Taxation of contingent fee awards.

In many tort cases, as well as in class action lawsuits, the attorneys receive a contingent fee equal to a fixed percentage of the award or recovery. Whether the taxpayer must include the full award in his or her income or only the part remaining after paying the contingent legal fee, however, has not always been clear.

In June 1988 Arthur Clarks was awarded $5,600,000 in damages from K-Mart for injuries he sustained while unloading his truck. In 1991 K-Mart paid Clarks $11,307,875 ($5,600,000 award plus $5,707,875 interest) to satisfy the judgment. Clarks' attorney received $3,766,471; Clarks received the balance.

Following Clarks' death, his estate filed form 1040 and included only $3,806,532--the amount of interest income he actually received. The estate excluded the interest that was paid to his attorney. The IRS audited the return and included the full amount of interest in Clarks' taxable income, assessing a tax deficiency of $254,298. The district court held for the IRS and the taxpayer appealed.

Result. For the taxpayer. Prior appeals courts that considered this issue were split. The Fifth Circuit Court of Appeals, in Cotnam, 263 F.2d 119, held that the taxpayer did not have to include the contingent fee in income. The Fifth Circuit based its decision on Alabama law, which gives attorneys a unique lien on any award received under a contingent fee contract. In contrast, the Federal Circuit Court of Appeals, in Baylin, 43 F.2d 1451, held that the full award was taxable based on the assignment-of-income doctrine. The court said the taxpayer earned the amounts in question and then assigned them to the attorneys.

The Clarks case took place in Michigan, which provides an attorney lien similar to Alabama's. The Sixth Circuit Court of Appeals, therefore, held that the fee Clarks paid his attorney was not includable in his income.

The Tax Court considered the same issue in an Arizona case, Sinyard, TC Memo 1998-364, and held that the taxpayer must include the full amount of the award as income. The court distinguished its decision from Cotnam, because Arizona law does not provide a lien similar to Alabama's. The Sinyard decision is currently under appeal.

Regardless of the ultimate decision in Sinyard, there is an apparent conflict among the circuit courts on this issue. Taxpayers can reconcile the various decisions based on whether state law provides a lien to enforce the contingent fee. Those taxpayers in states with a lien provision can omit the fees from income. In other states, the full amount may be taxable, depending on the outcome of future decisions, including the Sinyard appeal.

* Estate of Arthur Clarks, 2000-1, USTC [paragraph] 50, 158.

Prepared by Edward J. Schnee, CPA, PhD, Joe Lane Professor of Accountancy and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.