When plaintiffs in class actions pay tax on attorneys' fees.

• Author: Wood, Robert W.
• Position: Gross Income

In Banks, 543 U.S. 426 (2005), the Supreme Court held that contingent attorneys' fees generally represent income to the plaintiff, even if the fees are paid directly to the lawyer without passing through the plaintiff's hands. The Court announced this only as a general rule, carving out several substantive issues it did not address. For example, the Court did not address the tax treatment of attorneys' fees in cases involving injunctive relief or statutory fee-shifting provisions. More important, Banks was silent on class action attorneys' fees, leaving unanswered the big question of whether amounts paid to class counsel are income to class members.

If attorneys' fees do represent income to the plaintiffs, then deducting them may not be easy. In 2004, Congress eked out a partial reform concerning the deductibility of attorneys' fees in employment and certain other cases (Sec. 62(a)(20), added by the American Jobs Creation Act, P.L. 108357, [section] 703). Yet, outside the employment litigation arena, if plaintiffs are attributed income measured by the amount of attorneys' fees their counsel receives, there is often no way to deduct them. In effect, the plaintiffs pay tax on money they never see. The problem can be particularly acute in class actions, where counsel fees may be out of proportion to the net amount each class member receives.

Prior to Banks, there was a split in the circuit courts. A majority of circuits had held that contingent attorneys' fees constituted gross income to both the plaintiff and the attorney. (See Alexander, 72 F.3d 938 (1st Cir. 1995); Raymond, 355 F.3d 107 (2d Cir. 2004); O'Brien, 319 F.2d 532 (3d Cir. 1963); Young, 240 F.3d 369 (4th Cir. 2001); Kenseth, 259 F.3d 881 (7th Cir. 2001); Bagley, 121 F.3d 393 (8th Cir. 1997); Benci-Woodward, 219 F.3d 941 (9th Cir. 2000); Coady, 213 F.3d 1187 (9th Cir. 2000); Sinyard, 268 F.3d 756 (9th Cir. 2001); Hukkanen-Campbell, 274 F.3d 1312 (10th Cir. 2001); and Baylin, 43 F.3d 1451 (Fed. Cir. 1995).)

A minority of circuits had held that the fees were not income to the plaintiff, only to the attorney. (See Cotnam, 263 F.2d 119 (5th Cir. 1959); Estate of Clarks, 202 F.3d 854 (6th Cir. 2000); Davis, 210 F.3d 1346 (11th Cir. 2000); Srivastava, 220 F.3d 353 (5th Cir. 2000); Banaitis, 340 F.3d 1074 (9th Cir. 2003); and Banks, 345 F.3d 373 (6th Cir. 2003).) This split created disparate results in different circuits, with some plaintiffs escaping tax on the attorneys' fees and some not.

Banks made it worse for plaintiffs. For those who are caught by Banks's general rule and must therefore include counsel fees in their income, the deduction choices may include:

* An above-the-line deduction now provided by Sec. 62, but only in employment cases and federal False Claims Act cases;

* A trade or business expense deduction (perhaps on Schedule C) if the litigation can fairly be attributed to the conduct of a trade or business;

* A miscellaneous itemized deduction, subject to a 2% adjusted gross income threshold, various phaseout rules, and nondeductibility for purposes of the alternative minimum tax; and

* No deduction at all if the litigation is...