Contingent attorney fees included in taxpayer's income.

The IRS has long held that contingent fees paid by a taxpayer from a favorable award or settlement (whether actually paid or withheld) are included in the taxpayer's gross income and deducted as a miscellaneous itemized deduction (Rev. Rul. 80-364). Practitioners searching for a more favorable treatment for these fees will find no comfort in the Tax Court's recent decision in Kenseth, 114 TC No 26. In this case, the Tax Court held, under the assignment-of-income doctrine, that contingent fees paid to (withheld by) the attorney constituted gross income to the taxpayer. This decision was rendered despite Estate of Clarks, 202 F3d 854 (6th Cir. 2000), which held contingent fees should not be included in the taxpayer's gross income. The Tax Court noted that there is a split in the circuits on this issue--Estate of Clarks and Cotman, 263 F2d 119 (5th Cir. 1959), in the taxpayer's favor, and Baylin, 43 F3d 1451 (Fed. Cir. 1995), and Brewer, 172 F3d 875 (9th Cir. 1999), ruling against the taxpayer. The Tax Court chose to follow its prior reasoning on this issue, rejecting the Sixth Circuit's reasoning that a favorable outcome depended on the attorney's involvement, which prevented an assignment. It also rejected the Fifth Circuit's reasoning, which relied on nuances in Alabama law that gave the attorney a lien interest in the settlement. With a split in the circuits, the issue should end up before the Supreme Court. While under the Tax Court's ruling, a taxpayer can deduct the portion of the settlement given to the attorney as a miscellaneous itemized deduction subject to the 2%-of-adjusted-gross-income (AGI) floor, due to the itemized deduction and alternative minimum tax (AMT) rules, the tax benefit of this deduction is greatly reduced.

Most taxpayers who receive a settlement feel that they should not be taxed on the portion paid to attorneys, as they have little control over that and do not have any legal right to receive it. In most cases, legal counsel would have a lien for its fees and costs against any recovery that has to be satisfied concurrently with the disbursement of the settlement. For these reasons, it seems unfair and illogical to view the attorney's portion of the settlement as income to the taxpayer. The Service, however, has a different opinion. The Tax Court, in previous cases, has concluded that contingent fee arrangements fall within the assignment-of-income doctrine, resulting in such fees not being excluded from the assigners' gross income. While it may be true that a taxpayer may not physically receive the portion of settlement proceeds used to pay the attorney's fees, it is the Tax Court's opinion that the taxpayer did receive the full benefit of those funds in the form of payment for services required to obtain the settlement.

Example: Individual T has just received a $300,000 settlement in which the attorney was retained on a one-third contingent fee agreement. Without the settlement proceeds, T had AGI of $93,000, itemized deductions of $19,000, zero AMT and a $11,000 Federal tax liability. If T had to report the flail settlement, with attorney fees deducted as a miscellaneous itemized deduction, his AGI would be $393,000, his itemized deductions $103,000, his AMT $15,200, and his Federal tax liability $103,000. If T were to report the $200,000 actually received, his AGI would be $293,000, his itemized deductions $14,000, his AMT zero, and his Federal tax liability $83,000.

As presented in this example, the tax consequences of reporting the flail settlement has a harsh impact on the taxpayer. The situation gets even worse when the taxpayer is a resident of a state that does not allow for Federal itemized deductions, but instead taxes the resident on Federal AGI. In the example, if T is a resident of Ohio, the state tax liability would increase by approximately $8,000. The total tax consequences of forcing this taxpayer to report the full settlement, coupled with the amount paid directly to the attorney, results in this injured taxpayer netting less than 30% of the total settlement. Conversely, if T were to report only the actual amount received, he would be netting (after attorney's fees and taxes) about 40% of the settlement. This example also points out the importance of AMT planning for an individual in the year a settlement is expected. It would behoove the taxpayer to minimize (to the extent possible) other AMT preference items (such as state and local taxes and other miscellaneous itemized deductions), as these deductions will have no value to him.

In Kenseth, the dissent did not agree that the assignment-of-income doctrine applies to contingent fee agreements. This opinion was based on the reasoning that, when a taxpayer executes a contingent fee agreement, he relinquishes substantial control over the conduct and outcome of his suit. A taxpayer is not trying to turn his back on income, but rather trying to ensure, through the efforts of an attorney, that some type of settlement is awarded. It is not difficult to assume that there would be no award or settlement absent a skillful and knowledgeable attorney. Therefore, the attorney actually earned the income, not the taxpayer who sought an attorney to convert a speculative claim into a favorable settlement.

As previously mentioned, there have been some pro-taxpayer decisions, in which the courts decided that the attorney fees should not be included in the taxpayer's income if payable out of a judgment under a contingency arrangement and not as a result of the taxpayer's independent obligation to the attorney. In Cotnam, the court viewed the amount paid to the attorney as an equitable assignment, which gave him the same rights as the client in the judgment, and felt that the attorney's contingent fees were never in the taxpayer's control. This decision was based on applicable state law that holds the attorney to be the owner of a portion of the judgment. In Estate of Clarks, the court employed reasoning similar to that used in Cotnam. Great emphasis was placed on the fact that the taxpayer's claim was speculative and dependent on the services of counsel when it was assigned (similar to the dissenting opinion in Kenseth). The courts viewed the assignment as a partnership between the taxpayer and the attorney. As an equitable assignment, when the attorney holds an equitable interest in the cause of action to the extent of the contingent fee agreement, the ownership of that percentage of the judgment is held by the attorney.

A taxpayer and his attorney should carefully structure the fee arrangement between them. When possible, a formal partnership should be considered. By forming a partnership with the attorney, when an individual is contributing a cause of action and the attorney is contributing his expertise in converting that cause of action into a settlement or award, a taxpayer may avoid the assignment-of-income designation, and be treated as a partner with a right to receive money yet to be determined. The partnership should be structured consistent with the contingent fee agreement, which would allow the income to be charged to the one who earned and received it. This will help to alleviate some of the tax burden associated with a settlement or award and allow more of the proceeds to stay with the injured party. In lieu of this type of arrangement, counsel should be aware of the potential tax impact of his contingent fee when determining whether to recommend a particular settlement to a client. It is important the client fully understand the amount of cash yielded from a settlement after fees, costs and taxes. Failure on the attorney's part to properly advise his client may open the door to a future malpractice claim.

FROM MICHAEL H. HOSO, CPA, COHEN & COMPANY, LLC, YOUNGSTOWN, OH

Editor: Anthony Bakale, CPA, MT Cohen & Company, CPAs Summit International Associates, Inc. Cleveland, OH