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Laura Sager and Stephen Cohen

Excerpted from: Laura Sager and Stephen Cohen, How the income tax undermines civil rights law. 73 Southern California Law Review, vol. 73, pages 1075-1104, 1075-1080 (2000) (citations omitted).

Federal statutes entitle the prevailing plaintiff in civil rights litigation to recover attorney's fees from the defendant. The recovery of attorney's fees under these so-called "fee-shifting provisions" constitutes a deliberate departure from the usual American rule that each litigant must bear her own legal costs.

A civil rights plaintiff acts not just for herself alone, but also as a "private attorney general," vindicating national policy. The fee- shifting provisions enable the plaintiff who cannot pay a private attorney, and whose potential recovery is not sufficient for a contingency fee arrangement, to perform this private attorney general function.

This objective has been undermined by recent decisions of the federal courts of appeals and the tax court, as well as by rulings of the Internal Revenue Service (IRS), concerning the taxation of plaintiffs in cases of employment discrimination. Under these decisions, an employment discrimination plaintiff must report her entire recovery as income. However, the attorney's fees--the cost of producing the income--are not fully deductible under the regular tax and are not deductible at all under the alternative minimum tax (AMT).

The disallowance of AMT deductions is particularly significant. Suppose that a plaintiff settles an employment discrimination claim for a total of $120,000, out of which she pays $50,000 in attorney's fees. The plaintiff's economic income is only $70,000, which equals the $120,000 recovery, less the $50,000 in attorney's fees that are the cost of producing the recovery. However, the plaintiff's taxable income under the AMT is calculated as $120,000, which equals the entire recovery without any deduction for the attorney's fees and overstates the plaintiff's economic income by $50,000. At the lower AMT tax rate of twenty-six percent, the overstatement of income by $50,000 increases the plaintiff's AMT liability by $13,000.

If the ratio of attorney's fees to the entire recovery is high enough, a before-tax gain may metamorphose into an after-tax loss. In Alexander v. Commissioner, for example, the plaintiff settled a state law employment claim for $250,000 but incurred $245,000 in attorney's fees, for a pre-tax profit of $5,000. Under the AMT, the entire $250,000 recovery was taxable but none of the $245,000 in attorney's fees was deductible. If we assume that the taxpayer files jointly and has no other income, his AMT liability would be $53,900. Under these assumptions, the non-deductibility of the employee's attorney's fees under the AMT would convert a $5,000 before-tax gain into a $48,900 after-tax loss.

We believe that the AMT's disallowance of deductions for attorney's fees in these instances is wrong as a matter of tax policy. The disallowance is even more troubling because it undermines the national policy of encouraging the pursuit of meritorious civil rights claims. We are aware of no instance in which the IRS has applied these rules to civil rights plaintiffs in areas other than employment discrimination. Nevertheless, given the precedents involving employment discrimination, such a result is entirely possible and would frustrate the private enforcement of civil rights claims for discrimination in education, housing, and public accommodations and for the violation of constitutional rights.

The tax treatment of attorney's fees in civil rights cases was unimportant until recently for a simple reason. For many years, the Code excluded from taxation all damages received in personal injury cases, including civil rights claims. Since all personal injury damages were tax-exempt, no deduction was allowed for the cost of producing them. In 1992 and 1995, however, the Supreme Court held in two employment discrimination cases that damages were taxable, a result codified and extended by Congress in 1996 to cover all nonphysical injuries, including all claims of unlawful discrimination. With damages for civil rights violations now taxable, the question of the tax treatment of attorney's fees in such cases has assumed new importance.

Part I of this article discusses two preliminary issues that help determine whether attorney's fees are in fact deductible under current law. The first is whether a plaintiff might be able to exclude from taxable income the portion of a recovery expended for attorney's fees, thereby obviating the need to claim a deduction. The second concerns how the Internal Revenue Code categorizes the expense for attorney's fees.

Part II examines the legislative history of Internal Revenue Code provisions that affect the tax treatment of attorney's fees in employment discrimination cases. These provisions distinguish between reimbursed employee business expenses, which are fully deductible, and un-reimbursed expenses, which are not fully deductible under the regular tax and not deductible at all under the AMT.

Part III criticizes the decisions of the federal courts that decline to classify the attorney's fees in employment cases as a reimbursed expense, with the consequence that the plaintiff's income is overstated and overtaxed.

Part IV explains how the income tax may also frustrate the fee-shifting provisions of federal civil rights statutes that provide remedies for discrimination in education, housing, and public accommodations and for violations of constitutional rights.

Part V evaluates two possible solutions: careful drafting of settlement agreements and amending the tax law.

We conclude that the tax law should permit civil rights plaintiffs either to deduct fully or to exclude from income the portion of a recovery expended for attorney's fees. Either a deduction in full or exclusion would provide a more accurate measure of the plaintiff's income and also preserve the purposes of the fee-shifting provisions of federal civil rights law.