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Principal-Agent relationship blurred?

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tombyrne

Member
What is the name of your state? California
Apologies for length, I wish this weren’t so complicated. In 2018 I won a legal settlement which arose from my eviction from my home and studio, where I meet criteria for using as a home office tax deduction. Not a passive claim, it’s where I do all administrative, store equipment and edit. Rent being what it is in San Francisco, I ended up moving over 30 miles away from the greater majority of my client base. The complicated portion of my question is that my business is creating legal presentations for trial and mediation. Mostly for tenants rights lawyers. I was represented by one of my clients and his firm. AND at the same time I was working for them, helping us to win the larger award we did, BUT not being paid for my services. My work for this case greatly exceeded what I normally do for this client, and included the hiring and supervision of 3rd party service providers, and whose findings were key to winning the decision. Setting aside issues of principal / agent this relationship might involve, can I deduct a 20% pass-through on the initial check issued to me? I received about 2/3 up front and 1/3 structured over the next 5 years (the structured portion I’ve filled tax paperwork for, and will be taxed accordingly the years they’re incurred). Sorry about the longer explanation, I shouldn’t be doing this, but I feel my accountant may be too intimidated by the new tax laws to dig deep into this. Thanks for any reply!
 


Taxing Matters

Overtaxed Member
The award was related to your eviction from your personal residence (a home you rented or apartment from the sound of it). It is therefore not business income for you. Doing the work you did for your lawyer on behalf of your own case does not convert what is personal income into business income.
 

tombyrne

Member
Sound. And since I'm not a tax pro, would your opinion change at all if: 1) this were an informal profit-sharing activity? 2) The entire settlement check paid to law firm, who then 3) issued company check to me for my initial withdrawal, and, 4) I'm not getting any kind of 1099 or tax documentation? Perhaps this passage (Supreme Court and Attorneys Fees, 439) plays?: "Much of the time, the decision how to treat such informal profit- sharing activities will not matter, because even if one party is required to report all the proceeds of the joint production activity as income, the party will be entitled to fully offsetting deductions for payments that compensate other parties for their contributions." If that "one party" is the law firm, are my profits from the sharing activity not open to deductions of any kind?
 

LdiJ

Senior Member
Sound. And since I'm not a tax pro, would your opinion change at all if: 1) this were an informal profit-sharing activity? 2) The entire settlement check paid to law firm, who then 3) issued company check to me for my initial withdrawal, and, 4) I'm not getting any kind of 1099 or tax documentation? Perhaps this passage (Supreme Court and Attorneys Fees, 439) plays?: "Much of the time, the decision how to treat such informal profit- sharing activities will not matter, because even if one party is required to report all the proceeds of the joint production activity as income, the party will be entitled to fully offsetting deductions for payments that compensate other parties for their contributions." If that "one party" is the law firm, are my profits from the sharing activity not open to deductions of any kind?
There is nothing you can say that is going to change the answer you got from Taxing Matters.
 

Taxing Matters

Overtaxed Member
And since I'm not a tax pro, would your opinion change at all if: 1) this were an informal profit-sharing activity?
No, trying to cast this as a "profit sharing activity" does not change my mind. It does not fit the facts you have.

What was going on here is that the attorney was representing you in your claim against the landlord. That is a personal claim you had against the landlord and had nothing to do with the business. The fact that the check was made out to the law firm and then disbursed to you after any law firm expenses were paid does not change that. That wasn't money due the law firm. It was money due to you. The lawyer handled the money as your agent. And again, it was money for a personal claim, not a claim in connection with your business. It was not business income. And no amount of fiddling with the business relationship you had with the law firm is going to change that.

Nothing you have said indicates an "informal profit sharing activity". This was not you and the law firm joining together in some business enterprise. This was litigation on your claim against the landlord.

Law firms are limited in how they can share in the litigation they do for clients. If the law firm had wanted to share in whatever award was collected in your case, the lawyer would have entered into a contingent fee agreement with you (assuming you were willing, of course). In a contingent fee agreement, the lawyer takes his/her fee a share of what the attorney collects for the client in the lawsuit, e.g. 33%, 40% or whatever. If the attorney wins nothing for you, the attorney gets no fee. So in this arragement the attorney shares the risk of a bad outcome. You might think of that as, in some sense, profit sharing. But under California law such agreements MUST be in writing at the start of the representation. You can't have an "informal" contingent fee agreement. Note that even under a contingent fee agreement, the U.S. Supreme Court has held that the entire award is income to the client. So the idea of an informal profit sharing activity isn't one that gets you anywhere.

Prior to the Trump backed tax reforms enacted in December 2017, you could have at least taken an itemized deduction for the legal fees you paid the law firm and related expenses of litigation, like the filing fees, etc. (You could not have deducted the value of your own work however.) But that Act eliminated the itemized deductions for 2018 through 2025, so if this award was won in 2018 or 2019 you get stuck paying tax on the entire award. It's not an answer I like to give. I'll have clients adversely affected by that change. But that is the fault of Congress. I don't think they really fully considered the impact of all the changes they made when the Republicans rushed it through.
 

tombyrne

Member
Law firms are limited in how they can share in the litigation they do for clients. If the law firm had wanted to share in whatever award was collected in your case, the lawyer would have entered into a contingent fee agreement with you.

tombyrne: this WAS a contingency fee agreement. Signed in advance. Thanks for your replies. I'll grant that I have some sour grapes about paying taxes on money I've never seen, the seemingly double-taxation that exists now (?) within these settlements, AND the fact I could not cajole the firm to pay me at 1/2 my rate. Mostly, I was frustrated in my attempts to alert the firm's owner and partners of the changes in the air with these reforms, and what it will mean to their future clients. Yet even my attempts to include some kind of tax language into the settlement or include a stipulation to attempt describing the tax implications, just told: "I don't need to know it, I don't want to know it. It is not something that matters to me." Thus endeth the gripe. I suppose they'll find out sooner or later. Thanks again!
 

Taxing Matters

Overtaxed Member
Law firms are limited in how they can share in the litigation they do for clients. If the law firm had wanted to share in whatever award was collected in your case, the lawyer would have entered into a contingent fee agreement with you.

tombyrne: this WAS a contingency fee agreement. Signed in advance.


Well, that might have been good to know when you laid out your theory on the profit sharing. :D Because that clearly spells out that the arrangement is a splitting of the award in YOUR case (not a joint venture). The result of that for tax purposes is, as I noted, that the entire fee is included in your income per the Supreme Court and because the nature of the claim was a personal one, it is not business income for you.

I'll grant that I have some sour grapes about paying taxes on money I've never seen,


Yes, I totally understand that having to pay tax on this without at least being able to deduct the legal fees and expenses really sucks. It does give a feel as though you are taxed on money you haven't seen. Blame Congress for that one. I'm not sure that result was truly intended, but this is the sort of stuff that happens when Congress rushes through large complex bills that representatives and senators have barely even read, let alone really studied.

And, of course, that will hit you with California tax, too.

the seemingly double-taxation that exists now (?) within these settlements, AND the fact I could not cajole the firm to pay me at 1/2 my rate.
Well, it doesn't amount to double taxation, but that's a whole different discussion. And, btw, getting the law firm to pay you for the work you did would not have helped you save tax here.

Mostly, I was frustrated in my attempts to alert the firm's owner and partners of the changes in the air with these reforms, and what it will mean to their future clients. Yet even my attempts to include some kind of tax language into the settlement or include a stipulation to attempt describing the tax implications, just told: "I don't need to know it, I don't want to know it. It is not something that matters to me."
I give you credit then for thinking of the taxes when you went into it. Even though in this case I don't see a good way to get a different result, its always a good idea to think about the tax effects of litigation and other things you do before you start them in case there is indeed a way to do it that would save tax. Clients should be looking into the tax effects of their cases. And lawyers who do not practice tax ought to at least have an idea of how tax law applies to the kind of practice they have or, better yet, consult their tax law colleagues to be sure of what the tax impact will be. I try to get my non tax colleagues to be more interested in that, but it's not been easy.
 

tombyrne

Member
sorry about the "contingency fee" omission. I can tread water, but not really swim well underwater. My tax status as sole proprietor / self-employed / pass-through (20% off the first 157K?) won't allow me to include the legal fees as a deduction? Have these new tax reforms obviated Code of Civil Procedure 1032(b)? And, in a final swan song of an attempt to re-characterize: A contingency fee arrangement (i.e. NOT a partnership), is based on the principal-agent character of the lawyer-client relationship, yes? Has that relationship not been upset by my acting as an agent of the law firm (with the ability to hire and fire 3rd party support) and doing so without being paid? They have received the entire benefit of my services and I'm left with no recourse for deduction of any kind? Was it not reasonable to expect that they make some effort to address the tax concerns within the settlement agreement after my asking them to do so?
 

Taxing Matters

Overtaxed Member
sorry about the "contingency fee" omission. I can tread water, but not really swim well underwater. My tax status as sole proprietor / self-employed / pass-through (20% off the first 157K?) won't allow me to include the legal fees as a deduction?
No. Those legal fees were paid for a personal claim against your landlord. They are not expense of running your business. The income is personal income, not business income. And the expenses to produce that income are personal expenses, not business expenses. As a result you cannot deduct them as a business expense.

Have these new tax reforms obviated Code of Civil Procedure 1032(b)?
That section of California law allows a prevailing party to recover certain defined costs (which do not include attorneys fees) from the losing party. It has nothing to do with tax law and even if it did, it would only apply to state tax law. Federal law trumps state law, and so for federal tax law matters you need to look at federal law, not state law.

And, in a final swan song of an attempt to re-characterize: A contingency fee arrangement (i.e. NOT a partnership), is based on the principal-agent character of the lawyer-client relationship, yes?
Yes.

Has that relationship not been upset by my acting as an agent of the law firm (with the ability to hire and fire 3rd party support) and doing so without being paid?
No.

They have received the entire benefit of my services and I'm left with no recourse for deduction of any kind?
You could have had them pay you for those services, which would then have been income to you, but it would not have reduced your income from the lawsuit.

Was it not reasonable to expect that they make some effort to address the tax concerns within the settlement agreement after my asking them to do so?
As I said before, in this particular situation, there really wasn't anything to be done that would have saved you tax on this. The income is personal income because that is the nature of the claim involved against the landlord. You can't change that. You have to deal with the facts as they are, not as you might like them to be.
 

davew9128

Junior Member
Let me just add one tidbit here. Even though federal tax law no longer allows miscellaneous itemized deductions for the legal fees, California still does.
 

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