Contingency fees revisited.

The dispute over the proper taxation of contingency fees paid to an attorney continues. Several circuit courts have maintained the amounts were not taxable. A recent case expanded the exclusion.

Mattie Foster won a verdict in an Alabama state court of $50,000 compensatory damages and $1 million punitive damages. She previously had signed a contingency fee agreement granting her attorney one-half of all collections. After the verdict, she signed a new contract giving the attorney all post-judgment interest, in addition to the amounts previously granted, if he handled the appeals litigation. In 1994 Foster settled the suit and received $525,000. Under the two contracts, her attorney got $681,033 ($525,000 plus $156,033 post-judgment interest). Foster included only $525,000 in her income. The district court ruled she should have reported one-half of the post-judgment interest as income. Foster appealed the decision.

Result. For the taxpayer. The Eleventh Circuit Court of Appeals reaffirmed and clarified its position that, in states such as Alabama, taxpayers who give their attorneys special liens under contingency fee agreements do not have to report those amounts as income. The amount they can exclude from income includes a portion of the judgment as well as any post-judgment interest the attorney retains. (Recently, the Sixth Circuit Court of Appeals, in Brisco, also ruled that post-judgment interest paid to attorneys under contingency fee agreements was not includable by the taxpayer.)

In Foster, the Eleventh Circuit extended this ruling to include the contingency fee agreement the taxpayer signed after the verdict. According to the court, this second agreement did not come under the assignment-of-income doctrine because significant uncertainty remained about whether Foster would prevail and receive any part of the judgment. Therefore, she did not need to include in income amounts the attorney retained under the second fee agreement. (The attorney would have reported these amounts--including the post-judgment interest--as income.)

The court made another decision in this case that is of interest. Foster sued for court costs. Although the district court denied her suit, the Eleventh Circuit awarded her costs under IRC section 7430. The court acknowledged the circuits had split on the issue of contingency fees. However, since the Eleventh Circuit previously had ruled for Foster, it said the IRS should "not expect the individual taxpayer to fund its crusade to change the law."

Sea of Returns

The IRS projects taxpayers will
file 232.5 million tax returns this
year. It expects filings to swell to
258.1 million in 2007.

200 million returns

2007   258.1 million returns
2001   232.5 million returns

Source: IRS, www.irs.gov.

The courts are divided on a wide variety of issues. Taxpayers who live in circuits where the courts have rendered pro-taxpayer decisions should consider seeking court costs under section 7430 if the IRS attempts to convince the court to change its position. This advice applies regardless of the outcome in other circuits.

* Mattie Foster v. United States, 87 AFTR2d [paragraph] 2001-865 (CA-11).

Prepared by Edward J. Schnee, CPA, PhD, Joe Lane Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.