Contingent attorney's fees taxed as income.

In 1991 Eldon Kenseth was terminated by his employer after 21 years of service. He retained an attorney, under a contingent fee arrangement, and sued his employer under the 1967 Federal Age Discrimination in Employment Act. In 1993, he agreed to settle the case for $229,501. A portion of the settlement, $32,477, which represented back pay and lost wages, was paid directly to Kenseth. The balance, $197,024, was deposited in his attorney's trust account. The attorney subtracted his contingent fee of $91,800, which was 40% of the gross settlement, and issued Kenseth a check for the balance.

On his 1993 federal return, Kenseth reported the wages of $32,477 but excluded the $197,024 as personal injury damages.

During an audit, the IRS determined that the entire settlement was taxable. The service did allow Kenseth to deduct the $91,800 contingent attorney fee as a miscellaneous itemized deduction. However, because of the 2% limit on these deductions, the overall limit on total itemized deductions, and the disallowance of miscellaneous itemized deductions in computing minimum taxable income, the IRS determined a deficiency of $55,037, which included a $17,198 minimum tax liability.

Kenseth agreed that the settlement was taxable, but he argued that he should not be taxed on the attorney's contingent fee, because he did not and could not receive those funds and had no "legal" right to obtain them. The court rejected his arguments and held that the attorney fee was includable in Kenseth's income under the assignment-of-income doctrine. The court followed the reasoning of O'Brien v. Commissioner (38 TC no. 707, 1962), which held that, even if the taxpayer made an irrevocable assignment of a portion of his future recovery to his attorney, to the extent that he never, even for a moment, became entitled to that portion, it would still be gross income to him under the assignment-of-income principles.

The court: agreed that including the attorney fee in income--without a dollar-for-dollar offset--was harsh and inequitable. However, it also felt it was Congress' responsibility to remedy the situation.

Observation. According to dissenting judges in the case, the itemized deduction and alternative minimum tax rate are working in ways that are inappropriate and unanticipated by Congress. Kenseth was taxed on $91,800 he never received and was never entitled to receive.

While waiting for Congress to act, CPAs can only hope the courts will change their view and rely on an old case, Cotnam v. Commissioner (263 F.2d 119, 5th Cir., 1959), where the Fifth Circuit excluded contingent attorney's fees from gross income in a state where the attorney lien statute gave an attorney a lien on a taxpayer's cause of action.

* Kenseth v. Commissioner (114 TC no. 26, 5-24-2000).

--Michael Lynch, Esq., professor of tax accounting at Bryant College, Smithfield, Rhode Island.