The Tax Cuts and Jobs Act (TCJA) of 2017 had a significant impact on plaintiffs receiving taxable settlements. Prior to this change in the law, plaintiffs could list their attorney’s fees as a deduction on their tax returns, avoiding paying tax on the attorney fee portion. However, the TCJA changed this. Now, individual plaintiffs cannot claim a deduction for attorney’s fees except in limited circumstances, resulting in plaintiffs paying taxes on the entire gross recovery, including 100% of their attorney’s fees. This double taxation of attorney’s fees is known as the Plaintiff Double Tax Trap.
The Plaintiff Double Tax Trap
To better understand the impact of the Plaintiff Double Tax Trap, let’s walk through an example. Let’s say there is a $10 million gross settlement for a plaintiff with a taxable damages case. $4 million goes to attorney’s fees, and $6 million goes to the plaintiff. After the Tax Cuts and Jobs Act, the plaintiff pays tax on the entire $10 million, even though the plaintiff only received $6 million. In addition, the attorney also pays taxes on the $4 million of attorney’s fees they receive, resulting in the attorney’s fee portion being effectively taxed twice and the plaintiff effectively taxed twice as well.
As a result, plaintiffs often find that they only receive five to 20% of the total settlement after paying taxes. To illustrate this, let’s assume a 40% contingent legal fee, and the plaintiff’s tax rate is 40%. This means that 40% of the $10 million will go to legal fees, and another 40% of the $10 million will be paid by the plaintiff in taxes. The plaintiff has to pay taxes on the full $10 million gross recovery at a 40% tax rate, leaving only $2 million or 20% for the plaintiff as their net recovery.
Tax Planning Strategies to Reduce the Plaintiff’s Taxes
Tax planning strategies can be used to significantly reduce the amount of tax the plaintiff has to pay, resulting in the plaintiff only paying tax on the amount they receive and not on the attorney’s fee portion. These strategies can often double or even triple the amount of money that the plaintiff ends up with after taxes. It’s important to note that these strategies only work if they are set up before the case settles.
If you are involved in a taxable damages case, it’s crucial to reach out to a certified financial planner who can help you understand the best tax planning strategies for your situation. Greg Maxwell, an attorney and CFP with Amicus Settlement Planners, can help plaintiff attorneys and plaintiffs reduce their taxes and maximize their legal recoveries. Book a call with him today to explore these strategies and increase your after-tax net recovery dramatically.
