Contingent Attorneys’ Fees: The Income Tax Dilemma

By Ted Englebrecht, Mary Anderson, and Tracy L. Bundy

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Two divergent methodologies have emerged to highlight this dichotomy. On the one hand, several appellate circuits have concurred with the assignment of income doctrine. On the other hand, state statutes have been controlling in some judicial forums, while ruled irrelevant in others. An analysis of the various judicial interpretations reveals a number of controversial issues and presents certain planning considerations for taxpayers faced with such a dilemma. Such an analysis also presents policy suggestions for settling the issues with the objectives of equity, uniformity, and certainty of application.

Statutory Background

Gross income, as defined by IRC section 61(a), includes all income from whatever source derived, unless excluded by law. Within this broad definition, IRC sections 71–90 enumerate specific sources of income. Likewise, IRC sections 101–139 detail precise exclusions from income. Punitive damages under antitrust laws and exemplary damages for fraud are detailed in Treasury Regulations section 1.61-14. Under IRC section 104(a)(2), the amount of any damages (other than punitive) received on account of personal physical injuries or physical sickness is excluded from gross income.

Because IRC section 212 provides for a deduction of all ordinary and necessary expenses paid or incurred for the production and collection of income, attorneys’ fees sustained in the action are deductible, whether contingent or certain, as an itemized deduction. IRC section 67, enacted by the Tax Reform Act of 1986, allows miscellaneous itemized deductions only to the extent that they exceed 2% of adjusted gross income (AGI). Legal fees are subject to this limitation. When AGI exceeds an applicable amount adjusted annually for inflation ($142,700 for married filing jointly in 2004), itemized deductions are reduced by the lesser of 3% of the excess of AGI over the applicable amount or 80% of the allowable itemized deductions. The AMT tends to eliminate the remediation effect of allowing legal fees as an itemized deduction.

The two treatments of contingent legal fees, excludable from the recovery proceeds as opposed to itemized deductions, can result in grossly divergent tax liabilities, motivating the controversial cases brought to the U.S. Circuit Courts of Appeals. For an illustration of the impact of these two treatments, see Exhibit 1.

Administrative Stance

The IRS has consistently denied the excludability of contingent attorney fees, based upon the inability of an individual to assign income to another. The anticipatory assignment of income doctrine, also known as the “fruit of the tree” doctrine, evolved from the Supreme Court decisions in Earl, Horst, and Eubank. Notices of deficiency allow the contingent legal fee as an itemized deduction.

Judicial Stance

On contingent fee issues, the Tax Court generally issues a memorandum decision implying that the case concerns well-established principles of law and requires only a determination of fact. Taxpayers can then appeal.

The two-pronged test has developed in appellate reviews of contingent fee cases. Raymond established that state statutes determine the legal interest in the property, while federal tax law dictates the tax consequences of transactions. The circuit courts are split between the applicability of the anticipatory assignment of income doctrine versus state statutes regarding the legal interest in the property. Some courts agree that the assignment of income doctrine is applicable. The state law issues concern the type of interest the attorneys have in the contingent fee arrangement. Generally, if state law dictates that a contingent fee arrangement is a property interest for the lawyers, the assignment of income doctrine is not relevant. Where state statutes provide only a security interest, the doctrine becomes relevant. Banks II, however, said decisions should not turn on state law.

Anticipatory Assignment of Income

In its 1930 opinion Lucas v. Earl [8 AFTR 10287 (50 S.Ct. 241), 3/17/1930], the Supreme Court addressed directly the issue of taxability of earnings where a contract between husband and wife stipulated that any property would be acquired as joint tenants. The Court decided the proper reasoning should be in accordance with tax statutes. Contractual arrangements and anticipatory arrangements could not prevent earned income from vesting in the person that earned it, at least momentarily. The Court provided this anticipatory assignment of income doctrine with its sobriquet stating that “no distinction can be taken according to the motives leading to the arrangement by which the fruits are attributed to a different tree from that on which they grew.”

While the facts and findings in Earl revolved around the inability to relinquish control over earned income before it was rendered, the taxpayer in Helvering v. Horst (61 S.Ct. 144, 11/25/40) argued that he had relinquished all control over bond coupons gifted to his son. The Court reasoned that the ability to collect the principal and interest constituted an economic gain to Horst. Economic gain, however, is not a taxable event until realized by receipt. Diverting the actual proceeds did not divest Horst of the enjoyment of the benefit when paid. The satisfaction of directing the income to another person or obligation constituted the taxable realization event. Repeating the language of Earl, the Court found that the cases were not distinguishable.

Eubank v. Helvering [311 U.S. 122, 61 S. Ct. 194 (1940)] was a companion case to Horst, involving the assignment of income from a husband to wife. Relying upon its reasoning in Horst, the Court upheld the IRS’s assessment.

With these three decisions, the Supreme Court provided the origin for the judicially created anticipatory assignment of income doctrine. Its purpose is to prevent taxpayers from avoiding income taxation. Implicit in these cases is the distinction between the disposition of income-generating property and the disposition of income from property. A number of subsequent decisions have used the anticipatory assignment of income doctrine in determining the income tax consequences of contingent attorneys’ fees.

Opposing Opinion

With Old Colony Trust Co. [279 U.S. 716,729 (7 AFTR 8875) (1929)], the Supreme Court established that the realization of income, beyond receiving payment, is affected by the closure of economic gain already accrued to a taxpayer. Horst clarified that the amount used to satisfy the economic gain need never have passed through the taxpayer’s hands. Additionally, Horst amplified the concept that the power to divert income in satisfaction of one’s wants or needs is equivalent to ownership of the income.

While several circuits agree that the assignment of income doctrine fits the facts and circumstances of a contingent fee arrangement, notwithstanding applicable state laws, the Sixth Circuit has taken the opposing view. The Sixth Circuit determined that the taxpayer’s claim that resulted in the judgment was analogous to property, making the issue a disposition of property. Following the judicial reasoning in Estate of Clarks [85 AFTR 2d 2000-405 (202 F.3d 854), 01/13/2000], the court overturned the Tax Court and agreed with the taxpayer in Banks II. Contingent attorney fee contracts were distinguished from the facts in the Earl, Horst, and Eubank cases on four points:

• At the time of the contingent fee contract signing, the potential claim is an intangible expectancy (i.e., property). It is not earned, vested, or certain of being paid. Fruition of any value to the expectancy is dependent upon the skills of an attorney.
• As such, the taxpayer assigns away a portion in hope of recovering the remaining percentage. The resulting arrangement is comparable to a partnership or joint venture.
• There is no tax-avoidance purpose, only a business purpose. The attorney earns the income as a result of his own skill and judgment.
• Applying the assignment of income doctrine, under the facts, results in double taxation.

State Statutes

Under a contingent fee arrangement, Ethel Cotnam pursued and won a claim characterized as an amount due under a verbal contract for services rendered to a deceased friend. Disagreeing with the contention that the judgment received by the plaintiff was a legacy, the IRS determined that the judgment was an award for breach of contract. The Tax Court found for the IRS.

On appeal, the judiciary affirmed the includability of the judgment as an award for breach of contract. On the other hand, the court determined that the contingent fee arrangement was excludable from the proceeds. The IRS argued for the inclusion of the contingent fee, using the assignment of income doctrine. The court stated that this interpretation was based on the false premise that Cotnam had obligated herself to pay the attorneys. Citing the Code of Alabama (1940) section 64, the court noted that the statute provides that an attorney’s lien was superior to all liens except tax liens. Under statute, the attorney’s rights and powers over the decrees are the same as the client’s. Finding for the taxpayer, the court used the fruit-of-the-tree analogy, by stating that “Mrs. Cotnam’s tree had borne no fruit and would have been barren if she had not transferred a part interest in that tree to her attorneys, who then rendered the services necessary to bring forth the fruit.”

With this statement, the court in Cotnam provided a foundation for the numerous cases that followed. The circuits have since been split in their interpretations concerning the exclusion of contingent legal fee arrangements from income. In his dissent to Cotnam, Judge Wisdom wrote that the assignment of income doctrine was the proper foundation for a finding in the case.

Judicial Analysis

In light of Cotnam, the various courts have developed two alternatives. The first is to disagree wholly with the contention that state laws provide a foundation for analysis of the issue. Banks II said this “state-by-state” approach is not an acceptable methodological interpretation of federal tax statutes and is detrimental to the objectives of the court system. By relying on differing state statutes, it is impractical, if not impossible, to define that stance.

The other alternative is to concur with Cotnam. The analysis turns to interpretation of the statutes for the situs of the case. The court examines applicable state law to determine whether statutes confer property rights greater than the contractual rights under the contingent fee arrangement. Litigation may be successful if state laws accord property rights rather than security interests. The evolved litmus test for the state statutes includes:

• Are attorneys invested with “a lien superior to all liens but tax liens” in suits, judgments, and decrees for money?
• Does state law mandate that “no person shall be at liberty to satisfy said suit, judgment or decree, until the lien or claim of the attorney for his fees is fully satisfied”?
• Does state law determine that “attorneys at law shall have the same right and power over said suit, judgments, and decrees, to enforce their liens, as their clients had or may have for the amount due thereon to them”?

Other approaches. The taxpayer in Alexander [77 AFTR 2d 96-301 (72 F3d 938), 12/22/95] claimed that the lawsuit and resulting award represented a breach of his employment contract (i.e., property rights), implicitly distinguishing his position from the anticipatory assignment of income doctrine. As such, the attorneys’ fees would be a cost of disposition of an intangible asset under IRC sections 1001 and 1016. The court disposed of this argument by noting that it has been established that awards are taxed relative to the characterization of what the damages are in lieu of. The court also dismissed the taxpayer’s alternative arguments that the attorney’s fees constituted a business expense or reimbursement arrangement.

For a thorough listing of the judicial decisions involving attorneys’ contingent fees in the various circuits, see Exhibit 2.

The Interpretive Problem

The interpretive dilemma of contingent attorney fees is both conceptual and pragmatic. Conceptually, there appears to be significant confusion and disagreement about the applicability of the assignment of income doctrine and the impact of state statutes. The evolution of the assignment of income doctrine in Earl, Horst, and Eubank involved locus of taxation issues. In those early cases, the locus entailed deciding between one of two taxpayers. More current cases, however, result in income taxation for both involved parties: the plaintiff taxed on the gross proceeds of the award, and the attorneys taxed on their contingent percentage. Additionally, while state law varies as to the type of lien attorneys receive under a contingent contract, the concepts embodied within liens (dominion and control) are not granted only by specific liens. That is, dominion and control may exist outside the context of a statutorily defined lien. Another central question is that of value. Value has a presence because the taxpayer has been wronged; yet, that value will not be realized without the attorney’s services. How much value is created and by whom provides fodder for subjective interpretations. Furthermore, equity is provided by only taxing the plaintiff on the amount actually received. This treatment results in one locus of taxation for this income.

Pragmatically, the imposition of IRC sections 67 and 68 results in different taxable income for the same set of circumstances. This is further confounded by the AMT provisions. The same income is taxed both to the client and the attorney. As noted in Kenseth (114 TC 399), while these results are inequitable, they are mandated by conflicting provisions in the code, which is Congress’ responsibility.

These conceptual and pragmatic problems surrounding the issue of proper income tax treatment of contingent attorneys’ fees make it almost impossible to develop general rules of law that are consistently applicable. Legislative action could effectively settle the problems by clearly delineating treatment.

Proper Planning Is Essential

In those circuits that have determined that state laws are relevant, knowledge of those statutes is essential. In jurisdictions that do not grant attorneys a property right–type lien in the litigation, this can be structured into the contract between the litigant and her attorney. An idea that some have suggested is that the taxpayer and her attorney form a partnership, with the ownership percentages reflecting the agreed-upon fee split. On formation of the partnership, the taxpayer contributes the potential claim. IRC section 83 (property transferred in connection with performance of services) is a consideration, but, theoretically, an unlitigated claim is without value and highly uncertain. The partnership then hires the attorneys to pursue the action. To avoid self-employment income consequences, the taxpayer should be a limited partner. The use of an S corporation can provide some income classification flexibility to the attorney-partner. Additionally, tax planning in the year of an award can serve to mitigate the potential effects of AMT or AGI minimums. Postponing potential revenues while accelerating certain deductions and losses can lessen the impact of the minimum tax provisions.

With the plethora of penalties for underreporting income, the downsides must be evaluated when determining a position. Nonetheless, the substantial authority depicted in Exhibit 2 should mitigate underreporting penalties. Additionally, if a structured payoff of an award is agreed upon, cash flow considerations become paramount. As reported in a Chicago Sun-Times article (S.I. Banoff and R.M. Lipton, “Attorney’s Fees Tax Whipsaw: The Public Beware!,” Journal of Taxation, October 2002), one taxpayer found herself in the position of owing the IRS income taxes in excess of the cash settlement she agreed to in order to avoid an appeal. Litigants in class action suits could also find themselves in similar situations (R.W. Wood and D.L. Daher, “Contingent Attorney’s Fees in Class Action Cases—From Bad to Worse for Taxpayer-Plantiffs,” Journal of Taxation, October 2003).

Considering the subjective interpretations currently at the heart of this controversy, alleviating one inequity often leads to the creation of another. Under these circumstances, fixed attorneys’ fees are, indisputably, allowed only as itemized deductions. Legislatively excluding contingent fees from taxability would serve to codify that disparity in treatment. As such, reporting only net proceeds provides parity with other before-tax netting provisions in the tax code. A statute mandating deductibility of contingent attorneys’ fees, however, would serve to enhance the perceived inequities of the minimum tax provisions.

The Supreme Court had denied certiorari to both Hukkamen-Campbell [88 AFTR 2d 2001-7238, 274 F3d 1312, 2002-1 USTC para.50351 (CA-10, 2001), cert.den.] and Sinyard [88 AFTR 2d 2001-6034, 268 F3d 756, 2001-2 USTC para. 50645 (CA-9, 2001), cert. den.], but granted certiorari to Banks II and Banaitis [92 AFTR 2d 2003-5834 (340 F3d 1074), 8/27/2003] on March 29, 2004. The cases represent the dichotomy of the controversy; Banks II found for the taxpayer based upon the assignment of income doctrine, while Banaitis found for the taxpayer based upon Oregon statute. A Supreme Court decision has just come down, holding that contingent attorneys’ fees are to be treated as itemized deductions. This necessary judicial response brings clarity to this issue and provides certainty of application, with the resulting desired attributes of equity and uniformity of application across taxpayers in all circuits.