Attorneys’ Contingent Fees

In a reviewed opinion, the Tax Court ruled 8-5, in Kenseth, 114 TC 399 (2000), that a client, as well as his attorney, is taxed on the attorney’s contingent fee, even though the value of the client’s claim was uncertain and dependent on the attorney’s services. Although Kenseth could deduct the fee as a miscellaneous itemized deduction, miscellaneous itemized deductions are not deductible for the alternate minimum tax (AMT), resulting in a large AMT liability. This ruling is arguably unfair and is contrary to Fifth and Sixth Circuit decisions on this issue. Kenseth is important because sex, race and age discrimination awards are generally includible in an employee’s gross income, and the U.S. Supreme Court recently eased the burden on employees in proving Federal discrimination law violations (Reeves v. Sanderson (2000)).

Under Sec. 61(a), gross income includes all income from whatever source derived. In the first assignment-of-income case (Lucas v. Earl, 281 US 111 (1930)), the Supreme Court interpreted Sec. 61(a) to require income to be taxed “to those who earn or otherwise create the right to receive it and enjoy the benefit of it when paid.” Traditional assignment-of-income cases consist of transferring income earned by one taxpayer (such as wages or interest) to a relative in a lower tax bracket. Following Lucas v. Earl, courts have not allowed the assignment of such income for tax purposes. When the income assigned is an attorney’s contingent fee, appellate courts that have ruled on the issue have followed Lucas v. Earl and included the fee in the client’s income, with two exceptions.

In Cotnam, 263 F2d 119 (1959), rev’g on this issue 28 TC 947 (1957), the Fifth Circuit ruled 2-1 that the attorney’s fee should be excluded from the client’s income, for two reasons: (1) under applicable Alabama law, an attorney’s right to enforce a lien against a client for the fee prevents the client from receiving the fee; and (2) it was the attorney’s effort that converted a speculative claim into a judgment. In all cases on this issue since 1959, the Tax Court has distinguished Cotnam based on a particular state’s lien statute, and ruled that the fee should have been included in a client’s income, unless the case could have been appealed to the Fifth or Eleventh Circuit. (Cases decided by the Fifth Circuit prior to Oct. 1, 1982 are also binding on the Eleventh Circuit.)

In Est. of Clarks, 202 F3d 854 (2000), the Sixth Circuit, following Cotnam, ruled that a similar fee was excludible from the client’s income. The Sixth Circuit first ruled that the Michigan lien statute was similar to Alabama’s in that it transfers ownership in the fee portion of the judgment to the attorney. Next, the court ruled that the only benefit Clarks could receive from his injury claim was to transfer a portion to the attorney who, through his efforts, would help Clarks convert the remainder of the claim into money. Finally, the court found no tax avoidance purpose, and concluded that the transaction was more like a division of property than an assignment of income.

A case that included the attorney’s fee in the client’s income is Baylin, 43 F3d 1451 (1995). The Federal Circuit pointed out that the client benefited from the funds used to pay the attorney in that the funds discharged the client’s obligation to the attorney. The fact that the amount was uncertain when the fee agreement was made does not mean the amount never belonged to the client. Finally, the court ruled that the Maryland lien statute does not give the attorney an ownership interest in his fee. Adopting these arguments, the Ninth Circuit recently followed Baylin in Coady, 213 F3d 1187 (2000), as did the First Circuit in Alexander, 72 F3d 938 (1995).

In Kenseth, Eldon Kenseth and several other former employees filed age discrimination charges against their employer. They signed contingent fee agreements, under which 40% of any recovery would go to the attorneys. The agreements gave the attorneys a lien for the fees against any recovery. The parties settled. Kenseth’s share was $229,501, and the attorneys deducted their 40% fee before issuing a check to Kenseth.

On his return, Kenseth reported only the $32,477 of the settlement allocated to lost wages. The IRS included the entire $229,501 in his gross income and allowed legal fees of $91,801 as a miscellaneous itemized deduction (subject to the 2%-of-adjusted gross income floor under Sec. 67 and the reduction for high-income taxpayers under Sec. 68). However, under Sec. 56, miscellaneous itemized deductions are not deductible at all for AMT purposes. The Service’s $55,037 deficiency notice included $17,198 for the AMT from the disallowance of the legal fees. Kenseth argued that he exercised insufficient control over the portion of the settlement used to pay the legal fees; therefore, he should not be taxed on them.

The Tax Court ruled it would follow its prior rulings that attorneys’ contingent fees are included in their clients’ gross income under Lucas v. Earl. The court reasoned that Kenseth had already been discriminated against when he entered into the contingent fee agreement. Therefore, he was owed damages, and he “earned” the entire recovery. In fact, his claim was valuable from the beginning or the attorneys would not have accepted the case. In addition, Kenseth benefited from the attorneys’ fee because the fee paid for their services.

The Tax Court ruled that, under Wisconsin law, attorneys do not have the same rights as Alabama and Michigan attorneys. More importantly, the court held that its ruling does not depend on the state’s lien statute. Citing O’Brien, 38 TC 707 (1962), the court pointed out that, even if the client’s assignment to the attorney is irrevocable and the client never became entitled to that portion of any future recovery, the entire recovery is still includible in the client’s gross income. The Tax Court concluded that any unfairness in this policy should be changed by Congress, not the courts.

The first of two dissenting opinions emphasized that, because they created it, courts can modify the assignment-of-income rule. Also, the rationale for the doctrine (tax avoidance by families) is not present in Kenseth. The second, very lengthy dissent, written by the trial judge, argued that Kenseth, after signing the contingent fee agreement, had little control over his discrimination claim and “absolutely no control” over the legal fees. He could not settle without the attorneys’ consent and he was liable for their fee if he recovered damages, even if he fired them. Also, the contingent fee agreement created no personal obligation for Kenseth, because the only source of payment was the recovery. Finally, the dissent disagreed with the majority on the nature of Wisconsin’s attorneys’ lien statute.

The Tax Court will include attorneys’ contingent fees in their client’s gross income in all circuits except the Fifth, Sixth and Eleventh. Kenseth can be appealed to the Seventh Circuit, which may adopt the dissents’ viewpoint, given their arguments and the closeness of the Tax Court’s vote. It is unclear how much weight the Seventh Circuit would assign to Wisconsin’s lien statute compared to the other arguments. Meanwhile, unless the Supreme Court rules on this issue or Congress changes the AMT, the luck of where taxpayers live will determine their tax consequences.

From Peter Barton, MBA, CPA, J.D., Professor of Accounting, and Clayton Sager, Ph.D., Associate Professor of Accounting, University of Wisconsin-Whitewater, Whitewater, WI (Neither associated with AFAi)