Contingency Fees Paid Directly to Attorney Are Excludible

Z  retained law firm X to represent him in a wrongful termination suit. Under the agreement between Z and his attorneys, X would receive a contingency fee of one third of the net recovery, plus expenses. Any fees for an appeal would be paid at an hourly rate. A trial by jury resulted in a verdict in Zs favor for $869,156; the Second Circuit affirmed.

The defendant sent checks for the interest and principal to X; Zs share of the proceeds was deposited into his bank account and Xs share into its account. On Zs original 1998 Federal income tax return, he included the entire judgment in adjusted gross income (AGI), including the amounts paid as attorneys fees. Because of the amount of Zs income for that year, he was subject to the alternative minimum tax (AMT). Ordinarily, Z would have been able to take a miscellaneous deduction for the attorneys fees to the extent they exceeded 2% of AGI, but this is not allowed under the AMT. Thus, Z had to pay income tax on $929,587, although $306,898 of it went directly to X.

Z filed an amended return excluding the contingency fees from gross income and requested a refund of $55,489, which the IRS denied.

Analysis

At issue is whether fees paid directly to an attorney under a contingency agreement should be excluded from the clients gross income because it is the attorneys income and not the clients.

Those courts that have included contingency fees paid directly to attorneys in the clients gross income have relied on the anticipatory-assignment-of-income doctrine first articulated in Lucas v. Earl, 281 US 111 (1930). The doctrine was devised to prevent a taxpayer from assigning income before it is realized to avoid the tax consequences of earning it. Traditionally, the doctrine was applied to the donative transfer of income or property between family members. The essence of the doctrine is that income should be taxed to the one who earns it.

The critical factor in determining whether a taxpayer has engaged in an anticipatory assignment of income is the degree of control over the asset that he or she has retained. In Helvering v. Horst, 311 US 112 (1940), an owner of negotiable bonds made a gift to his son of the interest coupons prior to the bonds maturity. Had the taxpayer transferred the bonds themselves, he would have given up the right to control the disposition of the income and would not have been taxed.

If the issue is defined as whether the taxpayer-client has given up ownership or control over the lawsuit itself by entering into a contingency agreement, the answer is clear: he or she has not. Rather, the issue should be whether the taxpayer-client ever had or could have had control over the portion of the anticipated judgment that was designated to his or her attorneys. If, at the time the transfer under the contingeny agreement was made, the taxpayers rights had not yet ripened to the point that he or she was entitled to the gain, the taxpayer should not be taxed on the transferred portion; the anticipatory-assignment-of-income doctrine applies when a fixed right to income has matured at the time the transfer is made; see Greene, 13 F3d 577 (2d Cir. 1994).

State law determines the nature of a legal interest in property, although Federal law determines whether that interest was intended to be taxed. In this case, state (Vermont) law provides, [w]here the parties have contracted that the attorney shall receive a specified amount of the recovered fund, such agreement will create an equitable lien on the fund in favor of the attorney to the extent of the amount stipulated (Est. of Button, 112 Vt. 531 (1942)). Accordingly, under Vermont law, an equitable lien on the recovery was created in Xs favor.

A contract that creates a lien for attorneys fees on a recovery associated with a claim before the allowance of the claim and before any services have been rendered by the attorney, in effect gives him or her an interest or share in the claim itself. Given that a contingeny fee contract effectively confers an interest in the claim itself on the attorney, it operates more like an assignment of income-producing property than an assignment of future income from property.

Applying the assignment-of-in-come doctrine to attorneys contingency fees is inconsistent with the doctrines purpose, which is to thwart tax avoidance schemes. Contingent-fee contracts are not tax avoidance schemes; they provide greater access to legal services when clients cannot afford to pay attorneys to pursue their claims.

Because the contingency agreement is not a tax avoidance scheme, operates more like income-producing property than income from property and does not satisfy the substantial-control test of the assignment-of-income doctrine, the portion of Zs recovery paid directly to his attorneys under the agreement was not income to Z. Thus, he is entitled to a refund on his 1998 taxes.

David Raymond, DC VT, 12/17/02

REFLECTIONS: There is a split of authority on the subject; the Fifth, Sixth and Eleventh Circuits exclude contingency fees from clients gross incomes; the Third, Fourth, Seventh, Ninth, Tenth and Federal Circuits include them. The Second Circuit has not decided the issue.