The DC Circuit Court's <i>Murphy</i> Ruling

For early background coverage of this topic, see the November 2003 and November 2004 editions of A&FP.

The first step in rectifying the rule-interaction problem was taken by Congress. As summarized by Ron Seigneur in A&FP's December 2004 edition:

A little publicized provision of the 2004 American Jobs Creation Act (AJCA) greatly assists law firm clients who seek damages for 'nonphysical' injuries ' notably in wrongful termination and other employment cases, breach of contract cases and civil rights discrimination cases. The AJCA overrides prior IRS rules that required the contingent fee component of nonphysical damage awards to be included in plaintiffs' taxable income, notwithstanding the fact that such contingent fee payments ordinarily go directly to the attorneys, who then pay income taxes on them. U.S. appellate courts had been divided on suits seeking to block that IRS rule, which caused great hardship to some plaintiffs through its congressionally unintended interaction with other rules. (Actual damage awards to plaintiffs in these cases are often small or even nominal, with attorney fees being substantial ' and the cases therefore being feasible ' only thanks to federal fee-shifting statutes. While the IRS technically allowed plaintiffs a Schedule A miscellaneous deduction to cancel out their contingent fee 'income,' the size of the contingent fee often threw the plaintiff into AMT territory for the year, rendering the miscellaneous deduction inapplicable.) As a result, some plaintiffs prior to the AJCA could not proceed with their cases because their income taxes on the contingent fee would far exceed the value of their actual award… .

By making contingent fees in these cases nontaxable to the client, the AJCA considerably alleviated the tax burden on plaintiffs. What continued to irk nonphysical PI plaintiffs with larger damage claims, however, was that the IRS still treated the compensatory damages themselves as taxable income.