An assignment by any other name: contingent-fee agreements as partial assignments of the claim.

• Author: Lycans, Andrew P.

TABLE OF CONTENTS INTRODUCTION I. (MIS)APPLYING THE ANTICIPATORY ASSIGNMENT OF INCOME DOCTRINE A. Lack of an Assignment Satisfying a Debt B. Enjoyment of Income II. IF IT LOOKS LIKE AN ASSIGNMENT, WALKS LIKE AN ASSIGNMENT, AND QUACKS LIKE AN ASSIGNMENT A. The Indications of a Partial Assignment B. The Case for Partial Assignment of the Claim III. ESTABLISHING A VALUE FOR THE CAUSE OF ACTION A. Section 83 Mainly Applicable to the Employee-Attorney B. No Substantial Risk of Forfeiture Exists C. Barter Analysis: The Better Approach CONCLUSION INTRODUCTION

In 1959, Mrs. Ethel West Cotnam of Alabama won a groundbreaking lawsuit against the Internal Revenue Service when the Fifth Circuit Court of Appeals allowed her to subtract her legal fees, paid to her lawyer on a contingency basis, from her gross income. (1) Mrs. Cotnam sued the estate of her former employer when the administrator refused to honor the decedent's promise to pay her one-fifth of his estate if she would care for him the rest of his life. (2) Upon the successful disposition of this suit, (3) the Supreme Court of Alabama awarded Mrs. Cotnam $120,000. (4) Of that amount, $50,365.83 went to her attorney, and the Internal Revenue Service determined she owed $36,985.02 in taxes. (5) The Tax Court upheld this decision. (6) Mrs. Cotnam appealed, claiming she possessed no control over the funds diverted to her attorney, and that, once she signed the contingent-fee contract, (7) she never could lay claim to the money. (8) In a two-to-one decision, the Fifth Circuit agreed, reasoning that, because Mrs. Cotnam never enjoyed the benefit of this alleged income, it in fact did not constitute income as to her. (9) This decision created a split between the circuits (10) that has irked the Internal Revenue Service and a majority on the Tax Court to this day. (11)

For nearly forty years, the Fifth Circuit stood alone in holding that plaintiffs can subtract attorneys' fees from gross income. (12) The majority of circuit courts, less sympathetic to those in Mrs. Cotnam's position, (13) distinguished her case based on the unique attributes of the attorney charging-lien statute under which her lawyers collected. (14) In their view, a contingent-fee agreement constitutes nothing more than an anticipatory assignment of income, whereby the taxpayer transfers his or her right to income to someone else in order to decrease tax liability. (15) The taxpayer remains firmly in control of the income-generating vehicle, the lawsuit, and merely directs the proceeds to another, either in order to satisfy a debt, (16) or to divert the funds to someone in a lower tax bracket. (17) Under such an analysis, taxpayers do possess dominion over the portion of their awards going toward legal fees. They have simply chosen to direct these proceeds to others in order to settle debts or lower their tax burden. (18) Although taxing successful litigants in this manner may seem unfair, a number of circuits have made it clear that, because Congress remains in control of tax policy, the courts should not make ad hoc adjustments in an attempt to promote equity. (19)

Rejecting this analysis, the Sixth Circuit, in 2000, decided to follow Cotnam v. Commissioner (20) in Estate of Clarks ex rel. Brisco-Whitter v. United States, (21) stating to do otherwise would constitute double taxation. (22) The Estate of Clarks court noted that, in the anticipatory assignment of income cases cited by other courts, the Internal Revenue Service either taxed the donor or the donee, but not both. (23) Significantly, though the panel briefly discussed the Alabama attorney charging-lien statute, Michigan, where Estate of Clarks originated, has only a common law attorney lien, not a statute. (24) Attributing no great weight to this issue, the court noted, "Michigan law operates in more or less the same way as the Alabama lien in Cotnam." (25) Thus, the court refused to require any statutory grant of power to the plaintiff's attorney over the judgment award before finding that the plaintiff lacked sufficient control over the portion paid to the attorney to avoid tax on this amount.

Another significant decision in 2000 arose in Srivastava v. Commissioner (26) when the Fifth Circuit considered a Texas case and refused to limit Cotnam to Alabama. (27) The Internal Revenue Service sought to isolate Alabama residents as the only taxpayers entitled to take advantage of the Cotnam decision. (28) The panel found the differences in the Texas and Alabama attorney charging laws irrelevant in regard to the taxpayer-plaintiff. (29) The sole consideration before the court in regard to the anticipatory assignment of income doctrine consisted of the "degree of control and dominion over the asset." (30) Finding Cotnam controlling in this case, the panel concluded that a contingent-fee agreement constitutes a significant shift of control from the plaintiff to the attorney. (31)

This Note argues that plaintiffs assign a portion of their cause of action to their attorneys when they sign contingent-fee agreements. Part I argues the anticipatory assignment of income doctrine is inapplicable to contingent-fee agreements. Part II contends the Fifth and Sixth Circuits have already implicitly held that plaintiffs assign a portion of their claims to their attorneys upon signing contingent-fee agreements, and explains why this approach is correct. Part III concludes that section 83 of the Internal Revenue Code--property transferred in connection with performance of services--is ill suited to contingent-fee arrangements, and supports a barter analysis for determining the tax liability of each party.

1. (MIS)APPLYING THE ANTICIPATORY ASSIGNMENT OF INCOME DOCTRINE

   This Part examines the anticipatory assignment of income theory applied by courts in the majority from two perspectives--paying off a debt by assigning income previously earned, and the actual enjoyment of the income test--and finds both inapplicable to contingent-fee situations. Section I.A argues that a contingent-fee agreement does not pay off a debt in such a way as to trigger the anticipatory assignment of income doctrine. Section I.B contends that whether or not the taxpayer enjoys the income should be irrelevant to a court's holding, and reveals that the courts actually disagree on whether the taxpayer realizes the income.

   1. Lack of an Assignment Satisfying a Debt

      For over seventy years courts have policed transactions with an eye toward preventing tax evasion in the guise of transferred assets. (32) Justice Holmes first enunciated the anticipatory assignment of income doctrine in Lucas v. Earl, (33) concluding "tax[ation] ... [can]not be escaped by anticipatory arrangements and contracts however skilfully [sic] devised." (34) The dissent in Cotnam itself asserted that such language should prevent successful plaintiffs from using contingent-fee arrangements with their lawyers to avoid paying income taxes on these amounts. (35) Later courts have advocated this position insisting that to allow such results would permit litigants to avoid taxation. (36) Courts use phrases such as "but for the taxpayer's effort to shift the receipt" of the proceeds of the lawsuit, the taxpayer would have come into the entire amount. (37) Other ways, however, exist to interpret Lucas in these situations.

      In fact, one can easily distinguish Lucas and its progeny from the typical arrangement in a contingent-fee case. (38) As others have noted, "it is not clear that the rationale of the assignment of income cases should apply to contingency-based attorneys' fees." (39) This implication arises because of what the Lucas Court sought to prevent. (40) When Justice Holmes referred to "skillfully devised contracts to avoid paying wealth," (41) he meant just that. Mr. Earl attempted to reduce his income tax liability by relying on a contract with his wife to share all wealth, however acquired, equally. (42) The Court refused to allow contractual arrangements to shift the tax burden from the source of the income. (43)

      Unlike arrangements meant to reduce tax liability, contingent-fee agreements do not attribute income to anything other than the source of the income. (44) Plaintiffs do not hire lawyers with the goal of avoiding taxation on the money due them by transferring a portion of their claims to their lawyers as a gratuity. (45) Some, such as the dissenters in Cotnam, argue these arrangements amount to an anticipatory assignment of income because they discharge a debt to the client's attorney. (46) This argument misconstrues the contingent-fee arrangement. Attorneys have no recourse against their clients when seeking payment until the defendant makes good on the judgment. When plaintiffs prevail, their attorneys look solely to their portion of the judgment, not to their client's. In fact, the whole structure of the anticipatory assignment of income doctrine rests on the notion that the taxpayer would have received the income, but for the assignment. (47) Here, but for the assignment, neither would have received the income because payment would not have been forthcoming. Simply put, the "skillfully devised" scheme arises from an attempt to collect the money, not an attempt to avoid taxation. (48) Thus, the correct analysis of contingent-fee agreements does not involve the anticipatory assignment of income doctrine.

      Considering what role the attorney plays in recovery clarifies the objections to applying the anticipatory assignment of income doctrine in these situations. (49) While the client may have earned the right to the income, collecting these funds requires an attorney's efforts. (50) The lawyer earns the contingent fee through skill and judgment. (51) Taxes should accrue only to those who earn the money. (52) Nominal owners who serve as funnels without real access to the money should not suffer the taxation of such "income." (53) This proposition holds the most sway in areas such as punitive...