There have been two bills introduced by Senator Spector that, if passed and signed into law, would be good for those of us who do contingent fee work and for the clients who hire us.
S. 813 provides as follows:
(a) In General- Section 162 of the Internal Revenue Code of 1986 (relating to trade or business expenses) is amended by redesignating subsection (q) as subsection (r) and by inserting after subsection (p) the following new subsection:
`(q) Attorney-Advanced Expenses and Court Costs in Contingency Fee Cases- There shall be allowed as a deduction under this section any expenses and court costs paid or incurred by an attorney the repayment of which is contingent on a recovery by judgment or settlement in the action to which such expenses and costs relate. Such deduction shall be allowed in the taxable year in which such expenses and costs are paid or incurred by the taxpayer.’.
(b) Effective Date- The amendments made by this section shall apply to expenses and costs paid or incurred after the date of the enactment of this Act, in taxable years beginning after such date.
His comments on the bill:
Mr. President, the first bill which I am introducing, and that is to permit attorneys to deduct payment of litigation costs as ordinary and necessary business expenses. In litigation, illustratively on a personal injury claim, the plaintiff frequently is without funds and can only move forward with the litigation on a contingency fee basis. In these situations, it is customary for the attorney to advance the costs of filing fees, depositions, and other costs there may be. The Internal Revenue Service has taken the position that those are loans from the attorney to the client, so the attorney cannot immediately deduct litigation payments as ordinary business expenses. If the litigation costs are treated as ordinary business expenses, the attorney would be able to deduct the expenses as they are incurred.
The Ninth Circuit has held that the Internal Revenue Service is wrong. As a result, attorneys in States within the Ninth Circuit can deduct as ordinary and necessary expenses advances on litigation. This legislation would make it explicit under the Internal Revenue Code that these advanced costs could be deducted by attorneys across the country.
Again, I ask that the Record contain my extemporaneous comments and the explanation as to why there is some repetition in the formal statement which I now ask unanimous consent be printed in the Record, as well as the two bills which follow these two pieces of legislation which I am introducing.
In part because the IRS deems these payments to be loans, and State canons of legal ethics–based on common law of medieval England–prohibited loans to clients, contingency fee lawyers for many years were not able to pay these expenses. In the latter part of the 1800s States began permitting attorneys to advance client expenses as long as the client remained obligated to repay the advances. Even for their indigent clients, if there ultimately was not an award, attorneys were required to seek repayment. The ABA Model Rule has been updated to state that "a lawyer may advance court costs and expenses of litigation, the repayment of which may be contingent on the outcome of the matter." Many States model their rules on these Model Rules, and their ethics rules have
In addition, I note that tax treatment of these payments is not consistent across all jurisdictions. In Boccardo v. Commissioner, 56 F.3d 1016 (9th Cir. 1995) the Ninth Circuit disagreed with the IRS and held that advances on behalf of clients were "ordinary and necessary expenses" in contingency cases with "gross fee" contracts. So the rule is different in States in the Ninth Circuit; the IRS continues to take the position that expense advances are not deductible as ordinary and necessary business expenses in other jurisdictions. This different treatment is neither logical nor equitable.
This change will encourage lawyers to represent those who may not otherwise be able to pay an attorney for his work. This is good policy and common sense.
S. 813, also introduced by Senator Spector, provides as follows:
SECTION 1. ABOVE-THE-LINE DEDUCTION FOR ATTORNEY FEES AND COSTS IN CONNECTION WITH CIVIL CLAIM AWARDS.
(a) In General- Paragraph (20) of section 62(a) of the Internal Revenue Code of 1986 is amended to read as follows:
`(20) COSTS INVOLVING CIVIL CASES- Any deduction allowable under this chapter for attorney fees and court costs paid by, or on behalf of, the taxpayer in connection with any action involving a civil claim. The preceding sentence shall not apply to any deduction in excess of the amount includible in the taxpayer’s gross income for the taxable year on account of a judgment or settlement (whether by suit or agreement and whether as lump sum or periodic payments) resulting from such claim.’.
(b) Conforming Amendment- Section 62 of the Internal Revenue Code of 1986 is amended by striking subsection (e).
(c) Effective Date- The amendments made by this section shall apply to fees and costs paid after the date of the enactment of this Act with respect to any judgment or settlement occurring after such date.
The Senator’s comments on this bill:
Mr. President, I have sought recognition to introduce legislation that will allow taxpayers to subtract from their gross income, in arriving at adjusted gross income, the attorneys fees and court costs paid by, or on behalf of, the taxpayer in connection with any income from any settlement of legal claims or award of damages. This is known as an "above the line" deduction.
This change does not affect the requirement that attorneys pay federal income tax on legal fees they receive. What it does eliminate is the inequity of the client also paying tax on those same fees, when the client not entitled to, and did not receive that money under the terms of a contingency fee contract.
The tax treatment of these contingency fees is determined through a patchwork of rules that are confusing and inequitable. The legislation would ensure more uniform treatment of contingency fees in all types of litigation and across jurisdictions. In particular, it will eliminate situations in which a plaintiff’s recovery may be diminished, primarily as a result of the Alternative Minimum Tax (AMT), by taxation at a rate of approximately 60 percent on the taxpayer’s net recovery, after contingency fee.
This change is common sense and will ensure consistent and fair treatment of taxpayers. Congress never intended that the attorneys’ portion of recoveries should be included in taxable income–whether for regular income or alternative minimum tax purposes.
Section 61(a) of the Code requires taxpayers to include in their gross income "all income from whatever source derived," absent a contrary provision in the Code. Awards for physical personal injury, other than punitive damages, are not taxable (26 U.S.C. 104(a)(2)). Awards of fees in cases primarily related to employment may be deducted "above the line" as a result of the American Jobs Creation Act.
With these exceptions noted above, the Code treats taxpayers as having received the entire amount of any award or settlement (including any contingency fee portion). This means that for awards based on certain claims or for punitive damages, the taxpayer must include in adjusted gross income the entire award, even though the true benefit or income to the taxpayer after contingency fees and costs may be only 50 percent or 60 percent of the award. This
Accordingly, the current tax structure, when coupled with the compensation arrangement found in contingency fee contracts, generally (1) creates an enormous tax burden, especially for lower income individuals who often have contingency fees as their only avenue of obtaining legal counsel; and (2) may drive up settlement costs as a result of the serious diminution of the plaintiffs actual award after taxes.
An illustration of the tax inequities and inconsistencies follows: an individual/client who obtains $500,000 in a legal settlement on a fraud claim, who incurs $200,000 in legal fees and costs, and nets only $300,000, still may owe AMT on $500,000, and would have to pay approximately $160,000, or about 60 percent of the damage award, in federal and state taxes. This leaves the client with only $140,000 of an award intended to compensate the client in the amount of $500,000.
This clarification of tax law is common sense and will ensure consistent and fair treatment of taxpayers, especially those who can get representation only on a contingency fee basis. I encourage my colleagues to consider this legislation and join me in helping to correct this unfair situation.
To keep an eye on the bills go here.