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Contingent attorney fees.

Taxpayers often hire an attorney on a contingent fee basis. If the recovery is taxable, the attorney fee is deductible. Because of the interaction between regular tax and alternative minimum tax rules, however, these taxpayers can owe significant amounts--sometimes exceeding their entire receipt. In such situations they have argued that the correct amount of their taxable income is the net proceeds (recovery minus contingent legal fees). The courts of appeals have split over the answer. The Supreme Court agreed to hear the issue and delivered a short but significant opinion.

The Supreme Court decision covered two consolidated cases. In the first, John Banks II was fired from his position as educational consultant to the California Department of Education. He sued for employment discrimination, hiring an attorney on a contingent fee basis. He did not include any of the $464,000 settlement in income on his tax return. The IRS issued a deficiency notice based on the full amount, and the Tax Court upheld the deficiency. The appellate court held that the correct amount of included income was the settlement minus the $150,000 attorney fee.

In the second case Sigitas J. Banaitis left his job as vice-president and loan officer at the Bank of California. He hired an attorney on a contingent fee basis to sue the bank and its successor, Mitsubishi Bank, for willful interference with the employment contract, attempting to induce him to breach his fiduciary responsibility and firing him for refusing.

Banaitis was awarded compensatory and punitive damages. He settled for a payment of $4.9 million, which he included in income, plus $3.9 million to be paid directly to his attorney, which he did not. The IRS determined that the amount paid to the attorney should have been included in income. The Tax Court agreed, but the appellate court reversed based mainly on state law.

Result. For the IRS. The Supreme Court opinion began with two clarify
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Title Annotation:TAX MATTERS
Author:Schnee, Edward J.
Publication:Journal of Accountancy
Date:May 1, 2005
Previous Article:The tax is assessed, not the taxpayer.
Next Article:substantiate travel and entertainment costs: writing off a corporate fishing trip.

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