Supreme Court agrees with IRS on contingent attorney fee cases.

AuthorO'Leary, D. Michael

Resolving a conflict among the circuits, the Supreme Court held in Commissioner v. Banks, and Commissioner v. Banaitis, 125 S. Ct. 826 (2005), that the portion of a recovery paid to an attorney as a contingent fee constitutes income to the taxpayer.

Facts

Banks. The California Department of Education terminated the employment of John W. Banks II. Mr. Banks hired an attorney under a contingent-fee agreement and filed suit against his former employer. The complaint filed by Mr. Banks' attorney contained a claim of employment discrimination under the Civil Rights Act of 1964 and certain other claims under state laws that were later abandoned. In 1990, the parties eventually settled the claims of Mr. Banks for a total of $464,000, $150,000 of which was paid to the attorney of Mr. Banks.

Mr. Banks excluded all of the settlement proceeds from his 1990 federal income tax return. The commissioner issued Mr. Banks a notice of deficiency for the 1990 tax year that included the entire $464,000 in the income of Mr. Banks. The Tax Court held that the entire $464,000 was taxable income to Mr. Banks. (1)

The Court of Appeals for the Sixth Circuit concluded that the contingent fee agreement was not an anticipatory assignment of income because the litigation recovery was not already earned, vested, or even relatively certain to be paid when the contingent fee contract was entered. In addition, the Sixth Circuit concluded that the contingent fee arrangement was essentially a partial assignment of income-producing property. Accordingly, the Sixth Circuit held that the $150,000 paid to the attorney of Mr. Banks was excludable from the income of Mr. Banks. (2)

Banaitis. Mr. Banaitis was forced to leave his job as a loan officer and vice president at the Bank of California. Thereafter, he hired an attorney under a contingent-fee arrangement and filed suit against the Bank of California and its successor, Mitsubishi Bank. The complaint filed by Mr. Banaitis' attorney alleged that Mitsubishi Bank willfully interfered with Mr. Banaitis' employment and caused the Bank of California to discharge him. The complaint further alleged that the Bank of California improperly discharged him and improperly attempted to force him to breach his fiduciary duty to his customers.

The jury found for Mr. Banaitis. While the case was on appeal, the parties settled the case for $8,728,559. The defendants paid Mr. Banaitis $4,864,547 and $3,864,012 directly to Mr. Banaitis' attorney.

Mr. Banaitis excluded the amount paid to his attorney from gross income on his federal income tax return. The commissioner issued a notice of deficiency that included Mr. Banaitis' attorneys' fees in his gross income.

The Tax...

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