|March 7, 2005|
Previously published on February 18, 2005
Should plaintiffs pay taxes on attorney fees recovered in employment actions through settlement or judgment? This has been a recurrent issue in employment litigation, and one that on occasion impacts the resolution of the case. This eAlert discusses two important recent developments in the area: first, a United States Supreme Court decision that resolves a conflict among the circuits and holds that attorney fees are not excludable from plaintiff's gross income; and, second, federal legislation, applicable to amounts received after October 22, 2004, that in effect relieves plaintiffs in employment cases of tax liability on attorney fee recovery.
The Federal Circuit Courts of Appeal had been in conflict about the excludability of contingent fees paid to a plaintiff's attorney out of a taxable damage award or settlement. A minority of Federal Circuits had determined that these fees are excludable from the plaintiff's gross income. A majority, however, determined that they are includable in gross income and can be deductible only as Schedule A miscellaneous itemized deductions. On January 24, 2005, the United States Supreme Court resolved the conflict among the courts by holding with the majority rule, that contingent fees paid to a plaintiff's attorney out of a taxable damage award or settlement are not excludable from the plaintiff's gross income.
On October 22, 2004, President George W. Bush signed into law the American Jobs Creation Act of 2004 (the Jobs Act). Section 708 of the Jobs Act, entitled Civil Rights Tax Relief, creates an above-the-line deduction for attorneys' fees which should result in a plaintiff paying income tax on only the net amount received (after paying attorney fees) pursuant to an employment-related lawsuit. The new law, however, applies only to judgments and settlements occurring after the October 22, 2004, date of enactment. Because the new law (the Jobs Act) does not generally provide relief in non-employment related lawsuits (i.e., business litigation lawsuits), the Supreme Court's ruling results in the taxation of attorney fees in cases not involving an employment relationship, both before and after the date of the new law's enactment.
This article will briefly discuss the background regarding the taxation of attorneys' fees; the Jobs Act's provisions (such as Civil Rights Tax Relief); and the Supreme Court's recent ruling regarding the taxation of attorneys' fees in contingency fee-type cases.
Damages received (whether by judgment or settlement) by an individual on account of personal physical injuries are generally not included in gross income. Expenses related to the recovery of such non-taxable damages are generally not deductible. Conversely, other types of damages are generally included in gross income, and the expenses related to the recovery of such taxable damages, including attorneys' fees, are generally deductible only as Schedule A itemized deductions. However, there are disadvantages to a Schedule A deduction for attorneys' fees. First, the attorneys' fees are classified as a miscellaneous itemized deduction and therefore are only deductible to the extent the plaintiff's total miscellaneous itemized deductions exceed 2 percent of the plaintiff's adjusted gross income (AGI). Second, any amount allowable as a deduction is subject to reduction if the plaintiff's AGI exceeds a threshold amount ($145,950 in 2005). Third, attorneys' fees are not deductible for alternative minimum tax (AMT) purposes. Because of such limitations, plaintiffs generally pay income tax on their gross award or settlement with no reduction for fees paid to their attorney.
American Jobs Creation Act of 2004
The Jobs Act allows individuals who win or settle any case involving a claim for "unlawful discrimination" (as defined below) to deduct the fees paid to their attorneys as an above-the-line deduction (i.e., no longer subject to the Schedule A limitations described above).1
The deduction applies to cases brought under a laundry list of federal rights statutes and under other federal, state, or local laws "providing for the enforcement of civil rights" or "regulating any aspect of the employment relationship." Under the new law, "unlawful discrimination" means an act that is unlawful under certain legal statutes, including:
- the Civil Rights Act of 1991;
- the Congressional Accountability Act of 1995;
- the National Labor Relations Act;
- the Fair Labor Standards Act of 1938;
- the Age Discrimination in Employment Act of 1967;
- the Rehabilitation Act of 1973;
- the Employee Retirement Income Security Act of 1974;
- the Education Amendments of 1972;
- the Employee Polygraph Protection Act of 1988;
- the Worker Adjustment and Retraining Notification Act;
- the Family and Medical Leave Act of 1993;
- Chapter 43 of Title 38 of the United States Code;
- Sections 1977, 1979, or 1983 of the Revised Statutes;
- the Civil Rights Act of 1964;
- the Fair Housing Act;
- the Americans with Disabilities Act of 1990;
- any provision of federal law (popularly known as whistleblower protection provisions) prohibiting the discharge of an employee, discrimination against an employee, or any other form of retaliation or reprisal against an employee for asserting rights or taking other actions permitted under federal law; or
- any provision of federal, state, or local law, or common law claims permitted under federal, state, or local law providing for the enforcement of civil rights or regulating any aspect of the employment relationship, including claims for wages, compensation, or benefits, or prohibiting the discharge of an employee, discrimination against an employee, or any other form of retaliation or reprisal against an employee for asserting rights or taking other actions permitted by law.
Accordingly, unless and until further guidance is issued by the Internal Revenue Service, the courts, or others, it appears that the new law applies broadly to almost any case involving an action by an employee (i.e., plaintiff) against his or her employer.
Taxation of Attorney's Fees
Are contingent fees paid to an attorney out of a taxable damage award or settlement excludable from the plaintiff's gross income (as the minority of Federal Circuits had determined)? Or are they includable in the plaintiff's gross income and deductible only as miscellaneous itemized deductions (as a majority of Federal Circuits had determined)? In March 2004, the Supreme Court agreed to settle this conflict among the Federal Circuit Courts of Appeal.
The First,2 Second,3 Third,4 Fourth,5 Seventh,6 Tenth,7 and Federal8 Circuits all held that attorney fees awarded to a prevailing party (plaintiff) in litigation generally are treated as received by the plaintiff-taxpayer and, therefore, as items of gross income taxable to the plaintiff. Consequently, even if attorney fees are paid directly to the plaintiff's attorney by the defendant-payor, the entire gross amount of the award, including attorney fees, is included in the plaintiff's gross taxable income.9
The majority rule's rationale for finding that attorney fees are taxable to a plaintiff is based generally on the "assignment of income" doctrine.10 More specifically, although a plaintiff may not physically receive a portion of the award used to pay the plaintiff's attorney fees (i.e., payment made directly to plaintiff's attorney), the plaintiff does receive the full benefit of those funds in the form of payment for the services required to obtain the award. Thus, the discharge of an obligation is equivalent to the receipt of a benefit which is taxed to the party that received the benefit.11 Additionally, a number of the majority rule circuits believe that, unlike the minority rule noted below, with regard to attorney fees received in contingency-type cases, an attorney lien under its particular state law (for instance, California) does not confer any ownership interest upon attorneys or grant attorneys any right and power over the awards received by their clients.
Ninth Circuit Law
The Ninth Circuit held that whether contingency fees are includable in a plaintiff's gross income is dependent on the state law involved (that is, the appropriate attorney lien statute).12
The Fifth,13 Sixth,14 and Eleventh15 Federal Circuits have held that contingent attorney fees recovered in litigation, not including non-contingent attorney fees,16 may be excluded from the plaintiff-taxpayer's gross taxable income.
In Cotnam v. Commissioner,17 the Fifth Circuit held that a taxpayer-plaintiff did not have to include in gross taxable income the amount of contingent attorney fees that were withheld from a judgment and paid directly to the plaintiff-taxpayer's attorney. The Fifth Circuit's holding was based on the fact that, under applicable Alabama law, the fee payable to an attorney was a charge in the nature of an equitable assignment or attorney lien, which gave the attorney the same rights as the client in the award.
Since Cotnam, only two circuit courts have defended the view originally articulated in that case. In Srivastava v. Commissioner, a Texas case, the Fifth Circuit engaged in a lengthy analysis discussing why the majority rule was more compelling, but then followed Cotnam as a matter of stare decisis.18 In Davis v. Commissioner, an Alabama case, the Eleventh Circuit followed Cotnam insofar as it served as "former Fifth Circuit" precedent, but offered no real argument in its support (i.e., Alabama now in Eleventh Circuit).19
In Banks v. Commissioner,20 the court rejected using state law lien statutes to determine the tax treatment of the attorney fee portion of an award. In Banks, the taxpayer plaintiff had worked as an educational consultant with the California Department of Education (CDOE). In response to being terminated, the taxpayer sued the CDOE and eventually settled for $464,000, $150,000 of which was paid to his attorney under a contingency fee arrangement. The taxpayer lived in Michigan (i.e., the Sixth Circuit) at the time he was audited by the IRS. In Banks, the Tax Court acknowledged the Sixth Circuit prior case law which found contingent attorney fees non-taxable, (see endnote 14). The Tax Court, however, distinguished Estate of Clarks v. United States on the ground that the taxpayers' underlying lawsuit, from which an attorneys' contingent fee was generated, took place in California.21 California's law on attorneys' contingency fees, unlike Alabama's law, does not operate under a lien theory. Thus, the Tax Court held that the attorney fees were taxable. The Sixth Circuit reversed the Tax Court in Banks and found that, although the attorney lien statute is relevant, other factors are more persuasive in distinguishing contingency fees, including the following: (1) the fact that the claim, at the time the contingency fee agreement was signed, was an "intangible, contingent expectancy"; (2) the taxpayer's claim was like a partnership or joint venture in which the taxpayer signed away one-third in hope of recovering two-thirds; (3) no tax-avoidance purpose was at work with a contingency fee arrangement, as there ostensibly had been in prior cases; and (4) including the contingency fee in the taxpayer's income would result in double taxation. Accordingly, the Sixth Circuit held that the contingency fee portion of the award was not includable in the taxpayer's gross.
Review Granted to IRS in Two Pro-Taxpayer Cases
The Supreme Court agreed to review two pro-taxpayer decisions, including Banks v. Commissioner (see endnote 20), and Banaitis v. Commissioner (see endnote 12). In Banaitis, the Ninth Circuit held that a taxpayer who reached a settlement with two banks after he successfully sued them for wrongful discharge did not have to include in gross income contingent fees paid directly from the settlement to his attorneys. Under Oregon law, which governed the case, attorneys have a property interest in the settlement. The Ninth Circuit, therefore, applied the minority rule discussed above.
The Supreme Court's Ruling
On January 24, 2005, consistent with the majority rule, the Supreme Court held that the taxpayers in Banks and Banaitis could not exclude from gross income the contingent fees paid to their attorneys from their settlement claims because the contingent fee arrangements were determined to be "anticipatory assignments" of their income. The Supreme Court noted that the key question is whether the plaintiff has dominion and control over the "income-generating asset" which is their cause of action derived from their legal injuries. In reaching its conclusion, the Court found that a plaintiff retains dominion over the asset (cause of action/case) throughout the lawsuit. Although the Court acknowledged that the value of a taxpayer's claims may be speculative at the time the fee agreements are signed, it stressed that the anticipatory assignment of income doctrine is not limited to instances where the precise dollar value of the assigned income is known in advance.
Next, the Supreme Court rejected the argument that the attorney-client relationship should be treated as a business partnership or joint venture for tax purposes. The Court noted that, in agency relationships, all income collected by the agent is generally attributable to the principal. The Court found that the attorney-client relationship is a "quintessential" principal-agent relationship and that the plaintiff's attorney remains the plaintiff's agent regardless of any state law protections for attorney's fees.
Although the Supreme Court's result does not have a negative effect on employment-related cases settled after October 22, 2004, the tax consequences will still be unfavorable to those plaintiffs whose causes of action are deemed not to be employment related as defined under the new Jobs Act or in those employment-related cases settled before October 23, 2004.
1 New I.R.C. § 62(a)(19).
2 Alexander v. IRS, 72 F.3d 938 (1st Cir. 1995).
3 Raymond v. Commissioner, 355 F.3d 107 (2nd Cir. 2004).
4O'Brien v. Commissioner, 319 F.2d 532 (3rd Cir. 1963).
5 Young v. Commissioner, 240 F.3d 369 (4th Cir. 2001).
6 Kenseth v. Commissioner, 259 F.3d 881 (7th Cir. 2001).
7 Hukkanen-Campbell v. Commissioner, 274 F.3d 1312 (10th Cir. 2001).
8 Baylin v. United States, 43 F.3d 1451 (Fed.Cir.1995).
9 See Treas. Reg § 1.6041-1(f)(2), examples 1 & 2.
10Lucas v. Earl, 281 U.S. 111 (1930).
11 Old Colony Trust Co. v. Commissioner, 279 U.S. 716, 729 (1929).
12 Compare Banaitis v. Commissioner, 2005 WL 123825 (Jan. 24, 2005) rev'd 340 F.3d 1074 (9th Cir. 2003) (not includable under Oregon law) with Benci-Woodward v. Commissioner, 219 F.3d 941 (9th Cir. 2000) (includable under California law) and Coady v. Commissioner, 213 F.3d 1187 (9th Cir. 2000) (includable under Alaska law); see also, Biehl v. Commissioner, 351 F.3d 982 (9th Cir. 2003) (payment to attorney under accountable plan rules not excludable).
13 Cotnam v. Commissioner, 263 F.2d 119 (5th cir. 1959) (Alabama case); Srivastava v. Commissioner, 220 F.3d 353 (5th Cir. 2000) (Texas case).
14 Estate of Clarks v. United States, 202 F.3d 854 (6th Cir. 2000).
15Davis v. Commissioner, 210 F.3d 1346 (11th Cir. 2000) (Alabama law); Foster v. U.S., 249 F.3d 1275 (11th Cir. 2001) (Alabama law).
16 The positions of the Fifth, Sixth, and Eleventh Circuits appears to apply only to contingent fee cases, and not to other types of fee arrangements between taxpayers and their attorneys because all relevant cases decided by those courts involved contingent attorney's fees. See Gadlow Estate, 50 T.C. 275 (1968); see also Srivastava, 220 F.3d at 362.
17 Cotnam v. Commissioner, 263 F.2d 119 (5th Cir. 1959).
18Srivastava, 220 F.3d at 357-65.
19 Davis, 210 F.3d at 1347.
20 Banks v. Commissioner, 2005 WL 123825 (Jan. 24, 2005), rev'd 345 F.3d 373 (6th Cir. 2003).
21 Under the Golsen rule, the Tax Court must follow a court of appeals decision that is "squarely on point" where an appeal lies to that particular court of appeals. Golsen v. Commissioner, 54 T.C. 742 (1970). It appears the taxpayer was audited by the IRS after he became a resident of Michigan, which is within the Sixth Circuit. Because at the time the taxpayer's petition was filed with the Tax Court, the taxpayer was a resident of the Sixth Circuit, the Tax Court case was appealable to the Sixth Circuit, rather than the Ninth Circuit.