The Tax Code Keeps Legal Help Out of Reach for Harmed Consumers. A Bill Could Change That

The Tax Code Keeps Legal Help Out of Reach for Harmed Consumers. A Bill Could Change That

By Christine Hines
National Association of Consumer Advocates

Paul Bland
Public Justice Executive Director

Fee-shifting provisions in statutes serve to make so many legal actions on behalf of wronged consumers possible, but a serious issue with America’s tax laws is critically undermining them. A critical feature of many state and federal consumer protection laws, fee shifting laws provide that if a consumer prevails in a case against a corporation – the consumer successfully proves that the corporation violated a consumer protection law, and they win a recovery under the law – that the corporation has to pay the consumer’s attorneys’ fees.

The fee shifting laws are crucial, because they’re often the only thing that makes it affordable for a consumer to bring a case, even if a corporation has really cheated them or broken an important consumer protection law. Affordability of legal representation is a huge problem for consumers — according to a 2020 survey of 1,000 likely voters, less than 30% of people across political parties and major demographics believe they can afford to bring a case against a corporation that has harmed them. Furthermore, 89% of Democrats and 85% of Republicans agree that it should be made easier to afford to bring such a case. If a consumer knows that the cost of a lawyer to represent them will be covered by the corporation if they win, they can go forward with a consumer protection case.

The fee shifting laws also help make the consumer protection laws serve their purpose. They help assure legislators that the protective laws they pass can be enforced by the persons they were meant to protect.

Yet an obscure but confounding anomaly in the tax code has complicated this benefit. The End Double Taxation of Successful Consumer Claims Act, a Senate bill introduced in March, would fix it.

Specifically, under the IRS’s current interpretation of the Internal Revenue Code, consumers who recover legal expenses after successfully suing the corporation that harmed them are expected to pay income taxes on all parts of their award, including the reimbursed legal expenses. But, as the name “attorneys’ fees” suggests, these monies go to the consumer attorneys who win a case, the consumer clients don’t get the money. The attorneys pay income tax on the fees as well, creating a double taxation conundrum.

The impact of this interpretation has prolonged financial difficulty for many. In 2015 a debt collector sued Tonya Latz, an Arkansas consumer, over an expired debt. Knowing she would need legal help, she hired an attorney who helped her counter-sue the collector for violating the Fair Debt Collection Practices Act, a federal law intended to protect consumers from debt collection abuses. The case settled in 2017 with the debt collector agreeing to pay Ms. Latz a small amount of statutory damages and her legal expenses for the past two years of litigation, as allowed under the FDCPA.

Unexpectedly, in 2019, Ms. Latz received an IRS deficiency notice claiming she owed thousands in unpaid taxes on the reimbursed legal expenses that went to her attorney, enough to completely wipe out her recovery in the case. Thanks to help from an accountant and the IRS’ consideration of her individual case, Ms. Latz was able to avoid the severe tax penalty. However, other consumers in Ms. Latz’s position may not be so lucky.

The policy rationale behind fee-shifting provisions, similar to the FDCPA statute, is circumvented when the tax code works against them. The vast majority of state and federal consumer protection laws have fee-shifting provisions, so that consumers will be able to afford enforcing their rights under those statutes. They provide an important incentive for consumers and remain one of the cornerstones of effective enforcement. Without fee-shifting, far fewer suits could be brought against bad actors and consumer protection laws would lose much of their teeth, leaving consumers vulnerable in the marketplace.

Public sentiment for fee-shifting is positive as well: 79% of voters support fee-shifting with 54% strongly supporting it. Keeping lawsuits accessible by shifting the cost burden of litigating corporate misconduct from consumers onto the bad actors should be a winning policy, but it is frustrated by unfair taxes.

The unfair tax code interpretation saddles consumers with a tax bill for funds that they don’t see and that go to their attorneys. It’s not only unfair from the perspective of the tax laws by taxing people for money they don’t personally receive, it also complicates access to justice for many. And in extreme cases some consumers can end up paying much more in additional taxes than they are awarded.

Roger Phillips, a consumer attorney in New Hampshire, recently successfully represented a consumer in a complex and long-running fraud case in state court. A fraudster forged a power of attorney to take out a $100,000 mortgage on a consumer’s mortgage-free home. After five and half years of litigation, the consumer was awarded several thousand dollars in statutory damages.

Because of the length of the case, Phillips expects the fraudster will be ordered to pay a substantial amount to reimburse his client’s legal expenses. The prospect of the defrauded consumer potentially having their damages taxed out from under them is disheartening.

“If my client ends up having to pay taxes on the attorneys’ fees we receive, that would be incredibly unfair and disproportionate,” Phillips said. “My client is on Social Security and disability, she doesn’t even make enough to file a tax return.”

Because of the way the reimbursed fees are treated, consumers may also find their incomes artificially inflated by funds they never receive, threatening their qualification for benefits such as the Earned Income Tax Credit, Child Tax Credit, subsidized housing, and a host of other vital safety nets. Penalizing vulnerable consumers for fighting back against abuse puts them in a risky spot: they can let bad actors continue to run wild or try to enforce their rights and risk losing money and benefits to an unfair tax policy.

The End Double Taxation of Successful Consumer Claims Act presents a simple, common-sense solution to the double taxation problem: it would allow consumers to deduct reimbursed legal expenses from their income so that they do not have to pay taxes on funds that do not belong to them. In the poll, voters overwhelmingly said they would favor such a change in the tax code.

Congress should act to make sure consumers are able to afford to stand up for themselves and hold bad market actors accountable. If passed, the law will work to keep lawsuits affordable for harmed consumers and reaffirm the principles behind consumer protection laws.

Image by David Boeke via Creative Commons.

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