Is a Contingent Attorney’s Fee Includible in Plaintiff’s Income?

The courts disagree on whether taxpayers must report (and can deduct) certain attorneys’ fees
BY LESLI LAFFIE

  

gnes, a 64-year-old resident of California, successfully sued her ex-employer in 2000 for wrongful termination; a jury awarded her $2 million. Agnes paid her attorney $800,000, 40% of the award, in accordance with their contingent fee agreement; thus, her net proceeds from the suit were $1.2 million. In March 2001 Agnes will visit her tax preparer, explain the suit and the outcome, and provide all her documentation.

How much lawsuit income must the preparer report on Agnes’s return? Is it $2 million, $1.2 million, or something in between? If it is $2 million, can Agnes deduct her attorney’s fees and litigation costs? The answers depend on the state in which Agnes lives and that jurisdiction’s law. Because of the dollars involved, this issue is extremely controversial and has produced a rift in the U.S. circuit courts of appeals.

EXCLUSIONS, INCLUSIONS AND DEDUCTIONS

Why would a contingent fee be excludible from a plaintiff’s income? One theory is that, under state law, an attorney may have an equitable assignment or lien and, therefore, an equity interest in the cause of action (that is, the nature of the suit) to the extent of the contracted fee. Further, the value of the lawsuit might be completely speculative and dependent on the attorney’s services, so that the right to the income is the attorney’s from the outset.

One inclusion theory is that the taxpayer has retained all proprietary rights in the claim and simply is using a portion of the award to discharge a personal liability to the attorney. In such case, the attorney’s fee and litigation costs may be deductible by the taxpayer as a miscellaneous itemized deduction, subject to the 2%-of-adjusted-gross-income floor (and overall phaseout on itemized deductions, if applicable). Thus, the taxpayer may have to include the contingent fee in income, but the deduction for it is limited (that is, smaller).

Another inclusion theory is that the taxpayer received the benefit of the lawsuit proceeds even if he or she did not take possession of the funds. Still another is that the taxpayer’s control over the transferred income justifies holding him or her liable for taxes on it. The assignment-of-income doctrine (court created), assigns income back to a taxpayer who has tried to shift its receipt and taxability to another (for example, through a contingent fee agreement). A preparer should look at applicable court decisions to determine how to analyze the taxability of a contingent fee for reporting purposes.

COURT DECISIONS

To date, several of the circuit courts of appeal, in addition to the Tax Court, have weighed in with decisions on this issue. The Fifth, Sixth and Eleventh Circuits hold contingent fee income to be excludible; the Ninth and Federal Circuits, and the Tax Court, hold such income to be includible (but an itemized deduction may be available for attorney’s fees and litigation costs).

FIFTH CIRCUIT

In Sudhir P. Srivastava (7-19-00, aff’g in part, rev’g and remd’g in part, TC Memo 1998-362), the Fifth Circuit Court of Appeals held that a contingent fee paid under Texas law was excludible from the plaintiff’s income. In that case, the taxpayer, a doctor, had sued a television station for defamation of character; the suit was settled for $8.5 million.

The court held that, under Texas law, the attorneys had an ownership interest in the taxpayer’s recovery to the extent of their contingent fee. The fee was a division of property, not an assignment of income; thus, it had to be charged to the attorneys who earned and received the funds, not to the taxpayers, because the income was the result of the attorneys’ personal skill and judgment.

SIXTH CIRCUIT

In Estate of Arthur L. Clarks (202 F.3d 854 (2000), rev’g ED Mich., 11-23-98), the Sixth Circuit Court of Appeals held that an estate could exclude from income an award stemming from a personal injury lawsuit. According to the court, the only economic benefit the decedent could derive from his claim against the defendant in state court was to use the contingent part of it to help him collect the remainder. Under Michigan law, the contingency fee agreement was an assignment that operated as a lien on a portion of the decedent’s prospective judgment that transferred ownership of that portion of the judgment to the attorney. Further, because the contingency fee was the result of the lawyer’s personal skill and judgment, it had to be charged to the party who earned and received it, not to the decedent.

NINTH CIRCUIT

In the Ninth Circuit Court of Appeals, Franklin P. Coady (6-14-00, aff’g TC Memo 1998-291), held that a married couple could not exclude from income the portion of the wife’s proceeds from settlement of a wrongful termination suit that was retained by her attorneys under a contingent fee agreement. Under state (Alaska) law, attorneys do not have a superior lien in their clients’ suits, judgments or decrees. Thus, the wife retained all proprietary rights in her claim, subject to a statutory lien held by the attorneys on any proceeds derived from that claim. The entire award was therefore includible in income; however, attorneys’ fees and litigation costs were allowable as itemized deductions.

ELEVENTH CIRCUIT

In Willie Mae Barlow-Davis (4-27-00, aff’g TC Memo 1998–248), the Eleventh Circuit Court of Appeals held a contingent fee to be excludible. According to that court, under Alabama law, the attorneys had an ownership interest in the taxpayer’s recovery to the extent of their contingent fee. The court rejected the IRS’s contention that the contingency fee agreement constituted a sale of part of the taxpayer’s cause of action, the value of which could not be determined or taxed until she received a judgment.

FEDERAL CIRCUIT

In this circuit, the seminal case is Jack L. Baylin (43 F.3d 1451 (1995), aff’g 30 Fed. Cl. 248 (1993)). In this case, the court held that, under Maryland law, the lien statute did not give an attorney an ownership interest in a contingent fee; thus, the entire award was includible in the plaintiff’s income.

TAX COURT

In a recent case, Eldon R. Kenseth (114 TC no. 26 (2000)), the Tax Court held that, under the assignment-of-income doctrine, a Wisconsin taxpayer had to include the full amount of an age discrimination award in income, but could deduct the attorney’s fee as an itemized deduction.

COMPLIANCE STRATEGY

CPAs whose clients have been awarded judgments or settlements subject to contingent fee agreements should be mindful of state laws governing who maintains rights in a lawsuit and the circuit within which a court decision would fall.

Agnes’s tax preparer, therefore, should examine California law as to the attorney lien issue. The outcome of any litigation would be appealable to the Ninth Circuit, so familiarity with the Coady decision (although decided under Alaska law) is also warranted. Because a large dollar amount is at stake, litigation may be worthwhile if the fee is excluded and the IRS challenges.

—Lesli S. Laffie, JD, LLM
Technical Editor,
The Tax Adviser

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