Issue: April, 2005
Author: Scott W. Meier
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Contingent Fees in Anti-Discrimination Cases: The Bad News for Winners
Explain this to your client: You have good news and bad news. First, the good news; you have won your anti-discrimination case. The jury has returned a verdict awarding you damages and the judge has entered judgment in your favor.
Now the bad news; despite your victory, you may walk away with nothing and still owe the IRS money.
Three principal federal anti-discrimination statutes - Title VII of the Civil Rights Act of 1964 (“Title VII”), the Age Discrimination in Employment Act (“ADEA”), and the Americans with Disabilities Act (“ADA”) - generally confer broad equitable powers on the courts to devise remedies making the victims of discrimination whole in economic terms. The Internal Revenue Code (“IRC”), however, sometimes operates to frustrate this make-whole objective by taxing a discrimination award more heavily than if the plaintiff earned the award as income during the normal course of business. This excess taxation can lead to adverse consequences.
In 1996, Congress amended IRC § 104 making awards for nonphysical injuries taxable. As such, a discrimination plaintiff may suffer adverse tax consequences in two distinct ways. First, the IRC may subject amounts recovered to compensate for back pay and front pay losses to higher income tax rates than if the plaintiff had earned such amounts as wages in due course. This increase in tax rates is typically due to the fact the plaintiff’s recovery is in a lump sum; as a result, part of the recovery may be subject to marginal rates higher than the plaintiff’s typical marginal rate. Second, an employment discrimination recovery could trigger the Alternative Minimum Tax (“AMT”).
The IRS’ position is that the plaintiff must report as income the entire award, including attorney fees under a contingent agreement or fee award. Although the taxpayer must include the entire award in computing gross income, the taxpayer is entitled to deduct the attorney fees as a miscellaneous itemized deduction. Such deductions, however, are “below the line.” Deduction being “below the line” means these expenses are deductible only to the extent they exceed 2 percent of the taxpayer’s adjusted gross income, and are further reduced at higher incomes. If the Alternative Minimum Tax (“AMT”) kicks in, they are not deductible at all.
The AMT, if it applies, may cause the recovery to be effectively taxed at rates significantly higher than the top marginal rate of 35%. In fact, in certain cases, the AMT could, theoretically, cause the tax on the recovery to exceed what the plaintiff actually receives. As a result, the amount of the award or settlement allocated to attorney fees is, at least in part, taxed twice. Nevertheless, the Tax Court and most U.S. circuit courts have agreed with the IRS.
In March 2004, the United States Supreme Court agreed to review the following two pro-taxpayer decisions: John W. Banks, II, (CA 6 9/30/2003) 92 AFTR 2d 2003-6298 and Banaitis, (CA 9 8/27/2003) 92 AFTR 2d 2003-583. In Banks, the Sixth Circuit Court of Appeals, reversing in part the decision of the Tax Court, held that the IRC did not require Banks to include in gross income the fees his attorney received settling an employment termination lawsuit. Banks had retained an attorney on a contingent fee basis when the California Department of Education fired him from his consulting job. After suing his employer, Banks eventually settled for $464,000. Pursuant to his fee agreement, Banks paid his attorney $150,000. Although under California law attorneys were not entitled to any special lien in contingent fee arrangements, the Sixth Circuit held that a contingent fee arrangement was more like a partial assignment of income-producing property rather than an assignment of income. Therefore, Banks did not have to include in gross income the fees he paid to his attorney.
In Banaitis, the taxpayer retained an attorney on a contingent-fee basis after leaving his employment as vice-president and loan officer at a local bank. In his complaint, Banaitis claimed the bank and its successor in ownership, interfered with his employment contract. A jury awarded Banaitis compensatory and punitive damages. The defendants eventually paid Banaitis $4,864,547 and paid Banatis’ attorneys an additional $3,864,012. The Ninth Circuit, again reversing the Tax Court, held the IRC did not require a taxpayer to include in gross income the contingent fees paid directly from the settlement to his attorneys. In reaching its decision, the Ninth Circuit relied on Oregon law. Unlike California law which conferred no special property rights to attorney fees, Oregon granted attorneys a superior lien in the contingent-fee portion of any recovery. As such, the Ninth Circuit held contingent-fee agreements under Oregon law were not anticipatory assignment of the client’s income, but served as a partial transfer of some of the client’s property in the lawsuit.
On certiorari to the Supreme Court in Commissioner v. Banks, the taxpayers in Banks and in Banaitis argued the anticipatory assignment of income doctrine did not apply, permitting them to exclude the contingent fees from their income. According to the taxpayers, the value of their underlying legal claims was speculative.
In addition, the taxpayers argued their contingent-fee agreements were similar to a joint venture or partnership. Under this argument, the taxpayers were not the sole source for recovery; besides the clients’ claim, the attorneys’ efforts and expertise - without which the claimant would likely not prevail - must be considered. As such, the claimant and attorney combine their respective assets - the claimant’s claim and the attorney’s skill - and apportion any resulting profits. The IRS, however, argued the contingent-fee arrangements were anticipatory assignments to the attorneys as part of their clients’ income from a litigation recovery and thus were taxable to the clients.
The Supreme Court held the taxpayers in Banks and in Banaitis could not exclude the contingent fees paid to their attorneys from their settlement claims from gross income because the contingent fee arrangements were anticipatory assignments of their income. Although the Court acknowledged that the value of the taxpayers’ claims may have been speculative at the time the parties signed the fee agreements, the Court stressed that the anticipatory assignment of income doctrine is not limited to instances where they know the precise dollar value of the assigned income in advance. In these cases, the taxpayers retained control over the income-producing asset, diverted some income to another party and realized a benefit for doing so.
The Supreme Court also concluded that a contingent fee arrangement was not a business partnership or joint venture in which the taxpayers did not solely retain dominion or control over their underlying claims. The Court noted that the relationship between client and attorney is a quintessential principle-agent relationship. While the client may rely on the advice and expertise of counsel to obtain a result the client could not obtain alone, the client retains the ultimate decision-making authority. As such, the attorney, although he may exercise independent judgment without supervision by, or consultation with, the client, must act solely on behalf of, and for the exclusive benefit of the client.
According to the Supreme Court, although portions paid to attorneys may be deductible, absent some other provision of law, they are not excludable from the taxpayers’ income. The Court emphasized that this was true whether or not the attorney-client contracts or state law conferred any special state rights or protections on the attorneys. Therefore, neither state law nor the structuring of contingent fee agreements will alter the fundamental principal-agent character of the relationships. The Court also noted that it knew of no state law, even those purporting to give attorneys “ownership” interest in their fees, converting the attorney from an agent to a partner.
After the Supreme Court ruling in Banks and Banaitis, it seems clear attorneys’ fees are included as part of the plaintiff’s gross income, at least with respect to federal anti-discrimination statutes. Attorneys should be aware of the holding in Banks and Banaitis to adequately inform their clients in not only valuing cases, but in structuring their causes of action and settlements.
Scott W. Meier attended the University of Wyoming where in 1982 he received his B.S. in Accounting. He worked as a CPA in Dallas and Denver before returning to the University of Wyoming College of Law to earn his J.D. in 1996. Scott is an attorney with the firm of Hickey & Mackey in Cheyenne, Wyoming.
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