New York Army Sergeant Patrick Clarke took a credit union to court after it wrongfully repossessed his car. After a years-long court battle, Sgt. Clarke managed to show that the credit union had acted unlawfully and that it had subjected many other servicemembers to similar wrongdoing. Sgt. Clarke was awarded damages as compensation and legal fees to be paid to his attorneys for their work.
What should have been a victory for Sgt. Clarke and New York servicemembers got complicated quickly when Sgt. Clarke learned he was expected to pay income tax on the legal fees his attorneys earned. Potential taxes on the fees — funds that Sgt. Clarke did not receive — were enough to wipe out his entire recovery, leaving him worse off after winning his case.
Last week, Senator Cortez Masto (D-NV) introduced the End Double Taxation of Successful Civil Claims Act, S. 2627, to provide much-needed relief to consumers like Sgt. Clarke who have been saddled with irrational tax burdens after winning civil legal cases.
The bill would amend the Internal Revenue Code to create an above-the-line deduction for reimbursed legal fees in all civil cases. This would allow consumers to rightfully exclude any legal fees they recover from their income, eliminating the need to pay income tax on the fees.
Consumers and other taxpayers who bring winning claims can sometimes have their legal expenses reimbursed under the respective law. The reimbursed fees are paid to the consumer’s attorney, not to the consumer. However, both the consumer and their attorney may be on the hook for taxes on the fees even though the consumer never receives them. This is an illogical result because the fees are not income to the consumer, only their attorney.
Sen. Cortez Masto should be commended for addressing this unfair and perhaps unintended consequence of our tax laws which was made worse by recent tax law changes.
Previously, consumers could apply the Miscellaneous Itemized Deduction to any legal fees they recovered. This alleviated some, but not all, of the additional tax burden. However, the Tax Cut and Jobs Act of 2017 suspended the deduction until 2025, leaving consumers with no chance of relief.
Now, consumers are at greater risk of losing money even when they win their claims. Consumer protection cases are often labor-intensive and difficult to prove. Some consumers may recover relatively small amounts in damages but more in legal fees due to the time needed to win the case.
In order to incentivize private enforcement of consumer protection statutes and make it affordable, Congress designed the laws (such as in debt collection, credit reporting, discriminatory lending, borrower disclosures, servicemember protections, etc.) to allow successful consumers to have their legal fees reimbursed. Because they do not receive the funds that go to their attorneys, consumers are essentially penalized for bringing successful civil claims. This outcome undermines congressional intent and impedes enforcement of crucial protections.
The End Double Taxation of Successful Civil Claims Act ensures that important laws and rights will continue to be enforced. People who have been harmed and mistreated will be able to bring their claims without fear of unfair tax consequences.
