No Deduction for Attorney’s Fees under the Tax Cuts and Jobs Act
The Tax Cuts and Jobs Act of 2017 (the “2017 Act”) eliminates miscellaneous itemized deductions as part of individual tax reform (this change will sunset on December 31, 2025).
Prior to the 2017 Act, an individual taxpayer who took itemized deductions instead of a standard deduction could deduct legal fees that were greater than 2% of his or her adjusted gross income as a miscellaneous expense. After the 2017 Act, clients can no longer deduct legal fees as a miscellaneous expense even if they choose to itemize their deductions.
This change will adversely impact clients and attorneys alike because clients are now bearing higher after-tax costs for attorney’s fees. However, there are still some situations where the legal fees may be deducted by the clients or not included in the clients’ income:
1. Clients can still deduct attorney’s fees based on claims that qualify for “above the line” deductions.
“Above the line” deductions are set forth in Internal Revenue Code (“IRC”) Section 62 and are deducted against the taxpayer’s gross income to reach a lower Adjusted Gross Income (“AGI”). “Below the line” deductions are set forth in IRC Section 63 and are deducted against AGI to reach a lower taxable income. The “line” is set by the Adjusted Gross Income.
The standard deduction or itemized deductions are “below the line” deductions. Because legal fees based on claims that qualify for above the line deductions are deducted before taxpayers apply itemized deductions, the repeal of the miscellaneous itemized deduction has no impact on their deductibility.
2. Which claims qualify for above the line deductions?
a. Discrimination suits (especially employment claims) and attorney’s fees relating to awards to whistleblowers.
IRC Section 62(a)(20) and (21) allow a taxpayer to deduct costs involving discrimination suits and attorney’s fees relating to whistleblower awards. Specifically, under IRC Section 62(e)(18), unlawful discrimination is defined to include: “any provision of Federal, State, or local law, or common law claims permitted under Federal, State, or local law… regulating any aspect of the employment relationship, including claims for wages, compensation, or benefits, or prohibiting the discharge of an employee, the 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.”
However, a plaintiff’s above the line deductions for fees in employment and qualifying whistleblower cases cannot exceed the income the plaintiff receives from the litigation in the same tax year.
b. Trade or business expenses.
IRC Section 62(a)(1) allows deductions that are attributable to a trade or business carried on by the taxpayer, if such trade or business does not consist of the performance of services by the taxpayer as an employee. Thus, if the client’s recovery relates to the taxpayer’s trade or business, the taxpayer can deduct his or her legal fees as a business expense.
(i) However, according to IRC Section 162(q), tax deductions for settlement payments in sexual harassment or abuse cases are denied, which includes attorney’s fees, if such settlement or payment is subject to a nondisclosure agreement (also called the “Harvey Weinstein tax”). This caveat could also disallow the above the line deductions for employment and qualifying whistleblower claims when a sexual harassment claim is part of the employment or whistleblower claim.
3. Clients do not need to include attorney’s fees (i.e., money damages that were awarded to pay for attorney’s fees) in their income.
Excludable fees include: (i) compensatory damages awarded under a pure physical injury case with no interest and no punitive damages; (ii) court awarded fees; and (iii) statutory attorney’s fees.
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