Blaney + AMT = Opportunities?

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1 Blaney + AMT = Opportunities? by Herman Wacker and Monna Lux CPA 1 The October, 2002 Blaney decision by Division I of the Court of Appeals added much complexity to the already problematic issue of assessing tax liability in employment cases. Blaney v. International Association of Machinists and Aerospace Workers, District No. 160, 114 Wash. App. 80; 55 P.3d 1208 (Wash.App.Div.1 10/21/2002). The Supreme Court is reviewing Blaney in this term, but it does not seem likely the court will change the result. 2 If Blaney is overruled, plaintiffs will continue to face the unusual litigation risk of having their taxes exceed the net value of a jury verdict. If Blaney is affirmed, defendant employers will face the litigation risk of having to pay additional damages to compensate plaintiffs for adverse tax consequences from a jury verdict. Even with affirmance, plaintiffs will still have complex tax problems, which Blaney may not fully remedy. This article explains how employment litigation is affected under Blaney. It discusses the issues posed by Blaney and the potential for structured settlements to offset some of the adverse consequences in employment cases. If you already understand the AMT, how to calculate it, how it relates to employment litigation and the relevance of the holding in Sinyard v. IRS, you can skip to the section: Are There Alternatives? If not, read on! What Is The AMT? Interpreting and applying Blaney requires knowledge of the AMT. AMT is the acronym for Alternative Minimum Tax. You may have paid AMT at some time but, you may not be aware you paid it if an accountant prepared your taxes. AMT is a feature of the tax code affecting very few taxpayers until the last few years. Understanding the history of AMT helps to appreciate how it became a significant issue in employment litigation. In the late 70's and early 80's there was a perception that rich people had so many deductions they were not paying their fair share of income taxes. Congress responded with the AMT. The AMT first applied to individuals in The AMT requires two parallel tax calculations. The tax preparer prepares the traditional Form 1040 with itemized deductions to determine the taxpayer's tax liability. Then the preparer prepares a second form - Form which uses an alternate means for calculating tax. The most significant difference relevant to employment law cases is that the AMT limits itemized deductions with a sliding scale based on income. The higher the income, the smaller the allowable 1 Monna Lux is a CPA and principal of Lux and Associates. Herman Wacker is a mediator/attorney and principal of Herman Wacker P.S. 2 The reason outright reversal is unlikely is that without some shift of adverse tax consequences of lump sum damages, it is not possible to meet the statutory goal of making discrimination victims whole. Blaney + AMT = Opportunities? Page 1

2 deduction. The two results are compared and the higher result becomes the taxpayer's tax liability. Initially, the AMT had little impact, affecting the taxes of only 132,000 taxpayers. The current problem arose because Congress did not index the tax rates or the limits on deductions for the AMT. As a result, inflation caused AMT creep. It is estimated that 1.3 million people paid AMT in A congressional paper estimates that an astonishing 17 million taxpayers will pay AMT in Currently, an employee who earns $50,000 per year and receives a lump sum settlement of $100,000 may be subject to the AMT. This lump sum settlement would adversely impact the plaintiff's tax liability because the AMT, in the tax year of the settlement, will be greater than the same sum spread over 4 years at $25,000 per year. This is something entirely different than simply raising a person into another tax bracket, although that also is an adverse tax consequence of lump sum payments. The problem compounds to an absurd result when attorney fees are brought into the equation. Here Sinyard takes on importance. Sinyard v. Commissioner of Internal Revenue, 268 F.3d 756 (9th Cir. 09/25/2001). The Ninth Circuit ruled in Sinyard that the entire award in a judgment for an ADEA (Age Discrimination in Employment Act) violation, including the attorney s fees, must be included on the taxpayer's return as gross income. The court concluded that under California law an attorney has no ownership rights in the attorney fee award other than those conferred by the fee agreement. Even if the fees are paid for the plaintiff by the defendant with a separate check, the court concluded such an arrangement was a mere convenience that did not alter the fact the entire award was income to the plaintiff. By paying plaintiff's fee obligation, defendant has conferred income on plaintiff. Because there is no basis for distinguishing between ADEA and other discrimination cases, Sinyard will require treating attorney fees as gross income in all discrimination cases. It is fair to assume Sinyard will extend to other statutory and common law employment cases as well. It is not clear whether the same rule will apply in Washington because the courts decide this issue in the context of how state law treats attorney s fees. Sinyard turned on California law. In a very recent case decided under Oregon law, the Ninth Circuit reached the opposite result. Banaitis v. Commissioner of Internal Revenue, No (9th Cir. 08/27/2003). The distinction is based on whether state law vests ownership of a fee (either court ordered or contingent) in the attorney or the client. In Banaitis, the court framed this inquiry, we must examine applicable state law to determine whether the plaintiff's attorneys have particular property interests arising as a matter of law in the judgment or settlement independent of the fee contract. Emphasis added. Oregon's attorney lien statute provided the crucial distinction from California law and the Sinyard result. Oregon's lien statute, according to the court, affords attorneys generous property interests in judgments and settlements. Unlike California and Alaska law, an attorney's lien in Oregon is "superior to Blaney + AMT = Opportunities? Page 2

3 all other liens" except "tax liens." O.R.S Under Oregon law, "a party to the action, suit or proceeding, or any other person, does not have the right to satisfy the lien... or any judgment, decree, order or award entered in the action, suit or proceeding until the lien, and claim of the attorney for fees based thereon, is satisfied in full." O.R.S And Oregon law, like Alabama law, provides that attorneys shall have "the same right and power over actions, suits, proceedings, judgments, decrees, orders and awards to enforce their liens as their clients have for the amount of judgment due thereon to them." O.R.S Washington's lien statute resembles Oregon's. RCW This could result in a holding that attorney fees should be excluded from gross income. However, the outcome for Washington is not clear. With recent developments, it looks as if the U.S. Supreme Court will have to decide this issue. The circuits are split in three categories on the taxation of attorney s fees. The 5 th, 6 th, and 11 th Circuits have held that fees are should be excluded from income. The 4 th, 7 th, 9 th, 10 th and Federal Circuits have held fees are income and taxable. The Circuits have generally followed the attorney lien approach used in Sinyard. The 6 th Circuit has, however, developed a different approach. It criticized the lien approach as creating unreliable precedent, which varies from state to state. The 6 th Circuit analyzed contingent fees as intangible expectancies, which depend on the attorney's skills to realize value from it. Therefore the court charged the contingent fee income to the person who earned it, the attorney. Until the Supreme Court addresses this conflict, there can be no tax certainty for Washington parties to employment litigation. Let's look at how Sinyard affects a person with a $100,000 settlement and a salary of $50,000 per year. Assuming a 35% contingency fee, the attorney receives a $35,000 fee, leaving the client with $65,000. But the taxable gross income is $100,000. One would think this is not a problem because the fees would be deductible and thus set off the gross income represented by the fees. But, AMT drastically limits itemized deductions. Under the AMT calculation, the taxpayer is limited to deductions no greater than 2% of gross income. The client netted $65,000 after attorney fees, but must pay taxes at the AMT rate on $100,000 plus the taxpayer's regular $50,000 salary. If single, this taxpayer faces regular tax liability of $23,607 and AMT tax liability of $3,867 on the settlement proceeds after already paying attorney fees of $35,000. After taxes and attorney fees, the client retains slightly less than $45,000 of the $100,000 settlement. 4 This illustrates the problem, which Blaney addressed. 3 Washington's statute states in part: "Lien created. An attorney has a lien for his compensation, whether specially agreed upon or implied, as hereinafter provided:... (3) upon money in the hands of the adverse party in an action or proceeding, in which the attorney was employed, from the time of giving notice of the lien to that party; (4) upon a judgment to the extent of the value of any services performed by him in the action, or if the services were rendered upon a special agreement, for the sum due under such agreement, from the time of filing notice of such lien or claim with the clerk of the court in which such judgment is entered..." 4 See Table 1. Blaney + AMT = Opportunities? Page 3

4 How Does Blaney Interact With AMT? With Blaney now in the picture, the exposure for employers has increased dramatically. And the uncertainty and litigation costs for plaintiffs have increased as well. The court held Blaney's employer liable for the adverse tax consequences flowing from the judgment. The context of the court's discussion demonstrates the court was concerned with the tax consequences from the lump sum payment. Payment of the judgments triggers adverse tax consequences to Blaney. First, she will face a higher average tax rate because the additional lump sum income is not excluded from gross income and will be counted at the highest marginal rates. Second, she will be subject to alternative minimum tax because of the effects of the Internal Revenue Code on the payment of the attorney fees awarded to her. Emphasis added. Because Blaney makes it clear that the employer is now liable for the excess taxes caused by a lump sum payment, the AMT penalty of taxes on attorney fees shifts to the employer. In its simplest application, the result in Blaney suggests that the court should look at what the taxpayer would have paid in taxes over the back pay period if the taxpayer had remained employed and compare that amount to the taxpayer's liability in the year the judgment is paid. The employer must pay any excess taxes derived from the judgment because it is paid in a lump sum. As the previous example showed, the employer would have approximately $4,000 in extra damages from adverse AMT tax consequences. However, this is open to argument about how many years of economic damages the verdict represents. The results vary significantly depending on whether the judgment reflected one or four years of back pay. As the damages and attorneys fees increase, the penalties become even greater. The worst tax consequence occurs when the attorney fees exceed the amount of the judgment. For an absurd result, look at a case in which the plaintiff received a relatively small verdict of $25,000 and the court awarded attorneys fees of $75,000. The taxpayer plaintiff now has, according to Sinyard, taxable gross income of $100,000 even though the damage award is only $25,000. This triggers AMT and therefore limits deduction of the attorney s fees. The AMT tax is $13,675 and the total tax is $22,848 even though the verdict was only $25,000. Absent a Blaney adjustment, the winning plaintiff will have barely enough money from the judgment to pay the taxes. Under Blaney, the employer may be required to pay the AMT taxes above the regular income tax. However, this will not necessarily happen for the following reasons. Employment cases present many variations of these examples, which raise difficult questions regarding what Blaney means in practice. How do you determine the excess tax liability if there is no back pay award but a substantial taxable emotional distress award? 5 Because an emotional distress award does not reflect a lump sum payment of what would otherwise be several annual smaller payments, perhaps the employer has no liability for taxes if emotional 5 All emotional distress awards are taxable unless the emotional distress is a consequence of a bodily injury. Blaney + AMT = Opportunities? Page 4

5 distress damages trigger the AMT. If the emotional distress damages triggered the AMT by itself or jointly with the economic damages, whose responsibility is the inability to deduct the full amount of attorney fees? How do you model the normal tax liability of a front pay award in light of the annual changes to the tax code and its rates? What will the Ninth Circuit and ultimately the U.S. Supreme Court decide about whether contingent fees in Washington are gross income to the taxpayer? Until it knows if attorney fees are part of gross income in Washington, how can a trial court apply Blaney? To further complicate matters, it is not mathematically possible to calculate a fixed tax gross up figure, because each gross up becomes subject to tax, requiring another gross up, and so on into infinity. Perhaps recognizing the complexity of this situation, the Blaney court said plaintiffs will have to provide expert testimony in order to prove the tax penalty and reserved the decision for the judge after the jury renders a verdict. In addition to these questions, Blaney opens the door to areas of discovery, which previously were irrelevant. To some degree, the plaintiff's personal finances are now relevant for discovery because, in order for experts to construct tax comparisons, it will be necessary to know all of the plaintiff's income and deductible expenses. Experts on both sides will require this information in order to present tax comparisons to the judge. Blaney raises many issues of substantial consequence, however it is clear on one point. Blaney does not shift all taxes on the judgment or settlement to the employer. The opinion makes this point when it limits the tax adjustment to adverse consequences of the lump sum payment. This only shifts some of the consequences of higher rates and AMT to the employer. Defendants will argue, and courts will likely agree, that shifting all taxes to the employer would be a windfall to plaintiff, as those taxes would have been owed if plaintiff had not been discriminated against and continued working. Many of these questions can only be answered through years of case law development, but this is no place to be on the cutting edge of developing law. The cost of being on the wrong side of a decision can be substantial. This added uncertainty raises a concern for settlement negotiations. If each party attempts to protect itself from tax risks or to shift taxes to the other, the pie never can be large enough to cover all the uncertainty. What was once solely an argument over the facts and law regarding discrimination has also become an exercise in tax law. This situation interjects new complications in settlement negotiations. The tax issue has become too complex to handle with dead reckoning or rules of thumb. If a plaintiff intends to ask a court for tax relief, an expert will be required. Tax experts may be as important as economic and psychological experts depending on the amount of attorney fees and economic damages in the case. If both sides obtain and exchange expert reports on taxes prior to settlement negotiations or mediation, some common ground likely will exist and hopefully the uncertainties can be minimized. Blaney + AMT = Opportunities? Page 5

6 Are There Alternatives? One way to avoid the tax uncertainties is to use a structured settlement. A settlement can be structured to establish deferred annual payments, which keep the recipient below the AMT threshold. This is a mutual gain. Defendants are able to avoid shifted tax responsibility. Plaintiffs are able to avoid the AMT penalty, which flows from emotional distress payments, which Blaney may not shift to the employer. 6 Both parties are able to avoid the additional cost and uncertainty Blaney interjects into litigation. Using structured settlements is new ground in employment cases. However, now the benefits of structured settlements are now more evident. Both sides gain by a carefully structured settlement because it eliminates the uncertainties inherent in guessing how courts will treat the knotty questions raised by Blaney and Sinyard. Plaintiff gains by avoiding tax consequences, which the court may not shift to the defendant, getting maximum benefit from defendant s settlement budget, and by avoiding appeals and peripheral litigation on taxes. The concerns for proper tax planning are paramount. News sources have reported the case of Spina v. Cook County Forest Preserve. New York Times, 8/11/2002 and CBS Evening News, 1/12/04. Spina won a harassment claim and was awarded $3,000,000 by the jury. The court reduced her verdict to the statutory cap of $300,000. The court also awarded attorney fees and costs of $1,000,000. Therefore, Spina will be taxed on $1.3 million, which amounts to approximately $400,000 even though her award was only $300,000. The discussions of the case make clear the court did not shift this tax liability to the defendant. This outcome is a disaster for plaintiff. However, shifting this tax liability to the defendant would be an unpleasant outcome for the defendant as well. Settlement negotiations provide an opportunity for tax planning to deal with this exposure for mutual benefit. The advantage of the structured settlement is that, by receiving the settlement in annual or monthly installments, plaintiff avoids triggering AMT and losing the attorney fees deduction. The Plaintiff's Attorney's Dilemma This tax problem creates a potential conflict of interest between plaintiffs and their attorneys. The benefits of structuring a settlement disappear if the attorney fees are not structured as well. The law allows attorneys to receive a contingent fee on the present value of a structured settlement. For non-taxable claims, this is accomplished by structuring the settlement to include an initial lump sum to plaintiff sufficient to cover the attorney fees. However, this runs the hazard in employment cases of triggering AMT. If the lump sum to cover the attorney fees combined with plaintiff's other income exceeds $100,000, the likelihood of an AMT consequence increases. 6 The reason taxes on emotional distress may not be the employer's responsibility is that, by their very nature, they are paid in a lump sum. Because there is no installment payment alternative for comparison, as is the case with back pay, it can't be said there is a comparatively adverse tax consequence from the lump sum payment of emotional distress damages. Blaney + AMT = Opportunities? Page 6

7 Even though the structured settlement shelters the balance of the settlement from AMT treatment and higher rates, one of the most beneficial features of a structured settlement is avoidance of taxes on the attorney fee portion of the settlement. If the fees are paid up front, this benefit may be lost. This needs to be explored in a tax analysis so the client is fully aware of the implications before agreeing to a settlement. Full disclosure would require telling the client that a lump sum payment of attorney fees will result in a substantial tax penalty as well as telling the client of a more advantageous solution in the form of structuring the attorney fees. The tax consequences in an employment settlement are so different from a personal injury claim and so severe, that professional competence requires advising a client of the benefit of negotiating a structured settlement. There may be a solution to avoid the pitfall from paying attorney fees upfront in the structured settlement. One option is for the structured settlement to include a loan to the attorney funded by an insurance company, which is in turn repaid by assignment of a portion of each annual settlement payment plus market rate interest (to qualify the payment as a loan). This approach reconciles the attorney's interest in a prompt full payment of attorney fees and the client's interest in avoiding the loss of the deduction for those fees. Examples The following tables show comparisons of various settlements and jury verdicts paid in lump sum and installments. Table #1 demonstrates the taxes due on a $100,000 settlement paid in a lump sum and alternatively structured over 4 years. The example includes alternate scenarios in which plaintiff has no other income and in which plaintiff has other earnings. Table #1 also demonstrates an alternative trial outcome for the same case. This example illustrates what happens when the verdict is modest in comparison to the attorney fees award. Observations about these examples: Structuring a $100,000 settlement yields significant tax savings even when the client does not have other income. If the client is employed, the savings become more dramatic. The lump sum option shows that a structured $100,000 settlement will net a plaintiff, who has other income, $8,689 less than a $100,000 structured settlement. The trial verdict options demonstrate the adverse tax consequences, which are subject to further litigation under Blaney. Blaney + AMT = Opportunities? Page 7

8 Table 1, $100,000 settlement 100,000 Settlement 100,000 Structured 4 years Jury Verdict = 25,000 Court Ordered Fees = 75, ,000 Settlement Plus 50,000 Salary $100,000 Settlement Structured 4 years Plus 50,000 Salary Jury Verdict = $25,000 Court Ordered Fees = $75,000 Salary=50,000 Settlement / Verdict 100, ,000 25, , , ,000 Payment(s) 100,000 25, , ,000 25, ,000 Attorneys Fees 35,000 35,000 75,000 35,000 35,000 75,000 Structured Attorney Fee Payments 8,750 8,750 Other Income 50,000 50,000 50,000 Regular Income Tax 12,804 1,709 9,173 27,106 12,991 15,907 AMT Tax 2, ,675 3, ,065 Total Tax on Settlement 7 15,525 6,836 22,848 23,607 22,500 23,607 Plaintiff's Net 49,475 58,164 2,152 44,393 42,500 1,393 Defendant's cost 100,000< 100,000 8 >100, ,000 < 100,000 > 100,000 Table 2 introduces larger numbers and demonstrates how rapidly the AMT taxes increase. Using a settlement or verdict of $250,000, the net to plaintiff and the tax liability vary significantly depending on how the settlement is structured. This table demonstrates how the stakes become much higher as the amount increases above the $100,000 range. In this case, the structured settlement nets a plaintiff, who has additional income, $23,040, more than a lump sum settlement. Even allowing for lost opportunity to invest and the present value of the delayed payments, the saving is significant. Especially in the current interest rate environment, plaintiff would be hard pressed to find a secure alternative investment to guarantee this return over 4 years. The settlement opportunities improve here also. Rather than $250,000, the parties could settle at $225,000, which benefits defendant, and still would net plaintiff nearly the same as a $250,000 settlement paid in a lump sum. Therefore, both parties gain by structuring the settlement. This example does not include additional gains from the interest on principal, which is paid under an annuity. This feature of annuity financing provides further increases to the pie for the parties' negotiations. This table also demonstrates the uncertain exposure created by the Blaney court. If the case goes to trial and plaintiff is awarded damages of $150,000 with a fee award of $100,000, the tax liability is $23,010 more than in the structured 7 This reflects the taxes prorated between the settlement income and salary income 8 An annuity paying $25,000 per year for 4 years should cost defendant less than the principal amount of $100, Defendant's cost will exceed 100,000 if the court adjusts upward for plaintiff's tax hit. Blaney + AMT = Opportunities? Page 8

9 settlement and the client's net is nearly $35,510 less, unless the court makes a post trial tax adjustment to the verdict. Table 2, $250,000 settlement Settlement/ 250,000 Settlement 250,000 Structured 4 years Jury Verdict = 150,000 Court Ordered Fees = 100, ,000 Settlement Plus 50,000 Salary 250,000 Settlement Structured 4 years Plus 50,000 Salary Jury Verdict = 150,000 Court Ordered Fees = 100,000 Plus 50,000 Salary Verdict 250, , , , , ,000 Payment(s) 250,000 62, , ,000 62, ,000 Attorneys Fees 87, ,000 87,500 87, ,000 Structured Attorney Fee Payments 21,875 21,875 Other Income 50,000 50,000 50,000 Regular Income Tax 43,839 6,516 39,714 61,265 19,897 57,140 AMT Tax 21, ,141 19, ,360 Total Tax on Settlement 64,855 26,064 64,855 73,134 50,124 73,134 Plaintiff's Net 118, ,436 85,145 89, ,376 76,866 Defendant's cost 250,000 < 250,000 > 250, ,000 < 250,000 > 250,000 That adjustment is not a certainty however. Now the question is how much of this difference is the employer's responsibility? The answer will depend on what the plaintiff's annual earnings were before discharge and are currently, and the apportionment between emotional distress and economic damages. Here each party risks being worse off than with a settlement for the same amount as the total of the verdict and attorney fees award. The tax uncertainties increase the normal risk of trial for both parties. Clients cannot make an informed judgment about the risks of these positions without understanding the tax consequences before them. Employment attorneys have handled the tax issues in the past by telling clients to get their own tax advice. This usually occurs after the settlement decision has been made and it is too late to do any tax planning. It can be anticipated that some day a client will be faced with an unexpected tax result 10 and take the position that their attorney had the responsibility to provide the tax advice (by retaining the expertise) or explain the necessity of getting tax advice in sufficient detail that the client realizes the seriousness of the 10 This can be for the plaintiff's tax liability to the IRS, or for the defendant paying a significantly higher judgment than expected. Blaney + AMT = Opportunities? Page 9

10 tax issue. Malpractice cases loom on the horizon for attorneys who do not develop a comprehensive tax approach to settling employment cases. The Bottom Line A significant percentage of employment law cases settle or result in verdicts in the $100,000 - $200,000 range. This is the range at which the AMT is triggered. AMT has a dramatic impact on taxes as the amount of the settlement or verdict approaches $200,000 and attorney fees exceed $50,000. As a result of this, the decision in Blaney creates added uncertainty about the outcome at trial. The only way a client can make informed choices about the value of settlement and exposure at trial is with a tax work up which includes the plaintiff's current and past income, other deductions, and alternative scenarios for general damages, economic damages and attorney fees. In cases having over $100,000 in settlement value, a structured settlement is very likely to benefit both parties by creating significant tax savings, which can increase plaintiff's net award and decrease defendant's costs. Tax planning significantly complicates the settlement process, but future courts are likely to find that this analysis is part of an attorney's professional responsibility. However, the tax issues may also provide an additional incentive to negotiate a settlement as opposed to proceeding to trial, at least until the rules become clarified through other court decisions which apply and interpret Blaney. Blaney + AMT = Opportunities? Page 10

11 Resources: The following Internet references provide additional information about the AMT and structured settlements. Internet Articles On AMT and Structured Settlements The AMT From Smart Money Magazine Website: Forms and AMT calculator verview/0,1847,tt_1,00.html CNN Money Congressional Paper IRS News Bulletin IRS ATM Calculation Form Download ATM Form Instructions Includes Calculating Exemption Download Annuities Compilation of Annuity information links Securities Exchange Commission Publication on Annuities Blaney + AMT = Opportunities? Page 11

12 Structured Settlements Structured settlement is a term of art in the personal injury field, which refers to a specific statutory tax deferred vehicle for settlement of cases with nontaxable injuries. These websites usually refer this type of structured settlement, but have information about annuities from plaintiff and defense perspectives. When reading these sites it is important to recall that personal injury settlements do not involve the tax complications discussed in this paper. Plaintiffs' Structured Settlement Consultants Structured Settlements Services The Halpern Group (highly opinionated, but lot's of articles) No Self Identification as Plaintiff or Defendant Consultants EPS Settlements Davis Settlement Partners Congressional Paper Blaney + AMT = Opportunities? Page 12