Lawsuit Winners Lose the Tax Battle

The winners of big lawsuits may find themselves losers at tax time, thanks to a Supreme Court ruling Monday.

The justices, agreeing with the Internal Revenue Service, ruled that all the money plaintiffs won in lawsuits must be included in their gross incomes, even if a large portion of it went to lawyers.

To cover the cost of fighting lawsuits -- which can drag out for years -- lawyers often require clients to agree from the beginning to pay them as much as 40% of any judgment obtained.

But under the court’s ruling, all of the final award will be considered as income to the plaintiff -- even though he may receive 60% of that amount.

“It is a fundamental rule of taxation that income is to be taxed to the person who earns it, even when it is paid at the person’s direction to someone else,” the Justice Department and the IRS told the high court.

In a unanimous decision, the justices reversed the rulings of two lower courts, including the U.S. 9th Circuit Court of Appeals, which had held that plaintiffs should pay taxes on the amounts they received after subtracting lawyers’ fees.

John W. Banks, fired from his post with the California Department of Education, sued the agency for discrimination. Shortly after the trial began, the two sides settled and the department paid Banks $464,000. His lawyer received $150,000 of it.

However, the IRS said Banks owed income taxes on the entire $464,000, and the Supreme Court agreed in the case of Internal Revenue Service vs. Banks.

In many instances, a plaintiff can take the legal fees as an itemized deduction on his tax form. However, those itemized deductions gradually fade for high-income earners. In addition, as the court noted, taxpayers subject to the alternative minimum tax -- the special levy created to make sure wealthy filers could not evade taxation by claiming lots of deductions and credits -- are not allowed any miscellaneous itemized deductions.

Beyond that, some lawsuits that drag on for years result in a judge awarding legal fees that far exceed the amount won by the plaintiff. For example, Illinois police Officer Cynthia Spina sued her employer for sex discrimination and harassment and was awarded $300,000 in damages. But a judge awarded her lawyer $1 million in legal fees. The IRS insisted that the total amount of $1.3 million was taxable income to Spina, and she ended up “losing every penny of the award,” the court was told in one brief.

In his opinion for the court, Justice Anthony M. Kennedy acknowledged the ruling could “lead to the perverse result that the plaintiff loses money by winning the suit.”

Congress can change the tax laws, and while this case was pending, lawmakers did exempt from a taxpayer’s gross income “attorney fees and courts costs” that arose from “a claim of unlawful discrimination.”

Lawmakers said they wanted to shield from taxes legal fees that arose from federal civil rights and job discrimination claims.

However, the new law will not shield plaintiffs who bring other claims under state law -- including claims involving auto accidents, medical malpractice or insurance disputes. In those cases, the high court’s decision means that all money received from lawsuits must be included as part of the plaintiff’s gross income.

Chief Justice William H. Rehnquist did not vote in the decision.