by John Darer CLU ChFC MSSC RSP CLTC
Pardon me for stepping on the credentialed toes of an LLM in Taxation from the University of Florida and a Law Degree but in this case I can't help myself. The well-intention of Erica Dunmyer of Fort Lauderdale, Fl law firm Tripp Scott's "5 Things that Plaintiff Attorneys Need to Know About Tax Law" (August 16, 2010 Law.com), contains some inaccuracies or is written in such a way that it appears to be unintentionally misleading.
The first of the 5 points Dunmeyer makes is that attorney fees are taxable. She states "Clients need to be advised that they will be taxed on the gross amount of a judgment or settlement they may receive. This includes any attorney fees that will be paid on a contingency basis from the award.
Dunmyer seems to be relying on Commissioner v. Banks, 543 U.S. 426 (2005), together with Commissioner v. Banaitis, cases decided before the Supreme Court of the United States, dealing with the issue of whether the portion of a money judgment or settlement paid to a taxpayer's attorney under a contingent-fee agreement is income to the taxpayer for federal income tax purposes. The Supreme Court held when a taxpayer's recovery constitutes income, the taxpayer's income includes the portion of the recovery paid to the attorney as a contingency fee.
Per IRC 104 (a)(2) "gross income does not include the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or periodic payments) on account of personal physical injuries or sickness".
While Ms. Dunmyer recognizes that such exclusion exists for plaintiff settlements or judgments she fails to resolve the attorney fee issue stated in her first "thing". As the result of the IRC 104(a)(2) exclusion, a plaintiff who suffered injuries in an auto accident and her case settles for $2,000,000 (assuming no punitive damages) need not recognize the $666,666.66 representing 1/3 contingent fee amount.
The 4th "thing" that Dunmyer suggests that attorneys should know about tax law, is attempting to resolve whether the plaintiff should take lump sum or structured settlement payments. Yet she fails to discuss the benefits of structuring attorney fees. Structuring attorney fees offers tax benefits to the attorney and on taxable cases it may help the plaintiff avoid or mitigate Alternative Minimum Tax exposure. Given the timing of the post and the fact that attorney readers are heading into latter part of the year such discussion seems appropriate
When preparing a settlement agreement, care should be taken to make clear that the settlement is for personal physical injuries sustained by the plaintiff, in order to substantiate a claim for exclusion of an award received for personal physical injuries. However, the IRS may challenge settlement agreements where the facts and circumstances indicate that the allocation does not reflect the economic substance of the settlement.