Millionaires Leaving California Over Taxes Is Nothing New

Many Californians complain about high taxes, and some vote with their feet, moving to no tax states like Nevada, Texas, Washington, or Florida. A recent report says that dozens of millionaires fled California after the 2012 tax increase. The report quotes a study noting that 138 high income Californians left the state. That may sound draining, although the researcher said that, “We estimate that California lost 0.04 percent of its top earner population over the two years following the tax change.” That’s a tiny number, and California’s high taxes have always motivated some moves. The 2012 tax change is now old news, and yet there is still talk about the huge impact. However, that may be especially true when taxpayers see their 2018 tax returns next year.

California’s Proposition 55 extended until 2030 the “temporary” 13.3% tax rate on California’s high-income earners, the highest tax rate in the nation. It hits only 1.5% of Californians, those with a single income filing of at least $263,000, or joint income of $526,000. But the new federal tax law that limits state and local tax deductions to $10,000 seems likely to dramatically change taxpayer attitudes, but will it also change their behavior? If you are writing a several hundred thousand dollar check to California and cannot deduct it on your federal taxes, won’t it smart that much more?

The state law workarounds include a charitable deduction plan, but the IRS will surely try to shut it down. It should be no surprise that state taxes are a big reason for moves. Why else would there be such a high probability that Californians become residents of no-tax states like Texas? The IRS reported that between 2013 and 2014, over 250,000 California residents moved away between 2013 and 2014. More than 10% went to Texas alone. 

California’s tough Franchise Tax Board (FTB) polices the line between residents and non-residents, and does so rigorously. Like other high tax states, California is likely to probe how and when you stopped being a resident. For that reason, even if you think your facts are not controversial, be careful. A California resident is anyone in the state for other than a temporary or transitory purpose. It also includes anyone domiciled in California who is outside the state for a temporary or transitory purpose. The burden is on you to show that you are not a Californian.

If you are in California for more than 9 months, you are presumed to be a resident. Yet if your job requires you to be outside the state, it usually takes 18 months to be presumed no longer a resident. Your domicile is your true, fixed permanent home, the place where you intend to return even when you’re gone. Many innocent facts might not look to be innocent to California’s tax agency. For example, do you maintain a California base in a state of constant readiness for your return?

Year after year, no state has a bigger cadre of would-be tax fugitives than California. Some Californians look to flee the state before selling real estate or a business. Some get the travel itch right before cashing in shares, a public offering, or settling litigation. Some of the carefully orchestrated deals and moves can work just fine. Yet, many would-be former Californians have unrealistic expectations about establishing residency in a new state. They may have a hard time distancing themselves from California, and they may not plan on California tax authorities pursuing them. When fighting California tax bills, procedure counts.

You can have only one domicile. It depends on your intent, but objective facts can bear on it. Start with where you own a home. Where your spouse and children reside counts too, as does the location where your children attend school. Your days inside and outside the state are important, as is the purpose of your travels. Where you have bank accounts and belong to social, religious, professional and other organizations is also relevant. Voter registration, vehicle registration and driver’s licenses count. Where you are employed is key. You may be a California resident even if you travel extensively and are rarely in the state. Where you own or operate businesses is relevant, as is the relative income and time you devote to them. Taxpayers with unrealistic expectations can end up with big bills for taxes, interest and penalties.

How about audit times? Although the IRS can audit 3 or 6 years, California can sometimes audit foreverIn fact, several things give the FTB an unlimited amount of time to audit you. California, like the IRS, gets unlimited time if you never file an income tax return. You might claim that you are no longer a resident and have no California filing obligation. The FTB may disagree. That can make filing a non-resident tax return–just reporting your California-source income as a non-resident–a smart move under the right facts.

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IRS Closing Offshore Account Amnesty, Here’s How To Cut Huge Penalties

Undisclosed foreign accounts or income can trigger big civil penalties, conceivably even criminal prosecution. Since 2009, many  foreign accounts and income came within the IRS’s enormous offshore enforcement efforts. Nearly 10 years on, not everyone has entered the IRS Offshore Voluntary Disclosure Program (OVDP). The program is closing, but there is still time to get in under the wire. The OVDP involves a formulaic deal where at least the penalties are capped. The program isn’t perfect, but it is a finite way of getting beyond the fear of discovery and prosecution. And with FATCA, the IRS now has an easy time finding just about anyone’s account, no matter how cleverly hidden. That’s why stepping forward before it is too late is safest.

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For most people, paying the taxes, interest and penalties, even on up to 8 years as the OVDP requires, is not so bad. It is the bigger account-based penalty in the OVDP that is the hardest to swallow. It can be either 27.5% or 50% of the highest value of your account over the 8 year period. That penalty is simply part of the OVDP. Yet if you enter the OVDP, the prospect of opting out can be worth considering, before you pay all the penalties and sign the closing agreement. Enter the program to opt out? It sounds odd, and it certainly isn’t for everyone. But on the right facts, it can make a world of difference to the bottom line.

The opt-out election is irrevocable, and is typically made after the IRS has calculated a proposed miscellaneous offshore penalty. That might be a year or more after you enter the program. By then, you will have fully complied and fixed all of your errant reporting. You have also paid all the taxes and interest you owed, plus penalties on your under-reporting. But the biggest penalties are based on the size of your account, and that is what can be at stake in an opt out. Of course, can opt out case carries risks too. The IRS may assess civil fraud penalties or information return penalties. The IRS can also interview the taxpayer, although most interviews are over the phone. 

According to the Taxpayer Advocate Service, over 1,000 taxpayers opted out of the 2009 and 2011 offshore voluntary disclosure programs. One thing it meant was delays. For 2009 opt-outs, the IRS took about 590 days to close the case after the opt-out election. For 2010 OVDI opt-outs, the IRS took a more streamlined 129 days. Most reported opt-outs involved small dollars, which seems counter-intuitive. For some tax lawyers, the situation is the reverse, where most opt outs they handle involve big money. After all, the incentives to opt-out seem much higher if large dollars are at stake.

If you might pay a $50,000 penalty in the OVDP, opting out probably can’t save you too much, even if you end up with non-willful penalties. A $500,000 penalty within the OVDP, however, may make opting out hard to resist, particularly if you have good facts and no evidence of willfulness or evasion. If you face a $1M penalty or higher, it may be even more compelling. On the other hand, potential FBAR penalties can be high. If the maximum account balance exceeds $1 million, a willful FBAR penalty could be the greater of $100,000 or 50% of the account balance. The taxpayer can argue that FBAR penalties are inappropriate after opting-out. However, the IRS can conceivably seek FBAR penalties per account, per year.

If there are passive foreign investment company (PFIC) issues, the amended tax returns submitted as part of the OVDP may need to be modified to reflect statutory PFIC computations, not the OVDP’s mark-to-market computations. Some advisers believe the IRS may be more likely to assert additional income tax penalties after an opt-out. But this has not been our experience. Indeed, the opt out results can be quite dramatic on the right facts. Past admissions, even OVDP submissions themselves, can be used against the taxpayer if he or she opts-out. Thus, it is important to consider what you’ve told the IRS prior to making the opt-out election.

Bottom line? The OVDP is predictable. Opting out is much less so, but the time and expense can pay huge dividends. If you have no evidence of willfulness, the sheer numbers may make opting out attractive. Individual advice about the particular facts is important. And facts that might suggest willfulness may be especially so. How about moving money from one bank to another when the banks turned away undisclosed American accounts? That does not always spell willfulness. Some taxpayers do not understand what their advisers or bankers are doing. Even legal entities, shell companies set up to hide someone’s identity, do not necessarily preclude opting out. For those with the right facts and a willingness to endure some risk, opting out can sometimes save large dollars. It can be worth evaluating carefully, in some cases even as one enters the program.

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IRS Offshore Account Amnesty Closing, How To Get In Under The Wire

Offshore accounts and income are still in the IRS crosshairs. And your chance to fix your situation before the IRS catches you is about to get much harder. For ten years, the IRS has run its Offshore Voluntary Disclosure Program (OVDP), a type of tax amnesty. But now, OVDP will formally close on September 28, 2018.  The Streamlined program will still exist, but in comparing the two, you should consider Streamlined audits. If you want the protection of the OVDP, there’s not much time left. The IRS announcement is not 100% clear exactly what you must do before then if you want to join it. But most commentators agree that the September 28 deadline is the date by which a taxpayer must submit their “Initial Submission” requesting admission.

Internal Revenue Service building in Washington (Photo By Bill Clark/CQ Roll Call)

A Preclearance Request is not enough. This is an optional first step before entering OVDP that involves a small number of details about you.  The purpose of requesting preclearance is to confirm that the IRS isn’t already investigating you. Preclearance always has a yes or no answer. Usually the answer is yes, which means you can go to the next step to join the OVDP.

If the answer is no, you may already be under investigation. So you might not want to give them even more information. Preclearance requests are generally a good idea. But as the September 28 deadline inches closer, more people may forego this step and skip directly to the Initial Submission. A Preclearance Request only requires the following information:

  1. Information about Taxpayer: Complete Name, Date of Birth, Tax ID/Social Security Number, Addresses, Telephone Numbers
  2. Information about Undisclosed Foreign Financial Institutions, including Name of Financial Institution, Address, Telephone Number
  3. Information about Non-Public Entities (Corporations, Partnerships, LLCs, Trusts, Foundations) through which Undisclosed Foreign Accounts and Assets are Held, including Name of Entity (including d/b/a name), EIN (if applicable), Address of Entity, and Jurisdiction in which Entity was Organized.

A Preclearance Request can usually be prepared quickly. But it may take the IRS 30 days to respond. With the OVDP closing, a Preclearance Request should be submitted soon, perhaps no later than August 28, 2018, ideally significantly earlier. With the September 28 2018 OVDP deadline, assemble the Initial Submission while waiting for a response to a Preclearance Request. That way the Initial Submissions can be submitted immediately upon the receipt of the IRS’s response to the Preclearance Request.

In the past, once a taxpayer was precleared to enter OVDP, the taxpayer had 45 days to submit their Initial Submission. But it is not clear if you will get that time if it extends beyond September 28, 2018. Again, one should prepare Initial Submissions while waiting for the IRS to respond to a Preclearance Request.

The Initial Submission requires more information than the Preclearance Request, but does not require completed tax returns or FBARs. Initial Submissions include a cover letter that describes the facts and reporting history. A narrative that describes the history of the foreign accounts, foreign assets, and reporting is a good start. In addition to the cover, two forms are included in the Initial Submission. The first is Form 14457.  To complete it, include how you learned about OVDP, the source of the foreign funds, an estimate of the combined account/asset values for each year, and other general information. Only one Form 14457 is needed.

The second form is Form 14454.  You must complete a Form 14454 for each foreign account. Form 14454 contains more detailed questions. For example, it asks whether you made deposits into the foreign account from the United States, or whether you transferred funds from the account to the United States. It also asks about the people at the financial institution who advised about the foreign account.

The most time-consuming aspects of an OVDP disclosure are collecting bank statements and preparing tax returns and FBARs. They are not required for the Initial Submission. They are normally completed and submitted with the “Final Submission,” which does not need to be completed by September 28, 2018. If you want to join the OVDP–and that is not a simple question–it is best to keep an eye on the calendar. That September 28, 2018 deadline will arrive soon.

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Emotional Distress Damages Are Taxable, Physical Sickness Damages Are Not, How Come?

The tax treatment of litigation damages is varied and complex. But the rule for compensatory damages for personal physical injuries is supposed to be easy. They are tax free under Section 104 of the tax code. Yet exactly what is ‘physical’ isn’t so clear. Some of it seems to be semantics. If you make claims for emotional distress, your damages are taxable. If you claim the defendant caused you to become physically sick, those can be tax free. If emotional distress causes you to be physically sick, that is taxable. The order of events and how you describe them matters to the IRS.

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If you are physically sick or physically injured, and your sickness or injury produces emotional distress, those emotional distress damages should be tax free. Much of this seems artificial, but wording is important. These lines are hard to draw, and can sometimes seem contrived. Some of the line-drawing comes from a footnote in the legislative history to the tax code adding the ‘physical’ requirement. It says “emotional distress” includes physical symptoms, such as insomnia, headaches, and stomach disorders, which may result from such emotional distress. See H. Conf. Rept. 104-737, at 301 n. 56 (1996).

All compensatory damages flowing from a physical injury or physical sickness are excludable from income. Even in employment cases, some plaintiffs win on the tax front. For example, in Domeny v. Commissioner, Ms. Domeny suffered from multiple sclerosis (“MS”). Her MS got worse because of workplace problems, including an embezzling employer. As her symptoms worsened, her physician determined that she was too ill to work. Her employer terminated her, causing another spike in her MS symptoms. She settled her employment case and claimed some of the money as tax free. The IRS disagreed, but Ms. Domeny won in Tax Court. Her health and physical condition clearly worsened because of her employer’s actions, so portions of her settlement were tax free.

In Parkinson v. Commissioner, a man suffered a heart attack while at work. He reduced his hours, took medical leave, and never returned. He filed suit under the Americans with Disabilities Act (“ADA”), claiming that his employer failed to accommodate his severe coronary artery disease. He lost his ADA suit, but then sued in state court for intentional infliction and invasion of privacy. His complaint alleged that the employer’s misconduct caused him to suffer a disabling heart attack at work, rendering him unable to work. He settled and claimed that one payment was tax free. When the IRS disagreed, he went to Tax Court. He argued the payment was for physical injuries and physical sickness brought on by extreme emotional distress. The IRS said that it was just a taxable emotional distress recovery.

The Tax Court said damages received on account of emotional distress attributable to physical injury or physical sickness are tax free. The court distinguished between a “symptom” and a “sign.”  The court called a symptom a “subjective evidence of disease of a patient’s condition.” In contrast, a “sign” is evidence perceptible to the examining physician. The Tax Court said the IRS was wrong to argue that one can never have physical injury or physical sickness in a claim for emotional distress. The court said intentional infliction of emotional distress can result in bodily harm.

Notably, the settlement agreement in Parkinson was not specific about the nature of the payment or its tax treatment. And it did not say anything about tax reporting. There was little evidence that medical testimony linked Parkinson’s condition to the actions of the employer. Still, Parkinson beat the IRS. Damages for physical symptoms of emotional distress (headaches, insomnia, and stomachaches) might be taxable. Yet physical symptoms of emotional distress have a limit. For example, ulcers, shingles, aneurysms, and strokes may all be an outgrowth of stress. It seems difficult to regard them all as ‘mere symptoms of emotional distress.’  Extreme emotional distress can produce a heart attack, which is not a symptom of emotional distress. The Tax Court in Parkinson agreed.

Medical records and settlement agreement language can help materially. With the right combination, you may be able to resolve an IRS query or audit. To exclude a payment from income on account of physical sickness, the taxpayer needs evidence he made the claim. He does not necessarily have to prove that the defendant caused the sickness. But he needs to show he claimed it. In addition, he needs to show the defendant was aware of the claim, and at least considered it in making payment. To prove physical sickness, the taxpayer should have evidence of medical care, and evidence that he actually claimed the defendant caused or exacerbated his condition. This is one of many issues in the Taxation of Damage Awards and Settlement Payments.

The more medical evidence the better. Moreover, if there is a scant record of medical expenses in the litigation, consider what you can collect at settlement time. A declaration from the plaintiff will help for the file. A declaration from a treating physician or an expert physician is appropriate, as is one from the plaintiff’s attorney. Prepare what you can at the time of settlement or, at the latest, at tax return time. Do as much as you can contemporaneously. Support that you gather later is rarely as helpful.

And then there is the settlement agreement. Whenever possible, settlement agreements should be specific about taxes. The IRS is likely to view everything as income unless you can prove otherwise. Try to be explicit in the settlement agreement about tax forms too. You don’t want to be surprised by IRS Forms W-2 and 1099 arriving unexpectedly in January the year after the settlement. For a current snapshot of settlement taxes, see Settlement Awards Post-TCJA.

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Bitcoin Trusts Avoid Taxes, Including $10,000 SALT Deduction Cap

The IRS treats bitcoin and other crypto as property. That means each transfer can trigger taxes. There may be tax to the recipient, plus tax to the transferor. The latter catches many people by surprise. A key tax question on each transfer is the market value on transfer. With the wild swings in value, that can be frightening. Some crypto investors use legal entities such as corporations, LLCs or partnerships. They can face the same transfer issues, but it is often possible to contribute the crypto to the entity without triggering taxes.

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Another avenue now being considered is a crypto trust. This is really just a trust that holds crypto assets. Trusts can be taxed in several different ways, depending on their type. There are living trusts that people usually use for estate planning, and they are not separately taxed. If you transfer Bitcoin to your living trust, it usually isn’t a taxable transfer, since your living trust isn’t really a separate taxpayer. It is still you. The trust is not separately taxable, typically until you or your spouse die.

There are also non-grantor trusts, where the transferor is not taxed on them. These are separately taxed, and they file a separate trust tax return. The trust itself pays taxes, and there can be another tax on the distribution to beneficiaries. But leaving distribution issues aside, where does the trust pay taxes? Some trusts are foreign, set up outside the U.S. Those rules are complex, but if you are U.S. person, you should not assume that you can avoid U.S. tax with a foreign trust.

What about state taxes? Some trusts are being set up with an eye to reducing or avoiding state taxes. Remember, there’s a new federal tax deduction cap of $10,000. Say you are in California and don’t want to move to Nevada before you sell your Bitcoin. You want to cut the sting of California’s high 13.3% state tax, but you aren’t willing to move, at least not yet. You could consider setting up a new type of trust in Nevada or Delaware. A ‘NING’ is a Nevada Incomplete Gift Non-Grantor Trust. A ‘DING’ is its Delaware sibling. There is even a ‘WING,’ from Wyoming. Some marketers of NING and DING trusts offer it as an alternative or adjunct to a physical move. The idea is for the income and gain in the NING or DING trust not to be taxed until it is distributed. At that point, the distributees will hopefully no longer be in California.

Let’s say you can’t move quite yet, so you wonder if a trust in another state might work? The idea of a Nevada or Delaware Incomplete Gift Non-Grantor Trust is for the donor to make an incomplete gift, with strings attached. The trust has an independent trustee outside of California. When this was tried in New York, New York lawmakers changed the law to make the grantor taxable no matter what. California’s Franchise Tax Board has not yet ruled on the issue.

If the NING or DING trust is formed to facilitate a business sale and the proceeds will be capital gain, there is the federal tax of up to 20%. Then, there is also the 3.8% Obamacare tax on net investment income. It makes the current federal tax burden on capital gain up to 23.8%. California taxes all income at up to 13.3%, and there is no lower rate for long term capital gain. It is one reason Nevada, Texas, Washington, Florida and other no tax states may be tempting for California sellers.

Most non-grantor trusts are considered taxable where the trustee is situated.  For NING and DING trusts, one common answer is an institutional trust company in Delaware or South Dakota. For trust investment and distribution committees, the committee members should also not be residents of California. Even if you jump through all the requisite hoops, the NING or DING trust may still pay some California tax. For example, if the trust has California source income, it will still be taxable by California. Gain from California rental properties or the sale of California real estate is sourced to California no matter what.

Outside of New York residents, the jury is still out on NING and DING trusts. The facts, documents, and details matter. California  rarely takes moves that short the state lying down. State tax fights in California can be protracted and expensive. But if one is careful, willing to bear some risk, and there is sufficient money at stake, the calculated risks may be worth considering.

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Bitcoin Options And Other Tax Dangers

There is considerable talk today about crypto investments for everyone, for individual retirement accounts, via index funds, and more. There are also plenty of crypto-related start-ups, some of which have gotten big and valuable. That means options, crypto bonuses, restricted crypto, etc. All of these raise tax issues, and they can be confusing. Before we address crypto itself that is awarded to workers in connection with services, let’s start with stock options, and options to acquire crypto.

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Options can be either incentive stock options (ISOs) or non-qualified stock options (NSOs). ISOs (only for stock) are taxed the most favorably. There is generally no tax at grant, and no “regular” tax at exercise. When you sell your shares, you pay tax, but hopefully as long-term capital gain. The usual capital gain holding period is more than one year. But to get capital gain treatment for shares acquired via ISOs, you must: (a) hold the shares for more than a year after you exercise the options; and (b) sell the shares at least two years after your ISOs were granted. Even though exercise of an ISO triggers no regular tax, it can trigger alternative minimum tax (AMT).

Non-qualified options are not taxed as favorably as ISOs, but there is no AMT trap. There is no tax when the option is granted. But when you exercise, you owe ordinary income tax (and, if you are an employee, payroll tax) on the difference between your price and the market value. Example: You receive an option to buy stock at $5 per share when the stock is trading at $5. Two years later, you exercise when the stock is trading at $10 per share. You pay $5 when you exercise, but the value at that time is $10, so you have $5 of compensation income. If you hold the stock for more than a year and sell it, any sales price above $10 (your new basis) should be long-term capital gain.

Options to buy crypto are treated just like nonqualified options to buy stock. Usually the tax comes when you exercise the option, not when you are given the option. Restricted stock or crypto means delayed tax. Suppose you receive stock or other property—including crypto—from your employer with conditions attached? Say you must stay for two years to get it or to keep it. Special restricted tax rules in Section 83 of the Internal Revenue Code kick in.

As a carrot to stay with the company, your employer says if you stay for 36 months, you will be awarded $50,000 worth of crypto. You don’t have to “pay” anything for them. You have no taxable income until you receive the crypto. When you receive the crypto, you have $50,000 of income, or more or less, depending on how the crypto has done in the meantime. The income is taxed as wages.

With restrictions that will lapse with time, the IRS waits to see what happens before taxing it. Yet some restrictions will never lapse. With such “non-lapse” restrictions, the IRS values the property subject to those restrictions. Example: Your employer promises you crypto if you remain with the company for 18 months. When you receive it, it will be subject to permanent restrictions under a company buy/sell agreement to resell it for a fixed price if you ever leave the company’s employ. The IRS will wait and see (no tax) for the first 18 months. At that point, you will be taxed on the value, which is likely to be stated fixed price in the resale restriction.

The restricted property rules generally adopt a wait-and-see approach for restrictions that will eventually lapse. Nevertheless, under what’s known as an 83(b) election, you can choose to include the value of the property in your income earlier (in effect disregarding the restrictions). It might sound counter-intuitive to elect to include something on your tax return before it is required. Yet you might want to include it in income at a low value, locking in capital gain treatment for future appreciation. To elect current taxation, you must file a written 83(b) election with the IRS within 30 days of receiving the property. You must report on the election the value of what you received as compensation (which might be small or even zero).

Example: You are offered crypto by your employer at $5 per coin when it is worth $5. You must remain with the company for two years to be able to sell them. You are paying fair market value for the crypto. So filing an 83(b) election could report zero income. Yet by filing it, you convert what would be future ordinary income into capital gain. When you sell the crypto more than a year later, you’ll be glad you filed the election.

If the restricted property rules and stock options rules were each not complicated enough, sometimes you have to deal with both sets of rules. You may be awarded options that are restricted–your rights to them “vest” over time if you stay with the company. The IRS generally waits to see what happens in such a case. But be careful, these rules can be complex.

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Sexual Harassment Tax Law That Double-Taxes Victims Needs Fixing

The “Repeal the Trump Tax Hike on Victims of Sexual Harassment Act of 2018” has not yet been passed, and it is not clear that it will be passed. But it certainly should be passed. Most observers looking at the big tax reform law that passed at the end of 2017 note the potential confusion–or worse–caused by the so-called Harvey Weinstein provision. The provision was meant to stop defendants in sexual harassment cases from being able to deduct their legal fees and their settlement payments where they require confidentiality from their accusers in legal settlement agreements.

In this March 2, 2014 photo, Harvey Weinstein arrives at the Oscars in Los Angeles. The recent sexual harassment and assault allegations against Weinstein set off a wave of charges against other men and led to an obscure provision in the Senate tax cut bill. (Photo by Jordan Strauss/Invision/AP)

But the law actually reads that the accusers too cannot deduct their legal fees. That means if a plaintiff recovers $500,000 but must pay her lawyer 40%, the full $500,000 is taxable income. It means that the victim is paying tax on money she never receives. And if the legal fees and costs combined climb to say 50%? That means paying taxes on twice the money you collect. That sure sounds like double taxation. Section 162(q) of the tax code provides:

(q) PAYMENTS RELATED TO SEXUAL HARASSMENT AND SEXUAL ABUSE. — No deduction shall be allowed under this chapter for — (1) any settlement or payment related to sexual harassment or sexual abuse if such settlement or payment is subject to a nondisclosure agreement, or (2) attorney’s fees related to such a settlement or payment.”

It doesn’t say whose legal fees can’t be deducted, so it means everyone’s. Of course, virtually all legal settlement agreements have some type of confidentiality or nondisclosure provision. It is true in virtually any kind of legal case, and perhaps especially so in sexual harassment cases. The basic tax rules for legal fees surprises many people. Plaintiffs who use contingent fee lawyers are treated for tax purposes as receiving 100% of the settlement amount, even if their lawyer takes 40% off the top. So ruled the U.S. Supreme Court in Commissioner v. Banks, 543 U.S. 426 (2005).

That means the plaintiff must figure a way to deduct the 40 percent fee. In 2004, Congress provided an above the line deduction for legal fees in employment cases. Since then, plaintiffs in employment cases have been taxed on their net recoveries, not their gross. Yet a glitch in the tax law seems to mean that the plaintiffs–the very people the new law was presumably meant to help protect–cannot deduct their legal fees either. There is a movement to amend the law to correct this ridiculous and unjust result.

But sexual harassment victims who must settle in the meantime may be worried. In the topsy-turvy world of Congress, it is not clear that the law will pass. Even if it does eventually, it is not clear that will be anytime soon. Any mention of sexual harassment is a legal case could trigger the law. It could bar any tax deduction, even if the sexual harassment part of the case is minor. Plaintiff and defendant may agree on a particular tax allocation, perhaps allocating only a small amount to sexual harassment. However, the IRS is never bound by an allocation in a settlement agreement.

Hopefully the Repeal the Trump Tax Hike on Victims of Sexual Harassment Act of 2018 will be passed, and passed swiftly. Of course, there are many other parts of the new tax law that require technical corrections or other fixes too. But this one should be corrected without delay. 

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