Attorneys’ Fees: The Income Tax Dilemma
Ted Englebrecht, Mary Anderson, and Tracy L. Bundy
2005 - 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
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.
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.
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.
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
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
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.
two-pronged test has developed in appellate reviews of contingent
fee cases. Raymond established that state statutes
determine the legal interest in the property, while federal
tax law dictates the tax consequences of transactions. The
circuit courts are split between the applicability of the
anticipatory assignment of income doctrine versus state
statutes regarding the legal interest in the property. Some
courts agree that the assignment of income doctrine is applicable.
The state law issues concern the type of interest the attorneys
have in the contingent fee arrangement. Generally, if state
law dictates that a contingent fee arrangement is a property
interest for the lawyers, the assignment of income doctrine
is not relevant. Where state statutes provide only a security
interest, the doctrine becomes relevant. Banks II,
however, said decisions should not turn on state law.
Assignment of Income
its 1930 opinion Lucas v. Earl [8 AFTR 10287 (50
S.Ct. 241), 3/17/1930], the Supreme Court addressed directly
the issue of taxability of earnings where a contract between
husband and wife stipulated that any property would be acquired
as joint tenants. The Court decided the proper reasoning
should be in accordance with tax statutes. Contractual arrangements
and anticipatory arrangements could not prevent earned income
from vesting in the person that earned it, at least momentarily.
The Court provided this anticipatory assignment of income
doctrine with its sobriquet stating that “no distinction
can be taken according to the motives leading to the arrangement
by which the fruits are attributed to a different tree from
that on which they grew.”
the facts and findings in Earl revolved around
the inability to relinquish control over earned income before
it was rendered, the taxpayer in Helvering v. Horst
(61 S.Ct. 144, 11/25/40) argued that he had relinquished
all control over bond coupons gifted to his son. The Court
reasoned that the ability to collect the principal and interest
constituted an economic gain to Horst. Economic gain, however,
is not a taxable event until realized by receipt. Diverting
the actual proceeds did not divest Horst of the enjoyment
of the benefit when paid. The satisfaction of directing
the income to another person or obligation constituted the
taxable realization event. Repeating the language of Earl,
the Court found that the cases were not distinguishable.
v. Helvering [311 U.S. 122, 61 S. Ct. 194 (1940)] was
a companion case to Horst, involving the assignment of income
from a husband to wife. Relying upon its reasoning in Horst,
the Court upheld the IRS’s assessment.
these three decisions, the Supreme Court provided the origin
for the judicially created anticipatory assignment of income
doctrine. Its purpose is to prevent taxpayers from avoiding
income taxation. Implicit in these cases is the distinction
between the disposition of income-generating property and
the disposition of income from property. A number of subsequent
decisions have used the anticipatory assignment of income
doctrine in determining the income tax consequences of contingent
Old Colony Trust Co. [279 U.S. 716,729 (7 AFTR
8875) (1929)], the Supreme Court established that the realization
of income, beyond receiving payment, is affected by the
closure of economic gain already accrued to a taxpayer.
Horst clarified that the amount used to satisfy
the economic gain need never have passed through the taxpayer’s
hands. Additionally, Horst amplified the concept
that the power to divert income in satisfaction of one’s
wants or needs is equivalent to ownership of the income.
several circuits agree that the assignment of income doctrine
fits the facts and circumstances of a contingent fee arrangement,
notwithstanding applicable state laws, the Sixth Circuit
has taken the opposing view. The Sixth Circuit determined
that the taxpayer’s claim that resulted in the judgment
was analogous to property, making the issue a disposition
of property. Following the judicial reasoning in Estate
of Clarks [85 AFTR 2d 2000-405 (202 F.3d 854), 01/13/2000],
the court overturned the Tax Court and agreed with the taxpayer
in Banks II. Contingent attorney fee contracts
were distinguished from the facts in the Earl, Horst,
and Eubank cases on four points:
At the time of the contingent fee contract signing, the
potential claim is an intangible expectancy (i.e., property).
It is not earned, vested, or certain of being paid. Fruition
of any value to the expectancy is dependent upon the skills
of an attorney.
such, the taxpayer assigns away a portion in hope of recovering
the remaining percentage. The resulting arrangement is
comparable to a partnership or joint venture.
There is no tax-avoidance purpose, only a business purpose.
The attorney earns the income as a result of his own skill
the assignment of income doctrine, under the facts, results
in double taxation.
a contingent fee arrangement, Ethel Cotnam pursued and won
a claim characterized as an amount due under a verbal contract
for services rendered to a deceased friend. Disagreeing
with the contention that the judgment received by the plaintiff
was a legacy, the IRS determined that the judgment was an
award for breach of contract. The Tax Court found for the
appeal, the judiciary affirmed the includability of the
judgment as an award for breach of contract. On the other
hand, the court determined that the contingent fee arrangement
was excludable from the proceeds. The IRS argued for the
inclusion of the contingent fee, using the assignment of
income doctrine. The court stated that this interpretation
was based on the false premise that Cotnam had obligated
herself to pay the attorneys. Citing the Code of Alabama
(1940) section 64, the court noted that the statute provides
that an attorney’s lien was superior to all liens
except tax liens. Under statute, the attorney’s rights
and powers over the decrees are the same as the client’s.
Finding for the taxpayer, the court used the fruit-of-the-tree
analogy, by stating that “Mrs. Cotnam’s tree
had borne no fruit and would have been barren if she had
not transferred a part interest in that tree to her attorneys,
who then rendered the services necessary to bring forth
this statement, the court in Cotnam provided a
foundation for the numerous cases that followed. The circuits
have since been split in their interpretations concerning
the exclusion of contingent legal fee arrangements from
income. In his dissent to Cotnam, Judge Wisdom
wrote that the assignment of income doctrine was the proper
foundation for a finding in the case.
light of Cotnam, the various courts have developed
two alternatives. The first is to disagree wholly with the
contention that state laws provide a foundation for analysis
of the issue. Banks II said this “state-by-state”
approach is not an acceptable methodological interpretation
of federal tax statutes and is detrimental to the objectives
of the court system. By relying on differing state statutes,
it is impractical, if not impossible, to define that stance.
other alternative is to concur with Cotnam. The
analysis turns to interpretation of the statutes for the
situs of the case. The court examines applicable
state law to determine whether statutes confer property
rights greater than the contractual rights under the contingent
fee arrangement. Litigation may be successful if state laws
accord property rights rather than security interests. The
evolved litmus test for the state statutes includes:
Are attorneys invested with “a lien superior to
all liens but tax liens” in suits, judgments, and
decrees for money?
Does state law mandate that “no person shall be
at liberty to satisfy said suit, judgment or decree, until
the lien or claim of the attorney for his fees is fully
state law determine that “attorneys at law shall
have the same right and power over said suit, judgments,
and decrees, to enforce their liens, as their clients
had or may have for the amount due thereon to them”?
approaches. The taxpayer in Alexander [77
AFTR 2d 96-301 (72 F3d 938), 12/22/95] claimed that the
lawsuit and resulting award represented a breach of his
employment contract (i.e., property rights), implicitly
distinguishing his position from the anticipatory assignment
of income doctrine. As such, the attorneys’ fees would
be a cost of disposition of an intangible asset under IRC
sections 1001 and 1016. The
court disposed of this argument by noting that it has been
established that awards are taxed relative to the characterization
of what the damages are in lieu of. The court also dismissed
the taxpayer’s alternative arguments that the attorney’s
fees constituted a business expense or reimbursement arrangement.
a thorough listing of the judicial decisions involving attorneys’
contingent fees in the various circuits, see Exhibit
interpretive dilemma of contingent attorney fees is both
conceptual and pragmatic. Conceptually, there appears to
be significant confusion and disagreement about the applicability
of the assignment of income doctrine and the impact of state
statutes. The evolution of the assignment of income doctrine
in Earl, Horst, and Eubank involved locus
of taxation issues. In those early cases, the locus entailed
deciding between one of two taxpayers. More current cases,
however, result in income taxation for both involved parties:
the plaintiff taxed on the gross proceeds of the award,
and the attorneys taxed on their contingent percentage.
Additionally, while state law varies as to the type of lien
attorneys receive under a contingent contract, the concepts
embodied within liens (dominion and control) are not granted
only by specific liens. That is, dominion and control may
exist outside the context of a statutorily defined lien.
Another central question is that of value. Value has a presence
because the taxpayer has been wronged; yet, that value will
not be realized without the attorney’s services. How
much value is created and by whom provides fodder for subjective
equity is provided by only taxing the plaintiff on the amount
actually received. This treatment results in one locus of
taxation for this income.
the imposition of IRC sections 67 and 68 results in different
taxable income for the same set of circumstances. This is
further confounded by the AMT provisions. The same income
is taxed both to the client and the attorney. As noted in
Kenseth (114 TC 399), while these results are inequitable,
they are mandated by conflicting provisions in the code,
which is Congress’ responsibility.
conceptual and pragmatic problems surrounding the issue
of proper income tax treatment of contingent attorneys’
fees make it almost impossible to develop general rules
of law that are consistently applicable. Legislative action
could effectively settle the problems by clearly delineating
Planning Is Essential
those circuits that have determined that state laws are
relevant, knowledge of those statutes is essential. In jurisdictions
that do not grant attorneys a property right–type
lien in the litigation, this can be structured into the
contract between the litigant and her attorney. An idea
that some have suggested is that the taxpayer and her attorney
form a partnership, with the ownership percentages reflecting
the agreed-upon fee split. On formation of the partnership,
the taxpayer contributes the potential claim. IRC section
83 (property transferred in connection with performance
of services) is a consideration, but, theoretically, an
unlitigated claim is without value and highly uncertain.
partnership then hires the attorneys to pursue the action.
To avoid self-employment income consequences, the taxpayer
should be a limited partner. The use of an S corporation
can provide some income classification flexibility to the
attorney-partner. Additionally, tax planning in the year
of an award can serve to mitigate the potential effects
of AMT or AGI minimums. Postponing potential revenues while
accelerating certain deductions and losses can lessen the
impact of the minimum tax provisions.
the plethora of penalties for underreporting income, the
downsides must be evaluated when determining a position.
Nonetheless, the substantial authority depicted in Exhibit
2 should mitigate underreporting penalties. Additionally,
if a structured payoff of an award is agreed upon, cash
flow considerations become paramount. As reported in a Chicago
Sun-Times article (S.I. Banoff and R.M. Lipton, “Attorney’s
Fees Tax Whipsaw: The Public Beware!,” Journal
of Taxation, October 2002), one taxpayer found herself
in the position of owing the IRS income taxes in excess
of the cash settlement she agreed to in order to avoid an
appeal. Litigants in class action suits could also find
themselves in similar situations (R.W. Wood and D.L. Daher,
“Contingent Attorney’s Fees in Class Action
Cases—From Bad to Worse for Taxpayer-Plantiffs,”
Journal of Taxation, October 2003).
the subjective interpretations currently at the heart of
this controversy, alleviating one inequity often leads to
the creation of another. Under these circumstances, fixed
attorneys’ fees are, indisputably, allowed only as
itemized deductions. Legislatively excluding contingent
fees from taxability would serve to codify that disparity
in treatment. As such, reporting only net proceeds provides
parity with other before-tax netting provisions in the tax
code. A statute mandating deductibility of contingent attorneys’
fees, however, would serve to enhance the perceived inequities
of the minimum tax provisions.
Supreme Court had denied certiorari to both Hukkamen-Campbell
[88 AFTR 2d 2001-7238, 274 F3d 1312, 2002-1 USTC para.50351
(CA-10, 2001), cert.den.] and Sinyard [88 AFTR
2d 2001-6034, 268 F3d 756, 2001-2 USTC para. 50645 (CA-9,
2001), cert. den.], but granted certiorari to Banks
II and Banaitis [92 AFTR 2d 2003-5834 (340 F3d 1074),
8/27/2003] on March 29, 2004. The cases represent the dichotomy
of the controversy; Banks II found for the taxpayer
based upon the assignment of income doctrine, while Banaitis
found for the taxpayer based upon Oregon statute. A Supreme
Court decision has just come down, holding that contingent
attorneys’ fees are to be treated as itemized deductions.
This necessary judicial response brings clarity to this
issue and provides certainty of application, with the resulting
desired attributes of equity and uniformity of application
across taxpayers in all circuits.
Englebrecht, PhD, is the Smolinski Eminent Scholar
Chair, school of professional accountancy, college of administration
and business, Louisiana Tech University, Ruston, La.
Mary Anderson, CPA, and Tracy L.
Bundy, CPA, are both doctoral candidates at the school
of professional accountancy, college of administration and
business, Louisiana Tech University.