Congress Passes Bill Permitting Plaintiffs Who Recover Judgments or Settlements in Discrimination/Retaliation Cases to Take Full 'Above-the-Line' Deduction on Federal Tax Returns for Attorney Fees

Background

In Commissioner of Internal Revenue v. Schleier, 515 U.S. 323 (1995), the Supreme Court held that a plaintiff’s recovery by way of judgment or settlement in a discrimination case did not constitute “damages for personal injuries” within the meaning of 26 U.S.C. Section 104(a)(2) and thus were not exempt from income tax under that provision. Several courts have supported the Internal Revenue Service’s position that a plaintiff’s attorneys fees paid by the employer as part of a judgment or settlement likewise constitute income to the plaintiff (as well as plaintiff’s counsel) for federal income tax purposes. While the plaintiff is permitted a “below the line” deduction from his or her “adjusted gross income” for such fees, the deduction is often illusory.

More specifically, although expenses, including attorneys’ fees, related to the recovery of damages for discrimination, are currently generally deductible as expenses for the production of income, they are subject to the two-percent floor on itemized deductions and thus are deductible only to the extent the taxpayer’s total miscellaneous itemized deductions exceed two percent of adjusted gross income. Also, any amount allowable as a deduction is subject to reduction under the overall limitation of itemized deductions if the taxpayer’s adjusted gross income exceeds a threshold amount. And for purposes of the alternative minimum tax, no deduction is allowed for itemized deductions.

Now, however, as part of the American Jobs Creation Act of 2004, Congress has come to the aid of such plaintiffs by permitting them to deduct the attorneys fees in arriving at adjusted gross income, thus bypassing the limits on such deductions under current law. President Bush is expected to sign the bill into law.

The New Provision

Section 703 (“Civil Rights Tax Relief”) of the bill passed by Congress provides an above-the-line deduction for attorneys fees and costs paid by, or on behalf of, the taxpayer in connection with any action involving a claim of unlawful discrimination and other types of claims, meaning that the taxpayer will be able to reduce his adjusted gross income by the amount of the attorneys fees, provided that “the deduction [is not] 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.” It should be noted that the new deduction is permitted regardless of whether the plaintiff’s attorneys fees are paid by the employer under a statutory fee shifting provision or pursuant to a settlement or are paid by the plaintiff. President Bush is expected to sign the bill into law.

The bill will impact discrimination and retaliation claims brought against private employers under:

• Title VII of the Civil Rights Act of 1964
• The Age Discrimination in Employment Act
• 42 U.S.C. Section 1981 (equal rights in contracting)
• The Americans with Disabilities Act
• The National Labor Relations Act
• The Fair Labor Standards Act
• The Employee Retirement Income Security Act
• The Employee Polygraph Protection Act
• The Worker Adjustment and Retraining Notification Act
• The Family and Medical Leave Act
• 38 U.S.C. 4301 et seq. (veterans employment and reemployment rights)
• Any provision of federal law providing “whistleblower protection”, and
• Any provision of federal, state, or local law, or common law claims providing for the enforcement of civil rights, or regulating any aspect of the employment relationship, including claims for wages, compensation, or benefits.

The new provision applies to fees and costs paid after the date of enactment with respect to any judgment or settlement occurring after that date.

The Impact of the New Provision

Although the new provision provides no direct benefit to employers, if signed into law it should facilitate settlements in discrimination cases, as plaintiffs will no longer have a concern about being taxed on their attorneys fee awards and will be able to determine with greater certainty the after-tax value of the settlement. Employers certainly should use the new provision as a bargaining point in settlement negotiations.