In 1798, Benjamin Franklin sent a letter to his friend Jean-Baptiste Leroy reporting “our new Constitution is now established, and has an appearance that promises permanency; but in this world nothing can be said to be certain, except death and taxes.” Two hundred thirty years later, our Constitution maintains its permanency, and death and taxes remain certain. Taxes considerations will be at your next mediation, that is certain. (Let’s hope that taxes are the only certainty.) Here are two unique considerations about taxes in mediation.
There is Room to Negotiate
The first consideration to keep in mind is the opportunity to negotiate this issue. In business and employment mediation, the parties are free to negotiate where the tax burden may fall. While there may be certainty that taxes will be present, who pays is not certain. The parties are free to negotiate.
One approach is to allocate the tax responsibility. The parties are able to determine which side will bear that cost. This is a factor that often arises in employment disputes or business disputes. One party may take advantage of a deduction; one party may have a lower tax bracket. The parties should keep this in mind during mediation.
Taxes and attorney fees
Another unique consideration is how taxes bear out on attorney fees. Many parties in mediation have a contingent fee arrangement with their attorneys. Typically, a plaintiff will hire an attorney with an agreement that the attorney will be paid one-third or 40% of the amount recovered, whether through settlement or award. For example, when an attorney is successful in negotiating a settlement of $90,000, the client will receive $60,000 (less any out of pocket expenses, such as court filing fees and the like) and the attorney will be paid $30,000 (plus reimbursement for the court filing fees and the like). At that point, the certainty of taxes appears.
In a decision by the United States Supreme Court, Commissioner v. Banks, 543 U.S. 426 (2005), the Court held that an individual taxpayer must include in gross income the portion of a taxable judgment or settlement that goes to the taxpayer’s attorney under a contingent fee arrangement. This means that the entire settlement amount of $90,000 of a taxable judgment or settlement is reported as gross income. The taxpayer is able to treat the related contingent attorney fee as a miscellaneous itemized deduction. Of course, taxpayers blanch at this treatment because miscellaneous itemized deductions are subject to a 2% of adjusted gross income threshold. Doesn’t do much good if this amount is below the threshold for a deduction.
In order to maximize the recovery for the plaintiff, many parties will negotiate for separate payment of the settlement checks to the plaintiff and the plaintiff’s attorney. In our example, the parties may be willing to reach an agreement by which the plaintiff receives a check for $60,000 and the attorney receives a separate check for $30,000. As a result, the taxpayer is reporting only that portion of the taxable settlement in gross income. This is a creative way to maximize the recovery for the plaintiff in light of the Banks decision.
It is important to note that the Internal Revenue Code also provides a list of legal actions that are defined to be “unlawful discrimination” which permits an above-the-line deduction for attorney fees and costs paid in legal actions. These include claims of violations of the Civil Rights Acts of 1964 and 1991; the Family and Medical Leave Act of 1993; and the American With Disabilities Act of 1990. The above-the-line deduction treatment for these qualifying contingent legal fees effectively allows the plaintiff to directly subtract these expenses from the amount of the settlement that is reported. So, taxes are only paid on the amount reported; a good thing for the plaintiff.
Of course, the parties should also consider whether the settlement is taxable at all. Personal injury settlements, for example, are not taxable. Parties participating in a mediation should consult with an accountant before mediation in order to be prepared to address tax issues at mediation.
Although taxes are certain, the parties should come to mediation prepared to negotiate on this issue.