Second Circuit includes contingent fee award in client's income.

• Author: O'Driscoll, David

Rentered into a contingent fee agreement with law firm A to represent him in his wrongful termination suit. R prevailed and a Vermont district court entered judgment for approximately $900,000. The defendant sent a check to A, payable to R; A deposited approximately $300,000 in its own account as a contingent fee.

R initially included the entire judgment in his gross income and attempted to deduct the fees paid. However, his tax liability was controlled by the alternative minimum tax (AMT). Because legal fees are among the itemized deductions that may not offset the AMT under Sec. 56(b)(1)(A)(i), R's tax liability was based on the entire judgment proceeds.

R subsequently filed an amended return, excluding the fees from his gross income and claimed the IRS owed him a refund of approximately $55,000, which the IR.S denied. R filed a retired suit in the Vermont district court, which granted R's motion for summary judgment, holding the contingent fee excludable from gross income; the IRS appealed.

The district court held that, under Vermont law, a contingent fee agreement between taxpayer and attorney gives rise to an equitable lien in favor of the attorney on the taxpayer's recovery, effecting a transfer to the attorney of a proprietary interest in the taxpayer's claim under Est. of Button, 28 A2d 404 (VT 1942).Thus, it is gross income to the attorney, but not to R.

Discussion

Whether contingent fees are includible in a client's gross income is the subject of much debate among the circuit courts. The majority position is that the fees are includible in the client's gross income; see Campbell, 274 F3d 1312 (10th Cir. 2001); Kenseth, 259 F3d 881 (7th Cir. 2001); Young, 240 F3d 369 (4th Cir. 2001); and Baylin, 43 F3d 1451 (Fed. Cir. 1995). The minority position is that contingency fees are income to the attorney, but not to the client; see Davis, 210 F3d 1346 (11th Cir. 2000); Est. of Clarks, 202 F3d 854 (6th Cir. 2000); and Cotnam, 263 F2d 119 (5th Cir. 1959). The Ninth Circuit has held both ways, depending on the state law revolved; see Woodward, 219 F3d 941 (9th Cir. 2000); and Benaitis 340 F3d 1074 (9th Cir. 2003).

Courts generally recognize that state law determines the nature of legal interests in property, while Federal law determines the tax con sequences of the receipt or disposition of property. Thus, courts typically first analyze state law to determine the relative strength of the respective interests in the contingency fee. When the...