Wednesday, January 26, 2005

The US Supreme Court says lawsuit plaintiffs can lose by winning -- thanks to our ever-growing friend, the Alternative Minimum Tax.

If you are planning to sue somebody, and either pay your lawyer a contingency fee or collect an award of legal fees from the other side, beware -- you'd better talk to a tax lawyer first, or you may lose to the tax man more than you win from the defendant.

The U.S. Supreme Court on Monday upheld an IRS interpretation of the tax law that can hit a court award with a tax bill larger than the amount the plaintiff wins in the case. The key here is something plaintiffs had better not overlook from now on: the Alternative Minimum Tax (AMT).

In a nutshell, the AMT was created by Congress in 1969 after it was publicly reported that on 1967 tax returns 155 people had paid no income tax in spite of having had income over $200,000 ($1.1 million in today's money) due to their use of various legal tax-reduction devices -- deductions, exemptions, credits and so on. (Congress received more complaining letters from the pubic about this that year than it did about the Viet Nam war.)

It was designed to make sure that everybody with high economic income pays some tax. Basically, it applies a flat 28% tax rate to income while not allowing most of the deductions, exemptions and other tax-reducing items allowed under normal rules. If one owes more tax under AMT than normal rules, one owes AMT instead.

Now, the thing that is introducing more of us to the AMT each year is that Congress has never indexed it to inflation -- so it affects persons at a lower income level each year. While originally targeted at persons with income over $1 million (in 2005 dollars) today the amount of income exempt from AMT is $40,250 on a single return and $58,000 on a joint return. Estimates are that by 2010 it will hit 30 million taxpayers, including the majority of those with income over $75,000.

But that will be then -- as to now, and Monday's court decision, the operative fact is that under AMT rules one of the deductions that is not allowed is that for legal fees. Under normal rules legal expenses incurred to receive taxable income -- such as a taxable court award of damages of some sort -- are deductible. But under AMT calculations they are not.

Now imagine you want to sue someone and hire a lawyer agreeing to pay a standard one-third contingency fee, so the lawyer gets one-third of any award you collect. Under the AMT you owe tax on the whole award, including the part you pay to the lawyer (even though the lawyer has to pay income tax on that too). The tax you owe relative to the part of the award you keep, using the 28% AMT rate, will be 42%. And if you live in a state that applies income tax of its own to the award you are out of luck there too -- another deduction not allowed under the AMT is the one for state and local taxes. So just slap the entire state tax bill on top. (Note that you don't just lose the deduction for state income taxes on the court award, you lose your entire deduction for state taxes -- for taxes paid on wages, property taxes, and all else.)

But things can be much worse than that. If one wins a lawsuit and also receives an award to cover the cost of legal fees that are large relative to the amount of damages received, one can find oneself owing the IRS more in tax than the damages one collected from winning the case.

In one noted example, a woman won an award of $300,000 in damages plus legal fees of $1 million and ended up owing the IRS $99,000 more than she collected from winning.

A celebrity victim of the AMT legal fees rule may well have been Paula Corbin Jones, in her case against President Bill Clinton. As James Serven of the University of Denver College of Law wrote at Tax Analysts...
" the widely publicized Paula Jones case, Jones reportedly obtained a settlement of $850,000 from President Bill Clinton but incurred attorneys' fees of almost $650,000. If she is considered taxable only on her net recovery of roughly $200,000, her regular tax liability would be approximately $72,000, and she would net $128,000 after taxes.

"However, if she must report the entire $850,000 award and deduct her attorneys' fees below the line, her AMT liability would be approximately $238,000, with the result that she would be $38,000 out of pocket for bringing the action.

"While this result seems harsh, it is simply the direct result of applying the unambiguous statute as written, a result that has been recognized by some courts as inequitable."
And it can be worse than that. Imagine that you bring a case and win on the law, but the judge finds you weren't really harmed by the wrong done and so grants you only a nominal $1 in damages. But because you were right on the law, the judge also gives you an award of all your legal fees. This happens too.

Victoria Herring, an employment discrimination lawyer in Des Moines, said she had a client who was awarded $15,000 in punitive damages and $1 in actual damages in a job discrimination case. The IRS billed him $67,791 for income taxes under the AMT, because a judge also awarded $170,000 in legal fees for Herring as a result of the extraordinary efforts the other side made to thwart her.

"My client won, but he is far worse off for having brought this case," Herring said.

These results did indeed strike some courts as inequitable, and some bought arguments that saved plaintiffs from this inequitable result while others did not. The result of that was conflicting rulings arising among the federal Courts of Appeals, leading to Monday's Supreme Court decision that resolved them.

And the gist of its decision (.pdf) was very simple: Congress made the law and if the law is broken it is up to Congress to fix it. Until it does, the law will be enforced as written. Too bad for winning plaintiffs with big legal expenses.

So now the question is, will Congress fix the law?

And the answer is: Congress has already acted on this issue -- in what seems to many a bizarrely dysfunctional manner.

In the just recently passed Jobs Creation Act of 2004 Congress explicitly recognized this problem and included new law permitting legal fees to be deducted under normal tax rules notwithstanding the AMT, but only in civil rights cases.

Hello? One blogging tax law professor compared this to having a ship sinking with 3,000 people on board, Congress receiving its SOS, and sending out rescue craft to save a few carefully selected passengers. But selected on what grounds? Campaign contributions? Having the most effective lobbyists? Setting the most effective example to encourage others who want the same treatment to make more campaign contributions?

Does this action by Congress mean it really wants other taxpayers to pay income tax on the reimbursements for legal fees they pay? No Congressional tax writer will say that (and they've been asked). But then why were plaintiffs in all other kinds of cases excluded? No Congressional tax writer will say that either.

Let's just say that judging by its actions of recent years, Congress really, really enjoys receiving the revenue it collects from the AMT in what effectively is still a surreptitious manner regarding the majority of taxpayers who remain unaware of it (until it is too late), and it isn't going to be giving up any of that revenue easily.

So the bottom line is this word of advice for any of you out there who may be considering suing anybody else: make sure you have a tax lawyer who is as good as your tort lawyer, and who is in on the case from the start. You are going to need them both.