Contingent Attorneys' Fees

In taxpayers filed a California lawsuit Benci-Woodward, 219 F3d 941 (9th Cir. 2000), aff'g TC Memo 1998-395, against their former employer alleging, among other claims, false imprisonment, defamation, intentional infliction of emotional distress and wrongful discharge in violation of public policy. They also entered into a retainer agreement with their attorney, providing for a contingent fee arrangement and giving him a lien on any recovery in the case.

The jury awarded compensatory and punitive damages. The taxpayers initially excluded the punitive damages from income, but later conceded that the portion of those damages retained by them was taxable. However, they argued that the portion retained by their attorney as fees and costs should be excluded.

The Ninth Circuit held that the portion of the punitive damages retained by the attorney is taxable to the taxpayers. The court stated, "[u]nder California law, an attorney lien does not confer any ownership interest upon attorneys or grant attorneys any right and power over the suits, judgments, or decrees of their clients." The Ninth Circuit followed its previous decision in Coady, involving the same provision under Alaska law; see Tax Clinic, "Contingent Attorneys' Fees," TTA, October 2000, p. 694.The appeals court also concluded that the Tax Court correctly determined that these legal expenses are miscellaneous itemized deductions and, therefore, not allowable for alternative minimum tax (AMT) purposes. The taxpayers argued that "the AMT results in inequities to certain taxpayers." The Ninth Circuit responded that "such considerations, however, are more appropriately left for congressional resolution."

On Jan. 16, 2001, the Supreme Court denied certiorari in Benci-Woodward. Therefore, the taxability of retained legal fees depends on state law—which varies throughout the country; see Tax Clinic, "Attorneys' Contingent Fees," TTA, December 2000, p. 848.

In view of the Supreme Court's action (or inaction), a legislative remedy is essential. In the last Congress, Sen. Grassley (R-IA) (now Senate Finance Committee Chair) and then-Sen. Robb (D-VA) introduced S. 2887 on July 18, 2000 to provide such relief. However, this bill was not enacted into law. Hopefully, remedial legislation will be enacted soon.

From Stuart R. Josephs, CPA, Tax Assistance Practice (TAP), San Diego, CA