Deduction of Contingency Lawyers Fees in Personal Injury Cases

Deduction of Contingency Lawyers Fees in Personal Injury Cases

Facts

In 2008, Joshua was severely injured when a bookcase toppled over and hit him on the head. Joshua believed that the bookcase fell over because Zev was negligent by not installing the bookcase properly and overloading it with heavy books. Joshua's attorney, Jack, brought a lawsuit against Zev on a standard contingency basis, which called for his to receive one-third of any recovery. According to the settlement reached in 2010, Zev's insurance company agreed to pay Joshua $900,000 for his medical expenses, pain and suffering. Of the $900,000, Joshua received $600,000 and Jack received $300,000.

Question

How should Joshua report/deduct Jack's $300,000 legal fees?

Discussion

Individuals, as cash basis taxpayers, may deduct attorney's fees in the year they are paid, assuming the attorneys' fees otherwise qualify as deductible expense under some other provision of the Code. (§ 62(a)(1), §63(d)). In the majority of cases, attorneys' fees are paid pursuant to a contingent fee arrangement once damages have been recovered. Where the ultimate recovery is excludable from gross income, either in whole or in part, the payment of contingent attorneys' fees allocable to exempt income is not deductable. No deduction is allowed for legal fees properly allocable to non-taxable awards or settlements.

The question of whether the contingent legal fee paid to an attorney is included in the gross income of an individual taxpayer/plaintiff is important since inclusion in gross income allows the deductibility of the legal fee as an itemized deduction (Alexander v. IRS, 72 F.3d 938, 944 (1st Cir. 1995). If contingent legal fees are included in the plaintiff's gross income, a trade or business miscellaneous itemized deduction is permitted for the amount of the legal fee, either as an ordinary and necessary expense of the trade or business (I.R.C. §162(a)(2000); Guill v. Comm'r, 112 T.C. 325, 328 (1999)).

The inclusion is gross income of the contingent legal fee and the deduction as an itemized deduction triggers various limitations that may operate to reduce the benefit provided to the individual by deducting the contingent legal fee.

The first limitation imposed on deductibility of contingent legal fees, for regular tax purposes, is on all miscellaneous deductions (I.R.C. §67(2000)). Section 67(a) states that "the miscellaneous itemized deductions for any taxable year shall be allowed only to the extent that the aggregate of such deductions exceeds the two percent of adjusted gross income (§67(a)).

The second limitation imposed on the deduction of contingent legal fees is the limitation imposed on high income taxpayers that reduces the total amount of itemized deductions allowed (§68(2000)).