The Death of Deducting Litigation Expenses: What’s Next?
By William Rothrock, CSSC, Brant Hickey –
January 23, 2023
Over the next three-plus years, can you help your corporate clients defray litigation costs that lost deductibility after 2017? Examining the different sections of the Tax Cuts and Jobs Act (TCJA) illuminates the enormity of the change. However, looking beyond the TCJA provides a possible solution to the loss in deductions.
Section 11045 of the TCJA eliminated the deductibility of all expenses subject to the 2-percent rule through the year 2026. Sections 13306 and 13307 further refine eliminating deductible expenses related to litigation. Specifically, identifying fines, whether punitive or penal legal fees, and the inclusion of “non-disclosure” agreements in cases of a sexual nature are no longer deductible expenses. A recent court case further narrowed the deductibility of legal expenses as capital versus immediately expensed.
In Mylan v. Commissioner, 156 T.C. No. 10 (April 27, 2021), the IRS took the position that the legal cost of defending a patent infringement case needed to be capitalized. The line determining the deductible status of litigation expenses starts at the nature of the litigation. What types of litigation apply after the passage of TCJA? If litigation arises in pursuit of profit-seeking activity, the cost of litigation can be expensed. Does the Mylan case indicate a clear understanding of what constitutes profit-seeking behavior? Mylan’s litigation defense against patent infringement arose through the pursuit of profit indirectly, forcing them to capitalize the expense. Mylan’s litigation expense was directly attributable to creating a generic drug and qualified for an immediate expense by the company.
What Remains Deductible?
The litigation costs incurred defending a company from the government, plus remedial or compensatory damages, continue to be deductible. However, fines, penal or punitive, are not deductible.
Thus, profit-seeking and government-related litigation are deductible. But what about employee-related litigation mentioned above? Clearly, defense against allegations of sexual harassment and abuse does not qualify as profit-seeking behavior. However, the TCJA explicitly addresses this form of litigation. The TCJA eliminates the deductibility of all the associated litigation expenses for cases related to actions of harassment and abuse. Notably, including a non-disclosure agreement as a settlement term reinforces the non-deductibility of litigation expenses.
The CPA’s Role
How can CPAs help clients mitigate the cost of litigation? First, consider 26 U.S. Code § 104 — compensation for injuries or sickness. Employee cases related to harassment, sexual and otherwise, and sexual abuse do not qualify under 26 U.S. Code § 104. The proceeds the employee receives in settlement from the company constitute income taxable at the state and federal levels. The tax issue allows a CPA to help the defense litigation team reduce the settlement expense. Moreover, introducing a structured settlement for the client’s consideration allows the defense to reduce the actual cost of settling the case. Why? The constructive receipt doctrine determines when the income realization occurs for the plaintiff.
When considering this doctrine, the savings become clear to both parties when using a simple settlement. Consider the following example:
- A settlement of $1 million taxed at a federal applicable rate for those married filing jointly leaves the plaintiff with $693,478.75 in disposable income before state tax.
- Using an annual payout over three years reduces the tax liability, thus increasing the disposable income by $109,635.63 to $803,113.38.
- In addition, if the parties agree to split the benefit, it reduces litigation costs by 5.48 percent for the defense.
- Using a structured settlement, the plaintiff’s disposable income increases by $54,817.32. The defense sees their cost to fund the settlement reduced by the same amount.
When structured settlements originated, this form of needs-based cooperation represented an industry standard. Although larger insurance carriers know structured settlements, they are less aware of this particular strategy.
The TCJA severely restricted the deduction of litigation expenses where only the pursuit of profit and government defense remains deductible. Utilizing strategies like offering the plaintiff a structured settlement option opens avenues to reducing the client’s litigation cost.
This article appeared in the winter 2022/23 issue of New Jersey CPA magazine. Read the full issue.