The deductibility of legal fees and settlement payments is derived from the nature of the claim, per a Supreme Court ruling in 1963. Subsequent updates to the Internal Revenue Code (IRC) have further narrowed the deductible nature of both payments. These changes affected both parties to the litigation. Examining the impact on the employer first provides a clearer picture of deductibility.
Tax Rulings and Statutes
The Supreme Court ruling set the framework for all other IRS codes. For example, Internal Revenue Code §162(q) includes that using a non-disclosure clause in a release agreement for sexual harassment and sexual abuse precludes the deductibility of all related expenses. In comparison, a measure in the Tax Cuts and Jobs Act of 2017 concerns the restrictive nature of deductible expenses affecting both the plaintiff (employee) and the defense (employer) in equal measure.
The Tax Court of the Fifth Circuit took the view that the company could not deduct litigation expenses stemming from non-profit-seeking activity. Two major obstacles to the deductibility of litigation expense derive from the nature of the litigation and the added barrier of the release language requested by the defense. Litigation derived from non-business activity or using a non-disclosure clause in the release agreement eliminates the deductibility of litigation expense. Notably, cases of sexual harassment or sexual abuse often qualify for both.
The clearly defined threshold for employers regarding expense deductibility does not exist for employees who bring the claim as a plaintiff. The inclusion of Lines 24(h) and 24(i) of Part II, Adjustments to Income in 2021, made it easier to account for the expense but did little to clarify what, if anything, should be placed as such and whether the corresponding income was includable on the client’s 1040.
Exploring IRC §104a, IRC 62€(18), IRC 162(q), plus other sections with their corresponding private letter rulings, exceeds the scope of this article. However, some straightforward rules do exist that can help in guiding clients. Consider that IRC §104 represents the apex of the decision tree for employees. The 26 U.S. Code § 104, Compensation for Injuries or Sickness, eliminates the inclusion of settlements from ordinary income for the employee. The fee paid to the attorney reduces the settlement received by the employee or injured party. The settlement does not constitute income per the IRS if bodily injury occurred.
Definition of Injury
What constitutes an injury? Unfortunately, the very definition of injury changes almost monthly. Injuries with a direct impact on the body seem easy to define. However, post-traumatic stress disorder, sexual abuse and rape provide more complex definitions of injury. These kinds of events often require injured persons or employees to respond to uncomfortable questions to define the taxability requirements of the litigation. The critical thing to remember is that injury can equate to a physical manifestation or penetration event on the body.
National Structured Settlement Trade Association (NSSTA) members have addressed these problematic questions since 1985. For example, what if a case falls outside IRC §104, such as sexual harassment? Congress enacted an above-the-line deduction for attorney fees in 2005. As a result of Congress’s action, the plaintiff pays income tax only on the net settlement received. However, 100% of the net settlement taxed in one year can be a harsh tax bill.
Mitigating the Tax Impact
Avenues exist to mitigate the taxation impact of a settlement. The original product created for IRC §104 cases can be utilized on a non-qualified basis. Any form of unlawful discrimination, including those in the Civil Rights Act of 1964, would qualify for this tax treatment. A gray area emerges even further for those who handle plaintiff litigation cases that derive from the definition of “civil rights” or “injury.” Professionals in this position should rely on the legal and accounting teams at their insurance carrier to make that judgment.
The insurance carrier’s decision-making lines often shift when new information becomes available, but there are some simple guidelines. Consider the definitions for injury and civil rights. Injury can be stated straightforwardly as physical damage or discernable alteration to the body or body chemistry. Similarly, civil rights can be interpreted as any right humans would wish to possess. Some prefer the broadest interpretation of the term: “human rights.” Whether a CPA represents the employee or employer, the nature of the case, particularly regarding how an injury is defined, and the resulting agreement are essential in determining the tax treatment.