Labor
Logic
Court
rules on taxation of contingency fees
By
John D. Finerty
Feb.
2, 2005
 |
| John
D. Finerty, Jr.
|
Contingency
fee agreements in most cases allow an attorney or law firm to obtain compensation
for legal services by taking a portion of an award or settlement. How to treat
the contingency fee portion of an award or settlement for tax purposes has always
been a disputed issue. Some courts have held fees paid to an attorney are taxable
income to the client; other courts have held fees are not income to the client;
a third line of cases has held that state law controls.
The
U.S. Supreme Court settled the issue in Commissioner v. Banks and Commissioner
v. Banaitis when it held money paid to a plaintiff, from which an attorney takes
a contingency fee, must be included in the plaintiff's gross income.
Background
In
Commissioner v. Banks, John Banks was fired from his job as an educational consultant
at the California De-partment of Education. He filed a civil rights action against
the Department in California federal court, alleging employment discrimination;
he also signed a contingency fee agreement with the attorney he retained.
The
parties settled the case for $464,000, and Banks paid $150,000 of the total settlement
to his attorney pursuant to the contingency fee agreement. Banks, however, did
not report any of the $464,000 settlement proceeds on his federal income tax return.
In
Commissioner v. Banaitis, Banaitis quit his job as a loan officer at the Bank
of California and then sued the Bank's successor owner, Mitsubishi Bank. Banaitis
alleged Mitsubishi interfered with his employment contract with the Bank of California
and attempted to induce him to breach fiduciary duties to customers and then effectively
discharged him when he refused.
A
jury awarded compensatory and punitive damages; after post-trial motions and appeals
were resolved, the defendants paid Banaitis $4,864,547; the defendants also paid
$3,864,012 directly to Banaitis's attorney. Banaitis did not include the amount
paid to his attorney as gross income on his tax return.
The
Court's Opinion
The
Supreme Court resolved Banaitis first. It held the amounts paid by the defendants
directly to his attorneys were gross income to Banaitis for tax purposes. The
Court specifically rejected the argument that a plaintiff and his or her attorney
are in a type of joint venture or partnership that sought to enforce the plaintiff's
rights and then, in a sense, split the proceeds.
The
Court adopted, for the most part, the analysis on this point from the Seventh
Circuit case of Kenseth v. Commissioner, 259 F.3d 881, 883 (7th Cir. 2001). The
Court quoted Judge Posner as follows: "The contingency fee lawyer is not
a joint owner of the client's claim in the legal sense anymore than the commission
salesman is a joint owner of his employer's accounts receivable."
The
Court went on to write that the portion paid to the agent (i.e. the plaintiff's
attorney retained on a contingency fee basis) may be deductible, but it is not
excludable from the principal's gross income. The Court noted this rule applies
notwithstanding state law, so long as state law does not alter the fundamental
principal-agent character of the attorney client relationship.
The
Court then decided Banks. Banks took the position that his case was decided under
federal statutes that authorized a court to award attorney fees to prevailing
plaintiffs. As such, fees are awarded in typical cases over and above a plaintiff's
monetary recovery. Banks reasoned that taxing the attorney fee portion of an award
could lead to a perverse result wherein the plaintiff actually loses money by
virtue of additional tax paid on the portion of the award paid to his or her attorney.
The
Court was not persuaded that Banks' argument would change the outcome in his case.
Banks settled his case and the fee paid to his attorney was calculated solely
on the basis of the private contingency fee contract, not on the basis of actual
fees incurred and paid under a federal fee-shifting statute. The Court, therefore,
did not decide whether fees paid directly to a plaintiff's attorney pursuant to
a federal fee-shifting order would be included or excluded from gross income.
Additional
Considerations
After
these cases arose, Congress passed the American Jobs Creation Act of 2004. That
Act amended the tax code to allow a taxpayer to deduct "attorneys fees and
court costs paid by, or on behalf of, the taxpayer in connection with any action
involving a claim of unlawful discrimination."
The
Court noted that, "Had the Act been enforced for the transactions now under
review, these cases likely would not have arisen. The Act is not retroactive,
however, so while it may cover future taxpayers in respondents' position, it does
not pertain here." That means future plaintiffs may deduct contingency fee
payments to attorneys from gross income, but cases that arose prior to Oct. 23,
2004 (the effective date of the Act), fall under the rule of Commissioner v. Banks.
For
more information on these issues or for assistance in resolving federal discrimination
cases, contact John D. Finerty, Jr. at Michael Best & Friedrich at (414) 225-8269
or on in the Internet at JDFinerty@mbf-law.com.
