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January 24, 2005
Plaintiffs pay tax on portion of settlement that went to attorneys
The US Supreme Court held this morning that plaintiffs must pay tax on that portion of a settlement that went to attorneys as a contingent fee. Commissioner v. Banks (US Supreme Court 01/24/2004).
Former employees sued their former employers claiming various legal theories under state law and federal law. In each case settlements were reached. The employees filed federal income tax returns that excluded from income that portion of the settlements that the plaintiffs had to pay to their attorneys under contingent fee agreements. The Internal Revenue Service said these amounts should have been included as taxable income, and the Tax Court agreed. The 6th Circuit and the 9th Circuit both reversed, holding that these amounts were not part of the plaintiffs' taxable income. The US Supreme Court unanimously reversed, holding that plaintiffs must pay tax on that portion of the settlement that went to attorneys as a contingent fee.
The Court relied on two basic taxation principles. (1) "Gross income" as defined by the Internal Revenue Code includes "all income from whatever source derived" which means all economic gains not otherwise exempted. (2) A taxpayer cannot exclude an economic gain from gross income by assigning the gain in advance to another party. The Court held that the contingent fee agreement should be viewed as an anticipatory assignment to the attorney of a portion of the client's income from any litigation recovery.
One of the employee-taxpayers brought claims under federal statutes that authorize fee awards to prevailing plaintiffs' attorneys. He argued that the anticipatory assignment principle would be inconsistent with the purpose of statutory fee shifting provisions. The Court did not address these claims because the fee paid to his attorney was calculated solely on the basis of the private contingent fee contract. There was no court-ordered fee award, and no other indication that the fee paid to the attorney was in lieu of statutory fees.
The American Jobs Creation Act of 2004 amended the Internal Revenue Code [read amendment] to allow a tax deduction for amounts a plaintiff pays for attorney fees and court costs in connection with an action involving a claim of "unlawful discrimination" as defined by the Act. The new statute applies only to fees and costs paid after October 22, 2004.
Posted January 24, 2005 by Ross Runkel, Editor at LawMemo, publisher of Employment Law Memo. Try it.
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