Lawsuits and TAXES

Internal Revenue Commissioner v. Banks, John / Internal Revenue Commissioner v. Banaitis, Sigitas
Docket: 03-0892 / 03-0907

Term: 04-05

Appealed From: 6th Circuit Court of Appeals (Sept. 30, 2003) / 9th Circuit Court of Appeals (Aug. 27, 2003)

Oral Argument: Nov. 1, 2004

Subject: Income taxes, gross income, litigation, contingent fees

Questions presented: Whether, under Section 61(a) of the Internal Revenue Code, 26 U.S.C. 61(a), a taxpayer's gross income from the proceeds of litigation includes the portion of his damages recovery that is paid to his attorneys pursuant to a contingent fee agreement?

BY ALEXIA GARAMFALVI, MEDILL NEWS SERVICE

Plaintiffs sitting across wide conference room tables from a flotilla of lawyers probably don't always consider how large a bite Uncle Sam will take out of the amount they are being offered to settle a lawsuit. Even fewer of them consider that they may be taxed on a large chunk of the settlement they never see - the perhaps 33 percent going to their lawyer. Of course, their lawyer is paying taxes on that amount too. So, trial lawyers aren't the only beneficiaries of our increasingly litigious society. Uncle Sam is smiling too.
One such plaintiff, Sigitas Banaitis, worked at the Bank of California as a vice president and loan officer from 1980 to 1987. Mitsubishi Bank, which became the Bank of California's parent in 1984, controlled and operated companies which competed directly with several of Banaitis' loan customers. Worried about this potential conflict of interest, many of Banaitis' customers contacted him imploring him to keep their financial information confidential. After refusing to disclose this sensitive information to Mitsubishi employees, Banaitis was forced to resign on Dec. 30, 1987.

In December of 1989, Banaitis decided to sue the Bank of California and Mitsubishi Bank for wrongful discharge, having hired the law firm of Merten & Associates to represent him. Instead of paying his lawyer by the hour, Banaitis signed a contingent fee agreement. The agreement provided that Merten would be entitled to one-third of the gross settlement if the case settled before going to trial, or forty percent of any settlement made or judgment awarded after trial had begun.

An Oregon state court jury awarded Banaitis $6.27 million in damages in early 1991. Following appeals to the Oregon appellate and supreme courts, Banaitis and the banks settled their suit in 1995 for $8.73 million. Banaitis did not include any of this settlement in his calculation of gross income for his 1995 federal income tax return claiming that the compensatory damages, the punitive damages and the part of the award used to pay attorneys fees were excludable from gross income under the Internal Revenue Code. Five years later Banaitis received a notice of deficiency from the Internal Revenue Service stating that $8.10 million of his settlement was taxable which made him liable for an additional $1.71 million in 1995 income tax.

Banaitis appealed the IRS' determination to tax court which found in favor of the IRS, prompting him to appeal.

In a unanimous decision written by Judge Sidney Thomas, the 9th Circuit Court of Appeals upheld the tax court's holding that the portion of the settlement representing compensatory damages and punitive damages was to be included in Banaitis' gross income.

The court then turned to whether Banaitis should be taxed on the portion of the settlement that went to pay his attorney's contingency fee. The court wrote that the question of whether attorneys' fees are includable in a plaintiff's gross income involves two related questions: "(1) how state law defines the attorney's rights in the action, and (2) how federal tax law operates in light of this state law definition of interest." The court explained that "state law creates or defines the legal interests and property rights but that federal law defines when and how these interests and rights are taxed."

The court considered the long-established "anticipatory assignment of income" doctrine crafted by the U.S. Supreme Court in 1930 in Lucas v. Earl to prevent taxpayers from escaping tax liability by shifting income to lower bracket taxpayers. In Lucas, the taxpayer assigned one-half of his future salary to his wife to avoid paying taxes on his entire salary and argued that because he had never actually received the income before assigning it to his wife, it was not income to him. The Court disagreed and held that because the taxpayer had earned the right to receive the income before assigning it, he was subject to taxation on the whole salary, stating that it would not honor attempts to attribute fruits "to a different tree from that on which they grew."

The 9th Circuit noted if state law vests attorneys with a sufficient property interest in the judgment - the part of the judgment that goes to the attorney is not considered to be the plaintiff's property and so it does not figure in the plaintiff's calculation of gross income. In other words, under state law a contingent fee agreement might give an attorney sole right to some of the trees in his client's orchard, not just fruit from those trees.

To determine whether attorneys' fees are part of a plaintiff's gross income, the 9th Circuit analyzed what property interests Oregon law affords to attorneys in their clients' judgments and settlements. The court wrote that "Oregon law vests attorneys with property interests that cannot be extinguished or discharged by the parties to the action except by payment to the attorney." An attorney's property interest in his fee is so strong under Oregon law that the Oregon Supreme Court has "recognized that an attorney has a right to sue a third party for attorneys fees that were left unsatisfied by a private settlement with the attorney's clients."

The 9th Circuit concluded that the fees paid to Merten were not includable in Banaitis' gross income, "because of the unique features of Oregon law."

The IRS appealed the case to the U.S. Supreme Court. The IRS had already petitioned the Court to take another case on the issue - Commissioner of Internal Revenue v. Banks from the 6th Circuit.

In that case, John W. Banks II filed a federal civil rights employment discrimination lawsuit against his employer, the California Department of Education, after being terminated in 1986. Soon after the trial began in 1990, Banks settled all his claims for $464,000. Pursuant to a contingency fee agreement that Banks had entered into with his attorney prior to the filing of the suit, $150,000 of the settlement was paid directly to his attorney.

Like Banaitis, Banks did not include any of his settlement proceeds as gross income in his 1990 federal income tax return and was served with a notice of deficiency from the IRS in 1997 stating that his settlement was taxable. Banks requested a re-determination of the deficiency in tax court. The tax court ruled that the entire settlement was includable in gross income.

In a 2-1 decision written by Judge Eric Clay, the 6th Circuit upheld the tax court's holding that the settlement corresponding to Banks' damages was to be included in Banks' gross income. Like the 9th Circuit, the 6th Circuit then reversed the tax court's determination that the contingency fee paid to Banks' lawyer was taxable income to him.

However, the 6th Circuit based its ruling on different grounds and declined to look to state law as the 9th Circuit did. The 6th Circuit wrote that it was: "not inclined to draw distinctions between contingency fees based on the attorney's lien law of the state in which the fee originated. Given the various distinctions among the attorney's lien laws among the fifty states, such a 'state-by-state' approach would not provide reliable precedent ? or provide sufficient notice to taxpayers as to our tax treatment of contingency-based attorneys fees paid from their respective jury awards."

The 6th Circuit held that a contingency fee agreement was not akin to an anticipatory assignment of income prohibited by Lucas. The court wrote that a contingency fee was not already earned, vested or even relatively certain to be paid, but instead was "an intangible, contingent expectancy dependent on the attorney's skill to realize value from it." The court went on to compare a contingency fee agreement to a division of property: "Here the client as assignor has transferred some of trees in his orchard, not merely the fruit from the trees. The lawyer has become a tenant in common of the orchard owner and must cultivate and care for and harvest the fruit of the entire tract. Here the lawyer's income is the result of his own personal skill and judgment." The court concluded that the amount paid in contingency fees was excludable from Banks' gross income.

In her dissent, Judge Karen Nelson Moore wrote that the court should have looked to the law of California, the state in which the contingency fee agreement was entered into, to characterize the lawyer's contingency fee interest in Banks' settlement. Moore concluded that since it is clear that California law does not treat a contingency fee agreement as an ownership interest that the contingency fee should have been included in Bank's taxable income.

On March 29, 2004, the Supreme Court accepted both the Banaitis and Banks cases and consolidated them for review and oral argument.

Whether contingency fees must be included in gross income is hotly debated among the federal circuit courts. A minority of circuits agrees with the 9th Circuit and looks to state law to determine whether an attorney's property interest in the fee is sufficiently strong enough to conclude that the fee was never income to the plaintiff. The majority of circuits, however, agree with the 6th Circuit that the issue should be resolved by application of federal income tax law, and not by the property rights state law grants to attorney in his client's cause of action. However the circuits in the majority are split as to how federal income tax law comes out on the issue.

Although the debate on the taxation of contingency fees has been around for decades, the growing impact of the alternative minimum tax has intensified the consequences of the debate. Pursuant to ordinary tax calculations, the amount a client paid to his attorney pursuant to a contingency fee agreement could be claimed as a deductible expense in earning that income. Being able to deduct the fee as an expense negated the impact of having to include it in taxable income. However, under the alternative minimum tax scheme, attorney fee expenses are not deductible. Taxpayers who are subject to the alternate minimum tax must pay it, if it is higher than their ordinary tax calculation. A growing number of taxpayers are subject to the alternate minimum tax, so a growing number can no longer take a deduction for attorneys' fees and so, a part of a growing number of settlements are taxed twice by the government.

According to Banaitis' reply to the IRS petition for certiorari, if all asserted taxes were paid, Banaitis would be left with $1.98 million, or 22.7 percent, of his total settlement. Future plaintiffs, more aware of what a large piece of the pie goes to the taxman, might sit at the conference table longer holding out for larger settlements.

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