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Generally, plaintiffs in employment cases must report as taxable income the total judgement or settlement – before paying their legal fees and costs. Therefore, income tax withholding and Social Security and Medicare (“FICA”) taxes may be due on the “top line” judgement or settlement even though plaintiff’s net recovery after fees can be much less. The IRS has blessed tax planning that will lower plaintiff’s and employer’s taxes and perhaps simplify plaintiff lawyer’s taxes. This may make it easier to settle a case.
Plaintiffs’ income includes the total settlement – including legal fees owed
Take a simple case: Plaintiff settles an employment action for back pay for $100,000 and pays her lawyer $30,000; she nets $70,000. The Supreme Court says that plaintiff has $100,000 in taxable income (except in limited cases where recovery is tax free). Commissioner v. Banks, 543 U.S. 426 (2005). While plaintiff will get a deduction for legal fees and ultimately will pay tax on the $70,000 that she gets, the way that her recovery is structured affects her taxes.
The goal is to draft the settlement agreement so only her net $70,000 recovery is subject to income tax withholding and FICA taxes. With lower income tax withholding, plaintiff will have more cash immediately, and with proper structuring both her and the employer’s FICA taxes will be lower.
The IRS has shown the way to avoid taxes on the legal fees portion of a settlement
The key to lower taxes is the way that the settlement provides for the payment of legal fees. (These same rules apply to judgements.) Without planning, the IRS will require income tax withholding on our plaintiff’s $100,000 and will require FICA taxes on $100,000. But she wants withholding and FICA taxes only on the $70,000 that she gets after paying legal fees (eventually she will get a deduction for her legal fees).. Here’s how.
The IRS has said that if the settlement agreement clearly allocates part of the settlement amount to stated amounts of legal fees and if those fees are paid in a separate check made payable to the lawyer, then income tax withholding for our plaintiff will only be on $70,000. FICA taxes also will only be on $70,000, good for both our plaintiff and the employer.
To match this taxation with the Supreme Court’s Banks rule, the employer’s tax reporting to the IRS for the plaintiff will be done in two parts: a W-2 for $70,000 and a 1099 for $30,000. The employee still has $100,000 of income but has gotten immediate tax relief for paying her legal fees by lower withholding. She and her employer also have gotten lower FICA taxes, and this may have made settlement easier. IRS Chief Counsel Memorandum 20133501F (July 11, 2013) and Rev. Rul. 80-364, 1980-2 C.B.294.
With a clear allocation to legal fees and separate checks, taxes also are simpler for her plaintiff’s lawyer. He gets a 1099 from the employer for $30,000, only. In other situations – discussed below – her lawyer can receive a 1099 for $100,000 which complicates his tax life.
What if the lawyer has not yet tabulated his fees at the time of settlement, or what if the lawyer and client have not agreed on the final amount of fees and costs? The short answer is – do the best you can. If there is agreement on the base fee and costs, put that part in the agreement and have it paid as a separate check and work out the rest later. What if the client does not want the defendant to know her fees and costs? That does not fit with the IRS rule so higher taxes will be paid.
Be wary of these situations
The IRS has also said what will not work to reduce taxes.
If there is one check for $100,000 payable to the plaintiff and there is no allocation for fees, income taxes are withheld, and FICA taxes are paid, on $100,000. The plaintiff gets a W-2 for $100,000
If there is one check for $100,000 payable jointly to the plaintiff and lawyer, then both the lawyer and the plaintiff get a tax report for $100,000. The plaintiff gets a W-2 and the lawyer gets a 1099, each one reporting $100,000 for a total tax reporting of $200,000.
The IRS was silent on the case where there is a joint check to plaintiff and the lawyer and the settlement agreement clearly allocates legal fees. So the resulting income tax withholding and FICA tax payment are uncertain.
Get expert tax advice before settling
Before settling any case, get expert tax advice. A bit of planning often can reduce taxes and save unnecessary cost.
Important note — This article does not give tax advice – always work with your tax advisor because taxes depend on each person’s particular facts.
The class action plaintiffs are paid $150 million in 35 years, if at all. The plaintiffs’ lawyers are paid fees of $5 million in 2 years. Is this right? The case was settled with an experienced and respected mediator. Yet the Fifth Circuit was quite concerned about the payment of legal fees and sent the case back to the District Court for reconsideration of this and other issues. Jones v. Singing River Health Services Foundation, 865 F. 3d 285 (2017). The Fifth’s concern about payment of class counsel’s fees may have been misplaced.
An Underfunded Plan
One of the largest hospital and health systems in Mississippi was on the ropes. With the Great Recession of 2008 and changes in the reimbursement for medical care, it was losing money fast: a loss of $40 million in 2014 alone.
The system’s governing board decided to save money by shorting the pension plan. In 2009, the employer stopped making required contributions. (But the employees continued to pay in 3% of wages.) Finally, the employer threw in the towel and terminated the plan. The employer had failed to contribute a required $55 million from 2009 to plan termination in 2014.
The plan was seriously underfunded even without this contribution; it was short $305 million in 2015. The employees were seriously at risk, and the plan was not covered by the federal pension insurance program because it is a local government plan.
Lawsuits & more lawsuits
There were lots of lawsuits, in both state and federal courts. For the most part they were consolidated in a Federal District Court class action. Plaintiffs made many claims including constitutional violations, fiduciary breach, fraud and others. The financial facts were that the employer did not have the money to bring the plan up to a sound funding level.
After working with a respected and experienced mediator, the employer agreed to contribute to the plan the $55 million (plus interest) that should have been contributed before plan termination.
But cash was not available, so the settlement provided that the money would be contributed over the next 35 years, with 6 % interest. That brought the total to $150 million.
Under the settlement, class counsel would get about $6.5 million, which was later reduced by the District Court to about $5 million. Also, under the settlement the employer would make its contribution to the plan over 35 years, yet the lawyers would get their fees in 2 years.
The District Court approved the settlement. Several hundred class members objected, for reasons including the timing of payment of the attorneys’ fees.
The Fifth Circuit did not like the fee arrangement
One key issue for the Fifth was the timing of payment of class counsel’s legal fees.
The Fifth recognized that the District Court had applied a heightened standard of care when reviewing the fee arrangement. Nevertheless, the Fifth said that “[p]erhaps the most intriguing fact is that class counsel arranged for their agreed, complete payout of fees . . .before the end of 2018 and thus alleviated any significant future risk of nonpayment. Meanwhile the Plan participants bear considerable risk and, worse, uncertainty.” Moreover, the Fifth said that class counsel “could have accepted payments over [the] prescribed duration [of payment to the plan].” Additionally, “class counsel’s agreed payout is dubious.”
Evaluating the risks of plaintiffs and the risks of class counsel
The Fifth Circuit focused on the relative risks of plaintiffs and class counsel and strongly suggested that class counsel should have taken on the same risk as plaintiffs. Was that appropriate?
Before the employer ceased contributions, the plaintiffs were already living with the risk of not being paid their full pensions because the pension plan was significantly underfunded. It was already underfunded by much more than the $55 million of contributions that the hospital failed to make. The lawsuit was never going to provide a secure pension. There were very strong reasons to be concerned about the employees. But the issue here is whether the Fifth Circuit was right to strongly suggest that class counsel should assume the same risk as plaintiffs and be paid over 35 years.
When class counsel took on this case, they accepted the usual risk of non-payment if they did not win or get a decent settlement for plaintiffs. However, if counsel knew before taking the case that they would also have to take on the plaintiff’s existing risk of payment in addition to its risk from legal representation, they may well have declined the case. A precedent such as this also could affect the ability of future plaintiffs to get representation in other cases. Moreover, if class counsel were to be paid over 35 years, they certainly would ask for much higher fees to reflect the delay and would look to sell this receivable (at a discount). The net result of a delayed payment may be that class counsel would come out close to the same place as under the original arrangement while the plaintiffs would not be better off.
Was the Fifth Circuit right about the legal fees?
This was a very unfortunate case for the employees — it is quite uncertain that they will get their full pensions. Yet this case could not have changed that fact – the economics and the law were against them. But contrary to the suggestion of the Fifth Circuit, class counsel should not be required to take on the pre-existing risk of the employees. Counsel’s risk should be tied to their legal work. In this regard, their fees were closely scrutinized and the trial court reduced them by 25%. While heightened scrutiny of fee arrangements is quite appropriate, in this case, there is a strong argument for concluding that the timing of payment of their fees was fair and appropriate.