Small Law Firms

Tax Law's Latest Victims: Our Clients

Under the new tax law, clients may be paying taxes on thousands of dollars in income they'll never see.

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The hastily thrown together tax law will generate casualties all over the country, but one victim that’s not gotten enough attention is the poor client. Not every client is going to take it in the shorts under this abomination of a tax plan. Most personal injury plaintiffs are still fine and most suits against employers aren’t affected. But for most clients out there, they’re about to pay taxes on their entire recovery… with no deductions for legal fees.

As Robert W. Wood put it in Forbes:

Many plaintiffs will face higher taxes on lawsuit settlements under the recently passed tax reform law. Some will be taxed on their gross recoveries, with no deduction for attorney fees even if their lawyer takes 40% off the top. In a $100,000 case, that means paying tax on $100,000, even if $40,000 goes to the lawyer.

Ooof. Republicans have railed against the tort system for decades, but maybe they’ve finally found their silver bullet by rendering the whole process unduly expensive. Just how bad is this? Defamation, financial fraud, divorce, malpractice, false imprisonment — clients will be paying taxes on 100 percent of their recovery on all of these. It’s unclear how badly this will chill the prosecution of valid claims, but there’s going to be some effect at the margins.

Up until now, even if you did not qualify to deduct your legal fees above the line, you could deduct them below the line. A below the line (miscellaneous itemized) deduction was more limited, but was still a deduction. Now, there is no below the line deduction for legal fees. Do two checks (one to lawyer, one to plaintiff) obviate the income to plaintiff? Not according to Banks. IRS Form 1099 regulations generally require defendants to issue a Form 1099 to the plaintiff for the full settlement, even if part of the money is paid to the plaintiff’s lawyer.

Is there any way around this for the enterprising client? That’s unclear, but it’s definitely clear that clients and attorneys need to consider this matter from the outset of litigation:

For example, court awarded fees, statutory fees, or a partnership between lawyer and client divide the proceeds are all worth discussing. But tax advice early–before the case settles and the settlement agreement is signed–are going to be essential. For many, no tax deduction for legal fees will come as a bizarre and unpleasant surprise after the fact. Plaintiffs who have some advance warning and advice may go to new lengths to try to avoid the lawyer’s share being income to them, or to somehow deduct it. Few plaintiffs receiving a $100,000 recovery will think it is fair to pay taxes on the full amount, when legal fees consumed a third or more.

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Unfortunately, the tax law is a double-edged sword for tort reformers. While the prospect of paying taxes on thousands of dollars they’ll never see may dissuade some suits, the fact is that these taxes apply to settlements, but can potentially be avoided if the fees are court ordered. If that’s true, clients have a perverse incentive, where the amounts are large enough to matter, to litigate to the hilt rather than settle at a more efficient point in the process.

There’s a lot of uncertainty out there right now, but the one thing we know for sure is the client is getting a bum deal.

New Tax On Lawsuit Settlements — Legal Fees Can’t Be Deducted [Forbes]

HeadshotJoe Patrice is an editor at Above the Law and co-host of Thinking Like A Lawyer. Feel free to email any tips, questions, or comments. Follow him on Twitter if you’re interested in law, politics, and a healthy dose of college sports news.

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