Designing the Tax Treatment of Litigation-Related Costs

Abstract

Defendants often deduct for income tax purposes their litigation-related costs, such as attorney fees and payments to settle claims or satisfy judgments. The result is often a large gap between the sticker price of settlements or judgments and their after-tax cost—what defendants really pay out of pocket. The problem: For every dollar that a defendant avoids in tax liability by, for example, deducting the damage awards it pays, the civil justice system falls that much short of its corrective-justice or optimal-deterrence goals in that case. For this reason, the entire civil justice system should care about this question: How should income tax law treat litigation-related costs? This Article identifies the critical tax-design choices that must be faced but that prior commentary has largely ignored: How to attribute litigation-related costs to an income-producing activity; whether to treat liability insurer payments made on a defendant’s behalf as income to that defendant; whether to coordinate the tax treatment of a payor’s damages payments with the tax treatment of those receipts to the payee; and whether litigation-related costs should be treated as capital expenditures. Then, the Article offers a new default rule for settlement agreements: Unless a settlement agreement expressly indicates otherwise, a settling defendant promises not to seek an allowable tax deduction for litigation-related costs. In so doing, this Article reveals the issues that lawyers, judges, and scholars must no longer ignore when they argue over how an income tax system could or should treat litigation-related costs.