• Supreme Court Resolves Split in Circuits on Taxation of Contingent Attorney Fees
  • February 5, 2005 | Author: Lisa B. Petkun
  • Law Firm: Pepper Hamilton LLP - Philadelphia Office
  • On January 24, 2005, the U.S. Supreme Court resolved a split in the circuit courts of appeals over whether contingent attorney fees paid to a plaintiff's attorney under a contingent fee agreement are taxable income to the plaintiff. As a result of the Court's rulings in Commissioner v. Banks and Commissioner v. Banaitis, all plaintiffs must now include contingent attorney fees in income, and defendants paying such attorney fees must include them on the plaintiff's Form 1099.

    Three circuit courts had held that income inclusion is not required, and six circuit courts had required income inclusion by the plaintiff. In a rational tax system, this issue would be irrelevant because, if the plaintiff had to include the attorney fees in income, the plaintiff would be able to receive an offsetting deduction.

    However, the tax rules (until recently in certain circumstances) did not produce a rational result; and in this situation, although the plaintiff received a deduction, by the time the deduction ran the gamut of the alternative minimum tax (AMT), and 2 percent and 3 percent limitations on itemized deductions, generally the plaintiff received no or little benefit from the deduction. The Supreme Court resolved the split by holding that such fees are included in the plaintiff's income.

    However, just-in-time partial relief has arrived in the form of new Internal Revenue Code Section 62(a)(19)(20), added by the American Jobs Creation Act of 2004. It provides an "above the line" deduction (free of the various limitations) for amounts attributable to attorney fees and costs received by individuals on account of claims of unlawful discrimination or claims against the government under the False Claims Act.

    "Unlawful discrimination" is defined in new ┬ž62(e) to include a number of specific federal statutes, including civil rights, race, religious and age discrimination, any federal whistle blower statute, and a catchall for any federal, state or local law "providing for the enforcement of civil rights" or "regulating any aspect of the employment relationship┬┐, or prohibiting the discharge of an employee, the 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."

    However, the new provision is not a panacea. First, it only applies to fees and costs paid after the date of enactment (October 22, 2004) for any judgment or settlement occurring after that date. For payments that do not meet these effective date rules, the plaintiff's deduction is still subject to the deduction limits.

    Second, while the list of enumerated employment claims is broad, and there is a catchall category, certain claims may not be covered, such as defamation that is not in the context of employment, ERISA cases other than those under Section 510 (dealing with discrimination cases), personal injury, product liabilities, securities law, contract and invasion of privacy claims.