Prior to President Bush's signature late last week of the new tax law (known as the American Jobs Creation Act of 2004), there was a split of authority in courts across the country on the issue of whether contingent attorney's fees paid directly to attorneys out of a judgment or settlement were excludable from the taxpayer's income or were includible in income.  The courts in California consistently held that such contingent attorney's fees were includible into the taxpayer's income.

The two approaches yielded vastly different tax results for taxpayers.  Excluding the contingent attorney's fees from income involved no tax cost to the successful plaintiff in such lawsuits on the portion of the award or settlement paid to the attorneys. Having to include the entire award or settlement in income, however, had potentially disastrous tax results to the successful plaintiff as they were typically only entitled to deduct the contingent attorney's fees paid directly to attorneys as miscellaneous itemized tax deductions.  This had the result, due to the way the miscellaneous itemized tax deduction and alternative minimum tax rules operate, of some or even a large amount of tax being payable by the plaintiff on the portion of the award or settlement that ended up being paid to the plaintiff's attorneys.

Many plaintiffs in California, knowing they would end up owing tax on a portion of the award or settlement paid to their attorney in the form of contingent attorney's fees, refused reasonable settlement offers and negotiated hard for higher settlement offers that would provide them with the same net after-tax recovery they would have received had they been able to exclude the contingent attorney's fees from their income.

The new tax law signed into effect last week now allows successful plaintiffs in certain types of cases, most notably "unlawful discrimination" cases (a term that is defined below), to exclude the contingent attorney's fees from their income and avoid unfavorable tax results.  Under the new tax law, there is now no tax cost to the successful plaintiff in an unlawful discrimination case on the portion of the award or settlement that is paid to the attorneys (this remains the case whether or not the legal fees are paid on a contingency basis).  The real tax impact of this in California is that the net after-tax recovery for successful plaintiffs should increase (as successful plaintiffs will no longer owe taxes on the portion of the settlement or award paid to their attorney) which should drive down the cost to employers of settling lawsuits. 

There are numerous types of claims that fall within the term “unlawful discrimination” under the new tax law.  The following is a partial listing of the type of claims that fall within the definition of an "unlawful discrimination" claim  in which a successful plaintiff may exclude the contingent attorney's fees associated with such cases from their income: (1) a claim brought under the Civil Rights Act; (2) a claim brought under the National Labor Relations Act; (3) a claim brought under the Fair Labor Standards Act; (4) a claim brought under the Age Discrimination in Employment Act; (5) a claim brought under the Employee Retirement Income Security Act; (6) a claim brought under the Worker Adjustment and Retraining Notification Act; (7) a claim brought under the Family and Medical Leave Act; (8) a claim brought under the Fair Housing Act; (9) a claim brought under the Americans with Disabilities Act; (10) a claim brought under any federal law provision (known as whistleblower protection provisions) prohibiting discharge, discrimination, or other forms of retaliation or reprisal against an employee for asserting rights or taking actions permitted under federal law; or (11) a claim brought under a law regulating any aspect of the employment relationship, including claims for wages, compensation, or benefits, or prohibiting the discharge of an employee, the discrimination against an employee, or any other form of retaliation or reprisal against an employee for asserting rights or taking other actions permitted by law.

The new tax law signed last week is effective for any of the above described fees and costs paid after October 22, 2004, with respect to any judgment or settlement occurring after that date.