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 clarifying points. First, the issue really involved the alternative minimum tax. The legal fees for both taxpayers were deductible for regular tax purposes as miscellaneous itemized deductions, but the alternative minimum tax denies such deductions. Taxpayers who receive large recoveries, therefore, are subject to the alternative minimum tax on the gross amount rather than on the net after-expense amount. Second, the Jobs Creation Act of 2004 added IRC section 62(a)(19)(20), which allows taxpayers to deduct from adjusted gross income attorney’s fees and costs associated with cases involving unlawful discrimination. Therefore, in the Court’s opinion the issue was relevant mainly for tax years prior to the effective date of the 2004 act.

The IRS said attorney’s fees must be included in income under the assignment-of-income doctrine. The taxpayers argued the doctrine should not apply since the assignment occurred while the claim was speculative or contingent. The Court rejected this position because prior cases had upheld the doctrine even when the exact amount of income was undetermined. The conclusion did not address several distinguishing factors raised by the taxpayers. Therefore the doctrine will apply to any assignment of amounts that will be included in income.

The taxpayers’ second argument, as phrased by the Court, was that the fee should not be included in their income because they and their attorneys had entered into a business to jointly earn the income. The Court concluded there was no joint business. The attorneys were the taxpayers’ agents, not partners. This fact cannot be changed by contract or state laws, even ones that provide protection and special rights in the recovery. This part of the opinion overrules cases decided based on state property rights.

The Supreme Court also refused to consider any arguments presented in amicus briefs because they were new and had not been evaluated at the lower court level. Nor would it consider Banks’ argument that the statutory fee-shifting provisions overrode the assignment-of-income doctrine because, in his settlement, the attorney’s fee had been calculated under a contingent fee contract rather than by statutory provision.

Tax practitioners should be aware that new IRC section 62(a)(19)(20) does not apply to all lawsuits. For lawsuits brought under contingent fee contracts, which are not covered by the new law, taxpayers will have to include the full amount in income unless they are willing to risk a court fight in hopes the court will accept one of the arguments presented in the amicus briefs, which the Supreme Court labeled as “novel propositions of law.“

Commissioner v. John W. Banks II, 2005 US Lexis 1370.

Prepared by Edward J. Schnee, CPA, PhD, Hugh Culverhouse Professor of Accounting and director, MTA Program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.