Class actions and the attorneys' fees conundrum.

• Author: Wood, Robert W.

EXECUTIVE SUMMARY

* A plaintiff is subject to a significant (and arguably unfair) increase in tax when a fee award is included in gross income because, as a miscellaneous itemized deduction, it is subject to total disallowance for AMT purposes.

* Fees awarded directly to the attorneys under the common fund theory are not includible in the members' gross income.

* It is not yet clear the extent to which an upcoming Supreme Court decision on contingent fee awards will affect class actions.

An upcoming Supreme Court decision on contingent attorneys' fees may affect the taxation of such fees awarded in class actions. This article examines the class action fees issue and how the courts and the IRS currently determine whether such fees should be included in class members' gross income.

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Due to a variety of oddities in the tax system (most notably, the alternative minimum tax (AMT)), there is a dramatic tax difference between a plaintiff being taxed on a settlement's gross amount, instead of an amount net of recovered attorneys' fees. In class actions, the IRS and the circuit courts have taken different approaches on the proper tax treatment of fee awards in "opt-in" and "opt out" class action lawsuits. This article reviews the current law on contingent fee awards in general and in class actions in particular, analyzes whether class action attorneys' fees should be included in the plaintiffs' gross income and provides some recommendations.

Background

It is no secret that the circuit courts do not agree on the tax treatment of contingent attorneys' fees recovered by plaintiffs. The majority has held that contingent attorneys' fees are gross income to the recovering plaintiff (1); the minority has held that these fees do not constitute gross income to the recovering plaintiff. (2) Commentators have long noted the split in the circuits and the legislative efforts that have thus far failed to correct the problem. (3) Despite failing to reconcile these markedly different positions by denying certiorari on this issue on five prior occasions, (4) for reasons which are not yet clear, the Supreme Court recently agreed to consider the irreconcilable split in the circuits, by agreeing to review the Sixth Circuit's decision in Banks (5) and the Ninth Circuit's decision in Banaitis. (6) A petition for certiorari has also recently been filed from the Second Circuit's decision in Raymond. (7)

A significant difference in an individual's plaintiff's tax can result, depending on the treatment of fees.

Example 1: K, married and filing jointly, recovers a $1 million nonbusiness settlement, inclusive of $400,000 in attorneys' fees. Under the controlling circuit law, K is required to recognize the gross amount. Thus, he is taxed on the entire $1 million recovery and entitled to a miscellaneous itemized deduction, subject to the 2%-of-adjusted-gross-income (AGI) floor for the recovered legal fees. Thus, K owes $276,500 in Federal income tax on the recovery. Of this amount, over $75,000 stems from the AMT. In stark contrast, if K is only required to include the net amount of $600,000 in gross income, he would owe a mere $164,500 in Federal income tax--a staggering $112,000 difference!

For cases arising out of a trade or business, a plaintiff would normally be able to deduct the entire amount of contingent attorneys' fees recovered. The Code does not expressly provide a deduction for such legal fees to obtain damages or settlement payments; however, such payments in connection with a trade or business are usually deductible business expenses under Sec. 162. To be deductible under Sec. 162, damages or settlement payments must be:

* Ordinary, necessary and reasonable expenses;

* the Paid or incurred during the tax year for which a deduction is sought;

* Directly connected or proximately result from the taxpayer's trade or business;

* An expense rather than a capital expenditure;

* Not personal in nature;

* Paid by the person to whom such services are rendered; and

* Not contrary to public policy.

Class Action Nuances

Do the same rules apply to class actions? Are the (often enormous) attorneys' fees paid to class counsel gross income to class members? Does it matter what kind of class action is involved? Is there a different result if the plaintiffs actually elect to join the class instead of merely failing to opt out? Some of these questions are plaguing taxpayers; some are affecting lawyers. All of these questions should be a matter of concern for the IRS and the courts.

The taxation of contingent attorneys' fees in opt-in and opt-out class actions is discussed below. Historically, some commentators have argued that the Service has been somewhat lackadaisical in enforcement in this area. As will be seen, Sinyard (8) dispels any lingering misconceptions as to how the Service addresses this issue today.

Opt-in Class Actions

An opt-in class action...