Common questions disabled claimants have at this time of year are, “Can I deduct my attorney fees and expenses I incurred to get my disability benefits back after the insurance company denied them?” and “Has this changed under the new Trump Tax Plan that has restricted itemized deductions?” Below I will explore this question and hopefully provide some guidance.
As background, we first need to look at the scenario that leads to the questions at hand. Many disabled workers end up filing for long-term disability insurance benefits because of either injury or illness. Most workers obtain these disability insurance policies via an employee benefits plan, sponsored by their employer. The most common insurance carriers that sell these disability insurance policies are Unum, Cigna, Hartford, Aetna, Prudential, MetLife or Liberty Mutual. Unfortunately, many of these disability insurance claims are denied at the outset or benefits may be paid for a period of time, but then cut off at some point in the future.
Most disability insurance claims are governed under a federal law known as the Employee Retirement Income Securities Act (ERISA). ERISA is a complicated law with many traps for the unwary. As a result, most denied claimants will seek the help of an attorney to appeal the denied insurance benefits. In many cases, with the help of an experienced ERISA attorney, the monthly benefits can be reinstated. In other cases, when a lawsuit must be filed, a lump sum settlement or buyout is negotiated.
In either case the claimant will incur attorney fees and expenses. Expenses are defined as costs incurred in pursuing the claim that are not attorney fees. Examples include the cost of obtaining medical records and testing, obtaining expert reports, court filing fees and other costs associated with pursuing the claim.
Are Your Disability Benefits Taxable?
The first question the disabled claimant must address is whether their disability income benefits are taxable. This can be a complicated question depending on what type of benefits you receive, if the initial insurance premiums where paid for with pre-tax or after-tax dollars and who paid the premiums- you or your employer.
If the claimant paid for the disability income insurance premiums personally, then the benefits would naturally be paid for with after-tax dollars (the premiums would not be deductible) and therefore the benefits would not be taxable.
However, most claimants obtain their disability insurance via an employer-sponsored group disability plan. If you are enrolled in a group disability insurance plan sponsored by your employer, the taxability of your benefits depends on who pays the premium.
If you pay the total premium using after-tax income, then your benefits will be tax free. On the other hand, if your employer pays the total premium and does not include the cost of coverage in your gross income, then your benefits will be taxable.
If your employer pays part of the insurance premium and you pay the rest, then your tax liability will be split as well. The part of the benefit you receive that is related to the employer-paid share of the premium is taxable; any part of the benefit related to your share of the premium is tax free.
If you pay part of the premium for employer-sponsored disability coverage, the type of dollars you use to pay the premium determines whether your benefit will be taxable. If you pay your part of the premium with pre-tax dollars, through a cafeteria or medical reimbursement plan, you’ll owe income tax on any disability benefit you receive that is related to that part of the premium.
On the other hand, if you pay your part of the premium with after-tax dollars, you won’t owe income tax on any disability benefit you receive that is related to that part of the premium.
If your benefits are determined to be taxable, then the question is can you deduct your attorney fees. Obviously, if your benefits are not taxable (yea!) then there is no deduction for the attorney fees incurred in getting them.
Are Attorney Fees and Expenses still Deductible?
As a rule of thumb, attorney fees and the expense of litigation are no longer deductible for federal income tax purposes. The Tax Cuts and Jobs Act of 2017 (the “2017 Trump Tax Cut”) eliminates miscellaneous itemized deductions as part of individual tax reform (this change will sunset on December 31, 2025). Prior to the 2017 Act, an individual taxpayer who took itemized deductions instead of a standard deduction could deduct legal fees that were greater than 2% of his or her adjusted gross income as a miscellaneous expense. After the 2017 Act, clients can no longer deduct legal fees as a miscellaneous expense even if they choose to itemize their deductions. However, the legal fees and expenses incurred related to disability income payments may still be deducted by the clients or if court awarded, not included in income at all!
Clients can still deduct attorney fees based on claims that qualify for “above the line” deductions
“Above the line” deductions are set forth in the Internal Revenue Code (“IRC”) Section 62 and are deducted against the taxpayer’s gross income to reach a lower Adjusted Gross Income (“AGI”). “Below the line” deductions are set forth in IRC Section 63 and are deducted against AGI to reach a lower taxable income. The “line” is set by the Adjusted Gross Income.
The standard deduction or itemized deductions are “below the line” deductions. Because legal fees based on claims that qualify for above the line deductions are deducted before taxpayers apply itemized deductions, the repeal of the miscellaneous itemized deduction has no impact on their deductibility.
Disability Income Benefit Claims Qualify for Above the Line Deductions!
IRC Section 62(a)(20) and (21) allow a taxpayer to deduct costs and attorney fees involving discrimination suits including those relating to disability income benefit awards. Specifically, under IRC Section 62(e)(18), unlawful discrimination is defined to include: “any provision of Federal, State, or local law, or common law claims permitted under Federal, State, or local law… regulating any aspect of the employment relationship, including claims for wages, compensation, or benefits…”
One caveat, a plaintiff’s above the line deductions for fees in employment and qualifying whistleblower cases cannot exceed the income the plaintiff receives from the litigation in the same tax year. This would rarely be the case. Appended to the end of this article is the relevant text of the code section that controls.
Warning: Most Seasonal Tax Preparation Services Don’t Understand this Deduction!
It has been my experience that tax preparation workers, such as those at H&R Block, Jackson Hewitt, Walmart, etc. do not understand how to apply this above the line deduction.
Every tax season I get phone calls from clients that have their hair on fire because they got some bad advice from these people. Please remember, they are “seasonal tax preparers”, not Certified Public Accountants or tax lawyers. I certainly don’t mean to disparage them, but in the off-season they are working other jobs. They simply are not prepared to address complicated tax issues such as the application of IRC Section 62(a)(20) and (21).
Please feel free to contact us for a referral to a qualified CPA that can handle filing your tax return appropriately if this becomes a problem for you.
26 U.S. Code § 62 – Adjusted gross income defined
(a)General rule For purposes of this subtitle, the term “adjusted gross income” means, in the case of an individual, gross income minus the following deductions:
(20)Costs involving discrimination suits, etc.
Any deduction allowable under this chapter for attorney fees and court costs paid by, or on behalf of, the taxpayer in connection with any action involving a claim of unlawful discrimination(as defined in subsection (e)) or a claim of a violation of subchapter III of chapter 37 of title 31,United States Code  or a claim made under section 1862(b)(3)(A) of the Social Security Act (42 U.S.C. 1395y(b)(3)(A)). The preceding sentence shall not apply to any deduction in excess of the amount includible in the taxpayer’s gross income for the taxable year on account of a judgment or settlement (whether by suit or agreement and whether as lump sum or periodic payments) resulting from such claim.
(e)Unlawful discrimination defined
For purposes of subsection (a)(20), the term “unlawful discrimination” means an act that is unlawful under any of the following:
(i) providing for the enforcement of civil rights, or
(ii) regulating any aspect of the employment relationship, including claims for wages, compensation, or benefits, or prohibiting the discharge of an employee, the discrimination against an employee, or any other form of retaliation or reprisal against an employee for asserting rights or taking other actions permitted by law.