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Class Actions and the Attorneys Fees Conundrum An upcoming Supreme Court decision on contingent attorneys fees may affect the taxation of such fees awarded in class actions. This article examines the class action fees issue and how the courts and the IRS currently determine whether such fees should be included in class members gross income. Robert W. Wood, J.D.
For more information about this article, contact Mr. Wood at wood@rwwpc.com or Mr. Daher at daher@rwwpc.com.
Executive Summary
Due to a variety of oddities in the tax system (most notably, the alternative minimum tax (AMT)), there is a dramatic tax difference between a plaintiff being taxed on a settlements gross amount, instead of an amount net of recovered attorneys fees. In class actions, the IRS and the circuit courts have taken different approaches on the proper tax treatment of fee awards in opt-in and opt-out class action lawsuits. This article reviews the current law on contingent fee awards in general and in class actions in particular, analyzes whether class action attorneys fees should be included in the plaintiffs gross income and provides some recommendations.
Background
It is no
secret that the circuit courts do not agree on the tax treatment of
contingent attorneys fees recovered by plaintiffs. The majority has
held that contingent attorneys fees are gross income to the recovering
plaintiff1; the minority has held that these fees do not
constitute gross income to the recovering plaintiff.2
Commentators have long noted the split in the circuits and the
legislative efforts that have thus far failed to correct the problem.3
Despite failing to reconcile these markedly different positions by
denying certiorari on this issue on five prior occasions,4
for reasons which are not yet clear, the Supreme Court recently agreed
to consider the irreconcilable split in the circuits, by agreeing to
review the Sixth Circuits decision in Banks5 and the
Ninth Circuits decision in Banaitis.6 A petition for
certiorari has also recently been filed from the Second Circuits
decision in Raymond.7
For cases arising out of a trade or business, a plaintiff would normally be able to deduct the entire amount of contingent attorneys fees recovered. The Code does not expressly provide a deduction for such legal fees to obtain damages or settlement payments; however, such payments in connection with a trade or business are usually deductible business expenses under Sec. 162. To be deductible under Sec. 162, damages or settlement payments must be:
Class Action Nuances Do the same rules apply to class actions? Are the (often enormous) attorneys fees paid to class counsel gross income to class members? Does it matter what kind of class action is involved? Is there a different result if the plaintiffs actually elect to join the class instead of merely failing to opt out? Some of these questions are plaguing taxpayers; some are affecting lawyers. All of these questions should be a matter of concern for the IRS and the courts. The taxation of contingent attorneys fees in opt-in and opt-out class actions is discussed below. Historically, some commentators have argued that the Service has been somewhat lackadaisical in enforcement in this area. As will be seen, Sinyard8 dispels any lingering misconceptions as to how the Service addresses this issue today.
Opt-in Class Actions An opt-in class action is a class action lawsuit that requires individuals to take affirmative action to be included in and bound by the resulting settlement or judgment. Class action lawsuits brought under the Fair Labor Standards Act of 1938 (FLSA), the Age Discrimination in Employment Act (ADEA) and the Equal Pay Act (EPA), require that potential plaintiffs opt-in if they wish to participate in the litigation and share in any recovery. Sinyard: In Sinyard, the Ninth Circuit agreed with the Tax Courts determination that contingent attorneys fees recovered by a plaintiff in an opt-in class action were includible in the plaintiffs gross income. The Service argued that attorneys fees recovered in such class action, brought under the ADEA, resulted in gross income to the plaintiff.9 The taxpayer asserted that because the class action defendant was liable to pay the attorneys fees under court order, it had no gross income when the defendant actually paid its debt. The Ninth Circuit quoted Old Colony Trust,10 stating, [t]he discharge by a third person of an obligation to him is equivalent to receipt by the person taxed. The court went on to note that, under the ADEA, the prevailing plaintiff, not counsel, is entitled to attorneys fees. The taxpayer had personally executed an agreement with class counsel, agreeing to pay for their services. Citing Benci-Woodward,11 the court held the taxpayer to be in constructive receipt of the funds paid to class counsel; such amount was includible in gross income. The Tax Court distinguished Eirhart v. Libbey-Owens-Ford Co.12 from Sinyard, noting that Eirhart was based on a common fund theory that appears to apply only to opt-out class actions in which all class members have not yet been identified at the time the fees are awarded, and are not contractually obligated to compensate class counsel. The Tax Court reasoned that, for opt-out class actions, there may be policy reasons to treat recovered attorneys fees as nontaxable to the class members (i.e., additional class members may later be identified and held responsible for a portion of the legal fees). Hence, it is not unreasonable to treat the funds recovered and used to pay attorneys fees as nontaxable to the class members. In stark contrast, in an opt-in class action, such as one brought under the ADEA, all class members are identified when the class is closedlong before the settlement is finalizedand potential plaintiffs who failed to join the class are ineligible to share in any recovery. Payless Drug Stores cases: A series of Tax Court cases involved former employees of Payless Drug Stores, Northwest, Inc. (Payless), who successfully asserted violations of the FLSA.13 In a settlement with opt-in class members, Payless agreed to pay class members various amounts to settle their claims. The court held that attorneys fees deducted from the settlement payments were includible in the class members gross income. The Tax Court reasoned that, although the taxpayers did not physically receive the portion of the settlement proceeds paid to the attorneys, they did receive benefits from those funds, in the form of payment for services required to obtain the settlement.14 The taxpayers were permitted to deduct only the recovered fees as a miscellaneous itemized deduction, subject to the 2%-of-AGI floor and complete disallowance for AMT purposes. Kenseth: The Tax Court held in Kenseth15 that contingent attorneys fees recovered by a plaintiff in an opt-in class action were includible in gross income, notwithstanding the fact that recovering class members had very little control over disbursement of the settlement funds. As the Tax Court noted, under the ADEA the prevailing plaintiff, not his or her counsel, is entitled to attorneys fees. Moreover, Kenseth had personally executed a contingent fee agreement with class counsel, agreeing to pay for their services. The Tax Court found the taxpayer in constructive receipt of the funds paid to class counsel, and held the fees includible in gross income under the assignment-of-income doctrine (even though Kenseth had made an irrevocable assignment to his attorneys by executing the contingent fee agreement).
An opt-out class action is a class action lawsuit that does not require individuals to take affirmative action to be included in and bound by the resulting settlement or judgment. Potential plaintiffs in opt-out class actions whose needs will not be best served by the contemplated class action may opt-out. This will preserve any individual cause of action they might have against the defendant, and prevent them from being bound by any settlement or judgment.
IRS guidance:
In a series of letter rulings,16 the Service ruled that
contingent attorneys fees paid from qualified settlement funds, as
defined by Sec. 468B and Regs. Sec. 1.468B-1(c), do not result in gross
income to opt-out class members. Reasoning that the individual class
members had not agreed to personally compensate class counsel, the
Service held that attorneys fees paid to plaintiffs counsel were not
includible in gross income. State Farm cases: A series of Tax Court cases involved class members who unsuccessfully sought employment with State Farm General Insurance Company (State Farm).18 The class alleged discrimination, based on sex, in violation of Title VII of the 1964 Civil Rights Act. State Farm entered into a settlement agreement with class members, under which each member received a substantial sum.19 The settlement agreement specifically stated that the payments were being made inclusive of attorneys fees and costs, which the class members were entitled to as prevailing plaintiffs.20 It appears the payment of attorneys fees in these cases was not under a common fund theory of recovery. Not surprisingly, the IRS contended that the attorneys fees recovered by the plaintiff class members were includible in their gross income, and the Tax Court agreed. McKean: In McKean,21 the Court of Federal Claims granted a motion for summary judgment to members of an opt-out class action, permitting them to exclude from gross income their pro-rata share of attorneys fees awarded to the class in a suit brought under Title VII of the 1964 Civil Rights Act. In granting the classs motion for summary judgment, the court specifically noted that it was doing so merely because the government failed to challenge the motion. This begs the question: did the court truly agree with the classs position, or did it merely grant the motion because the government failed to question it? Unfortunately, the facts do not provide sufficient information to determine whether the recovery was paid under a common fund theory. The Service has not officially responded to the McKean outcome, which might mean that it would agree with the courts holding if the attorneys fees were paid out under a common fund theory of recovery. Eirhart: In Eirhart v. Libbey-Owens-Ford Co., an action to which the IRS was not a party, the court held that separately deposited funds paid to the opt-out class members attorneys in settlement of claims arising under Title VII of the Civil Rights Act of 1964 did not result in gross income to the class members, some of whom remained unknown. It is worth noting that in Eirhart, the funds were paid through a common fund. This seems to be an important factor in distinguishing the results from, e.g., the State Farm Cases, which appear not to have been paid through a common fund.
Reconciling Opt-in and Opt-out Actions This entire area of the tax law is extremely convoluted. Although this is true for the entire attorneys fee debacle, it is especially egregious in the case of class actions. Most class action plaintiffs do not realize they could potentially be taxed on their proportionate share of the millions in attorneys fees routinely recovered by class members. For that matter, many class action plaintiffs attorneys are completely oblivious to this possible result. What happens in a class action setting in which a small amount of damages are recovered (which is not uncommon), along with substantial attorneys fees?
The truly staggering result here is that each class member will actually end up losing $76,500. How? Each class member is allocated $1 million gross income and can deduct a proportionate share of recovered attorneys fees, $800,000. From a cashflow standpoint, that yields $200,000 in net positive cashflow. Subtracting out the tax leaves a $76,500 negative cashflow.22 It does not seem fair for a class action plaintiff to receive a favorable verdict in a lawsuit and then end up paying more in Federal income tax than he or she recovered. In contrast, if each class member in Example 2 above was only required to include the $200,000 net amount in gross income, he or she would have owed a mere $47,025 in Federal income taxa $229,475 difference; this is exactly what could happen in a minority versus a majority jurisdiction. In attempting to reconcile the different results reached by the various cases discussed in this article, it is important to differentiate opt-in class actions from opt-out class actions. This includes further distinguishing attorneys fees in opt-out class actions paid under the common fund theory of recovery from those not paid out under this theory. (Of course, it is appropriate to ask whether class action attorneys or their clients, or even tax lawyers, can fairly address this kind of nitpicking.) In differentiating opt-in class actions from opt-out class actions, it is also helpful to compare the results reached by the court in Sinyard with the results in Eirhart. In Sinyard, the court distinguished Eirhart, because it was based on a common fund theory that appears to apply only to opt-out class actions in which all class members have not yet been identified at the time the fees are awarded, and the class members are not contractually obligated to compensate class counsel. In opt-out class actions, additional class members may later be identified and held responsible for a portion of the legal fees. Accordingly, it is not unreasonable to treat the funds recovered and used to pay attorneys fees as nontaxable to the class members. In opt-in class actions, such as those brought under the FLSA, ADEA or EPA, all class plaintiffs are identified when the class is closed; potential plaintiffs who fail to join the class are ineligible to share in any recovery. As a result, the recovery of attorneys fees by opt-in class members generally constitutes gross income to the class members, but will qualify the class members for a miscellaneous itemized deduction, subject to the 2%-of-AGI floor and complete AMT disallowance. As to differentiating attorneys fees in opt-out class actions paid out under the common fund theory from those not paid out under that theory, the former are generally not includible in the opt-out class members gross income. Attorneys fees recovered by opt-out class members in noncommon fund recoveries are includible in the opt-out class members gross income. In the case of attorneys fees paid under a common fund theory of recovery, generally, the attorneys fees are awarded directly to the class counsel, based on judicial precedent.23 The Service has held that this does not result in gross income to the class members, assuming the class members did not individually agree to compensate the attorneys.24 This result can be reconciled with that in noncommon fund opt-out recoveries, in that these plaintiffs generally individually agree to compensate class counsel, and accordingly have income under Old Colony Trust when the attorneys fees are paid to class counsel.
Conclusion Admittedly, the facts in many of these attorneys fee cases vary dramatically. In any event, tax advisers should make sure that separate Forms 1099 are issued to class counsel and plaintiffs. Also, under current law, it can be critically important for class members not to sign a fee agreement with class counsel. As to the award of attorneys fees, a practitioner should petition the court to award the attorneys fees. If the attorneys are directly entitled to the attorneys fees (rather than the class members), a strong argument exists that the recovered attorneys fees are not income to the class members. Vitally important, the contingent fee agreement should specify in strong terms when the interest in the case is assigned. Also, the attorneys lien law in the state can be helpful in some cases, depending on the circuit in which the case is situated. Finally, still unclear is how the Supreme Courts upcoming review of Banks and Banaitis (nonclass action suits) will affect these strategies and the taxation of class action fee awards in general. |
