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Congress Allows Employment Discrimination Litigants to Take a Full Tax Deduction for Attorney’s Fees Which May in Turn Foster Lower Settlement Costs for Employers

Volume 3, Issue 16
October 20, 2004

Hidden inside the over 600 pages of the American Jobs Creation Act of 2004 ("the Act"), passed by Congress earlier this month and on its way to the President's desk for signature, are provisions ending the "double taxation" of settlements and damage awards in many types of civil rights and employment discrimination cases.

Currently, the Internal Revenue Service ("IRS") requires a civil rights/employment discrimination litigant that settles a case or obtains a damage award to pay taxes on the entire amount, even though a portion of the settlement or award is used to pay the litigant's attorney, who in turn is obligated to pay taxes on the fees received. The IRS takes the position that because the entire award or settlement is for the litigant, the litigant should be taxed for the entire amount, regardless of whether any portion of that settlement or award is eventually used to compensate the litigant's attorney.

The IRS's current "double taxation" policy is pending review by the United States Supreme Court in two cases: Banks v. Commissioner of Internal Revenue, 345 F.3d 373 (6 th Cir. 2003), cert. granted, 124 S.Ct. 1712 (2004), and Banaitis v. Commissioner of Internal Revenue, 340 F.3d 1074 (9 th Cir. 2003), cert. granted, 124 S.Ct. 1713 (2004).

Section 703 of the Act, which is entitled Civil Rights Tax Relief, allows taxpayers to take a full deduction on their tax returns for the attorney's fees and costs incurred by them as part of a civil rights and employment discrimination settlement or damage award. The Act applies to claims under Title VII of the Civil Rights Act of 1964, the National Labor Relations Act, the Fair Labor Standards Act, the Age Discrimination in Employment Act of 1967, ERISA, the Employee Polygraph Protection Act of 1988, the Worker Adjustment and Retaining Notification Act, the Family Medical Leave Act, the Americans with Disabilities Act of 1990, any federal whistleblower law, and any federal, state or local law, or common law claims for the "enforcement of civil rights" or "regulating any aspect of the employment relationship". These amendments only apply to judgments and settlements made afterthe date of enactment.

The Act's civil rights litigation tax language was supported by a broad spectrum of groups ranging from the U.S. Chamber of Commerce to AARP. Various employer associations, like the U.S. Chamber of Commerce, did not favor the double taxation policy because it had the effect of increasing the cost of settling suits as tax savvy litigants and their counsel would insist on higher settlement amounts to cover the extra tax payments, particularly when the settlement proceeds or damage award implicated the alternative minimum tax.

Thus, if signed by the President, the American Jobs Creation Act of 2004 will help to moderate the costs for both employers and employees to resolve employment-related disputes.

KZA Employer Report articles are for general information only; they are not intended and should not be construed to be legal advice. Reading or replying to such articles does not establish an attorney-client relationship. In addition, because the subject matters and applicable laws discussed in Employer Report articles are often in a state of change and not always applicable to every type of business entity or organization, readers should consult with counsel before making decisions based on the same.