Contingent attorney fees included in taxpayer's income.

• Author: Bakale, Anthony

The IRS has long held that contingent fees paid by a taxpayer from a favorable award or settlement (whether actually paid or withheld) are included in the taxpayer's gross income and deducted as a miscellaneous itemized deduction (Rev. Rul. 80-364). Practitioners searching for a more favorable treatment for these fees will find no comfort in the Tax Court's recent decision in Kenseth, 114 TC No 26. In this case, the Tax Court held, under the assignment-of-income doctrine, that contingent fees paid to (withheld by) the attorney constituted gross income to the taxpayer. This decision was rendered despite Estate of Clarks, 202 F3d 854 (6th Cir. 2000), which held contingent fees should not be included in the taxpayer's gross income. The Tax Court noted that there is a split in the circuits on this issue--Estate of Clarks and Cotman, 263 F2d 119 (5th Cir. 1959), in the taxpayer's favor, and Baylin, 43 F3d 1451 (Fed. Cir. 1995), and Brewer, 172 F3d 875 (9th Cir. 1999), ruling against the taxpayer. The Tax Court chose to follow its prior reasoning on this issue, rejecting the Sixth Circuit's reasoning that a favorable outcome depended on the attorney's involvement, which prevented an assignment. It also rejected the Fifth Circuit's reasoning, which relied on nuances in Alabama law that gave the attorney a lien interest in the settlement. With a split in the circuits, the issue should end up before the Supreme Court. While under the Tax Court's ruling, a taxpayer can deduct the portion of the settlement given to the attorney as a miscellaneous itemized deduction subject to the 2%-of-adjusted-gross-income (AGI) floor, due to the itemized deduction and alternative minimum tax (AMT) rules, the tax benefit of this deduction is greatly reduced.

Most taxpayers who receive a settlement feel that they should not be taxed on the portion paid to attorneys, as they have little control over that and do not have any legal right to receive it. In most cases, legal counsel would have a lien for its fees and costs against any recovery that has to be satisfied concurrently with the disbursement of the settlement. For these reasons, it seems unfair and illogical to view the attorney's portion of the settlement as income to the taxpayer. The Service, however, has a different opinion. The Tax Court, in previous cases, has concluded that contingent fee arrangements fall within the assignment-of-income doctrine, resulting in such fees not being excluded from the...