Contingent attorneys' fees - is help on the way?

The issue of whether contingent attorneys' fees are gross income to the recipient has been the subject of much debate among the circuits. Recently, the Supreme Court and Congress entered the arena and appear poised to settle this long-standing dispute. The Court has agreed to review the Sixth Circuit's decision in John Banks II, 345 F3d 373 (6th Cir. 2003), and the Ninth Circuit's decision in Sigitas Banaitis, 345 F3d 373 (9th Cir. 2003). In addition, a certiorari petition has also been filed from the Second Circuit's decision in David A. Raymond, 355 F3d 107 (2d Cir. 2004). (For additional details, see Wood and Daher, "Class Actions and the Attorneys' Fees Conundrum," TTA, July 2004, p. 428.)

This item discusses Raymond, as well as the provisions for civil rights tax relief proposed by Senator Chuck Grassley (R-IA), Chairman of the Senate Finance Committee, in his Jumpstart Our Business Strength Act (JOBS) (S 1637). Either way, it looks as though taxpayers will see a resolution of the issue in the near future.

Raymond

The taxpayer entered into a contingent fee arrangement with a law firm, under which he agreed to pay the firm one third of any recovery he received in his wrongful termination suit. He prevailed and was awarded $900,000. The defendant in the case satisfied the" judgment by sending a check to the law firm, payable to Raymond. The law firm deposited $300,000 in its account in accordance with its agreement and paid Raymond the balance.

On his originally filed 1998 return, Raymond included the entire $900,000 in income and claimed an itemized deduction for the $300,000 paid to the law firm. However, because of the amount of Raymond's income and deductions, he was subject to the alternative minimum tax (AMT). His total tax liability for 1998 was approximately $275,000.

In December 1999, Raymond filed an amended 1998 return, in which he excluded the $300,000 paid to the law firm. As a result, he was no longer subject to AMT; his total 1998 tax liability was reduced to about $220,000. After the IRS denied his refund claim, he filed suit in district court. The court found in Raymond's favor, holding that the contingent fee was excludible from gross income. The Service appealed.

Second Circuit's Analysis

The courts have generally established that while state law determines the nature of legal interests in property, Federal law dictates the tax consequences of receiving such property. To date, the courts have looked at the comparative strength of attorneys' interest in a contingency fee. The courts in the minority have held that when the interest is sufficiently strong, it rises to the level of a property interest and is exclusive of a client's interest. Thus, the fee is excluded from the client's gross income; see, e.g., Davis, 210 F3d 1346 (11th Cir. 2000) and Est. of Clarks, 202 F3d 854 (6th Cir. 2000).

Alternatively, the courts in the majority have held that state law provides the attorney merely with a security interest in a contingent fee arrangement. Accordingly, the fee is clearly income to the client, who can deduct it on his or her return; see, e.g., Campbell, 274 F3d 1312 (10th Cir.) and Kenseth, 259 F3d 881 (7th Cir. 2001).

Contract issue: In Raymond, the Second Circuit reasoned that Sec. 61(a) defines gross income as "all income front whatever source derived." The Supreme Court, in Lucas v. Earl, 281 US 11/ (1930), devised the "anticipatory assignment of income" doctrine, under which taxpayers are prevented from avoiding income realization. The Court applied this doctrine again in Helvering v. Horst, 311 US 112 (1940).

In Horst, the taxpayer made a gift of bond coupons to his son, who redeemed the coupons in the same year. In completing his return, the taxpayer failed to include the redemption proceeds in gross income. The Court held that the taxpayer was required to include the bond interest in income, stating, "he, who owns or controls the source of the income, also controls the disposition of that which he could have received himself and diverts the payment from himself to others as the means of procuring the satisfaction of his wants." In addition, the Court declared, "[t]he power to dispose of income is the equivalent of ownership of it." Consequently, because the taxpayer had retained control of the bonds, he retained control to dispose of the income (i.e., he retained the power to divert income to his son). That power created gross income.

In applying Horst to the present case, the Second Circuit concluded that Raymond had a gain--consequently, he had gross income. The court reasoned that Horst clearly indicates that a taxpayer can realize a gain subject to taxation, and although he "never receives the money he derives money's worth from the disposition of [the source of the income] which he has used as money or money's worth in the procuring of a satisfaction which is procurable only by the expenditure of money or money's worth." The court thus concluded that Raymond controlled the source of the income and diverted the payment from himself to others as the means of procuring the satisfaction of his wants, by directing a portion of his judgment to his attorney. As a result, the fee is income, for which he can take a deduction. According to the court, Raymond had control, because he could have dropped the case and fired his attorney, and only he had the power to settle. As in Horst, the taxpayer diverted income from his property. As Raymond had control over the flow of funds, he was the recipient of gross income for Federal tax purposes.

Civil Rights Tax Relief

Sen. Chuck Grassley has been working to allow a special, new "above the line" deduction for the portion of an award attributable to attorneys' fees and costs in cases involving claims of "unlawful discrimination." Section 643 of JOBS, which the Senate passed on May" 11, 2004, provides some relief for these types of cases. It defines unlawful discrimination to include a broad array of acts, ranging from sex and age discrimination to whistle-blower protection. The proposed legislation's effective date would be for fees and costs paid after 2002, for any judgment or settlement occurring afterward.

Conclusion

The circuits have been struggling for some rune with the Federal tax treatment of contingent attorneys' fees. The law may not be clear in this area; however, from an equitable viewpoint, the proper result should be to exclude the portion of the award pertaining to these fees from gross income. Help may soon be on the way: Although the Supreme Court's ultimate decision is uncertain, Congress clearly intends to exclude these amounts from gross income.

FROM PAUL DOUGHERTY, CPA, AMPER, POLITZINER & MATTIA, P.C., FLEMINGTON, NJ