I own a business, and a former employee is suing me for back pay and discrimination. My lawyer tells me that there is a new tax law that will make it easier to settle employment disputes, including my lawsuit. What is she referring to?


On October 22, 2004, President Bush signed the American Jobs Creation Act of 2004 (“AJCA”), the most significant new tax legislation since the 1986 overhaul of the Internal Revenue Code. The AJCA is very broad, affecting many different taxes paid by businesses and individuals.

Section 703 of the AJCA is known as the “Civil Rights Tax Relief” provision. This section eliminates the double taxation of proceeds received by plaintiffs in many types of employment-related lawsuits. The Civil Rights Tax Relief provision amends Section 62 of the Internal Revenue Code to provide an “above-the-line” deduction from amounts recovered for attorneys’ fees paid by plaintiffs in cases involving claims of “employment discrimination.” Employment discrimination is defined very broadly to include any provision of Federal, State or local law regulating any aspect of the employment relationship. In simple terms, individuals who receive court awards or settlements in most employment lawsuits will be able to deduct the fees and costs paid to their attorneys.

The following example show why this tax law may make it easier to resolve employment related lawsuits. Prior to the enactment of the AJCA, assume that a plaintiff in an employment discrimination case is awarded $100,000. The individual’s agreement with her attorney provides that the attorney is to receive 40% of any recovery. Under prior tax law, that plaintiff must recognize $100,000 of income, even though $40,000 is paid directly to her attorney. If the plaintiff’s combined tax rate is 40%, then after reduction for taxes, the plaintiff is left with only $20,000 ($100,000 award – $40,000 paid to attorney – $40,000 tax = $20,000). Additionally, the attorney is taxed on her $40,000 payment, so the $40,000 paid to the attorney is taxed twice.

Under the new law, that same plaintiff receiving a $100,000 award will pay her attorney $40,000 in legal fees. To determine her taxable income, the plaintiff will subtract the $40,000 paid to her attorney from the $100,000 award, arriving at a taxable recovery amount of $60,000. If the plaintiff’s combined tax rate is 40%, then she will have $36,000 after paying her taxes ($100,000 award – $40,000 attorney fees = $60,000 – $24,000 tax = $36,000), or $16,000 more than under pre-AJCA law. The new law applies to settlements and judgments paid after October 22, 2004.

Prior to the enactment of the AJCA, the double taxation of certain legal fees and expenses was challenged by a number of taxpayers with mixed success. The Civil Rights Tax Relief provision in the AJCA is clearly a victory for taxpayers and a defeat for the IRS. The National Employment Lawyers Group and the U.S. Chamber of Commerce, two groups who are frequently on opposite sides of the same issue, both support the Civil Rights Tax Relief, along with a number of other groups, and the wide-ranging support for the new legislation certainly helped with its enactment. This new legislation should help to settle employment disputes, because employees that bring such claims will be able to keep more of the settlement proceeds and pay less tax on the settlement amount.
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