Since 2018, it’s been tough to deduct legal fees, and some plaintiffs in contingent fee cases are even taxed on their gross recoveries, not net after legal fees. Creativity is needed in this new age, since sometimes the rules seem to say you shouldn’t be deducting fees at all. Fortunately, the mechanics of deducting legal fees in employment, whistleblower, and civil rights cases have been improved, at long last.
The tax code was amended in 2004 to allow legal fee deductions “above the line,” which is almost like not having income in the first place. But the deduction has been quirky to claim even for accountants. Not only was there no line for it on the IRS forms, but you had to include a code next to your write-in, “UDC” for unlawful discrimination claim.
But starting with 2021 tax returns, the IRS has a new Form 1040 with a line for attorneys’ fees. For 2021, Schedule 1 to Form 1040 gives you two lines.
Why worry about deducting legal fees in the first place? If the lawyer is entitled to 40%, the plaintiff might assume that the biggest tax they could face would be tax on their net 60%. But under Commissioner v. Banks, 543 U.S. 426 (2005), plaintiffs in contingent fee cases must generally include 100% in income, even if the lawyer is paid directly. That means plaintiffs must figure a way to deduct their 40% fee. Fortunately, in 2004, shortly before Banks was decided, Congress enacted an above-the-line deduction for employment claims, civil rights claims, and certain whistleblower claims.
Buy many people have trouble claiming this deduction. There are also technical limits, since the legal fees must be paid in the same tax year as the recovery. Even for contingent fees, the deduction only covers employment, civil rights, and certain types of whistleblower claims. For employment claims, the tax code says the deduction applies to attorney fees in claims of “unlawful discrimination.” The definition of what is a claim of unlawful discrimination refers to claims under a long list of laws, and adds a catchall that swallows up much more:
“Any provision of federal, state or local law, or common law claims permitted under federal, state or local law, that provides for the enforcement of civil rights, or regulates any aspect of the employment relationship, including claims for wages, compensation, or benefits, or prohibiting the discharge of an employee, discrimination against an employee, or any other form of retaliation or reprisal against an employee for asserting rights or taking other actions permitted by law.” IRC section 62(e)(18).
The catchall also covers legal fees to enforce civil rights. You might think of civil rights cases as only those brought under Section 1983. But the deduction extends to any claim for the enforcement of civil rights under federal, state, local, or common law (see IRC § 62(e)(18)). The tax code does not define “civil rights,” nor do the legislative history or committee reports. But some authorities suggest they are “a privilege accorded to an individual, as well as a right due from one individual to another, the trespassing upon which is a civil injury for which redress may be sought in a civil action. … Thus, a civil right is a legally enforceable claim of one person against another.” 15 Am. Jur. 2d Civil Rights § 1
Could invasion-of-privacy cases, defamation, debt collection, and other such cases be called civil rights cases? What about credit reporting cases? Might wrongful death, wrongful birth, or wrongful life cases also be viewed in this way? If all damages are compensatory for personal physical injuries, the Section 104 exclusion should protect them and make attorney fee deductions unneeded. But plaintiffs who receive punitive damages need an avenue to deduct their legal fees. (For further discussion, see Robert W. Wood, “Civil Rights Fee Deduction Cuts Tax on Settlements,” Vol. 166, No. 9, Tax Notes Federal (March 2, 2020), p. 1481.)
The IRS deserves thanks for fixing a deduction that’s been tough to claim since 2004. I’m still not used to the Schedule 1 idea for Form 1040, which was part of the failed effort to make tax returns like postcards. But those issues aside, the IRS change for 2021 returns—with a place for attorney fees—is a big win. Don’t overlook it.