High Court ruling on attorney fees expected to have limited effect.

In an 8-0 decision in January, the U.S. Supreme Court held that when litigants' recovery constitutes income, they must report to the IRS the portion of the recovery paid to their attorney as a contingent fee. (Comm'r v. Banks, No. 03-10983, 2005 WL 124006 (U.S. Jan. 24, 2005).) Although the decision increases the tax burden on some plaintiffs, its reach is expected to be limited.

"The decision doesn't apply to personal injury suits or employment discrimination suits or most of what ATLA members do," said Jeffrey White, senior counsel for amicus curiae at the association, which filed an amicus brief in the case. But, he said, the ruling could affect recoveries for some nonphysical injuries and punitive damages.

Congress provided a tax fix for employment discrimination and civil rights plaintiffs last year when it passed the American Jobs Creation Act, allowing taxpayers to deduct attorney fees. The act allows deductions for these fees for 17 causes of action, including suits under the Civil Rights Act, National Labor Relations Act, Fair Labor Standards Act, Age Discrimination in Employment Act, Americans with Disabilities Act, Family and Medical Leave Act, Title VII, and federal whistleblower statutes, as well as any other laws "providing for the enforcement of civil rights, or regulating any aspect of the employment relationship." The act does not apply to the plaintiffs in Banks because it was passed after the consolidated cases arose and is not retroactive.

In the case before the Supreme Court, John Banks and Sigitas Banaitis had each settled employment discrimination suits, but neither included fees paid to their attorneys under contingent fee agreements as gross income on their federal tax returns. The IRS commissioner sent notices of deficiency, which tax courts upheld.

The Sixth Circuit reversed in part for Banks, finding the amount he paid as fees should not be included in gross income; for Banaitis, the Ninth Circuit found that fees could not be included in gross income because of an Oregon law giving attorneys a superior lien for the contingent-fee part of any recovery. The Supreme Court reversed these decisions.

The Court sided with the IRS against the respondents on their main argument--that the so-called anticipatory-assignment doctrine is not relevant to contingent fees because the plaintiff does not control the outcome of the case.

"In the case of a litigation recovery, the income-generating asset is the cause of action that derives from the plaintiff's legal injury. The plaintiff retains dominion over this asset throughout the litigation," the Court wrote. "Though the value of the plaintiff's claim may be speculative at the moment the fee agreement is signed, the anticipatory-assignment doctrine is not limited to instances when the precise dollar value of the assigned income is known in advance."

ATLA's amicus brief argued that the exchange of a plaintiff's cause of action for money (in the form of a judgment or settlement) ought to be treated like the sale or exchange of stock or property. In other words, the taxpayer subtracts the fee paid to the broker or real estate agent before declaring the net proceeds as income. The Court noted ATLA's argument in its opinion but wrote that it was "especially reluctant to entertain novel propositions of law with broad implications for the tax system that were not advanced in earlier stages of the litigation."

"The Court seemed to suggest that it might look at the issue at a later date, but for now let it percolate back through the lower courts," said White.

What the ruling could do is raise new tax questions, he said. For example, the IRS says personal injury damages are income, but what about emotional distress damages for plaintiffs who are not the taxpayer? Also, the tax code treats punitive damages as income, even in personal injury suits. To minimize their clients' tax burden, attorneys with punitive damages claims might prefer to allocate their tees to the recovery of nontaxable compensatory damages, but the IRS might require them to allocate the fees to the punitive portion of the recovery.

While the Banks ruling will have little impact on most trial lawyers, the ruling makes a difference in nonphysical injury cases not involving civil rights, such as libel and defamation claims, bad-faith insurance actions for economic damage, and intellectual property suits, White said.