Since 2018, it has been more difficult to deduct legal fees, and some plaintiffs in contingent fee cases pay taxes on their gross recoveries, not net after legal fees. Some call it a new tax on legal transactions. It takes getting creative in this new age, as sometimes the rules seem to say you shouldn't deduct at all. Checklists of ways to deduct legal fees cam help. Fortunately, though, the mechanics of deducting legal fees in employment, whistleblower, and civil rights cases have been improved, at last. The tax code was amended in 2004 to allow "above the line" legal fee deductions, almost as if you didn't have the income in the first place. But the deduction has been rare to claim ever since, leaving many taxpayers and accountants in trouble. Not only was there no proper line for it on the IRS forms, but he had to include a particular code next to his brief, entering "UDC" for unlawful discrimination claim. But finally, starting with 2021 tax returns, the IRS makes it easier with a new Form 1040 with an line item for attorneys' fees. For 2021, Schedule 1 of Form 1040 gives you two lines. Line 24(h) and 24(i) of Part II, Adjustments to Income.
Why worry about deducting legal fees in the first place? Most plaintiffs prefer that the attorney be paid separately to avoid the need for the deduction. Unfortunately, it's not that simple. If the attorney is entitled to 40 percent, the plaintiff will generally receive only the net recovery after fees. Therefore, most plaintiffs assume that the largest tax they could face would be the tax on their net recoveries. But under Commissioner v. Banks, 543 US 426 (2005), plaintiffs in contingent fee cases generally must include 100 percent of income, even if the attorney receives direct payment, and even if the plaintiff receives only a net settlement. It's just one of many strange rules about how legal settlements are taxed. This harsh tax rule generally means claimants must find a way to deduct their 40 percent fee. Fortunately, in 2004, shortly before Banksse decided, Congress enacted an above-the-line deduction for employment claims, civil rights claims, and certain whistleblower claims. That should mean those claimants pay taxes on their net recoveries, not their gross winnings. Still, many taxpayers and return preparers have had trouble claiming it. 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 attorneys' fees on "unlawful discrimination" claims. The definition of what is an unlawful discrimination claim refers to claims under a long list of laws, including the Civil Rights Act of 1964, ERISA, ADA, ADEA, Title VII, Title IX, NLRA, FLSA, WARN, FMLA , 1983, 1981, and any civil rights or whistleblower protection laws. However, after a fairly long list of laws, the tax code adds a catchall that encompasses much more:
“Any provision of federal, state, or local law, or common law claims permitted by 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 termination of an employee, discrimination against an employee, or any other form of retaliation or retaliation against an employee for asserting their rights or taking other actions permitted by law.” IRC Section 62(e)(18).