Scott E. Vincent
Vincent, Fontg & Chartier LLC
Kansas City

The Ninth Circuit recently upheld a Tax Court decision denying deductibility of legal fees incurred by a taxpayer in a wrongful termination lawsuit against his former employer. Unfortunately, the taxpayer was not successful in a unique attempt to avoid a tax problem often encountered by successful plaintiffs: their entire damage awards end up subject to taxation, even though significant portions are paid for non-deductible attorney fees and litigation expenses.

In Biehl v. Commissioner, a Ninth Circuit opinion issued December 30, 2003, Biehl brought suit against his former employer alleging wrongful termination. The claim was settled for $1.2 million, and per Biehl's request, a separate check was issued directly to his attorney for fees in the amount of $401,000. Biehl reported the remaining $799,000 as income on his 1996 tax return.

The IRS determined that Biehl was required to include the $401,000 in adjusted gross income and that this same amount qualified as a miscellaneous itemized deduction. This characterization of the deduction effectively made it useless to Biehl, because miscellaneous itemized deductions do not reduce income in calculating alternative minimum tax ("AMT"). Thus, the IRS held that Biehl was required to report, as taxable income, the amounts paid to his attorney and, because of the application of AMT, that Biehl was not allowed an offsetting deduction for this amount. The Tax Court and the Ninth Circuit ultimately agreed with the IRS.

Biehl did make a unique argument for deductibility of the attorney fees. As noted, Biehl had his former employer pay the fees directly to the attorney. Biehl then treated the $401,000 as reimbursed employee business expenses and did not report this amount on his tax return. This character, if upheld, would have allowed Biehl to eliminate the attorney fee from income and avoid the AMT trap for these expenses. The IRS, and both courts, determined that only a current employee could treat expenses as "reimbursed expenses of employees" under the statute. The Ninth Circuit carefully considered this issue but was not able to avoid the conclusion that legal fees associated with a wrongful termination lawsuit against a former employer are not "in connection with the performance … of services as an employee," as required by the statute and regulations.

The Ninth Circuit notes that "what this case boils down to is an effort by the Biehls to circumvent the restrictive, and often criticized, provisions of the AMT by claiming an 'above-the-line' deduction…" and closes the opinion with the comment that "if this result strikes some as bad policy, or unfair, the remedy is with Congress, not the courts." The court is obviously expressing the same frustration that taxpayers and practitioners have been experiencing for some time. Hopefully, Congress will provide AMT relief, or more specifically address the inherent unfairness surrounding taxable but non-deductible attorney fees.