Taxation of Contingent Fees
Cases of this kind are not easy to decide. In seeking to reconcile the implications of the infinite variety of facts presented by the decided cases and all that has been said about the subject of anticipatory assignment of income, one is likely to be displeased with his own wits; and may find his mind teetering between conflicting conclusions.. . .1
Rarely is the federal income tax applied differently under identical circumstances depending on where in the country the taxpayer resides. That is the case, however, for taxpayers who receive payments on judgments or settlements and whose attorneys receive a share of those payments as contingent fees. Florida is among a handful of states within which taxpayers may be accorded much more favorable tax treatment for such payments. This article will explore applicable law, how we got there, and where we’re likely to go from here.
The issue is whether a contingent fee paid directly by a defendant or its insurer to the plaintiff’s attorney is excludable from the plaintiff’s gross income or includable as income but deductible.2
The issue arises only where at least a portion of the damage award is taxable. For example, it does not come into play in the case of a wholly-excludable personal injury award,3 but if that award includes interest or punitive damages, both of which are taxable,4 then how the fee is treated becomes important.
If the contingent fee is excludable then that part of the damage award does not even show up on the plaintiff’s tax return. On the other hand, an includable contingent fee normally may be deducted only when itemized.
Defining What’s at Stake
Itemized deductions including legal fees are subject to a two percent floor under I.R.C. §67, a pare-back based on income under I.R.C. §68, and the alternative minimum tax under I.R.C. §55. A typical situation in one case resulted in about $55,500 of additional tax when a $300,000 contingent fee was itemized rather than excluded from income.5 In another case itemizing the deduction resulted in $254,298 of additional tax on a contingent fee of about $1.9 million.6 As the contingent fee increases so does the tax resulting from application of the cited code provisions. Scenarios exist in which the contingent fee and tax liability actually exceed the net recovery.7
Importantly, otherwise taxable awards used to pay hourly or noncontingent legal fees may never be excluded from gross income on that account.8 The income must be reported in full and the legal fees then shown as a deduction on the return. Except in a pure trade or business setting, that deduction will be taken below-the-line, or itemized, making it subject to what can be severe limitations imposed by I.R.C. §§67, 68, and 55.
Conversely, if the taxpayer lives in the right part of the country, the taxpayer may exclude that part of a judgment or settlement representing a contingent fee regardless of whether the lawsuit is one for personal injury, including punitive damages and interest, lost wages based on age, sex or other types of discrimination, defamation, securities fraud, or anything else for that matter.
So here is how the map is drawn: the Third,9 Fourth,10 Seventh,11 Ninth,12 Tenth,13 and Federal14 Circuits require that contingent fees be included in taxpayers’ income and then deducted. The Fifth,15 Sixth,16 and 11th17 circuits permit taxpayers to exclude contingent fees from income altogether. The 11th Circuit evidently feels so strongly about the issue that it has shut down I.R.S. efforts to get it to reverse itself by imposing the taxpayers’ legal fees against the government in those cases where the I.R.S. continues to dispute the exclusion.18 Despite the split among the circuit courts, on at least two occasions the U.S. Supreme Court has declined review, presumably preferring that Congress fix the problem.19
The problem exists because there are compelling arguments on both sides of the issue.
The Split in Geography
Early on the question appeared to turn on the nature of an attorney’s charging lien for contingent fees granted by state law. It quickly evolved into one interpreting the assignment of income doctrine. Complicating a clear resolution of either is the disparity with fixed fees created by permitting exclusion of contingent fees, the apparent injustice of applying the alternative minimum tax in particular to these situations, and the unique perspective lawyers sitting as judges bring to a lawyer’s role in contingent fee cases.
The exclusion theory can be traced to the Fifth Circuit’s interpretation of the Alabama charging lien statute.20 It found the Alabama statute granted attorneys an equitable right in the claim tantamount to an ownership interest. As such, the fee resulting from an award or settlement was theirs, not the client’s, making it excludable from the client’s income.
Since most charging liens are based on a much more moderate statute, or on no statute at all but the common law, the charging lien rationale for excludability was of limited application.21
Interestingly, the only 11th Circuit opinions on this issue are cases out of Alabama under the same charging lien statute that had previously been reviewed by the Fifth Circuit.22 The 11th Circuit panels were bound to follow the Fifth Circuit opinion.23 It is conceivable, although unlikely, that another 11th Circuit panel reviewing the more security-oriented charging lien under Florida law would distinguish the precedent on that basis and join the majority of other circuit courts in denying an exclusion for contingent fee cases in Florida.
Turning back to the original Fifth Circuit decision, in a separate opinion, a majority of the panel held that the effect of the contingent fee arrangement was a transfer of a part of the client’s claim to her attorneys before it matured at a time when it was still only a “doubtful” expectancy.24 In effect the client was transferring a part of the tree before it had borne any fruit. Absent the attorney’s labor there would never be fruit on any part of the tree. It is here that the issue has been joined.
The Minority (Florida) View
The government’s position in these cases is based on the principle that the discharge of a taxpayer’s obligation to another invariably results in income to the taxpayer.25 Still, if a plaintiff has no personal liability for attorneys’ fees, and most plaintiffs don’t under typical contingent fee contracts, then no obligation of the plaintiff has been discharged when the attorney is paid from the judgment or settlement.
This is an important point. Many of the decisions disallowing the exclusion rest squarely on U.S. Supreme Court precedent holding that the discharge by a third person of the taxpayer’s obligation is equivalent to receipt by the taxpayer.26 But there is no taxpayer obligation under a contingent fee contract. The lawyer looks solely to the award and never to the client. The client’s interest in that part of the award represented by the contingent fee long since has been transferred to the lawyer.27 The third-party discharge rationale would not appear to support contingent fee includability.
Similarly, there can be no anticipatory assignment of the income inherent in the portion of the award used to pay the legal fee because, at the time of the contingent fee contract, the plaintiff is not entitled to that income. It is an expectancy that ripens as a result of the attorney’s efforts. The plaintiff did not have the requisite control over it prior to the transfer and the plaintiff does not have the requisite control over it after the transfer. This element of control deserves further exploration.
Once again many of the decisions denying excludability may rest on a faulty premise. Underlying the premise is the assignment of income principle that requires a court to analyze the degree of control retained by the taxpayer over the asset on which the disputed income is based. The error is made when the asset is defined as the lawsuit rather than that part of the claim to which the charging lien attaches. As stated by the Federal District Court for the District of Vermont:
If the issue is defined as whether the taxpayer-client has given up ownership or control over the lawsuit itself by entering into a contingent fee agreement, then the answer is clear: he or she has not.. . . [But] the debate should not concern whether or to what extent the taxpayer-client has given up control over the legal claim. The issue should rather be whether the taxpayer-client ever had or could have had control over the portion of the anticipated judgment that was designated to his or her attorneys.28
Nuances aside as to who actually controls a lawsuit—the client or the lawyer—the taxpayer never controlled and never will control that part of the claim to which the charging lien attaches. This is true even if the lawyer is fired.29 Moreover, for all the rhetoric in the pro-government cases about the prohibition in most states—including Florida—on lawyers acquiring a proprietary interest in a client’s cause of action, most states—including Florida—explicitly grant an exemption from the prohibition for a reasonable contingent fee contract.30 In other words, based on the clear language of the applicable rule, clients may assign and lawyers may take a proprietary interest in a lawsuit subject to a contingent fee contract.
The early opinions crediting lawyers with transforming inchoate claims into judgments,31 together with the phenomenon whereby those judgments become the source of revenue for both clients and their lawyers, have prompted at least one court to compare the relationship to that of a partnership or joint venture.32 While such an approach has drawn criticism for its implications under orthodox tax law,33 it also has prompted a spate of analogies, the most thoughtful of which compares contingent fee contracts to cropsharing arrangements.34 These sometimes imaginative efforts to find comparable situations represent the law’s yearning to find square pegs for square holes. However, if the assignment of income doctrine is a product of the common law, and it is, then it should be a dynamic doctrine: “[W]hat the courts have created and applied, courts can interpret, refine and distinguish to determine whether in changed circumstances the conditions for application of the doctrine have been satisfied.”35 The anticipatory assignment of income doctrine was invented by the judiciary to block tax avoidance schemes.36 It should not be applied by that judiciary to a contingent fee agreement that does not constitute a tax avoidance scheme.
The Majority (and Government) Position
Most of the circuits courts take a different view. Their opinions acknowledge the attorney’s role as much more limited, really just that of an agent, refusing to recognize the transfer of anything other than the naked fruit in the form of a fee.37 They also refuse to admit a disparity in the tax treatment between fixed and contingent fees and invariably find it is the contingent fee that must conform.38
Turning to this last issue its importance cannot be overstated. At first blush it may be easy to dismiss the importance of treating contingent and noncontingent fees the same. Still, there should be some compelling analysis that supports the intention of Congress, as the final arbiter of federal tax law, to treat the two kinds of fees differently, and there is none.39 Instead, there is overwhelming legislative and judicial precedent for subjecting non-contingent legal fees to the rigors of other itemized deductions,40 and no sound policy reason on which to distinguish contingent fees.41 For this reason it fairly can be presumed that Congress intends to treat all fees the same: includable but deductible.
The real issue separating the two sides comes down to what it is that actually is being assigned by the taxpayer to the lawyer in contingent fee cases. The fact is that the tax law always has regarded litigation as a process to determine the preexisting truth rather than something that creates anything new or different.42 That is why damages are taxed as though they were paid without regard to the litigation. “[T]he critical question is, in lieu of what was the settlement amount paid?”43 In other words, far from being a “doubtful” expectancy, historically the tax law has regarded a taxpayer’s rights as fully vested at the outset of the litigation and the lawsuit merely a process that sorts them out.
The taxpayer is entitled to the income on his or her claim from the start, and it is that income that is assigned to the lawyer under the contingent fee contract. The cause of action is not a tree from which fruit grows but the fruit itself. The lawyer is but an agent. The contingent fee contract is an arrangement in which the client secures services from an agent to obtain income and directs the obligor to discharge the liability for those services by paying a part of the income to the agent directly. “It is often the case that to obtain income from an asset one must hire a skilled agent and pay him up front; that expense is a deductible expense, not an exclusion from income.”44
For the time being taxpayers in Florida probably can exclude contingent fees from income. The fee contract clearly should limit the attorney’s rights to the judgment or settlement award, without any personal liability by the client, although the charging lien should be drawn broadly.45 Since excludability is not limited to actions for personal injury, the tax law applicable in our state actually encourages contingent fee agreements in all legal actions other than those for which they are forbidden.46
Ultimately, however, things will change. They will change here or they will change in most of the rest of the country, but a federal tax law that applies differently depending on where the taxpayer resides is not a situation that can or should continue.
1 Jones v. Commissioner, 306 F.2d 292, 296 (5th Cir. 1962).
2 This article is not concerned with taxation of the fee to the attorney, whether contingent or hourly, but presumes that fee will be fully includable in the attorney’s gross income under I.R.C. §61. Indeed, it is this fact combined with the incomplete deduction where a contingent fee is includable in the plaintiff’s income that creates a form of double taxation which has sparked the debate addressed by this article.
3 I.R.C. §104(a)(2) excludes from gross income “the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of physical injuries or physical sickness.”
4 See, e.g., O’Gilvie v. U.S., 519 U.S. 79 (1996); Estate of Clarks v. U.S, 202 F.3d 854, 855 (6th Cir. 2000).
5 Raymond v. U.S., 247 F. Supp.2d 548 (D. Vt. 2002).
6 Estate of Clarks v. U.S., 202 F.3d 854 (6th Cir. 2000).
7 Kenseth v. Commissioner, 114 T.C. 399, 426 (2000) (Beghe, J., dissenting), aff’d, 259 F.3d 881 (7th Cir. 2001).
8 See, e.g., Alexander v. Commissioner, 72 F.3d 938, 944-46 (1st Cir. 1995).
9 O’Brien v. Commissioner, 319 F.2d 532 (3d Cir. 1963).
10 Young v. Commissioner, 240 F.3d 369 (4th Cir. 2001).
11 Kenseth v. Commissioner, 259 F.3d 881 (7th Cir. 2001).
12 Coady v. Commissioner, 213 F.3d 1187 (9th Cir. 2000), cert. denied, 532 U.S. 972 (2001).
13 Campbell v. Commissioner, 274 F.3d 1312 (10th Cir. 2001), cert. denied, 535 U.S. 1056 (2002).
14 Baylin v. U.S., 43 F.3d 1451 (Fed. Cir. 1995).
15 Cotnam v. Commissioner, 263 F.2d 119 (5th Cir. 1959).
16 Estate of Clarks v. U.S., 202 F.3d 854 (6th Cir. 2000).
17 Davis v. Commissioner, 210 F.3d 1346 (11th Cir. 2000).
18 Foster v. U.S, 249 F.3d 1275 (11th Cir. 2001).
19 See notes 12 and 13 above.
20 Cotnam v. Commissioner, 263 F.2d 119 (5th Cir. 1959).
21 The charging lien in Florida is a product of the common law. See, e.g., Nichols v. Kroelinger, 46 So. 2d 722, 724 (Fla. 1950); Litman v. Fine, Jacobson, Schwartz, Nash, Block & England, P.A., 517 So. 2d 88, 91 (Fla. 3d D.C.A. 1987).
22 Foster v. U.S., 249 F.3d 1275 (11th Cir. 2001); Davis v. Commissioner, 210 F.3d 1346 (11th Cir. 2000).
23 Bonner v. City of Prichard, 661 F.2d 1206, 1209 (11th Cir. 1981).
24 Cotnam v. Commissioner, 263 F.2d 119, 126 (5th Cir. 1959).
25 See, e.g., Srivastava v. Commissioner, 220 F.3d 353, 361 (5th Cir. 2000).
26 Campbell v. Commissioner, 274 F.3d 1312, 1313-14 (10th Cir. 2001); Coady v. Commissioner, 213 F.3d 1187, 1191 (9th Cir. 2000); Baylin v. U.S., 43 F.3d 1451, 1454 (Fed. Cir. 1995).
27 Some courts have recognized that a transfer of a part of a claim in consideration for future (legal) services may be a taxable event for the client at the time of the transfer. See, e.g., Kenseth v. Commissioner, 114 T.C. 399, 411 n.4 (2000), aff’d, 259 F.3d 881 (7th Cir. 2001). The only time the government has used this argument, however, the statute of limitations had run on the year of the transfer and the government’s claim on that account was barred. Davis v. Commissioner, 210 F.3d 1346 (11th Cir. 2000).
28 Raymond v. U.S., 247 F. Supp.2d 548, 553 (D. Vt. 2002).
29 See, Litman v. Fine, Jacobson, Schwartz, Nash, Block & England, P.A., 517 So.2d 88 (Fla. 3d D.C.A. 1987).
30 Rule 4-1.8(i), Rules Regulating The Florida Bar.
31 See, e.g., Cotnam v. Commissioner, 263 F.2d 119 (5th Cir. 1959).
32 Estate of Clarks v. U.S., 202 F.3d 854 (6th Cir. 2000).
33 See, e.g., Kalinka, A.L. Clarks Est. and the Taxation of Contingent Fees Paid to an Attorney, 78 Taxes 16 (2000).
34 Kenseth v. Commissioner, 114 T.C. 399, 453-57 (2000) (Beghe, J. dissenting), aff’d, 259 F.3d 881 (7th Cir. 2001).
35 Id. at 427.
36 See, e.g., Helvering v. Horst, 311 U.S. 112 (1940); Lucas v. Earl, 281 U.S. 111 (1930).
37 See, e.g., Kenseth v. Commissioner, 259 F.3d 881 (7th Cir. 2001).
38 Id. at 883.
39 For a game effort at distinguishing contingent fees for tax purposes, see Charrier, Taxing Contingency Fees: Examining the Alternative Minimum Tax and Common Law Principles, 50 Drake L. Rev. 315, 345-46 (2002).
40 Alexander v. Commissioner, 72 F.3d 938, 944-46 (1st Cir. 1995).
41 Srivastava v. Commissioner, 220 F.3d 353, 362-63 (5th Cir. 2000).
42 For a general discussion on the tax aspects on damage awards, see M. Gardner, Tax Aspects of Damage Awards, Florida Civil Practice Damages Ch. 14 (The Florida Bar 5th Ed. 2000).
43 Bagley v. Commissioner, 105 T.C. 396, 406 (1995).
44 Kenseth v. Commissioner, 259 F.3d 881, 885 (7th Cir. 2001).
45 For a discussion of the elements necessary for an enforceable charging lien, see Litman v. Fine, Jacobson, Schwartz, Nash, Block & England, P.A., 517 So.2d 88, 91-92 (Fla. 3d D.C.A. 1987).
46 Contingency fee agreements are not permitted in criminal and certain marital cases. Rule 4-1.5(f)(3), Rules Regulating The Florida Bar.
Merritt A. Gardner practices with Gardner, Wilkes, Shaheen & Candelora, Tampa.
This column is submitted on behalf of the Tax Section, Richard B. Comiter, chair, and Michael D. Miller, Benjamin A. Jablow, and Normarie Segurola, editors.