A significant tax bill may await RICO plaintiffs involving cannabis lawsuits because in most cases the plaintiffs will be taxable not only on amounts recovered but also on the amounts spent on lawyers and court costs.
We recently discussed the latest in a series of Oregon RICO cases that generally involve property disputes. Plaintiffs and plaintiff attorneys find RICO cases attractive given the status of cannabis under the Controlled Substances Act and the availability of treble damages plus attorney’s fees. The most recent complaint alleges property damage from “noxious” odors and illegal activities that resulted in reduced property values.
There is at least an argument that the dollar value attributable to these items is zero or some nominal amount. One of the earlier RICO cases settled out of court. There are no public details of the agreed upon settlement. However, a number of the defendants successfully fought the cases against them and obtained dismissals. The remaining defendants probably found it cheaper to settle than face a drawn out legal battle. It is probably fair to say that a significant amount of the settlement went to pay attorney’s fees. This conclusion is, in part, based on the fact that the same attorney has represented multiple plaintiffs in cannabis RICO claims. While these claims might provide plaintiff attorneys a meal ticket, the plaintiffs themselves might be left holding the bag when they determine their federal income tax liability.
Specifically, section 61 of the Internal Revenue Code of 1986, as amended (“Code”) defines “gross income” for federal income tax purposes as income from “whatever source derived.” This means that the general starting point for determining taxable income is that any amount received is taxable to the recipient. Furthermore, under the “assignment of income” doctrine, a taxpayer is often taxed on the gross amount recovered, even if the taxpayer does not directly receive custody or take possession of the income amount. Thus, in the typical contingent fee arrangement, a plaintiff might agree to pay an attorney 40 percent of any damage award. Any settlement is generally paid to the plaintiff attorney’s client trust account where 60 cents of every dollar goes to the plaintiff and the remaining 40 goes to the plaintiff’s attorney. For tax purposes, this is generally treated as the plaintiff receiving the entire dollar and spending 40 cents for legal fees notwithstanding the contingency fee arrangement.
Several code provisions provide for excluding certain types of damage awards from taxable income. For example, section 104 of the Code excludes from taxable income amounts received that are on account of personal physical injury or physical sickness. Those income exclusion provisions are not likely to apply in these RICO cases.
Deductions from gross income are a “matter of legislative grace.” Trade or business expenses are generally deductible under section 162 of the Code — subject to denial under section 280E for any trafficking business. Alternatively, section 212 of the Code allows a deduction for all ordinary and necessary expenses paid or incurred for the production of income and for the conservation of property held for the production of income. Regulations under section 212 note that expenses paid or incurred for conservation of property used by taxpayer as a residence are not deductible under section 212, but are deductible if the property is used for the production of income (e.g., rental property).
Prior to 2018, section 212 expenses were considered miscellaneous itemized deductions that were subject to a minimum floor, typically two percent of adjusted gross income. If the expenses did not exceed the floor, then they were not deductible to the taxpayer. However, code section 67(g), added by the so-called Tax Cuts and Jobs Act of 2017, temporarily eliminates the availability of such miscellaneous itemized deductions even over a taxpayer’s 2 percent floor. Section 165 casualty losses were also materially limited by the same “tax reform” — now allowing itemized deductions for such losses only to the extent they exceed 10 percent of a taxpayer’s adjusted gross income.
Section 62 of the Code provides several so-called above-the-line deductions. Above-the-line deductions are not miscellaneous itemized deductions and subject to the temporary elimination noted above. They remain deductible for federal income tax purposes. Section 62(a)(2) provides a deduction for attorney fees and court costs involving most discrimination lawsuits, and claims under chapter 37 of title 31 of the United States Code. However, RICO claims typically fall under section 1962 of title 18 of the United States Code. Therefore, the deduction available under section 62 for legal fees in certain cases would not be available in connection with cases involving RICO damages.
In sum, if the RICO claims relate to property used for personal purposes (e.g., as a residence), then no deduction should be available under sections 162, 165 or 212 for any legal fees incurred. Indeed, whenever RICO plaintiffs are not engaged in the active conduct of a trade or business they probably cannot deduct their legal fees or even offset the gross amount recovered in such suits by legal fees retained by their lawyers.
Hypothetically, a plaintiff could settle a RICO case for a nominal amount of say $10,000 plus attorney’s fees of $50,000. The taxpayer-plaintiff probably needs to recognize the entire $60,000 as taxable gross income under section 61 and in many cases will not be entitled to claim a deduction for the $50,000 paid (or deemed paid) to the attorney. Assuming a 40 percent combined federal and state tax rate on the $60,000 of income, the tax due is $24,000, which significantly exceeds the plaintiff’s net proceeds of $10,000. The irony of this situation is that it is the exact problem many cannabis businesses face under section 280E — the taxpayer’s net income is less than the tax liability.
The takeaway? Potential RICO plaintiffs should consult with a tax advisor before pursuing RICO claims. Failing to do so could leave them with a tax debt exceeding a damage award or settlement amount.
Commissioner v. Banks and Commissioner v. Banaitis, 543 U.S. 426 (2005).
Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934).