2005 • Volume 30 • Number 3

To Tax or Not to Tax: Should Contingent Attorneys’ Fees Be Included in the Successful Litigant’s Gross Income?

Kenneth R. Pyle

The thrill of victory can quickly become the agony of defeat for the successful litigant, when the time comes to pay the income tax owed on his or her recovery. A majority of the circuits have held that contingent attorneys’fees must be included in the successful litigant’s gross income.

The tax consequences of doing so can be devastating. The litigant, especially one whose award is statutorily capped and who has appreciable attorneys ‘fees, can end up owing more in taxes than was received in the judgment.

What causes this apparent anomaly is a judge-made rule known as the “anticipatory assignment-of-income” doctrine, which considers the portion of the judgment used to pay the attorneys’fees to be income first to the litigant.

The rule was originally devised to prevent wealthier taxpayers from assigning income they had earned to someone else, typically afamily member, in an effort to avoid paying tax on that income. The rule has since been applied to non-family situations, such as the contingent fee arrangement between an attorney and client. The successful client is considered to have earned the entire recovery and then to have assigned a portion of it to the attorneys to pay their fee. The client can then deduct the fees paid as a miscellaneous itemized deduction. This was the position taken by both the Internal Revenue Service and the majority of the circuits.

The problem with this approach, however, was that under the tax code as it existed prior to October 22, 2004, the successful litigant could deduct only a portion of the fees paid, and if the taxpayer fell under the Alternative Minimum Tax, could not deduct them at all. Instead, he or she wouldpay tax on the entire recovery, including the portion used to pay the attorneys ‘fees. The taxpayer is therefore taxed on money he or she never saw, and the attorneys are also taxed on the fee, essentially resulting in double taxation.

A few circuits took a different approach and considered the attorneys ‘fees as being earned by the attorneys. Under the principle that income is taxed to the one who earns it, the successful litigant would therefore not include the fees in his or her gross income but would figure the tax owed on only the net recovery. At times, the strength of the state’s attorney-lien law was the deciding factor, causing the court to determine that the attorney had property rights in the judgment under state law and therefore owned theportion ofthe judgment that represented the attorney’s fee.

Five times the Supreme Court refused to grant certiorari to resolve this circuit split, until two cases, one in the Sixth and one in the Ninth Circuit, were decided against the IRS and for the minority view, holding that the fees were earned by the attorneys and should not be included in the successful litigant’s gross income. The two cases were Banks v. Commissioner of Internal Revenue and Banaitis v. Commissioner of Internal Revenue. Both involved unlawful employment practices.

The Internal Revenue Service petitioned the Supreme Court for certiorari, which was granted on March 29, 2004. Oral arguments were heard on November 1, 2004.

This note was originally written to advocate the minority circuit view, that contingent attorneys’ fees should not be included in the successful litigant’s gross income. It proposed that the Supreme Court should view the assignment-of-income doctrine in these cases as inapposite, andshould instead adopt the position that contingent attorneys’ fees are earned by the attorneys and should be taxable solely to them and not to the client.

After this note was written, however, two significant events occurred. First, Congress passed the American Jobs Creation Act of2004 (Jobs Act) on October 7, 2004, which the president signed into law on October 22, 2004, about one week before oral arguments were scheduled to begin on Banks and Banaitis. The Jobs Act amended the Internal Revenue Code and removed the limitations on deductibility of attorneys’fees in employment discrimination cases such as the Banks andBanaitis cases considered here. The two taxpayers consequently filed a supplemental brief on October 22, 2004, to have the Court consider their cases moot, but the Court opted to hear oral arguments and decide the case.

Second, the Supreme Court decided the Banks/Banaitis case on January 24, 2005, holding that, “as a general rule, when a litigant’s recovery constitutes income, the litigant’s income includes the portion of the recovery paid to the attorney as a contingent fee. We reverse the decisions of the Courts of Appeals for the Sixth and Ninth Circuits.”

While the Court’s decision appears to decide the issue, it actually leaves the window open a bit. First of all, “as a general rule” suggests that there may be exceptions, such as those cases now covered by the Jobs Act, which include federal whistle-blower, civil rights cases and unlawful employment discrimination cases such as Banks and Banaitis.

Second, the Court also intimated that if Banks had included language either in his fee agreement or in the settlement agreement to the effect that the contingent attorney fees were in lieu of statutory fees, there might have been a different outcome; that is, the attorneys’fees would not have to be included in the taxpayer’s income. The same would hold true if the attorneys’fees were a court-ordered award.

This suggests a tax-planning strategy that attorneys and their clients would do well to consider, particularly in cases seeking injunctive relief where there is a statutory cap on the award and significant attorneys’fees, as in the Spina case discussed herein. Having the appropriate language in the fee or settlement agreement with payment going directly to the attorneys, for example, may prevent a repeat of that debacle.

Raising the window a little more, the Court also at first rejected the joint venture argument, but then later in its opinion said it was not considering that question. The Court also said it would not consider the amicus theory that the proceeds of the litigation are property and that attorneys’fees should be subtracted as a capital expense. Nor did the Court address treating the fees as a deductible reimbursed employee business expense.

In short, the opinion is as significant for what it does not address as for what it does. Defamation cases, false imprisonment cases, and emotional distress cases were not touched on. Cases with punitive damages were not addressed either.

Even employment cases that had a verdict before the Jobs Act but were appealed and resolved after October 22, 2004 may still pose tax problems for successful litigants because the judgment, not the resolution, has to occur after that date. The Jobs Act was held to be nonretroactive.

Why, then, this note? Its purpose is not to rehash the Supreme Court’s January 24 opinion. Rather, its purpose is two-fold: (1) to discuss and analyze the arguments presented to the Court, including many of the amicus theories the Court chose not to address; and (2) to advocate the view that the Supreme Court should have ruled in favor ofBanks/Banaitis and declared that, in all cases involving contingent attorneys’fees, the fees should not be included in the successful litigant’s gross income.

Accordingly, the reader will still find this note extremely relevant and valuable in understanding the historical underpinnings of the issue of whether or not contingent attorneys ‘fees should be included in the gross income of the successful litigant. The explanations presented of the applicable tax law, the position of the various circuits, and the arguments raised on both sides of this issue can guide attorneys assisting clients whose cases fall outside the current Supreme Court ruling.