Class action attorney fee award not includible in member's income or subject to withholding.

P filed a class action lawsuit against B, alleging that B had miscalculated lumpsum distributions to participants (and their beneficiaries) in violation of the Employee Retirement Income Security Act of 1974. The lawsuit sought recovery of additional pension benefits from B payable to a class of plaintiffs comprised of all participants and their beneficiaries who had received lumpsum distributions from B, at any time after a specified date (class members).

The parties subsequently entered into a settlement agreement resolving all claims brought in the litigation. On the same date, the court granted preliminary approval to the settlement terms and granted conditional certification of a "settlement class" comprised of the class members under Rules 23(b)(1) and (2) of the Federal Rules of Civil Procedure. Under those rules, an individual who falls within the definition of a class member automatically becomes a class member entitled to the settlement benefits. No class member had a right to exclude himself or herself from the class.

The settlement agreement created a settlement fund from B's assets. Under the settlement, each class member was entitled to receive a base payment, plus a proportional share of the "net settlement fund," defined as the "settlement fund less the total base payments and the amount awarded by the court for attorneys' fees, administrative expenses and costs."

Class counsel sent notice of the settlement agreement to all class members. No individual class member personally entered into a fee agreement with the class counsel. Subsequently, the court granted final approval of the settlement agreement and awarded the class counsel $Z from the settlement fund for attorneys' fees, administrative expenses and costs. The settlement agreement provided that B pay attorneys' fees directly to the class counsel.

Pursuant to the settlement agreement, a class member could participate in the settlement only if he or she was a plan participant and (1) was identified by class counsel and the defendant as a confirmed class member or (2) met certain other requirements and confirmed to be a class member by class counsel and B's counsel based on a claim submitted by that person by the 90th day following the date of final judgment. Thus, as of the date of final judgment, the identity of all the individual class members and the quantification of their claims were not known.

Analysis

The attorneys' fees awarded to class counsel from the settlement fund are not includible in a class member's gross income, because the members do not have any express contractual relationship with class counsel and were not identified until after the final judgment. This conclusion is similar to Rev. Rul. 80-364, situation 3, involving the settlement of a lawsuit brought by a union against an employer to enforce a collective bargaining agreement.

Class actions are employed by the judicial system to consolidate in one lawsuit a group of common claims against the same defendant. Class actions frequently come about as representative litigation in which the claims of a great many similarly interested individuals are pursued by the class representatives. Under the class action at issue, a class member obtains the benefits of the settlement by merely coming within the definition of the class. The conclusion that the attorneys' fees are excluded from the gross income of class members is specific to the facts of this case.

Because the attorneys' fees do not constitute gross income to the class members, the attorneys' fees are not part of the "designated distribution" and, thus, are not subject to mandatory withholding under Sec. 3405(c)(1)(B).

Under Sec. 6041, "income" means only income includible in gross income under Sec. 61; thus, the payments of any portion of the attorneys' fees are not required to be reported as taxable income to any class member under Sec. 6041. No person is subject to the Sec. 6041 reporting requirements for such payments.

IRS LETTER RULING 200344022 (10/31/03)