Contingent Fee Awards - a Different Approach
For many years there have been disputes between taxpayers and the IRS concerning the taxable amount of court awards or settlements taxpayers receive from wrongful termination claims under a contingent fee arrangement. Some courts have held the gross amount of the award represents income to the taxpayer and the amount paid to the attorneys represents a deduction. Unfortunately for taxpayers the law treats the deduction as a miscellaneous itemized deduction subject to the 2% of AGI floor. In addition, due to the large dollar amounts involved, a transaction sometimes triggers the alternative minimum tax (AMT) since miscellaneous itemized deductions are not allowed when calculating AMT. Other courts have permitted a more favorable outcome, allowing tax-payers to include in gross income only the net amount they received after deducting attorney's fees. In either situation the nature of the attorney's legal interest under applicable state law usually has been the determining factor. For example, based on state law the Ninth Circuit Court of Appeals has required the gross approach for California and Alaska taxpayers but allowed the net approach for an Oregon taxpayer (see Coady v. Commissioner, 2000-1 USTC [paragraph] 50,528; Benci-Woodward v. Commissioner, 2000-2 USTC [paragraph] 50,595; and Banaitis v. Commissioner, 2003-2 USTC [paragraph] 50,638). Frank Biehl was an employee, officer, shareholder and director of North Coast Medical Inc. (NCM) in California. NCM terminated Biehl's employment. Subsequently, he filed a wrongful termination suit against the company. After a jury gave Biehl a favorable verdict, the two parties reached a settlement. The agreement required NCM to pay him $799,000 in settlement of his employment-related claims and to make a direct payment of $401,000 to Biehl's attorneys for their fees under a contingent fee agreement. The taxpayer included only the $799,000 as gross income on his federal income tax return. The IRS disagreed. Biehl petitioned the Tax Court for relief. Since the Ninth Circuit had previously ruled California law required the gross approach, the taxpayer argued the $401,000 NCM paid to the attorneys represented a reimbursed employee business expense under an accountable plan. Biehl's argument was based on (1) the presence of a shareholder agreement which required the losing party to pay the attorney's fees of the prevailing party in any suit due to a breach of the agreement and (2) the fact the lawsuit arose out of the taxpayer's former employment. …