Considerations for tax awards, settlements or transactions
March 21, 2014
What tax considerations to weigh in litigation process
March 21, 2014
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Tax considerations for plaintiffs vs. defendants

Yes. The tax considerations in litigation differ depending on whether you are a plaintiff or a defendant. Effective tax planning for litigation is best performed at the outset of litigation even before the complaint is filed. Often in order to achieve the most favorable results, extensive tax planning and strong documentation early on in the litigation stages.

Proper tax planning in litigation can serve as leveraging point during negotiation talks, and the effects could be significant. With proper tax planning, a plaintiff could maximize his net proceeds from a settlement or judgment. From a plaintiff attorney’s perspective, failing to consider the tax consequences in a case could potentially expose the attorney to legal malpractice.

Example. Suppose your client recovers of $1,000,000 in damages. Suppose also the worst case scenario, where the entire amount of the recovery is taxable as ordinary income (rather than, e.g., a capital gain), with an attorney contingent fee of 33% deducted as a miscellaneous itemized deduction (subject to the 2% floor). The federal tax burden in this case would be $216,305. However, because of the applicability of the Alternative Minimum Tax (“AMT”) in this situation, the deduction for attorney fees is disallowed and tax is applied to the entire $1,000,000 at a flat ~28% rate, resulting in a total federal tax liability of $276,500. After accounting for California income tax of $79,832, the taxpayer is left with a mere $313,668 out of a total $1,000,000 settlement. This is hardly an encouraging result for your client—a result that in many instance is avoidable. (Query whether your client would sue you if he learned that).