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Supreme Court Agrees With IRS on Contingent Attorney Fee Cases

Tax

Resolving a conflict among the circuits, the Supreme Court held in Commissioner v. Banks, and Commissioner v. Banaitis, 125 S. Ct. 826 (2005), that the portion of a recovery paid to an attorney as a contingent fee constitutes income to the taxpayer.

Facts
Banks. The California Department of Education terminated the employment of John W. Banks II. Mr. Banks hired an attorney under a contingent-fee agreement and filed suit against his former employer. The complaint filed by Mr. Banks’ attorney contained a claim of employment discrimination under the Civil Rights Act of 1964 and certain other claims under state laws that were later abandoned. In 1990, the parties eventually settled the claims of Mr. Banks for a total of $464,000, $150,000 of which was paid to the attorney of Mr. Banks.

Mr. Banks excluded all of the settlement proceeds from his 1990 federal income tax return. The commissioner issued Mr. Banks a notice of deficiency for the 1990 tax year that included the entire $464,000 in the income of Mr. Banks. The Tax Court held that the entire $464,000 was taxable income to Mr. Banks.1

The Court of Appeals for the Sixth Circuit concluded that the contingent fee agreement was not an anticipatory assignment of income because the litigation recovery was not already earned, vested, or even relatively certain to be paid when the contingent fee contract was entered. In addition, the Sixth Circuit concluded that the contingent fee arrangement was essentially a partial assignment of income-producing property. Accordingly, the Sixth Circuit held that the $150,000 paid to the attorney of Mr. Banks was excludable from the income of Mr. Banks.2

Banaitis. Mr. Banaitis was forced to leave his job as a loan officer and vice president at the Bank of California. Thereafter, he hired an attorney under a contingent-fee arrangement and filed suit against the Bank of California and its successor, Mitsubishi Bank. The complaint filed by Mr. Banaitis’ attorney alleged that Mitsubishi Bank willfully interfered with Mr. Banaitis’ employment and caused the Bank of California to discharge him. The complaint further alleged that the Bank of California improperly discharged him and improperly attempted to force him to breach his fiduciary duty to his customers.

The jury found for Mr. Banaitis. While the case was on appeal, the parties settled the case for $8,728,559. The defendants paid Mr. Banaitis $4,864,547 and $3,864,012 directly to Mr. Banaitis’ attorney.

Mr. Banaitis excluded the amount paid to his attorney from gross income on his federal income tax return. The commissioner issued a notice of deficiency that included Mr. Banaitis’ attorneys’ fees in his gross income.

The Tax Court upheld the determination of the commissioner.3 The Court of Appeals of the Ninth Circuit held that Oregon law vested Mr. Banaitis’ attorney with a property interest and accordingly, the contingent attorney fees paid to Mr. Banaitis’ attorney did not result in taxable income to Mr. Banaitis.4

Importance of Treatment of Contingent Attorney Fee
If the payment of contingent attorney fees is treated as a miscellaneous deduction, the deduction is subject to the two percent floor on itemized deductions.5 Accordingly, a taxpayer’s miscellaneous deductions are deductible only to the extent that they exceed two percent of the taxpayer’s adjusted gross income. In addition, all itemized deductions are subject to reduction if the taxpayer’s adjusted gross income exceeds a threshold amount.6 Most importantly, miscellaneous itemized deductions are not deductible in determining the alternative minimum tax.7 As a result of the American Jobs Creation Act of 2004, attorneys’ fees and court costs paid by, or on behalf of, a taxpayer in connection with any action involving a claim of unlawful discrimination8 are deductible in computing adjusted gross income and for alternative minimum tax purposes if paid after October 22, 2004.9

However, because this exception added by The American Jobs Creation Act of 2004 is limited to recoveries for unlawful discrimination and only for attorneys’ fees and costs paid after October 22, 2004, the tax treatment of contingent attorneys’ fees10 in many situations will be controlled by the Supreme Court’s decision in Banks and Banaitis.

Analysis of Supreme Court
The key issue in both cases was whether the “anticipatory assignment of income” doctrine applied. Under the anticipatory assignment of income doctrine, income is taxed to the party who earns the income and enjoys the economic gain represented by the right to receive income.11 The doctrine is intended to prevent taxpayers from avoiding taxation through arrangements and contracts designed to prevent income from vesting in the one who earned it.12 The Supreme Court held that the anticipatory assignment of income doctrine is applicable to contingent-fee arrangements, even though there is no discernible tax avoidance purpose to contingent-fee arrangements.

The Supreme Court noted that in the context of an anticipatory assignment of income, the assignor often does not have dominion of the income at the moment of receipt. Accordingly, in that instance, it must be determined whether the assignor retains dominion over the income-generating asset. The Supreme Court concluded that, in the case of a litigation recovery, the income-generating asset is the cause of action arising from the plaintiff’s legal injury and that the plaintiff retains dominion over the cause of action throughout the litigation.

Although the taxpayers did not dispute that they retained dominion over their causes of action, they argued that the anticipatory assignment of income doctrine should not apply because 1) the value of the legal claim was speculative at the moment of assignment and could be worth nothing, and 2) the attorney contributed income-generating efforts and expertise that were important in the success of the litigation and those efforts essentially created a business relationship similar to a joint venture.

The Supreme Court rejected the taxpayers’ arguments. First, it concluded that the anticipatory assignment of income doctrine can apply even though the value of legal claim was speculative at the moment of the assignment. Second, it concluded that the attorney-client relationship in a contingent fee case is a principal-agent relationship because, although the attorney can make tactical decisions without consulting with the client, the plaintiff must make all of the critical litigation decisions, including whether to settle or proceed to judgment.

The Supreme Court also stated that its ruling on contingent attorney fee cases is not altered by state laws that confer special rights or protection on the attorney as long as the special rights do not alter the principal-agent character of the attorney-client relationship to a partnership arrangement. The Supreme Court indicated that it was not aware of any state laws that converted the attorney from an agent to a partner.

Unresolved Issues
Arguments Not Presented to Lower Courts. The Supreme Court refused to consider certain other arguments not presented to the lower courts, including 1) the contingent-fee arrangement created a Subchapter K partnership; 2) the recoveries from the litigation are proceeds from the disposition of property and the attorneys’ fees are subtracted as a capital expense; and 3) the contingent attorney fees are deductible reimbursed employee business expenses. The Supreme Court characterized these arguments as “novel propositions of the law with broad implications for the tax system.” Based upon this characterization by the Supreme Court, it is questionable whether these arguments would have been successful even if they had been presented to the lower courts. However, an aggressive taxpayer may want to consider excluding from income contingent attorney fees and making one or more of these arguments. If that position is taken, it would be advisable for the taxpayer to disclose the position on the taxpayer’s income tax return to attempt to avoid the substantial understatement penalty under IRC §6662.

Contingent Fees Paid Pursuant to Fee-shifting Statutes. Mr. Banks brought his claims under federal statutes that authorize fee awards to prevailing plaintiffs’ attorneys. He argued that the application of the anticipatory assignment of income doctrine would be inconsistent with the intent of statutory fee shifting provisions. In cases where the plaintiff only seeks injunctive relief or damages that are substantially less than the attorneys’ fees, treating the attorneys’ fee award as income to the plaintiff could lead to the unhappy result that the plaintiff loses money by winning the suit. This result, Mr. Banks argued, would undermine the effectiveness of fee-shifting statutes because plaintiffs might be reluctant to pursue certain cases where the damages would be low when compared to the expected attorneys’ fees.

The Court decided not to address this claim because after Mr. Banks settled his case, the fee paid to his attorney was based entirely on his private contingent-fee contract. In addition, there was no court ordered fee award and there was no indication in Mr. Banks’ contingent-fee arrangement with his attorney or in the settlement agreement that the contingent-fee award paid to Mr. Banks’ attorney was in lieu of statutory fees.

This leaves open a potential planning opportunity if a claim by a plaintiff is under a statute that authorizes fee awards to prevailing plaintiffs’ attorneys. In that situation, an attorney should consider including a provision in the contingent-fee arrangement and also in any settlement agreement that any contingent fee paid to the attorney is in lieu of statutory fees the client might otherwise be entitled to recover. In addition, if a settlement is reached, an attorney should also consider, as part of the settlement, obtaining a court-ordered fee award. If these steps are taken, there may be a reasonable basis for excluding the attorneys’ fees from the taxpayer’s income. Again, if that position is taken, it would be advisable for the taxpayer to disclose the position on the taxpayer’s income tax return to attempt to avoid the substantial understatement penalty under IRC §6662.

Conclusion
The Supreme Court has apparently settled the tax treatment of contingent attorney fees not addressed by The American Jobs Creation Act of 2004 by holding that contingent attorney fees are includible in the taxpayer’s income. However, there are still potential arguments that a taxpayer can make, especially where there is a claim by a taxpayer under a statute that authorizes fee awards to prevailing plaintiffs’ attorneys. The Supreme Court’s decision will likely have catastrophic results for many plaintiffs who, after payment of attorneys’ fees and income taxes, may have relatively little (or nothing) left over. Before finalizing a settlement, it would be advisable for the plaintiff’s tax advisor to estimate the after-tax settlement proceeds available to the plaintiff and to advise the plaintiff of this amount. If the tax advisor fails to perform this analysis, the plaintiff may have an unhappy surprise the following April.

1 Banks, 81 T.C.M. 1219 (2001).
2 Banks v. Commissioner, 345 F.3d 373 (6th Cir. 2003).
3 83 T.C.M. 1053 (2002).
4 Banaitis v. Commisioner, 340 F.3d 1074 (9th Cir. 2003).
5 I.R.C. §67.
6 I.R.C. §68.
7 I.R.C. §56(b)(1)(A)(i).
8 Unlawful discrimination is defined in I.R.C. §62(e).
9 I.R.C. §62(a)(19).
10 If contingent attorney fees are paid in connection with a recovery on account of personal physical injuries (other than punitive damages) because the recovery is not includible in gross income pursuant to I.R.C. §104(a)(2), the attorneys’ fees are not deductible pursuant to I.R.C. §265(a)(1).
11 Lucas v. Earl, 281 U.S. 111 (1930).
12 Id.

D. Michael O’Leary is a shareholder in the Tampa office of Trenam Kemker. He graduated from Miami University with a B.S. in accounting; received his J.D. from Ohio State University; and acquired his LL.M. in taxation from the University of Florida. He is a board certified tax attorney and a certified public accountant.
This column is submitted on behalf of the Tax Section, William D. Townsend, chair, and Michael D. Miller, Benjamin A. Jablow, and Normarie Segurola, editors.

Tax