John D. Finerty, Jr.
Contingency fee agreements in most cases allow an attorney or law firm to obtain compensation for legal services by taking a portion of an award or settlement. How to treat the contingency fee portion of an award or settlement for tax purposes has always been a disputed issue. Some courts have held fees paid to an attorney are taxable income to the client; other courts have held fees are not income to the client; a third line of cases has held that state law controls.
The U.S. Supreme Court settled the issue in Commissioner v. Banks and Commissioner v. Banaitis when it held money paid to a plaintiff, from which an attorney takes a contingency fee, must be included in the plaintiff’s gross income.
In Commissioner v. Banks, John Banks was fired from his job as an educational consultant at the California De-partment of Education. He filed a civil rights action against the Department in California federal court, alleging employment discrimination; he also signed a contingency fee agreement with the attorney he retained.
The parties settled the case for $464,000, and Banks paid $150,000 of the total settlement to his attorney pursuant to the contingency fee agreement. Banks, however, did not report any of the $464,000 settlement proceeds on his federal income tax return.
In Commissioner v. Banaitis, Banaitis quit his job as a loan officer at the Bank of California and then sued the Bank’s successor owner, Mitsubishi Bank. Banaitis alleged Mitsubishi interfered with his employment contract with the Bank of California and attempted to induce him to breach fiduciary duties to customers and then effectively discharged him when he refused.
A jury awarded compensatory and punitive damages; after post-trial motions and appeals were resolved, the defendants paid Banaitis $4,864,547; the defendants also paid $3,864,012 directly to Banaitis’s attorney. Banaitis did not include the amount paid to his attorney as gross income on his tax return.
The Court’s Opinion
The Supreme Court resolved Banaitis first. It held the amounts paid by the defendants directly to his attorneys were gross income to Banaitis for tax purposes. The Court specifically rejected the argument that a plaintiff and his or her attorney are in a type of joint venture or partnership that sought to enforce the plaintiff’s rights and then, in a sense, split the proceeds.
The Court adopted, for the most part, the analysis on this point from the Seventh Circuit case of Kenseth v. Commissioner, 259 F.3d 881, 883 (7th Cir. 2001). The Court quoted Judge Posner as follows: "The contingency fee lawyer is not a joint owner of the client’s claim in the legal sense anymore than the commission salesman is a joint owner of his employer’s accounts receivable."
The Court went on to write that the portion paid to the agent (i.e. the plaintiff’s attorney retained on a contingency fee basis) may be deductible, but it is not excludable from the principal’s gross income. The Court noted this rule applies notwithstanding state law, so long as state law does not alter the fundamental principal-agent character of the attorney client relationship.
The Court then decided Banks. Banks took the position that his case was decided under federal statutes that authorized a court to award attorney fees to prevailing plaintiffs. As such, fees are awarded in typical cases over and above a plaintiff’s monetary recovery. Banks reasoned that taxing the attorney fee portion of an award could lead to a perverse result wherein the plaintiff actually loses money by virtue of additional tax paid on the portion of the award paid to his or her attorney.
The Court was not persuaded that Banks’ argument would change the outcome in his case. Banks settled his case and the fee paid to his attorney was calculated solely on the basis of the private contingency fee contract, not on the basis of actual fees incurred and paid under a federal fee-shifting statute. The Court, therefore, did not decide whether fees paid directly to a plaintiff’s attorney pursuant to a federal fee-shifting order would be included or excluded from gross income.
After these cases arose, Congress passed the American Jobs Creation Act of 2004. That Act amended the tax code to allow a taxpayer to deduct "attorneys fees and court costs paid by, or on behalf of, the taxpayer in connection with any action involving a claim of unlawful discrimination."
The Court noted that, "Had the Act been enforced for the transactions now under review, these cases likely would not have arisen. The Act is not retroactive, however, so while it may cover future taxpayers in respondents’ position, it does not pertain here." That means future plaintiffs may deduct contingency fee payments to attorneys from gross income, but cases that arose prior to Oct. 23, 2004 (the effective date of the Act), fall under the rule of Commissioner v. Banks.
For more information on these issues or for assistance in resolving federal discrimination cases, contact John D. Finerty, Jr. at Michael Best & Friedrich at (414) 225-8269 or on in the Internet at JDFinerty@mbf-law.com.