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DRI -- "Tax Breaks for Trial Lawyers: Making the Government a Partner in Litigation"

Marc Williams of Nelson Mullins Riley & Scarborough, LLP, the immediate past president of DRI, writes us:

When the American Association for Justice looked over their agenda for the Obama administration, they not only saw the opportunities to overturn the Bush successes at tort reform, but also to deliver a direct financial benefit for their members. While the AAJ has historically focused their political muscle on enlarging the opportunities for plaintiffs in personal injury litigation to succeed, the leadership decided that the time was ripe to bring something home that would benefit all of its members, regardless of the size or type of case they handled: a tax break.

What they proposed was a seemingly simple amendment to the tax code to allow lawyers to deduct the expenses incurred in litigation in the year in which they were incurred. What could be so controversial about that? After all, the tax code allows most small businesses to deduct business expenses in the year where they are incurred, so why not apply that simple rule to lawyers? As AAJ Senior VP of Public Affairs Linda Lipsen stated:

The tax legislation will treat the trial attorney profession like every other small business in this country, allowing them to deduct their expenses in the year incurred. Currently, trial attorneys pay all case costs from their own pocket when representing Americans that cannot afford exorbitant hourly fees. These attorneys must wait to deduct their expenses until the case concludes. This legislation will allow the IRS to treat this profession as every other small business.

AAJ Press Release, August 8, 2009.

Like a lot of things that come from PR specialists in this age of spin, what is most significant from the AAJ's position is what is missing. But to understand the ramifications of the tax proposal, we first need to understand how litigation in America is financed. Unlike most of the Western world, the United States allows litigants and lawyers to enter into agreements for contingency fees, whereby the lawyer takes a percentage of the recovery as a fee, rather than being paid for the work being done, as it is being done. These contingency fees are intended to provide access to justice for those who cannot afford to pay a lawyer to represent them. Since the client is not capable of paying for the lawyers' time, the lawyer must also arrange for some way to cover the expenses of litigation. In today's high stakes world of class actions, mass torts, and highly technical litigation, the expenses associated with bringing a case to trial can be staggering. It is not uncommon for the costs of document handling, trial exhibits, court reporters and expert witnesses to run into the hundreds of thousands of dollars. Even the simple cases can result in huge expenses. In a single plaintiff case that I tried a few years back, the plaintiffs' lawyer ran up expenses approaching a million dollars.

How are these expenses handled in modern litigation? In most states, the lawyer is permitted to front these expenses and then deduct them from the settlement or verdict at the conclusion of the case. The savvy plaintiff's lawyer will take his percentage of the recovery (set out in the contract with the client) before the expenses are deducted. Thus, in a $100,000 settlement of a case with $10,000 in expenses and a 33% contingency fee, the plaintiff's lawyer will first deduct a fee of $33,000, followed by the expenses of $10,000. The plaintiff collects the remaining $57,000.

So getting back to the AAJ and their "trial lawyers are just like the barber shop down the street" analogy - it should be obvious by now that unlike Floyd the Barber, the expenses that the trial lawyer seeks to deduct are usually reimbursed out of settlement proceeds at the end of the case. When Floyd deducts expenses for scissors, razors and the like, he is not going to get reimbursed for them down the road. So it is a bit disingenuous to compare the local trial lawyer to a typical small businessman. In fact, the only time under the current system that the trial lawyer is going to be able to deduct the expenses associated with litigation is if the case is not successful and the client recovers nothing. Under current law, the IRS treats the expenses paid by the trial lawyer as loans subject to reimbursement. If the case is unsuccessful, the loans are treated like bad debts that can be deducted.

Under the AAJ proposal, trial lawyer could deduct the expenses as they are incurred, regardless of when the case is resolved. Presumably, when the case is resolved and the expenses are reimbursed, the lawyer would then be required to claim that as income, which would be taxed, but the principal advantage to the trial lawyer of the proposed change would be to spread the risk associated with the expense of the litigation over time. The effect of this advantage may not be obvious, as some may argue that the proposal is just delaying the payment of the tax for a short time and that the value in that delay is not significant. But if that is the case, why has the AAJ made this such an important part of their legislative agenda? The answer requires an understanding of the interplay of a trial lawyer's capital and the risk of litigation.

The modern American contingency fee lawyers are very entrepreneurial in their approach to litigation. They recognize that the money spent on a single case may reap benefits many years down the road. Especially in the areas of mass torts and class actions, the plaintiffs' bar may toil in courtrooms for years before finally turning the tide in favor of their clients. For instance, while plaintiffs' verdicts in tobacco cases are common these days, it was not too long ago that the tobacco industry could boast of never having lost a jury trial in a smoking and health case. But trial lawyers kept pushing the claims, hoping that societal opinions about tobacco companies would change as more documents became public about what the defendants knew about the risks of smoking. Eventually, the tide turned and those lawyers who had fronted the cost of pursuing the tobacco industry reaped huge profits for taking on that risk. Some of that money was plowed back into future litigation as capital to front expenses for new cases against other industries.

Today, these entrepreneurial lawyers will pool their capital resources in syndicate-like fashion to finance litigation. After identifying the target for their litigation, they will divide responsibility for the preparation of the cases, realizing that it may take time to successfully recover money from the defendants. For instance, this money is committed to the compilation of documentary evidence, preparation of expert witnesses and retention of public relations consultants to drive public opinion against the defendant. They are taking an inherently scarce commodity, capital, and committing it to a scenario that carries with it a certain amount of risk. As with any investment, they evaluate that risk to determine whether they want to commit that capital. Part of the risk for that capital is that it may be years before that capital is recovered. But if the AAJ legislation is passed, those expenditures would be deducted in the year incurred, which would allow the syndicate to recoup some of that capital each year. The benefit is two-fold. Not only could that money then be used to finance other risky litigation, but the tax break would reduce the risk to the lawyer on the underlying case. Thus, the tax change would relieve the lawyer of some of the risk of commitment of that capital, freeing the lawyer to invest in more litigation, as part of the risk is now being borne by the government. This makes the government a partner with the lawyer in the litigation, a prospect that most taxpayers are likely to oppose.

This tax break would also be of value to the small case practitioner. Most AAJ members are solo practitioners or practice in small firms. Handling litigation can be very lucrative, but capital must be kept on hand to finance the litigation that might not get to trial or to resolution for several years. Any assistance in providing relief from having to commit capital for such a long time for the multitude of cases in the lawyer's office would be a welcome change.

The Joint Tax Committee of the 110th Congress values the AAJ proposal at $1.57 billion over ten years. For that reason, many members of Congress have questioned the value of this tax break. When it appeared that the legislation was not likely to be passed in this Congress, AAJ decided to take a different approach. John Bowman, the Director of Federal Regulations for AAJ stated that a regulatory change from the Treasury Department could be forthcoming that would allow plaintiffs' lawyers to deduct expenses in the year in which they were incurred. It is assumed that this regulatory change would be issued as a revenue ruling, which is a statement from the IRS as to how certain facts are to be interpreted in light of the tax code. Revenue rulings do not require Congressional approval, but are intended to reflect the IRS interpretation of existing law. It should be noted, however, that the United States Court of Appeals for the Ninth Circuit in San Francisco has interpreted existing laws to allow the deduction of litigation expenses in the year when they are incurred. Boccardo v. Commissioner, 56 F.3d 1016 (9th Cir. 1995). None of the other ten circuit courts of appeals have followed this decision. The AAJ proposal would make the Boccardorule the law of the land.

It is no surprise that the AAJ has made this proposal a priority. Current AAJ Vice President Mary Alice McLarty has openly acknowledged that the organization has seen a serious drop in membership. As a past-President of DRI, the organization representing the other side of litigation, I can attest to the need to provide tangible benefits to the membership. And while DRI has not suffered from the same membership losses as AAJ, it is evident that righting their ship requires a plan that would provide benefits to as many members as possible. But for those of us who believe that the expansion of litigation is not necessarily a good thing, we do not believe that the government should be involved in fixing the trial lawyers' problems with their membership. Letting the risk associated with litigation stay with the lawyer who is bringing the case seems to have worked to their benefit so far; no change seems necessary to this observer.

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Rafael Mangual
Project Manager,
Legal Policy

Manhattan Institute


Published by the Manhattan Institute

The Manhattan Insitute's Center for Legal Policy.