Contingent Attorney Fee Is Income to Client

TAX CASE

In today’s litigious society, many class action lawsuits have contingent attorney fee arrangements. Although the reasons for the lawsuits differ—age discrimination, wrongful termination and the like—the tax issue is the same. Contingent fees are paid directly out of a taxpayer’s judgment or settlement award. The IRS position is that the full amount of the award is includable in the taxpayer’s gross income under IRC section 61 and legal fees are potential itemized deductions under IRC section 67. The courts are split on whether taxpayers should include contingent fees paid directly to attorneys in gross income. The difference between including the fees and taking them as an itemized deduction or excluding them may be significant because of the 2% floor on miscellaneous itemized deductions, the deduction phase-out for high income taxpayers and the disallowance of miscellaneous itemized deductions for alternative minimum tax purposes.

James Sinyard, a division manager in the Mobile, Alabama, office of IDS Financial Services, Inc., was forced to resign in 1987 at age 49. Sinyard, along with 31 others, joined two class action lawsuits against IDS for age discrimination in violation of the Age Discrimination in Employment Act of 1967 (ADEA). The plaintiffs entered into a contingent fee arrangement with Winthrop & Weinstine that allocated one-third of any settlement or jury award to cover attorneys’ fees. In 1992 IDS agreed to settle for $35 million, one-third of which went to the plaintiffs’ lost wages, one-third to tort damages and one-third to attorneys’ fees.

On their 1992 joint federal income tax return, the Sinyards excluded from gross income the portion of the settlement ($252,608) attributable to attorneys’ fees. Upon examination the IRS determined the fees were gross income to the Sinyards and deductible as a miscellaneous itemized deduction. The Sinyards petitioned the Tax Court. It agreed with the IRS that the contingent fees were gross income. Because the Sinyards would not fully benefit from the deduction due to the 2% floor and their exposure to the AMT, they turned to the Ninth Circuit Court of Appeals for help.

Result. For the IRS. The Ninth Circuit, affirming the Tax Court, held the contingent fees were includable in the Sinyards’ gross income and deductible only as a miscellaneous itemized deduction. The court determined the Sinyards were in constructive receipt of the money paid to Winthrop & Weinstine. The Ninth Circuit cited Old Colony Trust Co., in which the court held “the discharge by a third person of an obligation to him is equivalent to receipt by the person taxed.” The Sinyards maintained that the ADEA differed from other fee-shifting statutes in its intent to make the plaintiff whole. The Ninth Circuit pointed out that the ADEA does make the injured party whole with respect to lost compensation. Attorneys’ fees are in addition to that. Although the unintended tax result, the Ninth Circuit said, might have seemed unfair, it was due to the operation of the AMT provisions, which the court could not change.

The lone dissenting judge agreed with the Sinyards as to the ADEA’s intent. She said the act’s language provided for the attorneys’ fees to be “in addition” to the plaintiffs’ recovery. The ADEA imposed the obligation for the attorneys’ fees on the defendant—IDS. The fees, therefore, should not have been included in the Sinyards’ gross income.

By concluding that contingent attorneys’ fees were gross income to the plaintiff the Ninth Circuit stood with the Federal Circuit, the Tax Court and the IRS. The Fifth, Sixth and Eleventh circuits, however, have held for the taxpayer. Since the courts are split as to treatment of contingent attorney fees and the issue is significant due to the popularity of class action lawsuits with such fee arrangements, the U.S. Supreme Court may have to settle the conflict. Alternatively, Congress could resolve the inequitable tax effects resulting from the 2% floor, the deduction phase-out and the AMT. Until that time taxpayers should consider what circuit they’re in and take into account the likelihood the IRS will scrutinize lawsuit awards or settlements.

James T. Sinyard, 88 AFTR 2d 2001-5350.

Prepared by Karyn Bybee Friske, CPA, PhD, assistant professor of accounting, and Darlene Pulliam Smith, CPA, PhD, professor of accounting, both at the T. Boone Pickens College of Business, West Texas A&M University, Canyon.