Taxation of contingent attorney fee awards.

Practitioners should be aware of a recent decision (Estate of Arthur L. Clarks, 202 F3d 854 (6th Cir. 2000)) that might provide some relief from a perplexing tax problem faced by individuals who win damage awards and must pay their attorneys a contingent fee based on the amount of the award. A standard attorney-client fee contract gives the attorney a percentage of the total recovery in a case in exchange for the attorney using his best efforts to prosecute his client's claim. Normally, the defendant pays the fee directly to the plaintiff's attorney. The IRS takes the position that the attorney's fee (but not interest) is excludible for personal injury awards, and that the full amount of other judgments or settlements must be included in the taxpayer's gross income. If deductible, the attorney's fee is usually treated as a miscellaneous itemized deduction. The problems with this treatment are threefold: (1) by including the full award in gross income, the 2%-of-adjusted-gross-income floor is inflated, causing more of the fees to be nondeductible; (2) for certain income brackets, the miscellaneous itemized deduction is phased out and; (3) miscellaneous itemized deductions are not allowed for alternative minimum tax (AMT) purposes. Taxpayers who are awarded an attorney's fee often incur AMT as a result.

In Est. of Clarks, in 1988 a jury awarded Arthur Clarks $5.6 million in personal injury damages in a suit against K-Mart for head injuries he incurred while loading his truck. Ultimately, K-Mart paid $11,307,875 in full satisfaction of the award (the additional amount being accrued interest). Pursuant to the fee agreement, K-Mart paid Clarks' attorney $3,766,471--one-third of the total award. When, after Clarks' death, his estate filed its income tax return, it did not include in income the portion of the interest income it paid to the attorney. The Service audited the return and asserted a deficiency against the estate of $254,298 plus interest. The estate paid the tax and sued for a refund. The trial court found for the government, but the Sixth Circuit reversed.

The appellate court in Clarks reasoned that the contingent fee agreement operated as a common law lien on the recovery, thereby vesting in the attorney the right to receive the agreed-on portion of the award. The court relied on a 1959 Fifth Circuit case arising under Alabama law (Cotnam, 263 F2d 119). The Cotnam court reasoned that Alabama law granted the attorney an equitable lien that operated as a transfer of that portion of the award to the lawyer. The court rejected Baylin, 43 F3d 1451 (Fed Cir. 1997), which followed the Supreme Court assignment-of-income cases (Lucas vs. Earl, 281 US 111 (1930), which prohibits the assignment of income from personal services, and Helvering vs. Horst, 311 US 112 (1940), which prohibits the assignment of income from property). The Sixth Circuit reasoned that, in Lucas and Horst, the primary motivation for the assignments was the saving of taxes, because the income was already "earned, vested and relatively certain"; the assignment was a gift for which the assignees performed no services. The Sixth Circuit reasoned that the facts in Clarks were very different; the assignment was for a good business purpose, the attorneys were required to render valuable services and the outcome was uncertain. The court likened the contractual arrangement between the attorney and client to a joint venture arrangement with a claim that amounted to an intangible, contingent expectancy. The court reasoned further that the attorneys were obligated to pay tax on the income, regardless of the tax implications to the assignor estate (unlike Lucas and Horst, in which the assignees had no such obligation unless the assignments were upheld). In Clarks, the court noted that the government's position would have required both the assignor and assignee to recognize the income.

The implications of the case for practitioners are several. First, the case provides authority for excluding a contingent attorney fee and associated interest portion of an award. Although Clarks involved only interest, the reasoning should apply to contingent attorney fees as well. Second, practitioners should counsel clients and attorneys involved in lawsuits to have fees paid directly to the plaintiff's attorney, and to document the arrangement. On a cautionary note, it is probable that the IRS will not follow Clarks outside of the Sixth Circuit. Further, because there is a conflict between appellate courts, the Supreme Court may agree to hear an appeal.

FROM MYRON HULEN, CPA, PH.D., COLORADO STATE UNIVERSITY, FORT COLLINS, CO, AND WILLIAM KENNY, ESQ., PORTLAND STATE UNIVERSITY, PORTLAND, OR (NEITHER ASSOCIATED WITH KPMG LLP)