Taxation of contingent fees.

• Author: Gardner, Merritt A.

Cases of this kind are not easy to decide. In seeking to reconcile the implications of the infinite variety of facts presented by the decided cases and all that has been said about the subject of anticipatory assignment of income, one is likely to be displeased with his own wits; and may find his mind teetering between conflicting conclusions.... (1)

Rarely is the federal income tax applied differently under identical circumstances depending on where in the country the taxpayer resides. That is the case, however, for taxpayers who receive payments on judgments or settlements and whose attorneys receive a share of those payments as contingent fees. Florida is among a handful of states within which taxpayers may be accorded much more favorable tax treatment for such payments. This article will explore applicable law, how we got there, and where we're likely to go from here.

The issue is whether a contingent fee paid directly by a defendant or its insurer to the plaintiff's attorney is excludable from the plaintiff's gross income or includable as income but deductible. (2)

The issue arises only where at least a portion of the damage award is taxable. For example, it does not come into play in the case of a wholly-excludable personal injury award, (3) but if that award includes interest or punitive damages, both of which are taxable, (4) then how the fee is treated becomes important.

If the contingent fee is excludable then that part of the damage award does not even show up on the plaintiff's tax return. On the other hand, an includable contingent fee normally may be deducted only when itemized.

Defining What's at Stake

Itemized deductions including legal fees are subject to a two percent floor under I.R.C. [section] 67, a pare-back based on income under I.R.C. [section] 68, and the alternative minimum tax under I.R.C. [section] 55. A typical situation in one case resulted in about $55,500 of additional tax when a $300,000 contingent fee was itemized rather than excluded from income. (5) In another case itemizing the deduction resulted in $254,298 of additional tax on a contingent fee of about $1.9 million. (6) As the contingent fee increases so does the tax resulting from application of the cited code provisions. Scenarios exist in which the contingent fee and tax liability actually exceed the net recovery. (7)

Importantly, otherwise taxable awards used to pay hourly or noncontingent legal fees may never be excluded from gross income on that account. (8) The income must be reported in full and the legal fees then shown as a deduction on the return. Except in a pure trade or business setting, that deduction will be taken below-the-line, or itemized, making it subject to what can be severe limitations imposed by I.R.C. [subsections] 67, 68, and 55.

Conversely, if the taxpayer lives in the right part of the country, the taxpayer may exclude that part of a judgment or settlement representing a contingent fee regardless of whether the lawsuit is one for personal injury, including punitive damages and interest, lost wages based on age, sex or other types of discrimination, defamation, securities fraud, or anything else for that matter.

So here is how the map is drawn: the Third, (9) Fourth, (10) Seventh, (11) Ninth, (12) Tenth, (13) and Federal (14) Circuits require that contingent fees be included in taxpayers' income and then deducted. The Fifth, (15) Sixth, (16) and 11th (17) circuits permit taxpayers to exclude contingent fees from income altogether. The 11th Circuit evidently feels so strongly about the issue that it has shut down I.R.S. efforts to get it to reverse itself by imposing the taxpayers' legal fees against the government in those cases where the I.R.S. continues to dispute the exclusion. (18) Despite the split among the circuit courts, on at least two occasions the U.S. Supreme Court has declined review, presumably preferring that Congress fix the problem. (19)

The problem exists because there are compelling arguments on both sides of the issue.

The Split in Geography

Early on the question appeared to turn on the nature of an attorney's charging lien for contingent fees granted by state law. It quickly evolved into one interpreting the assignment of income doctrine. Complicating a clear resolution of either is the disparity with fixed fees created by permitting exclusion of contingent fees, the apparent injustice of applying the alternative minimum tax in particular to these situations, and the unique perspective lawyers sitting as judges bring to a lawyer's role in contingent fee cases.

The exclusion theory can be traced to the Fifth Circuit's interpretation of the Alabama charging lien...