Contingent attorneys' fees.

A recent decision (Coady, 9th Cir., 6/14/00) is heating up the battle over whether a taxpayer may exclude from gross income the portion of proceeds received from a settlement and retained by his attorney pursuant to a contingent fee arrangement. In Coady, the Ninth Circuit held that the taxpayer could not; siding with the IRS, the court rejected the taxpayer's argument that an effective assignment of income had been made.

In Coady, the taxpayer received a judgment in a wrongful termination suit and paid her attorney a percentage of it pursuant to a contingent fee arrangement. The taxpayers, relying on Cotnam, 263 F2d 119 (5th Cir. 1959), contended they were entitled to exclude the attorneys' fees because that portion of their settlement was assigned to counsel. In Cotnam, the taxpayer entered into a contingent fee arrangement to pay her attorney 40% of any amount recovered on a claim prosecuted on her behalf. The Fifth Circuit excluded the attorneys' fees from Cotnam's gross income, holding that, under Alabama law, an attorney has an equitable assignment or lien, enabling the attorney to obtain an equity interest in the cause of action to the extent of the contracted fee. It was also noted that, in Cotnam, the value of the lawsuit was entirely speculative and dependent on the attorney's services. In Coady, however, the court noted that, under Alaska law, attorneys do not have a superior lien or ownership interest in their clients' suits, judgments or decrees. The court concluded that the taxpayer retained all proprietary rights in the claim and simply used a portion of the award, on receipt, to discharge her personal liability owed to the attorneys. Accordingly, the entire award, including the contingency fee, was includible in gross income, and the attorneys' fees and litigation costs were deductible as a miscellaneous itemized deduction (subject to the two-percent limit, as well as the overall phaseout of itemized deductions based on adjusted gross income).

There is a split of authority among the Federal courts on this issue. In Estate of Clarks, 202 F3d 854 (2000), the Sixth Circuit, mirroring Cotnam, concluded that, under Michigan law, the contingent fee paid an attorney should not be included in the taxpayer's gross income, as the agreement operated as a lien on the portion of the judgment transferred to the taxpayer's attorney. Emphasizing that the taxpayer's claim was speculative and dependent on the services of counsel, the court also reasoned the taxpayer neither earned nor received the money, but rather it was earned by the attorney as a result of his own personal skill and judgment. Two other recent cases (Srivastava, 5th Cir., 7/21/00, and Barlow Davis, 210 F3d 1347 (11th Cir. 2000) (which is bound by the decisions of the former Fifth Circuit)), have followed the Cotnam decision.

In contrast, in Baylin, 43 F3d 1451 (1995), the Federal Circuit held a taxpayer could not exclude from income contingent fees paid directly to the attorney by the court. The court noted the taxpayer received the benefit of the proceeds, even though he did not take possession of the funds. In Kenseth, 114 TC No. 26, the Tax Court also held settlement proceeds paid under a contingent fee arrangement includible in the taxpayer's gross income and deductible as an itemized miscellaneous deduction. The court cited the assignment-of-income doctrine, reasoning that the taxpayer retained sufficient control over the transferred income to justify holding him liable for taxes on the income. The characterization of the contingent fees as an itemized deduction caused an alternative minimum tax (AMT) liability, due to the disallowance of the miscellaneous itemized deduction for AMT purposes. The court declined to depart from Congress's imposition of the AMT and limits on itemized deductions, noting the additional tax burden.

In light of this continuing controversy, when advising taxpayers involved in settlements with contingent fee arrangements, tax professionals should keep in mind that the total settlement proceeds (rather than just the net proceeds received) may have to be included in income. This may result in a substantially greater tax liability than the taxpayer might anticipate based on the net proceeds actually received.

FROM DARA SIMON, AIDMAN, PISER & COMPANY, PA, TAMPA, FL

Philip E. Moore, CPA, MBA Brown, Dakes & Wannall, P.C. DFK International Fairfax, Va