Court cases determining whether contingent attorney
fees are includible in gross income differ in various jurisdictions. The inclusion
can add substantial taxes to the taxpayer. This material discusses the tax consequences
and lists which jurisdictions have ruled in favor of inclusion and which for exclusion.
ISSUE 6: CONTINGENT ATTORNEY FEES
With the continuing flood of age discrimination,
sexual harassment, racial discrimination and other similar lawsuits, tax preparers
may encounter clients who receive significant court awarded judgments. Since the
1995 Supreme Court decision in Commissioner v. Schleier,
515 U.S. 323 (1995), these types of judgments awarded are generally not
excludable from gross income.
I.R.C. §l04(a)(2), as amended in
1996, states: Gross income does not include
the amount of any damages (other than punitive damages) received (whether by suit
or agreement and whether as lump sums or as periodic payments) on account of personal
physical injuries or physical sickness.
The tax result is that judgments received after August 20, 1996, for nonphysical personal injury or sickness are includible in gross income. Examples of these (not all
- Employment discrimination (age, racial, gender)
- Wrongful termination of employment
- Defamation of character (libel/slander)
- Alienation of affections
- Wrongful prosecution
- Breach of contract (including business disputes)
CONTINGENT ATTORNEY FEES PAID BY CLIENTS
The tax issue is whether contingent attorney fees are includible
in the client’s gross income. The courts are split on this issue. Following is
a combined judicial/IRS “scoreboard” of the decisions/positions as of May 2001
(see the introduction to the Rulings and Cases chapter for the jurisdictions of
the various courts).
|Includable in Gross Income
||Excludable from Gross Income
|Internal Revenue Service
||5th Circuit Ct. of Appeals
||6th Circuit Ct. of Appeals
|Federal Circuit Ct.
||11th Circuit Ct. of Appeals
|9th Circuit Ct. of Appeals
|1st Circuit Ct. of Appeals
|4th Circuit Ct. of Appeals
|7th Circuit Ct. of Appeals
Two lines of reasoning in the conflicting court decisions
The assignment-of-income doctrine results in the inclusion
of income to the client. This doctrine, established by the Supreme Court in 1930,
ho1ds that taxpayers can’t assign income, to which they are legally entitled,
to a third party without first paying tax on it. The Tax Court applied this doctrine
to contingent attorneys fees in Kenseth v.
Commissioner, 114 T.C. 399 (2000). See pages 630–31 in the 2000 Farm Income Tax School Workbook for an analysis
of this important decision. The 7th Circuit court of Appeals affirmed the Tax
Court’s decision in 2001.
The nine majority Tax Court judges in the Kenseth decision held that state lien statutes
are irrelevant. The “shotgun” approach of I.R.C. §61 controls and the assignment-of-income
doctrine must be applied. Gross income means all income from whatever source derived
State law must be examined to
determine if attorneys have a superior lien or ownership right in judgments of
their clients. If not, the contingent fee must be included in the client’s
gross income. See Coady v. Commissioner, 213
F. 3d 1187 (9th Cir. 2000) discussed on pages 629–30 in the 2000 Farm Income Tax School Workbook. In the Coady case, Alaskan state law did not grant
a superior lien. Thus the contingent fee was includable in gross income
of the taxpayer/client.
From an analysis of the numerous court cases in this highly
litigated area, it appears that the courts have decided that only the statutes of
the following states do grant attorneys a superior lien or ownership right in judgments awarded to clients (based on cases decided as of August 2001):
Texas, Michigan, Alabama
Tax Complications Caused by Inclusion in Gross Income
of Contingent Attorney Fees Paid by Clients
1. These legal fees are a miscellaneous itemized deduction, subject
to the 2% of AGI floor.
The legal fees also are subject to the 3% of AGI reduction rules for itemized
deductions claimed by high-income taxpayers. In most cases, successful litigants
are high-income taxpayers in the year the
judgment is paid.
Miscellaneous itemized deductions are not deductible for alternative
minimum (AMT) purposes. This can cause a significant AMT liability for the taxpayer/client
in the year the judgment is received and the legal fee is paid.
Example from facts in the Kenseth
case (amounts listed are after the IRS exam results as affirmed by the Tax
- Total judgment received by taxpayer in 1993 $229,000
- Contingent fee paid directly to taxpayers’ attorney (40%)
by the defendant/employer (92,000)
- Net amount retained by taxpayer $137,000
- Amount of contingent fee deductible on Schedule A after the 2% of AGI
floor and the 3% of AGI reduction for high-income taxpayers 82,000
- AMT liability created by the $82,000 Schedule A
deduction (not deductible for AMT purposes) 17,000
- Additional regular tax owed to IRS 38,000
- Total additional tax owed on the 1993 Form 1040 $55,000
- After-tax settlement retained by taxpayer $82,000
- Legal fees paid by taxpayer in disputing the IRS exam result in Appeals and in Tax Court ?
- Interest paid to IRS on the $55,000 deficiency
Summary for Example. All of the facts and numbers aren’t shown, but
it is clear that the taxpayers kept less than $82,000 of the court awarded judgment
in the age discrimination suit against the husband’s former employer.
Conclusion. This is a difficult
issue for preparers. Since IRS is entering a more vigorous enforcement mode, this
area is a logical one for selected IRS exam projects. Both the IRS and the Tax
Court agree on the inclusion of contingent fees in gross income of clients.
Taxpayers who reside in the Fifth, Sixth, and
Eleventh Circuits can assert “substantial authority” for exclusion
of contingent fees. It is expected that the Supreme Court will eventually resolve
the conflict that now exists among the various appellate courts
© 2001 Copyrighted by the Board of Trustees of the University of Illinois