Suing for defamation can result in a major recovery. Unfortunately, the claiming plaintiff is taxed … [+]
Defamation judgments and settlements regularly make the news. But we rarely learn what prosecutors remember from their victories. After fees and taxes, it can be shockingly little.
This may be true what Alex Jones ends up paying the Sandy Hook families. And from defamation profits received by E. Jean Carroll of former President Donald Trump. Surprisingly, this also applies to individuals who successfully sue for damage to their professional reputation.
Plaintiffs often pay 15%-40% of the winnings to their litigator. Especially in a sizable case, keeping 60% is still a big win. But plaintiffs often pay tax on all 100%. They pay tax on their lawyer’s share and their lawyer pays tax on that in turn. Many call this a “double taxation”. After fees and taxes, some claimants keep less than 20% of what the defendant paid.
When taxes exceed profits in lawsuits
The Tax Cuts and Jobs Act of 2017 increased the standard deduction, but also abolished the … [+]
Legislation passed in 2017 prevents many claimants from deducting legal fees and costs. The Tax Cuts and Jobs Act of 2017 banned “miscellaneous itemized deductions” until 2025. The amendment is perhaps best known for eliminating the deduction from most investment advisor fees. It also eliminated the deduction most claimants need to avoid being taxed on the compensation portion of their winnings.
Even before 2017, restrictions on deductions regularly caused plaintiffs to pay double taxation. In 2002, the That reported the New York Times that a police officer who filed a lawsuit for discrimination owed $100,000 after spending all of her $1.25 million award to pay fees and taxes. Congress has reduced the “double taxation” on portion meals. For example, legal fees are now deductible in cases of “unlawful discrimination”.
Double taxation on defamation recoveries
But libel lawsuits rarely involve “unlawful discrimination.” And without any other basis for deducting fees, libel plaintiffs are typically stuck paying the double tax.
Slander is a common cause of action. Even if the damage is largely the result of loss of turnover … [+]
Before the 2017 legislation went into effect, defamation plaintiffs were generally able to deduct their fees Section 212 of the Internal Revenue Code. That section allows deductions from “ordinary and necessary expenses … for the production or collection of income.” Section 212, however, is one of several “miscellaneous itemized deductions” that have been eliminated by legislation through 2025.
Thus, most libel plaintiffs are found guilty of double taxation unless their legal fees can be deducted as a business expense under Article 162. Unfortunately, as discussed below, that doesn’t help much.
Why Plaintiffs Lose When Deducting Defamation Expenses
Legal costs associated with defamation actions are generally not deductible as a business expense.
Section 162 allows deductions for “ordinary and necessary expenses paid … in the course of a trade or business.” But if the IRS Lawsuit Audit Guide states, “Except in rare cases … legal fees will be a miscellaneous itemized schedule A deduction.” That is, they are not deductible as a business expense. The highly regarded American Law Reports writes: “[C]ours have generally denied a deduction for the cost of pursuing a libel or defamation action, even though the statements could be harmful to the taxpayer’s business.
Intuitively this seems wrong. The greatest harm caused by libel is often measured in lost revenue or business. This does not apply to the plaintiffs suing Alex Jones, and probably not to E. Jean Carroll in her suit against Trump. But it’s often true for cases brought by doctors, lawyers, and other professionals. Can’t they treat their legal fees as a business expense?
The US Tax Court considered this theory in the case of an offended doctor, who argued that his contingent legal fees were not deductible. In the 1980s, Dr. Sudhir Srivastava, a heart surgeon, slandered by a television station that falsely reported that he had performed unnecessary surgeries. The report “destroyed” his reputation and medical practice. He also lost hospital privileges and malpractice insurance. Soon after, he sued the television station, winning $30 million in the lawsuit. He eventually settled for $8.5 million, paying about $3.5 million in legal fees.
When he reported that no taxes were due on the reimbursement portion of his recovery, the IRS checked and contested. The doctor argued that his fees could be deducted as a business expense to the extent that they generated taxable income. The tax court disagreed: “Whether the defamatory attack targets the personal reputation or the professional reputation of the individual, the defamation is personal in nature.”
Decades earlier, the Seventh Circuit Court of Appeals wrote the same: “In virtually all cases where defamatory messages are spread about a person that damage his character or reputation, such messages indirectly influence, and to some extent, the matters in which he is involved. However, any expenses incurred by him in such circumstances in defending his good name cannot be said to be ordinary and necessary costs incurred in the conduct of its business.”
Similarly, in other contexts, the tax court has also treated defamation actions as inherently personal. Prior to 1996, non-corporal injury benefits were received tax-free if they compensated for ‘personal’ injuries. Both the Ninth and Sixth Circuit Courts of Appeal have ruled defamation as personal injury.
In general, therefore, a defamation plaintiff cannot deduct his legal costs. There are some authorities that plaintiffs may be able to rely on to justify a business deduction. For example, when taxpayers sued “solely” to protect a business, or were sued and defended against reputational claims, they got business deductions. But plaintiffs taking such a position are likely to face significant tax risk.
Conclusion
The “double taxation” often surprises plaintiffs and their lawyers. But it can be especially surprising in defamation cases. The case of Dr. Srivasta is a good example. He sued after his company was “destroyed” by false reports about his professional work. And yet, because libel of his reputation was a “personal injury,” the compensation portion of his recovery was taxable to both him and his attorneys.