Lemonade from Lemons: the Solution to Taxation of the Contingent Fee Portion of Damage Awards

• Publication year: 2022

37 Creighton L. Rev. 305. LEMONADE FROM LEMONS: THE SOLUTION TO TAXATION OF THE CONTINGENT FEE PORTION OF DAMAGE AWARDS

Creighton Law Review

Vol. 37

SHARON REECE(fn*)

ABSTRACT

The taxability of a client's damage award is a palpable concern which adds to the already long list of concerns for an attorney litigating a suit. The Internal Revenue Code currently requires taxpayers to report most damage awards as income, with the exception of awards resulting from physical injury or illness. Additionally, after the award is paid, to the taxpayer/client, the taxpayer in turn pays the attorney and this reduces the award even further. Taxpayers have argued, and some courts have agreed, that fees paid under contingent fee agreements should be excluded from the taxable portions of damage awards, where the fee is paid directly by the defendant to the lawyer and was never paid to the taxpayer/client. This paper will examine the dueling arguments and the competing policies in this area and advance a solution which could rectify the inequity without compromising jurisprudential analysis.

INTRODUCTION: A JUXTAPOSITION OF SCENARIOS

You successfully litigate a wrongful termination tort claim for your client, Mrs. Smith, to whom the jury awards $1,000,000 in punitive damages, and of which you are due one-third under a contingent fee agreement. Consider the following scenarios:

SCENARIO ONE:

You receive the $1,000,000 amount in Mrs. Smith's trust account and retain your $300,000. If you are in the 35% tax bracket, you pay $105,000 and net $195,000. You earned it.(fn1) Mrs. Smith receives $700,000, and, if she is in the same tax bracket, pays $245,000 in taxes on that $700,000, netting $455,000. The IRS gets $350,000, computed from your $105,000 and the client's $245,000. Everyone is happy and a happy client is a good thing.

SCENARIO TWO:

You receive the $1,000,000 amount in Mrs. Smith's trust account and retain your $300,000. In the 35% tax bracket you pay $105,000 and net $195,000. You earned it.(fn2) In this scenario, however, Mrs. Smith is said to constructively receive the entire $1,000,000, and regrettably is not allowed a deduction for the amount she pays for your services.(fn3) Therefore, in the 35% tax bracket, she pays $350,000 in tax, pays her lawyer $300,000, and nets $350,000. You receive your third, $300,000, and pay your tax of $105,000. The IRS gets a total of $455,000. That amount is very different from the $350,000 the IRS received in the previous scenario. The IRS is very happy. You are unhappy because you have a very unhappy client and an unhappy client is a bad thing.

The result in scenario two is endorsed by the majority of jurisdictions including the Tax Court, and will remain as the standard pending the United States Supreme Court's resolution of the split in the circuits,(fn4) or legislative action. According to the majority of the circuits considering this issue, the damage amount is deemed to constructively pass through the client, with a rest stop for taxation, and then to the attorney for taxation again.(fn5) This pass-through is akin to the double taxation of corporate profits an issue recently addressed by the legislature.(fn6) To alleviate the perceived, and often realistic, unjust tax burden, some circuit courts have devised a method of tax analysis whereby the amount due the attorney is deemed transferred to the attorney as the attorney's equitable property and therefore not taxable to the client.(fn7)

Under this analysis, amounts are not subject to double taxation and the IRS stands to lose an incredible source of revenue, as scenario one illustrates.(fn8) Recently, in the case of Raymond v. United States,(fn9) David Raymond sued his ex-employer, IBM, in the United States District Court for Vermont for wrongful termination.(fn10) Mr. Raymond entered into a contingent fee agreement with his attorneys, who successfully litigated a $869,156.00 jury verdict, which was affirmed on appeal with an additional interest payment, for a total of $929,585.90.(fn11) Mr. Raymond's attorneys received about $340,000.00 for both trial and appellate work, leaving about $590,000.00 to Mr. Raymond.(fn12) Because Mr. Raymond received no deduction for legal fees, he was required to pay tax on the entire damage award. This cost him additional taxes of $55,000.00 since he was required to pay tax on the fee amount.(fn13)

The economic burden is even more palpable where a taxpayer/client owes a tax bill greater than the amount of the damages collected.(fn14) Such situations demand Congressional attention to provide some narrow method to continue to allow taxation of the majority of these damage awards while providing an escape for truly unjust results. Without some relief, what should be a "sweet" victory in the form of a nice, cold glass of lemonade turns into a bowl of sour lemons for an injured plaintiff. The majority of circuits, which tax these awards twice, use the fruit-tree metaphor, popularized in the famous tax law cases of Lucas v. Earl(fn15) and Helvering v. Horst.(fn16) The lawsuit is perceived as the "tree" and the damage award, from which the contingent fee is paid, is the "fruit" growing from that tree. Traditional tax law interpretation of the fruit-tree metaphor prevents such ripe fruit from passing to the client untaxed.

Under current law, if an individual, non-business client receives a punitive damage award or a compensatory damage award in lieu of anything but physical injury or physical illness, the award is taxable. Generally, no deduction is allowed for the attorneys' fees. Scenario two of the introduction, providing for taxability, appears to be the status quo.(fn17) Understanding the concepts and policies on both sides is essential to arrive at a rational and workable solution to any perceived injustice.

Part I of this paper examines the statutory and case law bases for the taxability of contingent fee awards. Part II examines the innovative apportionment doctrine used in an attempt to relieve taxpayer/clients of the sometimes burdensome tax. Part III reviews the potential problems with the apportionment doctrine and Part IV attempts to offer some realistic approaches for fair Congressional resolution through the Internal Revenue Code.

PART I: TAXABLE LEGAL AWARDS

A. STATUTORY GROUNDS

The issue of whether or not an attorney fee can be excluded from the plaintiff's award for income tax purposes only arises in cases where all or a portion of the settlement proceeds is taxable and not deductible. Taxability, then, is the threshold question. Section 104(a)(2) of the Internal Revenue Code (hereinafter "I.R.C.") excludes from income the amount of any compensatory damages received where the "underlying cause of action giving rise to the recovery is on account of personal physical injuries or physical sickness."(fn18)

The "origin of the claim" test(fn19) is used to determine whether or not the recovery is based on such qualifiers with respect to which the legal fees were incurred.(fn20) Amounts paid for any reason other than physical sickness or injury, including all punitive damages, are taxable.(fn21) Consequently, cases arising from employment discrimination, wrongful termination, defamation, violation of constitutional and civil rights, sexual harassment, fraud and condemnation issues typically result in significant taxable awards.(fn22)

In 1995 then House Ways and Means Committee Chairman, Texas Republican, Bill Archer, introduced a bill, "apparently at the behest of the Internal Revenue Service" to have companies account for settlement amounts paid to lawyers(fn23) in a reported effort to learn what amounts attorneys kept and might be hiding from the taxman.(fn24)

On January 1, 1998, this bill became federal law(fn25) and required insurance carriers and other companies paying settlements to report both the attorney and client shares of the joint check.(fn26) At the time, former New Jersey State Bar Association President Harold A. Sherman asked, "[a]nd to what purpose? The purpose seems to be to ferret out income that is not disclosed, but I don't see how it's possible. The IRS can just look at the trust account," he said.(fn27) Another New Jersey attorney, Walter A. Lesnevich, doubted the new law would raise money for the IRS. He was quoted as calling the law ridiculous and "[noted] that if lawyers do not put payments into their trust accounts, the penalty is disbarment. 'Of all the areas that records are kept, it's the one area no one could cheat on, so [the new law] makes absolutely no sense.' "(fn28) However, if the IRS is actually planning to pursue the clients on their part of the contingent fees, the new law does make sense as a foundation to that policing function.(fn29)

B. THE ANTICIPATORY ASSIGNMENT OF INCOME DOCTRINE & CONSTRUCTIVE RECEIPT

The I.R.C. imposes a tax on all income,(fn30) with "gross income" defined as "income from whatever source derived."(fn31) The United States Supreme Court has interpreted "income" to mean "ownership."(fn32) The concept is quite intuitive and is one with which every taxpayer is at least vaguely familiar. If one takes home a paycheck or winnings from the casino, one pays tax. If one sells wares, one pays tax on the profit. If one receives a dividend from the stock one owns(fn33) or sells stock at a profit,(fn34) one pays tax.(fn35) When one profits in some way...