Making Plaintiffs Whole: A Tax Problem of Interest

Abstract

This article illustrates the dramatic tax impact of interest awards in otherwise non-taxable litigation recoveries and proposes two alternative legislative solutions for the over-taxing of plaintiffs in these cases. While plaintiffs who recover personal injury awards typically receive favorable tax treatment, those who receive interest on such awards are taxed on the interest and often are not able to utilize deductions for attorney’s fees and other costs paid to obtain the award. Further, the attorney’s portion of the recovery in a contingency fee arrangement will also be included in the plaintiff’s gross income. The result is that the plaintiff recovers less of the interest than the Treasury or her attorney, preventing the plaintiff from truly being made whole. After reviewing the historical and theoretical framework that produces these results, I suggest previously-proposed judicial solutions to the problem are impracticable and a legislative solution is necessary. I conclude with a proposal for two alternative legislative solutions - an expanded deduction and an exclusion - to provide relief for plaintiffs recovering partially taxable awards and to achieve the policy of fully compensating injured plaintiffs.