Circuits split on whether plaintiffs must pay tax on fees paid to lawyers.

The Ninth and Fifth Circuit courts recently reached opposite conclusions in cases deciding the taxability of the portion of a personal injury award that is paid to an attorney as a contingent fee. The rulings highlight a widening rift among the federal appellate courts on the issue, which experts say is ripe for U.S. Supreme Court review. (Benci-Woodward v. Commissioner, 219 E3d 941 (9th Cir. 2000); Srivastava v. Commissioner, 220 E3d 353 (5th Cir. 2000).)

Moreover, decisions like the Ninth Circuit's that have come down in favor of taxation are inherently unfair--resulting in double taxation on the same amount of money--and threaten to undermine the contingent fee system, plaintiff lawyers say.

"It's going to have a chilling effect on any plaintiff who seeks [taxable] damages for discrimination or any type of nonphysical injury because there is absolutely no financial incentive to go to court," said Philip Panitz, who represented the plaintiff in the Ninth Circuit case.

Michael Cropper, the lawyer who represented the plaintiffs in the Fifth Circuit case, agrees, even though that court ruled against taxation.

"We have a tax system that has run amok," Cropper said from his office in Midland, Texas. `We're only supposed to pay tax on a portion of our income, but [decisions like the Ninth Circuit's] result in a tax bill to the litigant that can almost exceed their recovery."

The Ninth Circuit case arose out of a claim for wrongful termination and personal injury brought by four employees of a California Target store. A jury awarded both nontaxable compensatory damages and taxable punitive damages.

Three of the four plaintiffs sought to exclude from taxation that portion of the punitive damages award that they paid to their attorney as a contingent fee. A tax court ruled against them, finding the entire amount taxable. It also ruled that the amount of the award pushed them into the alternative minimum tax category for high-income taxpayers.

Attorney fees ordinarily qualify as a miscellaneous itemized deduction, but individuals who are subject to the alternative minimum tax cannot claim miscellaneous itemized deductions. Consequently, the plaintiffs were prohibited from deducting any portion of the attorney fees from their taxes.

To illustrate the harsh result, Panitz said from his office in Westlake Village, California, "let's take a hypothetical case where you have an award of $1 million. The attorney takes a 40 percent contingent fee, which is $400,000, and he pays taxes on that amount. Now, you've got $600,000. Experts and other costs run about $50,000 to $100,000, leaving $500,000.

"Then, the IRS says the entire award is taxable and you're in the alternative minimum tax category because of the award, which takes away any deductions. You're taxed at the top brackets, which federal and state combined is close to 50 percent. Half of $1 million is $500,000. There goes the rest of the money."

And, he added, the government gets more than it should by double-dipping into the same pot.

"The government is unjustly enriched when they take from 100 percent of the plaintiff's recovery and from the 40 percent that goes to the attorney. That's a 140 percent tax base. It's hardly equitable when the government creates a tax base of 140 percent when there's only 100 percent of the money."

Judge Margaret McKeown, writing for the Ninth Circuit panel, dismissed these fairness issues, saying they were "more appropriately left for congressional resolution." Instead, she said, the court's decision had to conform to its month-old holding in Coady v. Commissioner, which had held that contingent fees are taxable. (213 F.3d 1187 (9th Cir. 2000).)

The Fifth Circuit ruling stemmed from a defamation action against a San Antonio radio station that had broadcast reports of alleged medical misconduct by a cardiac surgeon. The doctor, Sudhir Srivastava, claimed the reports ruined his practice and forced him to move to another city.

A jury awarded Srivastava and his wife $11.5 million in actual damages and $17.5 million in punitive damages. The parties later settled for $8.5 million, which the plaintiffs did not report as gross income on their federal taxes, reasoning the amount represented nontaxable actual damages.

The IRS issued a notice of deficiency, assessing taxes and penalties for failing to report the settlement as gross income. The plaintiffs challenged the deficiency in tax court, which rejected their claims that the entire amount was not taxable because it represented actual damages and that, at the least, they should not have to pay income tax on the amount of the settlement they paid to their attorney as a contingent fee.

Reversing, the Fifth Circuit said it was bound to follow the precedent set in Cotnam v. Commissioner, a 1959 ruling that excluded from gross income contingent fees paid by a plaintiff in an Alabama breach-of-contract lawsuit. (263 F.2d 119 (5th Cir. 1959).)

The IRS argued that Cotnam should not dictate what taxes were owed by Srivastava and his wife, because Alabama law gives lawyers in that state a proprietary interest in contingent fees due them that Texas lawyers are not granted by the laws of their state. Consequently, Texas plaintiffs, who have greater control over their awards and settlements, should not be shielded from taxation on contingent fees paid out of those amounts.

Judge Jerry Smith, writing for the three-judge panel, disagreed. "The answer does not depend on the intricacies of an attorney's bundle of rights against the opposing party under the law of the governing state," Smith wrote. Instead, the decision rests on the "economic reality facing the taxpayer-plaintiff," which is the same regardless of where he or she lives, the court found.

The Fifth Circuit added that the portion of the settlement monies representing interest and punitive damages could be taxed. The court remanded the case to the tax court to allocate the proceeds among actual damages, interest, and punitive damages.

Panitz says his client will appeal the Ninth Circuit's decision, which parallels rulings from the Federal and Third Circuits. The government has not yet decided whether to appeal the Fifth Circuit decision, which agrees with an earlier ruling out of the Sixth Circuit.