Contingent Fee Awards—A Different Approach

For many years there have been disputes between taxpayers and the IRS concerning the taxable amount of court awards or settlements taxpayers receive from wrongful termination claims under a contingent fee arrangement. Some courts have held the gross amount of the award represents income to the taxpayer and the amount paid to the attorneys represents a deduction. Unfortunately for taxpayers the law treats the deduction as a miscellaneous itemized deduction subject to the 2% of AGI floor. In addition, due to the large dollar amounts involved, a transaction sometimes triggers the alternative minimum tax (AMT) since miscellaneous itemized deductions are not allowed when calculating AMT.

Other courts have permitted a more favorable outcome, allowing taxpayers to include in gross income only the net amount they received after deducting attorney’s fees. In either situation the nature of the attorney’s legal interest under applicable state law usually has been the determining factor. For example, based on state law the Ninth Circuit Court of Appeals has required the gross approach for California and Alaska taxpayers but allowed the net approach for an Oregon taxpayer (see Coady v. Commissioner, 2000-1 USTC 50,528; Benci-Woodward v. Commissioner, 2000-2 USTC 50,595; and Banaitis v. Commissioner, 2003-2 USTC 50,638).

Frank Biehl was an employee, officer, shareholder and director of North Coast Medical Inc. (NCM) in California. NCM terminated Biehl’s employment. Subsequently, he filed a wrongful termination suit against the company. After a jury gave Biehl a favorable verdict, the two parties reached a settlement. The agreement required NCM to pay him $799,000 in settlement of his employment-related claims and to make a direct payment of $401,000 to Biehl’s attorneys for their fees under a contingent fee agreement.

The taxpayer included only the $799,000 as gross income on his federal income tax return. The IRS disagreed. Biehl petitioned the Tax Court for relief. Since the Ninth Circuit had previously ruled California law required the gross approach, the taxpayer argued the $401,000 NCM paid to the attorneys represented a reimbursed employee business expense under an accountable plan. Biehl’s argument was based on (1) the presence of a shareholder agreement which required the losing party to pay the attorney’s fees of the prevailing party in any suit due to a breach of the agreement and (2) the fact the lawsuit arose out of the taxpayer’s former employment. Under this theory the $401,000 would have represented gross income; however, the amount paid to the attorneys would have been an above-the-line deduction. Thus the two sums would have offset each other, producing the same result as the net approach in which the taxpayer included only $799,000 in his gross income. The Tax Court rejected these arguments stating wrongful termination suits were not mentioned in the shareholder agreement and settlement of the suit did not satisfy the business connection test required for accountable plans. Biehl appealed to the Ninth Circuit.

Result. For the IRS. The Ninth Circuit agreed with the Tax Court that an expenditure represents a reimbursed employee business expense only if it first qualifies as a trade or business expense under IRC section 162. If it satisfies that test, section 162(a)(2)(A) requires the taxpayer to meet the business connection, substantiation and “return of excess amounts” tests. The Ninth Circuit agreed with the Tax Court that the amount paid to the attorneys was a deductible business expense since the expenditure had its origins in the taxpayer’s trade or business of being an employee. The Ninth Circuit also agreed with the Tax Court that Biehl did not satisfy the business connection test. The court said to satisfy that test the expenditure must have been incurred by the taxpayer in the performance of services as an employee. It was clear Congress intended the above-the-line tax deduction to be available only when there was a current employer-employee relationship. Also, the employee must incur the expenditure on the employer’s behalf, which implies a beneficial relationship between the expenditure and the employer. Since Biehl’s employment had ended long before he incurred the legal fees, the expenditure could not satisfy the business connection test even though it had originated from his employment. Because the expense failed this test, the taxpayer was not eligible for above-the-line treatment.

Frank Biehl v. Commissioner, 2004-1 USTC 50,109.

Prepared by Charles J. Reichert, CPA, CIA, professor of accounting at the University of Wisconsin, Superior.