clock menu more-arrow no yes

Filed under:

Winners of consumer lawsuits ended up with an unwelcome tax-time surprise

A quirk in the tax code means some people who win court cases are being told they owe taxes on the fees awarded to their attorneys — even though the lawyers are taxed, too.

Consumer protection attorney Larry P. Smith hears complaints this time of year from clients who are shocked to learn that legal fees he was awarded for handling their cases are taxable income — for them.
Consumer protection attorney Larry P. Smith hears complaints this time of year from clients who are shocked to learn that legal fees he was awarded for handling their cases are taxable income — for them.
Anthony Vazquez / Sun-Times

Just before tax time every year, Chicago attorney Larry P. Smith says he gets about a dozen calls from clients who’ve been hit with an unwelcome surprise in the mail:

An IRS Form 1099 that lists legal fees that Smith was awarded for winning consumer-protection cases on their behalf as taxable income — for them.

The amount can be a shock — especially in bigger cases — because lawyer fees can be far more than what the consumer got.

“Now, my client’s worried — how am I going to come up with $20,000” to pay the taxes, says Smith, who specializes in consumer cases including credit reporting, debt collection and privacy issues.

Thanks to a quirk in the tax code made worse by Trump-era changes that did away with certain deductions, the problem is getting worse, consumer advocates say.

Debt collection, lemon law and other consumer-protection cases can be time-consuming, with judgments or settlements including big-dollar legal fees. As a result, the taxes on income listed on the Form 1099 can equal or exceed the judgment or settlement the consumer got.

And while many consumers are able to convince the IRS that it was not their earnings — and that their attorney will pay income tax on it anyway — the confusion creates a hassle that can stall tax refunds and affect whether people qualify for the Earned Income Tax Credit, housing benefits or educational scholarships based on financial need.

“It’s a serious problem for consumers who are dealing with unfair businesses,” says Steven Uhrich, another Chicago attorney who specializes in credit and debt cases. “They shouldn’t have to pay taxes on the attorney fees that go directly to the attorney.”

One client Uhrich recently represented in a successful financial fraud case just got a Form 1099 that included his fees. Uhrich says he’s helping the person gather documents to try to fight the added tax burden, but “we can’t give them any certainty about how it’s going to be treated.”

Chicago attorney Steven Uhrich.
Chicago attorney Steven Uhrich.
Provided

Tracy Van Buren is among those who won a consumer-protection lawsuit and then found to her surprise she was liable for taxes on the fees awarded to her lawyer.

“When I got the 1099, I lost it,” says Van Buren, who won a lengthy lemon-law case against a car manufacturer in 2019.

The single mother and Army veteran from California’s Bay Area already had filed last year for what she expected would be an income-tax refund and claimed the Earned Income Tax Credit. Then came the unexpected 1099 — showing additional income of $58,257, most of which was attorney’s fees and court costs. That pushed her into a higher tax bracket.

She filed an amended return and got a tax advocate to help plead her case to the IRS. She eventually straightened things out and got her refund. But it took about six months in the middle of the pandemic.

“It was stressful, and I was already experiencing a lot of stress,” she says.

Though experts say the issue worsened after the Trump-era tax changes limited taxpayers’ ability to deduct legal expenses, it’s been a problem for years.

In Portland, Oregon, Tana Spencer won a settlement in 2016 for a wrongful-debt collection that didn’t get her any money — only a promise that the collection agency would leave her alone.

So the divorced mom was stunned the following January when she got a Form 1099 listing $23,863 in attorneys’ fees and court costs as her income.

“I get a 1099 for this outrageous amount,” she says. “My car’s not even worth that.”

At first, she filed her tax return without including the amount from the surprise 1099. But she says the IRS sent her a letter back that she owed about $9,000. She fought it, and the agency ultimately decided in her favor.

Christine Hines, legislative director for the National Association of Consumer Advocates, says some people, unaware they can appeal to the IRS, just suck it up and pay the tax on the legal fees — meaning the lawyers’ earnings get taxed twice.

“The money goes to the attorney for doing that work … and yet it’s treated as money to the consumers,” Hines says.

A spokesman for the IRS declined to comment.

U.S. Sen. Catherine Cortez Masto, D-Nevada, introduced a bill this month in Congress — dubbed the End Double Taxation of Successful Consumer Claims Act — that would spell out that consumers have zero tax liability for attorney’s fees and court costs in credit-reporting, fair lending, debt-collection, deceptive trade practices and other consumer-protection cases.

Congress made a similar fix to the tax code in 2004 in civil rights and employment discrimination cases.