Why are taxpayers helping companies pay for all their litigation?

Feb. 8, 2012 — For years, a wide range of business and business-supported groups have railed against what they describe as an out-of-control civil justice system. As the story goes, greedy individuals and their even greedier trial lawyers are given carte blanche to burden corporations with the costs generated by meritless lawsuits. Under the banner of “tort reform” or “civil justice reform,” critics of the current system seek to protect companies from these voracious predators by creating a series of disincentives that would deter those who now hunt for “windfalls.” These include provisions to make it more difficult to get into court, especially in connection with a class action or group lawsuit; to restrict the information that can be obtained during the discovery process in the course of a lawsuit; and to cap or eliminate various types of damages that are currently available to be awarded to a plaintiff that prevails.

But there hasn’t been a peep about an important benefit to one class of litigants that is deeply baked into the current system. Unlike individuals who have to bear their own litigation costs in all cases where they lose and in almost all categories of cases even where they win, the tax code provides that businesses may deduct all of their legal expenses (for lawyer and expert fees, and for discovery costs) in all cases — win or lose, meritorious or non-meritorious, plaintiff or defendant.

Among other things, those deductions mean less federal revenue than if a different system — one that did not grant 100 percent deductibility — were in place. Since the average effective corporate tax rate is 22 percent, according to Andrew Fieldhouse of the left-leaning Economic Policy Institute, the current system could mean substantial money is routinely lost to the Treasury.

Alternatives to the current system are possible, but little thought has thus far been given to them. The current system continues in place despite the fact that comprehensive estimates of business litigation costs are apparently not available, the very costs that would give the full measure of the deduction’s impact on taxpayers.

Is the current system the only way to go?

Remapping Debate spoke with Joseph Bankman, a professor of law and business at Stanford Law School and an expert in tax law. Bankman confirmed that, in general, a company’s litigation expenses are deductible regardless of the litigation’s outcome (he pointed out that in some cases, as with some types of litigation over property, the ability to take advantage of litigation expenses for tax purposes might be deferred).

Moreover, given the example of a David and Goliath battle where an individual prevails against a meritless claim brought against him by a corporation, Bankman confirmed that, the winning David would not be able to deduct any of his legal costs, whereas the losing Goliath would be able to deduct all of its legal costs (in narrowly drawn areas, pursuant to some civil rights laws, for example, a prevailing David is able to recover reasonable attorney’s fees from his opponent).

Bankman himself thought it would be “odd” to change the current system. He said that full deductibility was consistent with the “norm” that “if you’re engaging in a profit-making activity, everything is deductible.” He argued that it was incongruous that a corporation that prevails in litigation — a corporation that, in general, would be taxed on the monies it secures through the litigation — would not be able to offset that income with its litigation expenses. He also said that there could be operational difficulties if an alternative system of deductibility came to depend on factors like whether the litigation was between two businesses or between a business and an individual, whether one litigant could be identified as prevailing, or whether the costs were properly attributable to litigation or to pre-litigation legal services.

Bankman readily acknowledged, however, that the existing rule does represent a “social policy judgment,” and that other policy judgments are possible. For example, it is already the case that the tax code caps at $1 million per year the amount a public company may deduct for compensation paid to its chief executive officer and three other top officers, with some performance-based pay excepted (Bankman said that “most people think [the limitations] have been ineffective, although we could certainly make them effective”).

Other caps exist on the individual tax side of the ledger: for example, caps on the mortgage interest deduction.

Though reiterating his own opposition to making change in the rules relating to deductibility of business litigation expenses, Bankman agreed one could create a tax regime under which there could be a maximum deduction, or a maximum in relation to adjusted gross income, or have 70 percent of these expenses able to be deducted. There is “no question you could do it,” Bankman said. “We have a million limitations in the tax law, and we could add these — it wouldn’t have to be all or nothing.”

Bankman concluded by saying that, while he “wouldn’t support the proposal” to limit deductions, “one benefit would be [that companies] would use the courts less.”

How much do corporations spend on litigation?

The question here is not how much corporations spend on the outcome of litigation (where they have to pay damages as a result of a judgment or pay money to settle a case), but rather the scope of spending for the conduct of litigation (in-house and outside counsel fees, plus litigation expenses like experts fees and deposition costs).

There is not, so far as well can tell, a comprehensive answer to the question, although the limited surveys that have been done suggest that the aggregate amounts involved are likely to be quite large.

For several years, the law firm of Fulbright & Jaworski has produced an annual “litigation trends survey report.” The 2011 report received responses from approximately 275 mostly large or very large corporations in the United States (almost half had annual revenues of $1 billion or more; and another 29 percent had revenue of at least $100 million).