Litigation Expenses and the Alternative Minimum Tax

Abstract

As the Article was going to press, a modified version of the Senate bill described in Part III cleared the Congressional conference committee and became effective when President Bush signed it into law on October 22, 2004 as part of the American Jobs Creation Act of 2004. This legislative development and its impact on the issues discussed in the Article are briefly addressed in an Addendum.

One of the chief features of the alternative minimum tax (the "AMT") is a broadened tax base, accomplished in part through the disallowance of deductions that are not central to measuring an individual's net income. Yet in achieving its objective of limiting deductions, the AMT casts a wide net. Thus, in certain instances, an individual can be robbed of the tax benefit of expenses that were critical to the production of the income being taxed. An extreme example of this problem is the treatment of certain litigation expenses under the AMT. If an individual incurs attorney fees and other associated costs in connection with litigation that produces a taxable recovery and the litigation does not relate to the individuals's trade or business (excluding the trade or business of performing services as an employee), then deduction for litigation expenses is disallowed. This "AMT trap" results in the individual being taxed on the gross proceeds of the litigation for AMT purposes.
The most common lawsuits in which the AMT trap arises are employment-related lawsuits, such as those involving discrimination, harassment, whistleblower, and breach of employment contract claims. However, the AMT trap also affects other common claims, such as civil rights, intentional infliction of emotional distress, and defamation claims, provided that these claims do not involve personal physical injury.' The AMT trap is disconcerting for a number of reasons. First, it so obviously violates the fundamental income tax policy principle that expenses incurred to produce taxable income should not be included in the tax base. Second, the adverse consequences of the trap are typically quite severe. Third, though a legislative amendment would be relatively inexpensive, such an amendment has not yet been enacted because the victims of the trap lack sufficient political muscle and coordination. Fourth, the trap has consumed a tremendous amount of judicial resources. While most of these resources have been devoted to litigating the underlying tax issue, courts have been called upon to address a host of non-tax issues that arise on account of the AMT trap.
This Article discusses the AMT trap, beginning in Part I with a description of the mechanics of the trap. This Part also examines the current Circuit Court split regarding the tax issue that underlies the AMT trap and previews the upcoming United States Supreme Court decision that will resolve the Circuit Court split. Part II of the Article then considers the implications of the trap on plaintiffs, their lawyers, defendants, and the courts. Finally, Part III describes and critically analyzes two bills that have been proposed, but have not yet been enacted, that were designed to solve the AMT trap.