| Excerpted from: Laura Sager and Stephen
Cohen, How the income tax undermines civil rights law. 73 Southern
California Law Review, vol. 73, pages 1075-1104, 1075-1080 (2000)
(citations omitted).
Federal statutes entitle the prevailing plaintiff in civil rights
litigation to recover attorney's fees from the defendant. The recovery
of attorney's fees under these so-called "fee-shifting
provisions" constitutes a deliberate departure from the usual
American rule that each litigant must bear her own legal costs.
A civil rights plaintiff acts not just for herself alone, but also as
a "private attorney general," vindicating national policy. The
fee- shifting provisions enable the plaintiff who cannot pay a private
attorney, and whose potential recovery is not sufficient for a
contingency fee arrangement, to perform this private attorney general
function.
This objective has been undermined by recent decisions of the federal
courts of appeals and the tax court, as well as by rulings of the
Internal Revenue Service (IRS), concerning the taxation of plaintiffs in
cases of employment discrimination. Under these decisions, an employment
discrimination plaintiff must report her entire recovery as income.
However, the attorney's fees--the cost of producing the income--are not
fully deductible under the regular tax and are not deductible at all
under the alternative minimum tax (AMT).
The disallowance of AMT deductions is particularly significant.
Suppose that a plaintiff settles an employment discrimination claim for
a total of $120,000, out of which she pays $50,000 in attorney's fees.
The plaintiff's economic income is only $70,000, which equals the
$120,000 recovery, less the $50,000 in attorney's fees that are the cost
of producing the recovery. However, the plaintiff's taxable income under
the AMT is calculated as $120,000, which equals the entire recovery
without any deduction for the attorney's fees and overstates the
plaintiff's economic income by $50,000. At the lower AMT tax rate of
twenty-six percent, the overstatement of income by $50,000 increases the
plaintiff's AMT liability by $13,000.
If the ratio of attorney's fees to the entire recovery is high
enough, a before-tax gain may metamorphose into an after-tax loss. In
Alexander v. Commissioner, for example, the plaintiff settled a state
law employment claim for $250,000 but incurred $245,000 in attorney's
fees, for a pre-tax profit of $5,000. Under the AMT, the entire $250,000
recovery was taxable but none of the $245,000 in attorney's fees was
deductible. If we assume that the taxpayer files jointly and has no
other income, his AMT liability would be $53,900. Under these
assumptions, the non-deductibility of the employee's attorney's fees
under the AMT would convert a $5,000 before-tax gain into a $48,900
after-tax loss.
We believe that the AMT's disallowance of deductions for attorney's
fees in these instances is wrong as a matter of tax policy. The
disallowance is even more troubling because it undermines the national
policy of encouraging the pursuit of meritorious civil rights claims. We
are aware of no instance in which the IRS has applied these rules to
civil rights plaintiffs in areas other than employment discrimination.
Nevertheless, given the precedents involving employment discrimination,
such a result is entirely possible and would frustrate the private
enforcement of civil rights claims for discrimination in education,
housing, and public accommodations and for the violation of
constitutional rights.
The tax treatment of attorney's fees in civil rights cases was
unimportant until recently for a simple reason. For many years, the Code
excluded from taxation all damages received in personal injury cases,
including civil rights claims. Since all personal injury damages were
tax-exempt, no deduction was allowed for the cost of producing them. In
1992 and 1995, however, the Supreme Court held in two employment
discrimination cases that damages were taxable, a result codified and
extended by Congress in 1996 to cover all nonphysical injuries,
including all claims of unlawful discrimination. With damages for civil
rights violations now taxable, the question of the tax treatment of
attorney's fees in such cases has assumed new importance.
Part I of this article discusses two preliminary issues that help
determine whether attorney's fees are in fact deductible under current
law. The first is whether a plaintiff might be able to exclude from
taxable income the portion of a recovery expended for attorney's fees,
thereby obviating the need to claim a deduction. The second concerns how
the Internal Revenue Code categorizes the expense for attorney's fees.
Part II examines the legislative history of Internal Revenue Code
provisions that affect the tax treatment of attorney's fees in
employment discrimination cases. These provisions distinguish between
reimbursed employee business expenses, which are fully deductible, and
un-reimbursed expenses, which are not fully deductible under the regular
tax and not deductible at all under the AMT.
Part III criticizes the decisions of the federal courts that decline
to classify the attorney's fees in employment cases as a reimbursed
expense, with the consequence that the plaintiff's income is overstated
and overtaxed.
Part IV explains how the income tax may also frustrate the
fee-shifting provisions of federal civil rights statutes that provide
remedies for discrimination in education, housing, and public
accommodations and for violations of constitutional rights.
Part V evaluates two possible solutions: careful drafting of
settlement agreements and amending the tax law.
We conclude that the tax law should permit civil rights plaintiffs
either to deduct fully or to exclude from income the portion of a
recovery expended for attorney's fees. Either a deduction in full or
exclusion would provide a more accurate measure of the plaintiff's
income and also preserve the purposes of the fee-shifting provisions of
federal civil rights law. |
