Contingent Attorneys' Fees: The Income Tax Dilemma

Article excerpt

Two U.S. Circuit Courts of Appeals recently rendered diametrically opposed decisions regarding the excludability of contingent attorneys' fees from gross income. The U.S. second Circuit Court of Appeals decided for inclusion in Raymond v. United States (93 AFTR 2d 2004-416. 01/13/2004): the Sixth Circuit Court of Appeals ruled for exclusion in Banks II v. Commissioner (92 AFTR 2d 2003-6298, 9/30/2003). While the Tax Court has consistently ruled for including contingent fees, basing their rationale on the anticipatory assignment of income doctrine, other judicial forums provide conflicting interpretations. The 1959 decision in Cotnam [3 AFTR 2d 517 (263 F.2d 119), 1/23/59], which relied on state statutes, provides the foundation for this controversy. The perceived inequities of alternative minimum tax (AMT) provisions are fanning the fires of this growing dispute.

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. …