The Fruit Of The Tree

 

I have a friend who is pressing an employment lawsuit.

It is not pretty: falsified records, deleted files, retaliatory firings. The legal process itself is glacial: may we live long enough to see the end. They enter discovery soon. I suspect the employer/defendant will then seek to settle rather than risk any further public disclosure.

I suppose I am my friend’s tax advisor.

The taxation of litigation is not what it used to be.

Let’s travel back to 2005. The Supreme Court was hearing two cases involving income recognition and legal contingency fees.

ISSUE: You sue for $100 grand. If you win, the attorney takes 30 percent. Are you taxed on $100 grand or on $70 grand?

The Appeals courts had split, which is how the Supreme Court got involved.

We will restrict ourselves to one case: Banks v Commissioner. Banks had brought an employment lawsuit. Before going to trial, he settled for $464,000 and paid a contingency fee of $150 grand. The Sixth Circuit reasoned there was no extant income when the contingency was created, making the agreement more akin to a division of property (the claim) than a division of spoils (the settlement). Banks did not have a sufficiently uninterrupted claim to require reporting of the entire amount ($464,000).

The Supreme Court took a different tack and saw anticipatory assignment of income. This is a classic tax doctrine; one I learned in school as “fruit of the tree.” The concept is that income (the fruit) should be taxed to the person earning or generating it (the tree). An example would be my working all week but having my paycheck go to my child. I earned the paycheck and cannot avoid taxation by redirecting its payment.

This result could have been disastrous to Banks, requiring him to pay taxes on $150 grand which he did not receive. Pause to consider that his attorney was also reporting the same $150 grand in income, so the contingency fee was being taxed twice. Unless there was a safety valve somewhere, this was not taxation – it was confiscation.

But Banks fortunately had a safety valve: itemized deductions. Take a look at this itemized deduction schedule (Schedule A) for 2015: 

             

Go to the bottom where you see “Miscellaneous Deductions.”

You know what was a miscellaneous deduction? Yes, contingency fees paid an attorney on a legal judgement or settlement.

Was it a perfect answer? No. The deduction came after Adjusted Gross Income (AGI), so a tax attribute based on AGI would be unfortunately skewed. It was an itemized deduction, and the taxpayer may not have been itemizing except for the contingency fee. And it was a “miscellaneous” itemized deduction, meaning that the taxpayer had to subtract 2% of AGI off-the-top before getting to the deductible amount.

Still, it was something and much better than nothing.

Then the tax law changed with the 2017 Tax Cut and Jobs Act (TCJA).

One of the things that the TCJA did was to eliminate almost all miscellaneous itemized deductions, beginning in 2018.

Those contingency fees were no longer deductible.

Congress argued that it was simplifying the tax Code by reducing the number of taxpayers who were itemizing. While this result did happen, Congress also eliminated the economic handcuff to the Banks case: a deduction somewhere on a tax return to offset that severe 100% income recognition.

COMMENT: Let’s clarify this issue by separating legal fees between business and nonbusiness lawsuits. Business legal fees are still deductible. Nonbusiness legal fees (think employment lawsuits) are generally nondeductible. There still exists a narrow deduction for selected nonbusiness litigation (such as certain discrimination and whistleblower claims), but for the vast majority of nonbusiness litigation there simply is no deduction for legal fees.

Let’s look at the Eiler case.

James and Kathryn Eiler sued LexisNexis, Equifax, Experian and Trans Union for inaccurate, incomplete or otherwise injurious information on their credit reports. The parties settled for $64,750, of which $4,700 went to the Eilers.

COMMENT: The comment writes itself, I would say.

The IRS came in, eyes gleaming and jaws slavering, with a Notice of Deficiency totaling over $11 grand.

The Eilers were in a tough spot. Under Banks the IRS was correct, and there remained only a few ways to deduct related nonbusiness legal fees. The Eilers started thinking: we brought action under the Fair Credit Reporting Act (FCRA), which is kinda-sorta like the Equal Credit Opportunity Act (ECOA), which has explicit discrimination protections. If the FCRA is like the ECOA, and if “unlawful discrimination” includes “enforcement of civil rights,” and if the moon hits your eye like a big pizza pie …

The Eilers wanted a deduction because of civil rights discrimination.

To be accurate, the Eilers just wanted a deduction. They were being creative on how to get there.

And the Tax Court shot them down.

They received $4,700 and owed over $11 grand.

My thoughts?

I question whether the Supreme Court would decide Banks the same way given today’s tax Code. When a line of reasoning (assignment of income rather than co-ownership of a claim) leads to absurd results (such as double taxation of the same “fruit”), a sober and responsible person would conclude that the reasoning is flawed.

And there you have the taxation of nonbusiness litigation since 2018.

Our case this time was Eiler v Commissioner, 167 T.C. No. 3, Docket No. 16903-22, 7/14/2026.

JPMorgan's Nondeductible Madoff Deal

On January 7, 2014, JPMorgan entered into a deferred prosecution agreement with the Justice Department. This is another payment in the ongoing Bernie Madoff saga, and the bank agreed to pay a $1.7 billion settlement as well as $350 million to the Office of the Comptroller of the Currency and $543 million to a court-appointed trustee.

Madoff kept significant balances with JPMorgan.  Banks are the first line of defense against fraud, but JPMorgan never filed suspicious activity reports with regulators, even though there were significant reservations as to when they became suspicious. The bank did not admit any criminal activity in the agreement, but it did allow that it missed red flags from the late 1990s to late 2000s.

What caught my eye was the following text from the following joint release by the Manhattan U.S. Attorney and FBI:
           

… JPMorgan agrees to pay a non-tax deductible penalty of $1.7 billion, in the form of a civil forfeiture, which the Government intends….”

This is unusual language.

The tax code provides a tax deduction for all of the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.

And then the tax Code starts taking back. One take back is Section 162(f):

162(f) FINES AND PENALTIES.— No deduction shall be allowed under subsection (a) for any fine or similar penalty paid to a government for the violation of any law.

Let’s drill down a little bit into the Regulations:

This prohibition applies to any fines paid by a taxpayer because the taxpayer has been convicted of a crime (felony or misdemeanor) in a full criminal proceeding in an appropriate court.   The prohibition also extends to civil fines if the fines are intended by Congress as punitive in nature.

So, if fines are paid pursuant to a criminal case, then the taxpayer is hosed. However, if fines are paid pursuant to a civil case, there is one more step: are the fines punitive in nature?

Attorneys differentiate damages between those that are remedial and those that are punitive. A remedial payment is intended to compensate the government or another party – to “make one whole,” if you will. It is intended to restore what was disturbed, upset or lost, and not intended as penalty or lashing against the payer.

Let’s complicate it bit. There is a court case (Talley Industries Inc v Commissioner) that allows damages to be deductible if they are remedial in intent, even if labeled as a fine or penalty.

EXAMPLE: The NFL fines a player for unnecessary roughness. The NFL can call this a fine, but it is not a fine per Section 162(f) and will be deductible to the player involved.

You are seeing how this is fertile hunting ground for tax lawyers. Unless the payment is pursuant to a criminal case, odds are good that it is deductible.

Now remember that this agreement is Madoff related, and that there are hard feelings about JPMorgan’s involvement with Madoff over the years, and you can see why the Justice Department included the “nondeductible” language in the agreement.

Let’s take this a step further. Under Talley, JPMorgan could deduct the $1.7 billion on its tax return. Remember, it is not a fine or penalty under Sec 162(f) just because somebody somewhere called it as such.

Would JPMorgan be likely to do this?

This is a “deferred prosecution” agreement.  If JPMorgan did deduct the settlement, they might not have an issue with the IRS, but they would likely have a very sizeable issue with the Justice Department.