Contingency fees paid directly to attorney are excludible.

• Author: Driscoll, David

Z retained law firm X to represent him in a wrongful termination suit. Under the agreement between Z and his attorneys, X would receive a contingency fee of one third of the net recovery, plus expenses. Any fees for an appeal would be paid at an hourly rate. A trial by jury resulted in a verdict in Z's favor for $869,156; the Second Circuit affirmed.

The defendant sent checks for the interest and principal to X; Z's share of the proceeds was deposited into his bank account and X's share into its account. On Z's original 1998 Federal income tax return, he included the entire judgment in adjusted gross income (AGI), including the amounts paid as attorneys' fees. Because of the amount of Z's income for that year, he was subject to the alternative minimum tax (AMT). Ordinarily, Z would have been able to take a miscellaneous deduction for the attorneys' fees to the extent they exceeded 2% of AGI, but this is not allowed under the AMT. Thus, Z had to pay income tax on $929,587, although $306,898 of it went directly to X.

Z filed an amended return excluding the contingency fees from gross income and requested a refund of $55,489, which the IRS denied.

Analysis

At issue is whether fees paid directly to an attorney under a contingency agreement should be excluded from the client's gross income because it is the attorney's income and not the client's.

Those courts that have included contingency fees paid directly to attorneys in the client's gross income have relied on the anticipatory-assignment-of income doctrine first articulated in Lucas v. Earl, 281 US 111 (1930). The doctrine was devised to prevent a taxpayer from assigning income before it is realized to avoid the tax consequences of earning it. Traditionally, the doctrine was applied to the donative transfer of income or property between family members. The essence of the doctrine is that income should be taxed to the one who earns it.

The critical factor in determining whether a taxpayer has engaged in an anticipatory assignment of income is the degree of control over the asset that he or she has retained. In Helvering v. Horst, 311 US 112 (1940), an owner of negotiable bonds made a gift to his son of the interest coupons prior to the bonds' maturity. Had the taxpayer transferred the bonds themselves, he would have given up the right to control the disposition of the income and would not have been taxed.

If the issue is defined as whether the taxpayer-client has given up ownership or control...