Attorney fees are often considered a tax-trap but the basic rule is that everything is income. Rob Wood, tax attorney in San Francisco, California, says that there are exceptions but you have to start with the basic notion that any money you get is going to be taxed.
Wood says that the average person may think of lawyers fees on a contingency basis, so the average client who gets a settlement looks, understandably, at their net dollars, not gross. For example, if the lawyer is charging one-third contingency and the case is settling, the client is looking at the other two-thirds as theirs, and that being the maximum amount on which to pay tax. According to Wood, that is wrong, based on a US Supreme Court case in 2005. The court said that in a contingency fee situation, the client is viewed as getting 100% of the money, even though the lawyer in most cases is paid directly and separately. The client, for tax purposes, is treated as receiving all three-thirds, to cite Wood's example. The main exception to this tax rule are employment cases, notes Wood.
Wood points out that when someone says they're paying taxes on their attorney fees, what they mean is they can only deduct attorney fees as a miscellaneous itemized deduction, which means they're paying AMT, or alternative minimum tax.
Regarding the BP oil spill case and taxation on attorney fees, it depends on what that person is getting, says Wood. They need to look at each element of damages they're receiving, whether it's for personal injury, emotional distress, property damages, etc. Wood explains that there are very complex tax rules for people getting the money and advises getting the proper professional help, well before tax time.
Attorney Robert Wood, of Wood, LLP in San Francisco is a featured commentator with The Tax Law Channel, part of The Legal Broadcast Network. For more information on his Forbes article on this case, click here.