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Second Circuit includes contingent fee award in client's income.

Rentered into a contingent fee agreement with law firm A to represent him in his wrongful termination suit. R prevailed and a Vermont district court entered judgment for approximately $900,000. The defendant sent a check to A, payable to R; A deposited approximately $300,000 in its own account as a contingent fee.

R initially included the entire judgment in his gross income and attempted to deduct the fees paid. However, his tax liability was controlled by the alternative minimum tax (AMT). Because legal fees are among the itemized deductions that may not offset the AMT under Sec. 56(b)(1)(A)(i), R's tax liability was based on the entire judgment proceeds.

R subsequently filed an amended return, excluding the fees from his gross income and claimed the IRS owed him a refund of approximately $55,000, which the IR.S denied. R filed a retired suit in the Vermont district court, which granted R's motion for summary judgment, holding the contingent fee excludable from gross income; the IRS appealed.

The district court held that, under Vermont law, a contingent fee agreement between taxpayer and attorney gives rise to an equitable lien in favor of the attorney on the taxpayer's recovery, effecting a transfer to the attorney of a proprietary interest in the taxpayer's claim under Est. of Button, 28 A2d 404 (VT 1942).Thus, it is gross income to the attorney, but not to R.


Whether contingent fees are includible in a client's gross income is the subject of much debate among the circuit courts. The majority position is that the fees are includible in the client's gross income; see Campbell, 274 F3d 1312 (10th Cir. 2001); Kenseth, 259 F3d 881 (7th Cir. 2001); Young, 240 F3d 369 (4th Cir. 2001); and Baylin, 43 F3d 1451 (Fed. Cir. 1995). The minority position is that contingency fees are income to the attorney, but not to the client; see Davis, 210 F3d 1346 (11th Cir. 2000); Est. of Clarks, 202 F3d 854 (6th Cir. 2000); and Cotnam, 263 F2d 119 (5th Cir. 1959). The Ninth Circuit has held both ways, depending on the state law revolved; see Woodward, 219 F3d 941 (9th Cir. 2000); and Benaitis 340 F3d 1074 (9th Cir. 2003).

Courts generally recognize that state law determines the nature of legal interests in property, while Federal law determines the tax con sequences of the receipt or disposition of property. Thus, courts typically first analyze state law to determine the relative strength of the respective interests in the contingency fee. When the attorney's interest in the fee is sufficiently strong, some courts--those in the minority--have held that the attorney has a "property" interest exclusive of the client's interest; these courts conclude that the fee was never income to the client, only to the attorney. Other courts--those in the majority--have determined that although state law might pro vide attorneys with an interest in the fee, that interest is merely a "security" interest; they conclude that the fee is plainly income to the client, albeit income in which the attorney has a lien.

Several courts have expressly disavowed reliance on the state law analysis. For example, in Young, the Fourth Circuit stated that "whether amounts paid directly to attorneys under a contingent fee agreement should be included within the client's gross income should be resolved by proper application of federal income tax law, not the amount of control state law grants to an attorney over the client's cause of action"; Young, 240 F3d at 378.

The Supreme Court has long held that income is not taxable until it is received, but has also crafted the "anticipatory assignment of income" doctrine, under which taxpayers are prevented front avoiding the realization of income; see Horst, 311 US 112 (1940). In Horst, the taxpayer made a gift of bond coupons to his son, but retained the bonds; his son redeemed the coupons in the same year. The Court held that the taxpayer was obligated to include the bond interest in his gross income.

In the present case, the district court first examined Vermont law to determine the respective legal interests in the contingency fee in question. In Button, the Vermont court held that an attorney has an "equitable lien" on the contingency fee. The district court noted that the Supreme Court has indicated that when an attorney has a lien for fees, he or she has "an interest or share in the claim itself"; Nuttv. Knut, 200 US 13 (1906). Thus, the court concluded that, in Vermont, a "contingent fee agreement operates more like an assignment of income-producing property than an assignment of future income from property."

R argues that the Button case indicates that, under Vermont law, an attorney's interest in the contingent fee portion of a judgment is a property interest; the client never owns it. However, R's argument seems to rely on a narrow conception of ownership. The concept of property is not exhausted by the right to possess; it is also about the right to control.

The district court suggested that R did not control the portion of his judgment earmarked for his attorney. This is true in a narrow, proximate sense; once he agreed to a contingent fee arrangement, R gave up his right to a portion of his judgment. However, the same was true in Horst. R suggests that this case is relevantly different from Horst, because the question is whether to treat only the attorney, or the attorney and the client, as having received income. In Horst, the transaction was a gift from father to son, and the question was whether to treat the father or the son as the income recipient. But it makes little sense to distinguish between circumstances in which an attorney is paid on an hourly basis and those in which the client and attorney have agreed to a contingent fee arrangement; cf., Kenseth, 259 F3d at 884.When a client pays an attorney on an hourly basis, the same fund generates gross income for each; the fund simply passes through the client's hands first. There seems no reason to treat contingent fee arrangements differently.

The court concludes that Vermont law does not provide attorneys with a proprietary interest in their clients' claims. When a taxpayer is in sufficient control of the source of income, Federal taxation principles deem him or her the recipient of gross income on its disposition. Thus, the Second Circuit reverses the district court's ruling with instructions to grant the IRS summary judgment and dismiss the complaint.

DAVID RAYMOND, 2d Cir, 1/13/04
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Author:O'Driscoll, David
Publication:The Tax Adviser
Date:Mar 1, 2004
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