Defamation Plaintiffs Regularly Caught By Double Taxation

Defamation verdicts and settlements regularly make the news. But we rarely learn what plaintiffs keep from their victories. After fees and taxes, it can be shockingly little.

This may be true of what Alex Jones eventually pays the Sandy Hook families. And of defamation winnings E. Jean Carroll receives from former President Donald Trump. Surprisingly, it’s also true for individuals who successfully sue for damage to their professional reputation.

Plaintiffs often pay 15%-40% of winnings to their trial lawyer. Especially in a sizeable case, keeping 60% is still a big win. But plaintiffs often pay tax on all 100%. They pay tax on their lawyer’s portion, and their lawyer pays tax on it again. Many call this a “double tax.” After fees and taxes, some plaintiffs keep less than 20% of what the defendant paid.

When Taxes Exceed Lawsuit Winnings

Legislation passed in 2017 prevents many plaintiffs from deducting legal fees and costs. The Tax Cuts and Jobs Act of 2017 disallowed “miscellaneous itemized deductions” through 2025. The change might best be known for eliminating the deduction of most investment advisor fees. It also eliminated the deduction that most plaintiffs need to avoid being taxed on the fee portion of their winnings.

Even before 2017, limitations on deductions regularly required plaintiffs to pay a double tax. In 2002, the New York Times reported that a police officer who sued for discrimination owed $100,000 after spending all of her $1.25 million award to pay fees and taxes. Congress has lessened the “double tax” in piece meal fashion. For example, legal fees are now deductible in cases of “unlawful discrimination.”

Double Tax in Defamation Recoveries

But defamation lawsuits rarely involve “unlawful discrimination.” And without another basis to deduct fees, defamation plaintiffs are typically stuck paying the double tax.

Before the 2017 legislation took effect, defamation plaintiffs could generally deduct their fees under Section 212 of the Internal Revenue Code. That Section allows deductions of “ordinary and necessary expenses…for the production or collection of income.” However, Section 212 is one of the many “miscellaneous itemized deductions” eliminated by legislation through 2025.

Thus, most defamation plaintiffs are caught by the double tax unless their legal fees can be deducted as a business expense under Section 162. Unfortunately, as discussed below, that doesn’t help much.

Why Plaintiffs Lose When Deducting Defamation Fees

Legal fees in defamation actions are generally not deductible as a business expense.

Section 162 permits deductions for “ordinary and necessary expenses paid…in carrying on any trade or business.” But as the IRS Lawsuit Audit Guide states, “Except in rare cases…legal fees will be a Schedule A miscellaneous itemized deduction.” That is, they won’t be deductible as a business expense. The well-regarded American Law Reports writes, “[C]ourts have generally denied a deduction for the costs of prosecuting an action for libel or slander, even though the statements could be detrimental to the taxpayer’s business.”

Intuitively, this seems wrong. The greatest damage caused by defamation is often measured in lost income or business. This isn’t true for the plaintiffs suing Alex Jones, and probably not for E. Jean Carroll in her suit against Trump. But it’s often true of cases brought by doctors, lawyers, and other professionals. Can’t they treat their legal fees as business expenses?

The U.S. Tax Court considered this theory in the case of a defamed doctor, holding that his contingent legal fee wasn’t deductible. In the 1980s, Dr. Sudhir Srivastava, a heart surgeon, was maligned by a television station falsely reporting that he performed unnecessary surgery. The report “destroyed” his reputation and medical practice. He also lost hospital privileges and malpractice insurance. Soon after, he sued the television station and won $30 million at trial. Ultimately, he settled for $8.5 million, paying some $3.5 million in legal fees.

When he reported no taxes owed on the fee portion of his recovery the IRS audited and challenged. The doctor argued that his fees could be deducted as a business expense to the extent that they produced taxable income. The Tax Court disagreed: “Whether the defamatory attack is on the personal reputation or the professional reputation of the individual, the defamation is personal in nature.”

Decades earlier, the Seventh Circuit Court of Appeals wrote similarly: “In practically every case where slanderous reports are circulated about an individual and damage his character or reputation, such reports affect indirectly, and, to a certain extent, the business in which he is engaged. Any expense, however, incurred by him in defending his good name under such circumstances, cannot be said to be ordinary and necessary expenses incurred in carrying on his business.”

Similarly, in other contexts, the Tax Court has also treated defamation actions as inherently personal. Prior to 1996, recoveries for non-physical injuries were received tax-free if they compensated for “personal” injuries. Both the Ninth and Sixth Circuit Courts of Appeals have found defamation to be a personal injury.

Thus, in general, a defamation plaintiff can’t deduct their legal fees. There are some authorities that plaintiffs might conceivably rely on to justify a business deduction. For example, on occasion, where taxpayers sued “solely” to protect a business, or were sued and defended against reputation-damaging claims, they were allowed business deductions. But, plaintiffs taking such a position are likely taking on considerable tax risk.

Conclusion

The “double tax” often surprises plaintiffs and their lawyers. But it can be particularly surprising in defamation cases. Dr. Srivasta’s case is a great example. He sued after his business was “destroyed” by false reports about his professional work. And yet, because defamation of his reputation was a “personal injury,” the fee portion of his recovery was taxable to both him and his lawyers.