Supreme Court decides contingent fee cases.

A recent Supreme Court decision held that, when law suit judgment or settlement is taxable, the litigant must include in income the portion paid to the attorney as a contingent fee. However, the Court did not address cases involving court-awarded attorneys' fees.

In one of the reviewed cases, Banks, 345 F3d 373 (2003), the Sixth Circuit had held the contingent fee portion of a litigation recovery is not included in the plaintiff's gross income. It reasoned that the contingent fee agreement was not an anticipatory assignment of the plaintiff's income, because the litigation recovery was not already earned, vested or even relatively certain to be paid when the contingent fee contract was made.

In the other case, Banaitis, 340 F3d 1074 (2003), the Ninth Circuit had held that the portion of the recovery paid to the attorney as a contingent fee is excluded from the plaintiff's gross income only if state law gives the plaintiff's attorney a special property interest in the fee. Six circuits had held that the entire litigation recovery (including the portion paid to an attorney as a contingent fee) is income to the plaintiff, with little emphasis on state law; other circuits have been explicit that the fee portion of the recovery is always income to the plaintiff.

Facts

In Banks, Ysued his former employer for employment discrimination under 42 USC Sections 1981 and 1983, Title VII of the Civil Rights Act of 1964 and Cal. Govt. Code Ann. [section]12965. He retained an attorney on a contingent fee basis. After trial commenced, the parties settled for $464,000. Y paid $150,000 of this amount to his attorney under the fee agreement.

In Benaitis, X retained an attorney on a contingent fee basis in a state court case against his former employer for willfully interfering with his employment contract, attempting to induce X to breach fiduciary duties to customers and discharging him when he refused. The jury awarded compensatory and punitive damages; the parties settled and in following the formula set forth in the contingent fee contract, the defendants paid an additional $3,864,012 directly to X's attorney.

Anticipatory Assignment of Income

The rationale for the so-called anticipatory assignment of income doctrine is the principle that gains should be taxed "to those who earn them"; see Lucas v. Earl, 281 US 111 (1930). The doctrine is meant to prevent taxpayers from avoiding taxation through "arrangements and contracts however skillfully devised to prevent ... [income] when paid from vesting even for a second in the man who earned it" (Lucas, 281 US at 115). X and Y argue that the anticipatory assignment doctrine is a judge-made antifraud rule with no relevance to their contingent fee contracts. The Service maintains that a contingent fee agreement should be viewed as an anticipatory assignment to the attorney of a portion of the client's income from any litigation recovery.

In an ordinary case, attribution of income is resolved by asking whether a taxpayer exercises complete dominion over the income in question (Glenshaw Glass Co., 348 US 426 (1955)). In the context of anticipatory assignments, however, the assignor often does not have dominion over the income on receipt. In that instance, the question becomes whether the assignor retains dominion over the income-generating asset, because the taxpayer "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"; see Horst, 311 US 112 (1940).

X and Y say that, in contrast to the bond coupons assigned in Horst, the value of a legal claim is speculative at the moment of assignment, and may be worth nothing. Second, they insist that the claimant's legal injury is not the only source of the ultimate recovery; the attorney also contributes income-generating assets--effort and expertise--without which the claimant would not likely prevail. Thus, they contend that, for tax purposes, the contingent fee agreement establishes something like a joint venture or partnership in which the client and attorney combine their respective assets--the client's claim and the attorney's skill--and apportion any resulting profits.

We reject X and Y's arguments. Though the value of the plaintiff's claim may be speculative when the fee agreement is signed, the anticipatory assignment doctrine is not limited to instances in which the precise dollar value of the assigned income is known in advance. Although Horst involved an anticipatory assignment of a predetermined sum to be paid on a specific date, its holding did not depend on ascertaining a liquidated amount at the time of assignment. In the instant cases, as in Horst, the taxpayer retained control over the income-generating asset, diverted some of the income produced to another party and realized a benefit by doing so. As Judge Wesley correctly concluded in a recent case, the rationale of Horst applies fully to a contingent fee contract (Raymond, 355 F3d 107 (2d Cir. 2004)).

We further reject the suggestion to treat the attorney-client relationship as a sort of business partnership or joint venture for tax purposes. The relationship between client and attorney, regardless of the variations in particular compensation agreements or the amount of skill and effort the attorney contributes, is a quintessential principal-agent relationship--it does not alter the fact that the client retains ultimate dominion and control over the underlying claim. The portion paid to the agent may be deductible, but absent some other provision of law it is not excludible from the principal's gross income.

This rule applies whether or not the attorney-client contract or state law confers any special rights or protections on the attorney, as long as these protections do not alter the fundamental principal-agent character of the relationship; cf. Restatement (Second) of Agency, [section]13, Comment b, and [section]14G, Comment a (an agency relationship is created when a principal assigns a chose in action to an assignee for collection and grants the assignee a security interest in the claim against the assignor's debtor, to compensate the assignee for his or her collection efforts). State laws vary on the strength of an attorney's security interest in a contingent fee and the remedies available to an attorney if the client were to discharge or attempt to defraud the attorney. However, no state laws, even those that purport to give attorneys an "ownership" interest in their fees, convert the attorney from an agent to a partner.

Federal Statutory Scheme

Y's case involves a further consideration, because he brought his claims under Federal statutes that authorize fee awards to prevailing plaintiffs' attorneys. Y thus contends that application of the anticipatory assignment principle would be inconsistent with the purpose of statutory fee-shifting provisions; see Venegas, 495 US 82 (1990) (observing that statutory fees enable "plaintiffs to employ reasonably competent lawyers without cost to themselves if they prevail"). In the Federal system, statutory fees are typically awarded by the court under the lodestar approach (Hensley, 461 US 424 (1983)), and the plaintiff usually has little control over the amount awarded. Sometimes, as when the plaintiff seeks only injunctive relief, the statute caps plaintiffs' recoveries, or for other reasons damages are substantially less than attorneys' fees, court-awarded attorneys' fees can exceed a plaintiff's monetary recovery; see Riverside, 477 US 561 (1986) (compensatory and punitive damages of $33,350; attorneys' fee award of $245,456). Treating the fee award as income to the plaintiff in such cases, it is argued, can lead to the perverse result that the plaintiff loses money by winning the suit; see Wood and Daher, "Class Actions and the Attorneys' Fees Conundrum," 35 The Tax Adviser 428 (July 2004).

We need not address these claims. After Y settled his case, the fee paid to his attorney was calculated solely on the basis of the private contingent fee contract. There was no court-ordered fee award, nor was there any indication in Y's contract with his attorney (or in the settlement agreement with the defendant) that the contingent fee paid to Y's attorney was in lieu of statutory fees Y might otherwise have been entitled to recover. Also, the amendment added by the American Jobs Creation Act of 2004 (AJCA) redresses the concern for many (perhaps most) claims governed by fee-shifting statutes.

The judgments of the Sixth and Ninth Circuits are reversed. JOHN W. BANKS, S.Ct., 1/24/05

REFLECTIONS: AJCA Section 703 allows an above-the-line deduction for a taxpayer's attorneys' fees and costs in cases involving unlawful discrimination, for fees and costs paid for settlements and judgments after Oct. 22, 2004. However, it is not retroactive, thus, the plaintiffs would have been entitled only to a miscellaneous itemized deduction, disallowed for purposes of the alternative minimum tax.