Regular readers of this blog know that one of the subjects that gets covered on a regular basis is the taxation of damage awards. So bear with me as I write about the latest court case to tackle this issue…because it understands the magnitude of the problem and is considerably more funny than your average case about tax law.
In the case of Jalali v. Root, the California Court of Appeal, Fourth Appellate District, Division Three encountered a common problem, the double taxation of attorneys fees in employment cases, in an unusual way. Rather than the plaintiff battling the IRS over whether taxes are to be paid on the attorney’s portion of the fee award, instead the plaintiff is up against her former attorney in a legal malpractice action., who she claims failed to inform her that she would be taxed on the attorney’s portion as she considered whether or not to accept the settlement offered her by the company.
Jalali had brought a race discrimination and sexual harassment lawsuit against her (unnamed) former employer, and was represented by attorney Walter Root III. When she went to trial on her claims, the jury awarded her $750,000 in compensatory damages for her pain and suffering. The trial was ready to proceed to its next phase, where the jury would determine how much in punitive damages to award Jalali, when the defendant employer offered Jalali $2.75 million for all claims, with a condition of confidentiality. While we know relatively little about Jalali’s underlying case, as a result, the opinion comments, “one could not say…that the circumstances behind Jalali’s claim were necessarily ‘most egregious,’ and that “[w]ithout in any way condoning the actions of the manager or (inferentially) her employer, it is fairly easy to find examples where the racial discrimination or sexual harassment was clearly more egregious.” In addition, the U.S. Supreme Court, in the case of State Farm v. Campbell, has even further limited the possibilities of extremely high damage awards, which made it less likely that Jalali could have received an award greatly in excess of the $2.75 million she was offered to settle her case. All in all, it’s fair to say that the court thought Jalali got offered a pretty good deal to settle her claim, concluding “Our point is not to minimize Jalali’s discrimination, but to note that in obtaining a large multimillion dollar settlement — which is money now, not after years of briefs and appellate wrangling — her lawyer had done a very good job for her.”
The court was thus astonished (as Root must have been as well) that after receiving such a generous settlement, that Jalali chose to sue Root for legal malpractice. She claimed that during the settlement negotiations and before she accepted the settlement, Root told her that her taxes would be “‘forty percent of your share,’ that is, Jalali’s share after deducting Root’s contingency fee.” After she settled the case and then paid taxes on her settlement, Jalali found that she was required to pay taxes on the entire $2.75 million, rather than just the portion she received after Root’s fee was deducted. In her legal malpractice action, she sought, and was initially awarded, $310,000, the difference between what she expected to receive and what she actually retained, after taxes. Root appealed this judgment, bringing this case before the California Court of Appeal.
What was it exactly that Jalali was claiming in this case? Is it that she could have held out for more money in a settlement? Or is it that if she knew her award would have been so diminished by taxes, she would have preferred to take the case to trial? The court said that while Jalali could have claimed the former, that she would have received more money had it not been for her attorney’s supposed negligence, that she did not do so. Even if she had made that particular claim, however, the court took a rather dim view of her ability to succeed under that theory, based on the relative strength of her case and restrictions on large punitive damage awards discussed above. The court does take more seriously the latter claim: that she would have preferred to go to trial. The court notes that
her theory is that, had Root not given her a faulty prophecy of what the tax law would do, she would have rejected the settlement offer, and forced a trial in open court of the punitive damage issue, even if it meant a lesser result. Her loss was thus not monetary. It was psychic. It was the loss of the opportunity to lay her employer’s dirty linen out for the world to see. It is the deprivation of that right — the right to publicly expose her former employer — that Root’s alleged malpractice caused Jalali to lose.
It is noteworthy for a court to recognize and seemingly understand that the so-called “psychic value” attached to litigation can be considerable. For many plaintiffs, having one’s “day in court” personally means more than any amount of money that can be or is ultimately awarded, and many a reasonable settlement has been derailed by employees who would rather “lay out the dirty linen” than accept a settlement denying them that opportunity. Ultimately, however, the court determined that even if this “psychic value” was considered tangible, that Jalali did not set out sufficient evidence of harm. Jalali could not show that her case had a value significantly higher than $2.75 million, such that by bringing it to trial, she could have recovered the $1 million after taxes she expected to receive (instead of the $700,000 she did receive) in exchange for forfeiting the right to a public trial. Therefore, she was ultimately out of luck.
What is exceptional about this case, however, in the annals of taxation of damage awards cases, is how the court simultaneously understands the gravity of the double taxation of attorneys fees problem, and throws in a little humor along the way, making it significantly more interesting than your average tax case. (My apologies to any tax attorneys or other tax professionals who read this opinion–my intent is not to disparage your profession, but merely to point out that most don’t consider it the most scintillating area out there.) The court recognizes that to understand Jalali’s position, you have to look at what has been happening in regards to the taxation of damage awards generally, and takes a general tour through the field.
Since it strikes most people as highly counterintuitive (a fancy way of saying unfair) that a civil rights plaintiff should not be able to either exclude the fees she pays her contingency-fee attorney from her gross income, or at least get a deduction for those fees, it is worth taking a small detour to understand the problem that got Root into trouble.
Would that more people would be aware of and understand the patent unfairness! It immediately gets to the “root” of the problem (pun intended) by noting the often-insidious nature of the alternative minimum tax:
The alternative minimum tax was originally designed to insure that millionaires (back when millionaires were really millionaires) couldn’t use itemized deductions and tax credits to shield themselves entirely from federal taxes. However, it has metamorphosed into a terror for civil rights plaintiffs.
Yes, indeed, it has. The court alludes to the current tax debate over whether to tax dividents, stating
Taxation of civil rights awards is normally not a case of classic double taxation like corporate dividends — successful civil rights plaintiffs still get to deduct their lawyers’ fees from their gross income on their regular 1040. The problem is that the alternative minimum tax doesn’t allow for the deduction of legal fees incurred in the production of income like the regular 1040 does. Because the successful civil rights plaintiff must include 100 percent of his or her recovery in calculating the alternative minimum tax, but can’t deduct the attorney’s portion, the plaintiff winds up paying taxes on income that he or she never really had. That is double taxation — the winning plaintiff pays taxes on the same income which the attorney pays taxes on. If the attorney’s fees are too high in proportion to the recovery, the results can be downright ludicrous.
[Emphasis added.] Next, the court notes the division in authority around the country on this issue (which alone makes it a good resource for those needing sites to the various cases), noting the differences between courts which despite the policy inequities, feel constrained to apply the alternative minimum tax as required by law, and those which have taken a different approach, descriptively noted by the court as follows:
Courts which have taken the taxpayers’ side have likened an attorney’s right to receive a portion of a judgment to a partner’s right to receive a share of income from a partnership (citation omitted) and you do not have to pay taxes on your partner’s income. Or, to use the dominant metaphor of the [law review article cited for this theory], there is more than one tree in the orchard and you aren’t responsible for the fruit from the ones that aren’t yours.
Ultimately, the court concludes:
The whole area is tailor-made for a national moot court competition, since it involves a substantial split in the federal appellate courts, and ultimately turns on a common law doctrine (the “assignment of income” doctrine) on which reasonable minds could differ, depending on how you see contingency fee agreements. (citations omitted) It is enough to say here that for Jalali to have successfully excluded Root’s fee from her gross income would have required nonmoot participation in the real world equivalent of such a competition at the highest possible level.
I’m certain that all plaintiffs, attorneys and other tax professionals looking at this problem would absolutely concur.
Despite its insight and humor, this case will not on its face directly affect that many people. Hopefully, given the flux of the law and the growing expertise of employment practitioners in this area, there are not very many malpractice cases based on this issue anyway. However, it does represent the ever-growing and near-universal recognition by the courts that current tax law is patently unfair to civil rights plaintiffs. Perhaps someday soon, Congress will listen. If you haven’t written your members of Congress yet, then do so today, and encourage them to listen to you!