Taxation of Contingent Fee Awards

Article excerpt

In many tort cases, as well as in class action lawsuits, the attorneys receive a contingent fee equal to a fixed percentage of the award or recovery. Whether the taxpayer must include the full award in his or her income or only the part remaining after paying the contingent legal fee, however, has not always been clear.

In June 1988 Arthur Clarks was awarded $5,600,000 in damages from K-Mart for injuries he sustained while unloading his truck. In 1991 K-Mart paid Clarks $11,307,875 ($5,600,000 award plus $5,707,875 interest) to satisfy the judgment. Clarks' attorney received $3,766,471; Clarks received the balance.

Following Clarks' death, his estate filed form 1040 and included only $3,806,532--the amount of interest income he actually received. The estate excluded the interest that was paid to his attorney. The IRS audited the return and included the full amount of interest in Clarks' taxable income, assessing a tax deficiency of $254,298. The district court held for the IRS and the taxpayer appealed.

Result. For the taxpayer. Prior appeals courts that considered this issue were split. The Fifth Circuit Court of Appeals, in Cotnam, 263 F.2d 119, held that the taxpayer did not have to include the contingent fee in income. The Fifth Circuit based its decision on Alabama law, which gives attorneys a unique lien on any award received under a contingent fee contract. In contrast, the Federal Circuit Court of Appeals, in Baylin, 43 F. …