A Double Tax on Defamation Plaintiffs
Last month, Forbes highlighted the “plaintiff double tax,” which has been reducing plaintiff recoveries since 2018. In most taxable cases, plaintiffs pay tax on a large portion of their recovery that they won’t keep – the portion that goes to their lawyers for fees and costs. Their lawyers then pay tax on the same amount again – hence, the “double tax.”
Getting taxed on legal fees and costs can cut a plaintiff’s take-home amount by more than 50%. And avoiding it can double, or even triple, what the plaintiff keeps. This tax trap hits nearly every defamation plaintiff, unless that plaintiff is an entity rather than an individual.
Origins of the Double Tax
If a plaintiff’s recovery is taxable, the plaintiff is taxed on the portion paid to their lawyer. The U.S. Supreme Court confirmed this in Comm’r v. Banks (2005). This isn’t a problem for plaintiffs if those fees can be deducted on the plaintiff’s tax return. However, as of 2018, they’re typically no longer deductible. In general, fees are now only deductible in cases involving “unlawful discrimination.”
Greg Maxwell, expert advisor to plaintiffs, and former President of the Society of Settlement Planners, notes, “Tax legislation dramatically decreased what plaintiffs keep in these cases. It makes every taxable settlement worth much less.”
Cases Hit by the Double Tax
Individual plaintiffs are generally taxed on recoveries unless their injuries were “physical.” Damages for injuries suffered in a car crash or from medical malpractice will typically be wholly tax-free (though verdicts change that, since interest and punitive damages are taxable). But lawsuits for defamation, verbal harassment, wrongful touching, and wrongful imprisonment are almost always taxable.
Defamation is an easy example. “Take the Alex Jones defamation cases,” says Maxwell. “While there were physical injuries involved, even deaths, the families are suing him for defamation, which didn’t involve any physical contact. Thus, they’ll be taxed on any recovery received.”
Especially if the contingent fee percentage and firm costs (e.g., for expert witnesses) are high, plaintiffs may be left with very little after taxes are paid.
Why Defamation Plaintiffs Can’t Take Business Deductions
Surprisingly, individual plaintiffs who sue for harm to their “professional reputation” can’t deduct their legal fees as business expenses. As this Forbes article details, the law treats defamation as a “personal” injury.
“This treatment seems very wrong,” says Maxwell. “Expenses paid to defend your professional reputation should absolutely be treated as a business expense. Just like expenses paid for marketing. But, until the courts say otherwise, plaintiffs will pay the price.”
Maxwell points to the IRS Lawsuit Audit Guide and multiple tax cases as the source of the problem. “Fortunately,” he says, “we do have trust solutions to address this unfair tax result.”
Solving the Double Tax with Trust Solutions
Eastern Point Trust Company offers the Plaintiff Recovery Trust, which Maxwell cites as the only current solution to the double tax problem. The split-interest trust allows plaintiffs to avoid taxation on the legal fee portion of their recovery, thus avoiding any reliance on deductions.
“Importantly,” notes Maxwell, “the Plaintiff Recovery Trust can facilitate tax deferral of the plaintiff’s damages as well, typically through the use of a ‘structured settlement annuity.’ And both of these solutions avoid any additional cost to the defendant.”
The “plaintiff double tax” is a relatively new problem, only impacting plaintiffs since 2018. But its detrimental effect is significant, sometimes reducing plaintiffs’ take-home amounts by more than 50%. With the Plaintiff Recovery Trust, plaintiffs can typically avoid the tax hit. Of course, as Maxwell says, “The Plaintiff Recovery Trust shouldn’t be necessary, but for now, it’s the only viable option for plaintiffs to avoid an unfair tax outcome.”
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