Designing the Tax Treatment of Litigation-Related Costs

This paper identifies key tax design issues for how income tax law should treat litigation-related costs paid by defendants, such as attorney fees, court courts, and payments to settle claims or to satisfy judgments, fines or penalties. After discussing how US and German income tax law treat litigation-related costs, the paper identifies four important tax-design issues: (1) how to attribute litigation-related costs to any particular income-producing activity; (2) whether to treat liability insurer payments made on a defendant’s behalf as income to that defendant; (3) whether to coordinate the tax treatment of a payer’s damages payments with the tax treatment of those receipts to the payee; and (4) whether litigation-related costs should be treated as capital expenditures related to the right to receipts established or sought to be established by the litigation itself. In addition, the paper models how the tax-deductibility of liability-related costs might affect liability insurance demand and the insured taxpayer’s level of care. Finally, the paper shows how, under current law, private parties can enforce settlement agreements under which a defendant promises not to seek an allowable tax deduction for litigation-related costs. In so doing, this paper substantially extends and reorients tax theory on how an ideal income tax system could or should treat litigation-related costs