New Federal Legislation Should Make It Easier

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United States: New Federal Legislation Should Make It Easier to

Settle Employment Lawsuits

29 June 2005

Originally published June 2005

By J. Ranallo (Chicago)

The U.S. Supreme Court's decision in Commissioner v. Banks makes it

clear that taxes are a big issue in settling employment litigation.

Plaintiffs look at the bottom line: what am I going to have in my

pocket, after taxes. The problem in many cases is caused by

contingent attorneys' fees paid out of the settlement proceeds. For

many years, the IRS has taken the position that the amount paid to

attorneys out of an employment litigation settlement is taxable

income to both the plaintiff and the attorney. In other words, the

plaintiff is taxed for the full amount of the settlement, even if

part of it goes directly to the attorney. The IRS has allowed

plaintiffs to deduct the amount paid as attorneys' fees as a

miscellaneous itemized deduction; however, the alternative minimum

tax wipes out that deduction for most plaintiffs, leaving them

obligated for taxes on the amount paid to the attorneys.

However, a recent change in the tax law has eliminated this problem

for many plaintiffs and should make it easier to settle employment

lawsuits. The Civil Rights Tax Relief Act, signed by President Bush

in late 2004, eliminates the double tax on attorneys' fees by

permitting plaintiffs in a wide range of employment cases to deduct

legal fees and costs in calculating their adjusted gross income

(i.e., " above the line " ) on Form 1040. Such a deduction is not

subject to the alternative minimum tax, so the plaintiff will

receive the full value of the deduction and will not be taxed on the

settlement amount paid to his or her attorneys.

The Civil Rights Tax Relief Act enumerates the employment-related

claims for which legal fees and costs are deductible from adjusted

gross income. Broadly speaking, all claims of unlawful

discrimination and violation of civil rights under federal, state

and local law are included under the Act. Among the claims that are

specifically enumerated are those brought under the following:

Civil Rights Act of 1964, as amended (Title VII)

National Labor Relations Act (NLRA)

Fair Labor Standards Act (FLSA)

Sections 1981, 1983 and 1985

Age Discrimination in Employment Act (ADEA)

Section 510 of the Employee Retirement Income Security Act (ERISA)

Family and Medical Leave Act (FMLA)

Americans with Disabilities Act (ADA)

Worker Adjustment and Retraining Notification Act (WARN)

The Act also includes unspecified federal whistleblower protection

claims. The sweeping, catchall provision of the Act includes all

federal, state and local laws, as well as common law

provisions " regulating any aspect of the employment relationship ...

including claims for wages, compensation, or benefits, or

prohibiting the discharge of an employee, or any form of retaliation

or reprisal against an employee for asserting rights or taking other

actions permitted by law. "

Significance

The Civil Rights Relief Act should make it easier to settle

employment claims for less money, because more of the settlement

proceeds will end up in the plaintiff's pocket. However, employers

must be aware that although many kinds of employment claims are

covered by the Civil Rights Relief Act, a number of common law

claims may not be covered. For example, it is unclear whether

defamation and invasion of privacy claims are covered by the Act. It

also is unclear whether breach of contract and promissory estoppel

claims are covered. The scope of the Act ultimately will have to be

defined by the courts.

The Act reads that it applies to " fees and costs paid after the date

of enactment (October 22, 2004) " with respect to any judgment or

settlement occurring after such date. " It is unclear how the Act

will be interpreted in cases where, for instance, a judgment is

entered before the effective date of the Act, but the judgment does

not become final and enforceable until some time after the effective

date. This is another area in which the courts will have to

intervene.

Even more importantly, the Civil Rights Relief Act does not change

the employer's obligations. Employers are still obligated to issue

the plaintiff a 1099 and/or W-2 covering the entire settlement

amount and also issue a 1099 to the attorney for the portion of the

settlement amount paid directly to the attorney. Failure to do so

could result in penalties from the IRS.

The Civil Rights Relief Act should make it easier to resolve

employment cases for less money because plaintiffs can keep a larger

portion of the settlement proceeds rather than paying them to the

government in taxes. Only time will tell, however, whether the Act

has this salutary effect.