John D. Finerty, Jr.
In previous columns, I have discussed the rules and regulations on taxing settlements in employment cases. Last year, for example, Martin Tierney and I wrote a two-part article that outlined IRS regulations on applying withholding rules to settlements in discrimination cases. Three weeks ago, I summarized the Banks and Benitas cases before the Supreme Court this term that will address whether payments made to a plaintiff’s attorney in an employment discrimination case are taxable to the plaintiff. Last week, however, Congress and the President changed the state of the law yet again.
President Bush signed the American Jobs Creation Act of 2004 on October 22, 2004. A provision of the bill contains an attorney fee provision known as the Civil Rights Tax Relief Act. That provision creates a deduction for attorney’s fees and costs in discrimination cases and addresses the tax law issues involved in applying the deduction. Attorney fee payments made on settlements or judgments after enactment of the Act are now deductible even if the plaintiff does not itemize deductions.
Under current tax law, damages and attorney’s fees in employment discrimination cases, in cases that do not involve an actual physical injury, are taxable income; attorney’s fees paid in exchange for legal services, however, may be deductible to the plaintiff. The U.S. Supreme Court in Commissioner v. Banks and Commis-sioner v. Benitas, is set to address the issue of whether or not attorney’s fees are taxable income.
When attorney’s fees are taken as a deduction, on the other hand, the deduction is subject to a 2 percent of gross income exclusion and may trigger the Alternative Minimum Tax. In other words, an attorney fee deduction is a type of double edge sword: the fee payment must be large enough to exceed 2 percent of the plaintiff’s gross income, but as the deduction grows, the plaintiff may pay more, dollar-for-dollar, in AMT.
The Civil Rights Tax Relief Act
The new law applies to most civil rights and employment statutes, including Title VII, the Americans With Disabilities Act, the Age Discrimination in Employment Act, the National Labor Relations Act and the Fair Labor Standards Act. Although each case should be evaluated for coverage by the new law, it is clear Congress intended a wide reaching scope. That is, the law contains a catch-all provision that applies the law to: "Any provision of federal, state or local law, or common law claims permitted under federal, state, or local law" that provide for the "enforcement of civil rights" or regulate "any aspect of the employment relationship." In cases in which settlements or judgments are paid, therefore, the Civil Rights Tax Relief provisions of the act allow plaintiffs or complainants to deduct his or her own attorney’s fees whether or not the person itemizes his or her deductions.
The Civil Rights Tax Relief provisions of the Jobs Creation Act apply prospectively only. That is, the Act applies only to fees and costs paid after the enactment of the Act. Further, the "judgment or settlement" must also occur after the enactment of the Act in order for the attorney’s fees to be deductible under these new rules. In other words, judgments entered or settlements reached prior to October 22, 2004 are not covered by the new legislation.
For more information on this new legislation or for assistance in defending an employment discrimination claim, contact John D. Finerty, Jr. at Michael Best & Friedrich LLP at (414) 225-8269 or on the Internet at [email protected].