Te Tax Man Cometh! I


by JAMES S. DICKEY, JR., The Marston Group, PLC


t is the best of seasons, it is the worst of seasons, it is the month of sunny days, it is the month of hay fever, it is the period of spring fever, and it is the period of tax deadlines.


With that I will stop with the terrible paraphrasing of Dickens. Although April may be past, the following is a mélange of tax is- sues of which attorneys should all be aware throughout the year. Some of these issues will affect you and some may affect your clients. By necessity I have kept the discussions brief. Please seek out your favorite CPA to discuss these topics in more detail. So I will now present my evidence and hope that these tidbits will prove helpful to you. And remember, in the immortal words of another favorite wordsmith, “Should five percent appear too small, be thankful I don’t take it all, ‘cause I’m the taxman, yeah… I’m the taxman!” Believe it or not, at some times our Internal Revenue Code


(IRC) behaves somewhat logically. One of those times, more or less, relates to litigation recoveries. Te tax treatment of re- coveries is determined by the origin and nature of the underly- ing claim. A recovery related to lost wages should result in the funds received being taxed in a manner similar to that of regular wages. Tis means that income Social Security and Medicare taxes will probably have to be withheld. If your client is suing over a decrease in value of his stock portfolio, a recovery would probably be treated as capital gain or maybe as an adjustment to basis. And finally if your client’s case involves lost profits then ordinary income treatment should apply. Some advice is in order; when drafting your agreement consider adding tax lan- guage that is as favorable to your client as possible. Your trusty neighborhood CPA should be able to help. What about the tax consequences of a recovery in a physical injury case? Easy, right? Well actually, no. We could devote an


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entire article to IRC section 104. Generally speaking, income re- coveries for personal physical injuries are not subject to tax. Also if there is a legitimate underlying physical injury or sickness, then damages resulting from that, due to emotional distress, are also excludable. However, damages received related to emotional dis- tress that are not directly tied to a physical injury will be taxable. When a contingent fee has been awarded, the client will


usually have to report income. While it is true that legal fees should be deductible, the manner in which they are deducted do matter. Generally, legal fees paid on a contingent fee basis are treated as a miscellaneous itemized deduction on Schedule A of their Form 1040. As such, they are potentially subject to certain limitations for both regular and Alternative Minimum Tax purposes. Why does that matter? Well, because this could result in the client losing some or all of the tax benefit of the deduction. Furthermore, even when a portion of a recovery is not subject to tax, any interest or punitive damages received will be taxable. In that case the attorney fees paid will have to be bifurcated with some of the fees being deductible, and another portion not. And then there is the situation involving employ- ment lawsuits and federal False Claims Acts. In employment cases, the client gets an above-the-line deduction meaning no limitations on said deduction. An often overlooked concern is that of the doctrine of con-


structive receipt. Keep in mind that if there is an unrestricted right to receive income, then it must be reported on that year’s income tax return. In short, constructive receipt is treated as actual receipt. For example, if a binding agreement has been executed calling for a cash payment then as a practical matter, any resulting tax is due and payable. In such a case one might think they can still ask for a series of periodic payments. Since


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