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The Double Taxation of Attorney Fee Awards Leaves Wronged Consumers In the Cold. Help Us End It.

The Double Taxation of Attorney Fee Awards Leaves Wronged Consumers In the Cold. Help Us End It.

Ask Your Senators to Support S. 2627

Russell and Jennie Kinney thought they had achieved the American Dream. Although they are of modest means and rely on what Russell is able to make as a mechanic in their small town in rural Maine to get by, they were able to save enough to buy a home together. They financed their home purchase through Bank of America, and started off making timely payments on their mortgage.

Suddenly, though, it all came crashing down around them. Without explanation, their monthly payment amount skyrocketed. At first, they tried to keep up, but they quickly fell behind. Before long, they found themselves on the verge of losing their home to foreclosure.

The Kinneys ultimately discovered that the sudden increase in their monthly payment amount was illegal. Even though the bank had clearly violated the law, it denied doing anything wrong and put up a number of defenses claiming various technicalities. Luckily, they were able to find a lawyer to take their case. Their lawyer helped them file a lawsuit against the bank, alleging that the bank had violated numerous state and federal consumer protection laws, including the Fair Debt Collection Practices Act (“FDCPA”) and Maine’s Consumer Credit Act. The bank eventually settled with the Kinneys, allowing them to stay in their home and avoid the threatened foreclosure. As a part of that settlement, the bank also agreed to pay the attorney fees the Kinneys’ lawyer had earned during the ordeal.

The Kinneys couldn’t have won their case on their own without a lawyer. Their lawyer had to expend a lot of time breaking down the various legal obstacles that the bank created to try to get away with cheating its customers. The law recognizes this: many statutes that protect consumers from predatory corporate conduct (like many laws that protect against discrimination, unfair workplace practices, and more) provide for plaintiffs to be able to collect attorney fees if they win. The whole point of these types of statutes is to make sure that people like the Kinneys will be able to find the lawyer they need to be made whole.

In the Kinneys’ case, the consumer protection laws worked as they should. They gave the Kinneys the tools to fight back against illegal and harmful corporate conduct that had threatened to render them homeless.  But the Kinneys’ ordeal was not over.

Current Tax Law Considers Attorney Fee Awards to be Income and Taxes Them Twice

Under current tax law, the attorney fees the Kinneys received as a part of their case would be considered taxable income. This means that the Kinneys would be forced to pay taxes on the attorney fees awarded as part of their settlement, even though those fees had already been earned by, and would go directly to, their lawyer. In the Kinneys’ case, the taxes they would owe on the attorney fee amount would wipe out the money the Kinneys won in their case, and drain their limited income.

The Kinneys are just one example of the many consumers who are harmed every day by the way the tax laws treat attorney fee recoveries. Their story, and the stories of other consumers harmed by this flaw in the tax laws, can be found in a report published by the National Association of Consumer Advocates, called Consumers Caught in Tax Law Flaw: IRS Undercuts Consumer Protection; New Tax Law Rubs Salt in the Wound.

Under the U.S. Tax Code, attorney fee awards are considered “income” for the plaintiff who receives them, even though the plaintiff cannot keep the money and may never even see it, as it goes directly to the attorney. Such attorney fee awards are also considered income for the attorney who ends up with the funds, meaning that, in the end, they are taxed twice.

Treating attorney fee awards as a plaintiff’s income for tax purposes causes a number of harms. Most obviously, plaintiffs are left with potentially huge tax bills, on money that isn’t actually theirs.  Because unraveling unjustified corporate defenses often requires a lot of attorney time and effort, these bills can sometimes dwarf the amount the plaintiff won in their case, meaning that they end up behind—owing more after having successfully “vindicated their rights” than if they had never gone to court at all.

For some individuals, an attorney fee award can also make it look like they have far more income than they actually do, and can render them ineligible for important programs, like the Earned Income Tax Credit (EITC). The EITC has been called one of the “largest anti-poverty programs” in our nation’s history. Through the EITC, many families see their monthly incomes boosted by more than $250 per month. Suddenly being rendered ineligible for this benefit because of an attorney fee award would be a serious economic hardship for many Americans.

Double Taxing Attorney Fee Awards Undermines Federal Law

Turning attorney fee awards into tax liabilities undermines federal law by making it more difficult for individuals to vindicate important rights. Congress has repeatedly recognized that some laws depend on everyday people being able to enforce them in court. But doing so would often be impossible without the assistance of a qualified and knowledgeable attorney. So for many of these laws, Congress has authorized courts to award attorney fees to plaintiffs who win their cases. These “fee shifting provisions” are included in dozens of statutes throughout the U.S. Code, including those designed to protect people from discrimination, labor abuses, environmental harms, unfair debt collection and credit reporting practices, and much more. Without these provisions, the substantive laws would be “but an empty gesture” because no one could afford to go to court to enforce them.

In some cases—especially those that arise under the consumer protection laws—the amount of money that it costs to litigate the case will be greater than the amount of money the person who was harmed is owed. This is not a bug in the system, it is a feature. In many consumer cases, each individual is harmed in some relatively small way: for example, they bought a car for a few hundred dollars that turned out to be a lemon, or illegal credit reporting practices caused them a few thousand dollars’ worth of damages. As a Michigan appellate court judge recognized in Jordan v. Transnational Motors Inc., “if attorney fee awards in these cases do not provide a reasonable return, it will be economically impossible” for people hurt by these illegal schemes to find attorneys to represent them. The point of fee shifting provisions is to make it possible for individuals to vindicate their rights. By incentivizing lawyers to take these cases, the law works as an equalizer, putting power back into the hands of consumers, and giving them tools to fight back against corporate abuses.

But the current tax treatment of attorney fee awards takes away that power.

That’s why Public Justice is supporting a new effort to find a legislative solution to this problem.

On October 17, 2019, U.S. Senator Catherine Cortez-Masto (D. Nev.) introduced the End Double Taxation of Successful Civil Claims Act (S. 2627). This bill would solve the problem for people like the Kinneys.  S. 2627 would change the law to provide an “above-the-line” deduction so that attorney fee awards will not count towards a plaintiff’s adjusted gross income for tax purposes.

The solution S. 2627 proposes is not novel. It simply extends a legal fix Congress used to preserve discrimination and whistleblower claims to other types of civil cases. In 2004, through the American Jobs Creation Act (118 Stat. 1418), Congress amended the Tax Code to provide an “above-the-line” deduction for fee awards recovered through certain discrimination and whistleblower cases, meaning that those sums would not count towards the individual’s adjusted gross income (the relevant number for tax purposes).

Why Now?

Although the 2004 fix did nothing to protect plaintiffs in other types of cases, until recently they also had a partial—if imperfect—solution: they could use the Miscellaneous Itemized Deduction to reduce their tax burden and obtain at least partial relief.  This solution was far from perfect. For instance, it did not necessarily allow winning plaintiffs to deduct the entire amount of their attorney fee award. And because it relied on plaintiffs using a “below-the-line deduction,” attorney fee awards were still considered income for certain purposes, like calculating eligibility for the EITC.

But with the Tax Cuts and Jobs Act of 2017, even that imperfect solution has evaporated. The TCJA suspended plaintiffs’ ability to deduct personal litigation expenses, meaning that successful plaintiffs now have to pay the full amount of taxes owed on attorney fee awards, even when the money goes directly to their lawyers. For some people, that may mean that they end up owing more than they gained in their winning lawsuit. This harms everyday Americans, and strips those statutes that depend on private enforcement of their power. It means that people with meritorious claims will be discouraged from bringing those claims to light, and corporate wrongdoers will be let off the hook.

That’s why we’ve added our voice in support of the End Double Taxation of Successful Civil Claims Act (S. 2627). The bill is currently before the Senate Finance Committee. On December 19, Public Justice sent a letter to each of the members of the Committee. We thanked Senator Cortez-Masto for her leadership in introducing the bill, and Senators Van Hollen, Merkley, Brown, Blumenthal, Booker, and Markey for their support as co-sponsors. And we urged the rest of the Senate Finance Committee to support the bill.

Join us!

Interested in adding your voice in support of S. 2627? Contact your senator today—especially if they are on the Senate Finance Committee—and tell them to support the bill.