Contingency Fee Agreements: Remedying The Enormous Tax Burden Of The Amt To Clients.

• Author: Andrew J. Foti
• Position: JD Candidate
• Pages: 07

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Andrew J. Foti is a second-year JD candidate at American University Washington College of Law. In 2002, he graduated Magna Cum Laude from the University of Miami, dual-majoring in Finance and Business Law, and receiving departmental honors in both. Mr. Foti published his senior honors thesis on consumer bankruptcy reform and substantial abuse in the bankruptcy system in the Boston University Public Law Journal. Currently, Mr. Foti is pursuing a career in civil litigation or general corporate law.

MANY CIVIL INJUSTICES EXIST in the world today and normally citizens attempt to remedy these before a court of law. A plaintiff comes before this body in hopes of being made whole or at least put in a more favorable situation. Recently, however, situations have arisen where a plaintiff's recovery is unfairly diminished as the jury award he receives is subject to unjust taxation.¹ This treatment arises because of the effect of two federal tax provisions. The Alternative Minimum Tax (AMT)² and Limitations on Itemized Deductions³ together cancel out personal itemized deductions and tax the client's gross income at a flat 26-28 percent. The combination of these rules no longer allows attorney's fees to be deductible by the client as miscellaneous itemized deductions. As a result, the client's gross income is largely inflated and the effective income tax rate on that client's jury award can be as high as 60 percent. It is hard to rationalize such a result when considering the 60 percent tax is 25 percentage points more than the highest tax rate and a little over double the standard AMT tax rate. Because of the differing views over the fairness of this taxation, discrepancies now exist among the Appellate Courts over what should constitute a successful plaintiff's taxable income with respect to his jury award.

The Sixth Circuit Court of Appeals recently reaffirmed in Banks v. Commissioner⁴ that legal fees paid under a contingency fee arrangement should be excluded from a client's gross income. In all, nine appellate courts have considered whether the portion of an award that comprises an attorney's fee should constitute taxable income to the plaintiff. Six circuits require this amount to be part of the client's taxable income. These circuits are condemning a successful plaintiff to pay over half of her award as income tax. Of the remaining amount, the client, who could not otherwise afford an attorney, must relinquish two-thirds to her lawyer via a contingency fee agreement. Only the minority of circuits, comprising of the Fifth, Sixth, and Eleventh, fully understand the tax burden placed on a plaintiff when she is forced to include as income amounts of money which belong to her attorney. Thus, these circuits have taken steps to alleviate the economic loss by ruling that a plaintiff shall not be taxed on such amounts.

The divergent opinions among the Circuits highlight the growing disparate tax treatment. This incongruency can be eradicated if the Supreme Court grants certiorari and rules on the issue, optimally by supporting the Banks decision. Alternatively, Congress could enact legislation that would either allow an attorney's fee to be excluded from a client's gross income, or, if the fee is included in gross income, allow it to be treated as a deduction not subject to disallowance or AMT treatment. Regardless of the means, a solution is necessary to stop the unjust taxation that has plagued plaintiffs throughout the country.

Federal Tax Inequity: The AMT Route

CONGRESS ORIGINALLY ENACTED THE AMT to ensure that highincome earners paid sufficient income taxes by placing limits on allowable deductions.⁵ Under the AMT, a taxpayer must first calculate his tax liability according to the regular tax system, and then calculate his tax liability under the AMT. In making this second calculation, the taxpayer is precluded from deducting expenditures classified as miscellaneous itemized deductions, state income tax, mortgage interest, standard deductions, and personal exemptions. The effect of such exclusions increases the taxpayer's gross income, resulting in higher taxes.

When determining taxable income, there is a fundamental concern over which items the government determines should be included in gross income. The Internal Revenue Code (Code) defines gross income as "all income from whatever source derived."⁶ While the Code does not give specific guidance on the inclusion of damage awards, courts have construed gross income as "instances of undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion."⁷ Thus, except Page 28for personal injury, courts have included damage awards, which include an attorney's fees, as part of a client's gross income.

If a plaintiff's damage award is considered part of his gross income, the concern then revolves around whether a successful plaintiff can deduct the contingency-based attorney's fees as an expense. Some plaintiffs can deduct this expense as an ordinary and necessary expense incurred while conducting trade or business. ⁸ Most people, however, cannot sue in the business capacity and are left with the only option of deducting this expense as a miscellaneous itemized deduction. This regulation has limitations that require the deduction to be reasonable in amount, and bear proximate relation to the production of income.⁹ In addition, the expense must exceed 2 percent of the client's gross income in order to qualify as a deduction. An example that fits these requirements is contingency-based attorney's fees that are deemed employee-related expenses, where the fees are considered a miscellaneous itemized deduction, provided the taxpayer is not subject to the AMT. The difficult issue, however, is when the AMT denies such deductions to an individual who exceeds a certain income threshold.

Suppose an individual sues a former employer for wrongful termination in a jurisdiction that includes contingency-based attorney's fees as taxable income, and the award consists of back wages, interest, and punitive damages in the amount of $10 million. In this situation, the client will have $10 million in gross income, and, applying the current AMT rate of 28 percent, the client will pay $2.8 million in taxes. Assuming that the average state tax imposed on this award equals 8 percent, the taxpayer pays an additional $800,000 in state taxes, for a total of $3.6 million in state and federal taxes.¹⁰ Finally, using a typical contingency fee percentage of 40 percent, the plaintiff's lawyer will be entitled to $4 million of the original $10 million award, for a net total of $7.6 million in taxes and attorney's fees.¹¹ So in reality, the employee will pay an astonishing $3.6 million in taxes out of the $6 million he was entitled to, meaning that the taxpayer pays 60 percent of the net damage...