Law makes it easier to settle civil rights and employment discrimination cases
By Susan G. Gainey A new law enacted in October 2004 will make it easier for attorneys to settle civil rights and employment discrimination cases. The American Jobs Creation Act of 2004 (AJCA) incorporates a portion of the Civil Rights Tax Relief Act (CRTRA) relating to the taxability of attorney’s fees in certain cases. The Act was supported by pro-employer groups, such as the US Chamber of Commerce, as well as the plaintiffs bar. The AJCA changed a provision of a law enacted in 1996 that sometimes made it difficult for employment lawyers to settle cases.
In the Small Business Job Protection Act of 1996, Congress made taxable all damage awards not based on “physical injuries or physical sickness.” This meant that employment discrimination awards involving back pay or non-physical injuries, including emotional distress claims not stemming from physical injuries or sickness, were taxable. Therefore, when a plaintiff received a verdict or a settlement in an employment discrimination case, the portion that was designated attorney’s fees was “double-taxed,” as both the plaintiff and the attorney had to pay taxes on the fee award. An award of attorney’s fees and costs was includible in income and was treated as a miscellaneous itemized deduction (“below the line” deduction), subject to the 2% of adjusted gross income on such deductions. If the plaintiff did not itemize deductions or was subject to the alternative minimum tax, then no portion of the attorney’s fees was deductible. The IRS took this position, even though the plaintiff was never in possession of the attorney’s fees portion of the judgment. The result was that plaintiffs could owe more in taxes than they received from the judgment or settlement. This was burdensome for settlement purposes as it sometimes significantly increased the amount needed by plaintiffs. Both parties had to consider tax consequences in order to try and settle the case. Attorneys had to “gross up” the total settlement amount to make up for the “double taxation” impact on the award to the individual plaintiff. This raised costs for employers as plaintiffs’ attorneys demanded settlement amounts that would allow a sufficient amount to go the individual plaintiffs. Ultimately, the result was fewer cases could settle prior to trial.
Tax consequences of settlement or judgment were particularly problematic when injunctive relief was the primary relief sought, or if there was a large court-ordered statutory attorney’s fees award. The most notable example was detailed in The New York Times on August 11, 2002. Officer Cynthia Spina of Chicago, Illinois sued the Cook County Forest Preserve for employment discrimination. She was awarded $3 million by the federal jury, which was later reduced by the court to $300,000, the statutory cap for compensatory damages. The Court awarded the plaintiff over $850,000 in attorney's fees and $100,000 in expenses. As a result, Officer Spina faced a net post-tax loss of $99,000.
On October 14, 2004, Congress passed the American Jobs Creation Act of 2004 (H.R. 4520), commonly known as the Corporate Tax Bill, which included a portion of CRTRA (H.R. 1155/S.557). President Bush signed the legislation on October 22, 2004 and it became public law 108-357. Section 703 of the law allows plaintiffs to deduct attorney’s fees and costs as an above-the-line deduction from gross income for an award involving “unlawful discrimination.” The law applies to Title VII, the National Labor Relation Act, the Fair Labor Standards Act, 42 U.S.C. sections 1981, 1983, 1985, the Age Discrimination in Employment Act, the American with Disabilities Act, the Family and Medical Leave Act, among various other federal laws, including the federal whistleblower laws. The deduction is allowed regardless of whether the fees are paid pursuant to a statutory fee shifting provision or as part of a settlement. The Act is prospective only, applying to fees and costs paid after the date of enactment, October 22, 2004. The law did not change taxes paid by attorneys, nor did it make any changes to the current tax treatment of punitive damages awards.
The AJCA did not enact other provisions of the original CRTRA. The bill originally introduced in the House eliminated taxes on emotional distress awards by excluding them from taxable gross income. Further, the original bill allowed income averaging so that plaintiffs could average the income over the number of years covered by back-pay awards, rather than imposing taxes on the total award in the year it is received. Many groups, including the American Bar Association and National Employment Lawyers Association, have pledged to continue lobbying for the unenacted provisions of the original legislation.
The US Supreme Court recently addressed the issue of taxability of attorney’s fees awarded before the passage of the AJCA. Prior to enactment of the Act, circuits were divided as to whether the income was taxable. The majority view, shared by the IRS and the Seventh Circuit, was that the fee payment was taxable to both the plaintiff and the attorney. The Supreme Court heard oral arguments on November 1, 2004 in two consolidated cases and decided the cases in an 8-0 decision on January 24, 2005. In Commissioner of Internal Revenue Service v. Banks and Commissioner of Internal Revenue Service v. Banaitis, 125 S.Ct. 826 (2005), the Supreme Court held that plaintiffs’ recoveries in employment lawsuits, including amounts paid for attorney’s fees, were taxable income.
In the Banks case, John Banks sued the California Department of Education for discrimination in 1990. Pursuant to a settlement agreement, the department paid Banks $464,000. His lawyer received $150,000 of the settlement as part of a contingency fee arrangement. The IRS said Banks owed income taxes on the entire $464,000 and issued a notice of deficiency. The Tax Court agreed with the IRS Commissioner, but the Sixth Circuit reversed, holding that the attorney’s fees should not be included in Banks’ gross income.
In the Banaitis case, Banaitis sued the defendant for interference with an employment contract and received a settlement of over $4.8 million. Banaitis had entered into a contingency fee agreement with his attorney and the defendant paid an additional $3.8 million directly to the attorney. Banaitis did not include the amount paid to his attorney in his gross income on his federal tax return in 1989. The Commissioner issued a notice of deficiency, which the Tax Court upheld, but the Ninth Circuit Court of Appeals reversed.
The Court rejected several arguments by plaintiffs, as well as arguments advanced by numerous amicus curiae, as to why attorney’s fees should not be taxed to individual plaintiffs. The Court reversed both lower courts, holding that “when litigant’s recovery constitutes taxable income, such income includes portion of recovery paid to litigant’s attorney as contingent fee.” Id. The Court noted that the AJCA was not retroactive. Therefore, for settlements that took place before October 22, 2004, an award of attorney’s fees as part of a contingent fee contract is taxable income. The Court specifically left open the issue of attorney’s fees awarded pursuant to a fee-shifting statute prior to enactment of the AJCA. The Court noted - but did not address - claims regarding fee-shifting statutes because both cases at bar involved contingent-fee contracts. Thus, the issue of the taxability of statutory fees awards prior to the effective date of the new legislation remains open.
The enactment of the AJCA makes it easier to settle civil rights and employment discrimination cases without substantial prejudice to either party. The Act makes settlement more attractive to plaintiffs because their net settlement amount will be larger. Thus, plaintiffs will be more likely to settle. This, in turn, will benefit employers. The question of attorney’s fees awarded pursuant to a fee-shifting statute, however, remains open and will likely re-surface during the next few terms of the Supreme Court. Nevertheless, employment lawyers currently settling civil rights and employment discrimination lawsuits will benefit from the enactment of the AJCA in that it will make settlement easier for both parties.
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