legitimate business expenses are still deductible, as in the case of lawsuits related to the business. But beyond these two situations, legal fees are no longer deductible.
Many people will likely be upset with this change in the law. This means that the plaintiff who settles a contingent fee lawsuit for $100,000, for example, and pays $40,000 off the top to a lawyer will pay tax on the entire $100,000. This is because, Wood says, the new law eliminates the miscellaneous itemized deduction category that was in the past provided deductibility for legal fees in contingent fee cases.
The next question might be, are there any options left that would provide a way to deduct legal fees. Wood suggests that there will be a lot of maneuvering by plaintiffs looking to find some way to avoid paying taxes on the large portion of settlements that never even reaches them. One way would be to find some means of connecting the lawsuit to employment. The IRS has been very liberal in its view of employment cases, so that is a possibility.
The second obvious approach would be to find some way to argue that the claim is related to one’s trade or business. Wood notes that Schedule C to the Form 1040 relates to a taxpayer’s business. Wood suggests that taxpayers will begin to file more Schedules C and list more business interests that might be related to the subject of a lawsuit. Wood adds that, historically, Schedules C are among the most audited portions of tax returns, so attempts to use this approach to picking up a deduction may be questioned by the IRS.
Another possible approach would be a partnership between a client and a lawyer. If such a partnership is formed and the lawsuit proceeds go to the partnership, then each partner might receive a portion of the settlement. That would insulate the plaintiff in a contingent fee lawsuit from being taxed on 100% of the settlement amount. Wood points out that any efforts like this must be completed before the settlement is completed and the documents are signed.
Robert W. Wood is the Managing Partner of Wood LLP, San Francisco. Often listed among the best tax lawyers in America, Wood has broad experience in corporate, partnership and individual tax matters. Concerning the tax treatment of litigation settlements and judgments, he is perhaps the preeminent tax lawyer in the United States. He is also an authority on merger and acquisition tax matters, tax opinions, offshore account and entity disclosures, and many types of tax controversies. The Legal Broadcast Network is a featured network of Sequence Media Group.