Attorneys' contingent fees.

• Author: Koppel, Michael D.

In a reviewed opinion, the Tax Court ruled 8-5, in Kenseth, 114 TC 399 (2000), that a client, as well as his attorney, is taxed on the attorney's contingent fee, even though the value of the client's claim was uncertain and dependent on the attorney's services. Although Kenseth could deduct the fee as a miscellaneous itemized deduction, miscellaneous itemized deductions are not deductible for the alternate minimum tax (AMT), resulting in a large AMT liability. This ruling is arguably unfair and is contrary to Fifth and Sixth Circuit decisions on this issue. Kenseth is important because sex, race and age discrimination awards are generally includible in an employee's gross income, and the U.S. Supreme Court recently eased the burden on employees in proving Federal discrimination law violations (Reeves v. Sanderson (2000)).

Under Sec. 61(a), gross income includes all income from whatever source derived. In the first assignment-of-income case (Lucas v. Earl, 281 US 111 (1930)), the Supreme Court interpreted Sec. 61 (a) to require income to be taxed "to those who earn or otherwise create the right to receive it and enjoy the benefit of it when paid." Traditional assignment-of-income cases consist of transferring income earned by one taxpayer (such as wages or interest) to a relative in a lower tax bracket. Following Lucas v. Earl, courts have not allowed the assignment of such income for tax purposes. When the income assigned is an attorney's contingent fee, appellate courts that have ruled on the issue have followed Lucas v. Earl and included the fee in the client's income, with two exceptions.

In Cotnam, 263 F2d 119 (1959), rev'g on this issue 28 TC 947 (1957), the Fifth Circuit ruled 2-1 that the attorney's fee should be excluded from the client's income, for two reasons: (1) under applicable Alabama law, an attorney's right to enforce a lien against a client for the fee prevents the client from receiving the fee; and (2) it was the attorney's effort that converted a speculative claim into a judgment. In all cases on this issue since 1959, the Tax Court has distinguished Cotnam based on a particular state's lien statute, and ruled that the fee should have been included in a client's income, unless the case could have been appealed to the Fifth or Eleventh Circuit. (Cases decided by the Fifth Circuit prior to Oct. 1, 1982 are also binding on the Eleventh Circuit.)

In Est. of Clarks, 202 F3d 854 (2000), the Sixth Circuit, following Cotnam...