Is a Contingent Attorney's Fee Includible in Plaintiff's Income?
The courts disagree on whether taxpayers must report (and can deduct) certain attorneys' fees. Agnes, a 64-year-old resident of California, successfully sued her exemployer in 2000 for wrongful termination; a jury awarded her $2 million. Agnes paid her attorney $800,000, 40% of the award, in accordance with their contingent fee agreement; thus, her net proceeds from the suit were $1.2 million. In March 2001 Agnes will visit her tax preparer, explain the suit and the outcome, and provide all her documentation. How much lawsuit income must the preparer report on Agnes's return? Is it $2 million, $1.2 million, or something in between? If it is $2 million, can Agnes deduct her attorney's fees and litigation costs? The answers depend on the state in which Agnes lives and that jurisdiction's law. Because of the dollars involved, this issue is extremely controversial and has produced a rift in the U.S. circuit courts of appeals. EXCLUSIONS, INCLUSIONS AND DEDUCTIONS Why would a contingent fee be excludible from a plaintiff's income? One theory is that, under state law, an attorney may have an equitable assignment or lien and, therefore, an equity interest in the cause of action (that is, the nature of the suit) to the extent of the contracted fee. Further, the value of the lawsuit might be completely speculative and dependent on the attorney's services, so that the right to the income is the attorney's from the outset. One inclusion theory is that the taxpayer has retained all proprietary rights in the claim and simply is using a portion of the award to discharge a personal liability to the attorney. In such case, the attorney's fee and litigation costs may be deductible by the taxpayer as a miscellaneous itemized deduction, subject to the 2%-of-adjusted-gross-income floor (and overall phaseout on itemized deductions, if applicable). Thus, the taxpayer may have to include the contingent fee in income, but the deduction for it is limited (that is, smaller). Another inclusion theory is that the taxpayer received the benefit of the lawsuit proceeds even if he or she did not take possession of the funds. Still another is that the taxpayer's control over the transferred income justifies holding him or her liable for taxes on it. The assignment-of-income doctrine (court created), assigns income back to a taxpayer who has tried to shift its receipt and taxability to another (for example, through a contingent fee agreement). A preparer should look at applicable court decisions to determine how to analyze the taxability of a contingent fee for reporting purposes. COURT DECISIONS To date, several of the circuit courts of appeal, in addition to the Tax Court, have weighed in with decisions on this issue. The Fifth, Sixth and Eleventh Circuits hold contingent fee income to be excludible; the Ninth and Federal Circuits, and the Tax Court, hold such income to be includible (but an itemized deduction may be available for attorney's fees and litigation costs). FIFTH CIRCUIT In Sudhir P. Srivastava (7-19-00, aff'g in part, rev'g and remd'g in part, TC Memo 1998-362), the Fifth Circuit Court of Appeals held that a contingent fee paid under Texas law was excludible from the plaintiff's income. In that case, the taxpayer, a doctor, had sued a television station for defamation of character; the suit was settled for $8.5 million. The court held that, under Texas law, the attorneys had an ownership interest in the taxpayer's recovery to the extent of their contingent fee. The fee was a division of property, not an assignment of income; thus, it had to be charged to the attorneys who earned and received the funds, not to the taxpayers, because the income was the result of the attorneys' personal skill and judgment. …