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The Libel Tax

The new law taxes people for winning defamation claims.

President Donald Trump’s new tax law has been roundly criticized for spending $1.5 trillion largely for the benefit of big corporations and extremely wealthy individuals, for further complicating the tax code, and for lacking intellectual or policy coherence. Lost in all of this valid criticism has been scrutiny of the large number of technical flaws in the law that will haunt innocent and unsuspecting taxpayers for years to come while simultaneously providing windfalls for more sophisticated taxpayers and their advisors.

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One ironic example of such a technical flaw is a change that will punish people like Summer Zervos. The former Apprentice contestant has sued Trump for defamation, based on his claim that she was lying when she accused him of making unwanted sexual advances.

The new tax bill denies defamation plaintiffs like Zervos any deductions for their attorney’s fees and costs, even when their claims succeed. The result is likely to be extremely high tax rates on defamation awards. In fact, this new tax burden on defamation plaintiffs would in some cases make it more expensive to sue someone who has defamed you than to just ignore them.

To understand why, you need to know how defamation litigation works. Most defamation plaintiffs hire their attorneys on a contingent-fee basis. This means that if the plaintiff wins, the attorney will recover her out-of-pocket expenses (such as court costs, travel expenses, and expert witness fees) plus a percentage of the jury award or settlement. For example, if the attorney spends $100,000 in expenses and the plaintiff receives a $500,000 damages award, a typical 40 percent contingent-fee agreement would result in the attorney receiving $300,000 ($100,000 of fee reimbursement plus 40 percent of the $500,000 award). The plaintiff would receive the remaining $200,000.

Before the new tax bill, the plaintiff could claim the $300,000 paid to the attorney as a miscellaneous itemized deduction against her taxable income, partially offsetting the $500,000 of income from the damage award. This makes sense as the plaintiff’s net income from the case is only $200,000, and therefore she should only be taxed on $200,000. The new tax bill, however, denies all miscellaneous itemized deductions, including a successful plaintiff’s deductions in defamation cases. The result is that the hypothetical plaintiff would now be taxed on the full $500,000 award, even though she only ends up with $200,000.

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This could cause Zervos, as an example, to pay a tax rate in excess of 100 percent even if she prevails in her claim against President Trump. It appears that Zervos lives in California, in which case her combined federal and state marginal tax rate could easily approach or even exceed 50 percent.

If she were to receive a $500,000 jury award, just to continue with the previous example, and pay her attorney $300,000 (to pay the expenses and attorney’s fee), she’d be left with $200,000 before taxes. But she would owe $250,000 in taxes (half of $500,000). The tax would exceed her net recovery of $200,000 by $50,000, resulting in an effective tax rate of 125 percent. She wins the case but loses money overall!

Even if Zervos were subject to a much lower marginal tax rate, the tax would still be confiscatory. If her combined federal and state effective rate were only 30 percent, for example, then she would owe $150,000 in tax on her $200,000 net recovery, which translates to a 75 percent tax rate. Other types of plaintiffs, such as emotional-distress and punitive-damage plaintiffs, will face the same problem. This can deter plaintiffs from bringing meritorious claims, because their expected after-tax recovery might not be worth the time, stress, and risk involved in litigation.

This preposterous situation highlights two important points. First, rushing this tax bill to meet a completely artificial year-end deadline was a serious mistake. The defamation plaintiff problem is the tiniest microcosm compared to the vast universe of loopholes that sophisticated taxpayers will be driving their proverbial trucks through. This is no way to run the tax system for the largest economy in the world. Second, to channel Leona Helmsley, it’s always only the little people, like defamation plaintiffs, who get nailed by stupid technical tax glitches. Big businesses and the wealthy have the lobbying clout to fix “mistakes” that might otherwise harm them pronto. For instance, after the Senate bill would have reinstated the corporate alternative minimum tax in its version, the Conference Committee quickly reversed the provision after corporations loudly complained, even though it would have raised roughly $70 billion over 10 years. By comparison, the flaw highlighted here raises a relative pittance of revenue, but it stayed in the final bill, a ticking tax time bomb for Zervos and other unsuspecting plaintiffs.

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