The Supreme Court Weighs In on the Taxability of Contingent Fees in Employment Cases
 
June 14, 2005
 
Michael J. "Mike" Ranallo- Chicago

In recent years, the federal circuit courts of appeals have disagreed on the federal income tax treatment of contingent legal fees paid by plaintiffs in employment cases and other cases in which the proceeds are taxable. On one side of this issue were the circuit courts holding that a plaintiff who obtains a settlement or damages award would be taxed only on the proceeds net of the contingent legal fees paid to his or her lawyer. These courts were of the view that the legal fees portion of a taxable damages recovery should be taxable only once – to the plaintiff’s attorney. On the other side of this issue were the IRS, the U.S. Tax Court, and a larger number of circuit courts, which held that a plaintiff’s contingent legal fees must be reported on both the plaintiff’s tax return and on the return of his or her lawyer. The courts in this camp adopted the rule that contingent legal fees are taxable twice – once to the plaintiff, and again to his or her attorney.

The U.S. Supreme Court finally entered the fray last January, resolving the split among the courts. It ruled that even when attorneys’ fees are immediately paid to the attorney by the employer as part of a settlement, the amount paid as attorneys’ fees is taxable to both the settling employee and the attorney. Although the impact of this case is lessened somewhat by the recently-passed Civil Rights Relief Act, which ensures that settling employees will be able to deduct their attorneys’ fees, the Banks decision will have continuing impact for employers.

Background

This issue arose in the consolidated cases of Commissioner v. Banks and Commissioner v. Banaitis. In Banks, the plaintiff had settled his employment discrimination case in which he asserted claims under Title VII, Sections 1981 and 1983, and under California’s anti-discrimination statute. The amount of the settlement was $464,000. The Sixth Circuit Court of Appeals upheld the plaintiff’s position that only the net amount be received – less the attorneys’ fees of $150,000 was taxable income to him. The Sixth Circuit reasoned that a contingent fee agreement is like a partial assignment of income-producing property. The plaintiff’s lawyer is not simply the beneficiary of the plaintiff’s largess, but rather, the lawyer earns his or her fee through skill and diligence.

In Banaitis, the plaintiff, a former bank vice president, brought suit against the bank that originally hired him and the successor bank that acquired the predecessor bank. The plaintiff claimed that the successor bank willfully interfered with his employment contract with the predecessor bank and that the predecessor bank attempted to induce him to breach his fiduciary duties to certain bank customers. When the plaintiff refused to breach his duties, the successor bank began giving him unfavorable reviews and placed him on probation. The plaintiff eventually quit. He then hired a lawyer, entered into a contingent fee agreement and filed a complaint claiming constructive discharge under Oregon law. The plaintiff’s case went to trial, and a jury awarded him compensatory and punitive damages. The parties later settled the case for $8,728,559, with $4,864,547 going to the plaintiff and $3,864,012 going to his lawyers under the terms of their contingent-fee agreement. The plaintiff did not include the amount paid to his lawyers in gross income on his federal tax return, and the IRS issued a notice of deficiency. The Ninth Circuit ruled against the government. It noted that Oregon state law, like the law of some other states, grants lawyers a superior lien in the contingent-fee portion of any recovery. Consequently, the court held that the plaintiff’s contingent-fee agreement with his lawyers operated as a partial transfer to the lawyers of some of the plaintiff’s property in the lawsuit. The plaintiff therefore did not have to include his lawyer’s legal fees on his tax return.

Supreme Court’s Decision

The U.S. Supreme Court reversed the decisions of the Sixth and Ninth Circuits, rejecting the view that contingent legal fees incurred by a plaintiff with a taxable recovery can simply be netted against or subtracted from the plaintiff’s recovery. Embracing the position of the majority of the circuit courts and the U.S. Tax Court, the Court instead concluded that the entire settlement or damages award, including the amount paid directly to attorneys, must be reported on the plaintiff’s tax return. The plaintiff can then separately deduct the legal fees as “below the line,” or miscellaneous itemized deductions. In taking this position, the Court acknowledged that “below the line” deductions do not reduce adjusted gross income, and that below the line deductions are not deductible for purposes of the alternative minimum tax. Nonetheless, the Court pointed out that the Civil Rights Relief Act, signed into law on October 22, 2004, (see previous article), amended the Tax Code to allow plaintiffs in employment cases to deduct attorneys’ fees and court costs above the line (i.e., in computing adjusted gross income). As the Court noted, these deductions are permissible even when the alternative minimum tax applies. Indeed, as the Court opined, the Banks and Banaitis cases probably would not have arisen had the Civil Rights Relief Act been in effect when the settlements in these cases were consummated.

Significance

The Supreme Court’s decision in Banks might appear to have little impact in light of the Civil Rights Relief Act. Such a conclusion, however, would be incorrect. First, as the previous article on the Civil Rights Relief Act explains, that Act applies only to the specific employment-related claims enumerated in the statute. Thus, the Supreme Court’s decision in Banks and Banaitis will apply to all claims giving rise to taxable recoveries that are not within the scope of the Act. As noted in the companion article, there may be many claims that arise in employment lawsuits, including claims for defamation and invasion of privacy, that will fall into this category. Settlements of these claims will be more challenging because, as noted above, contingent legal fees on these claims must be included on the plaintiff’s tax return and can only be deducted below the line.

More significantly, the Civil Rights Relief Act does not change the employer’s obligations with respect to a settlement involving the direct payment of attorneys’ fees by the employer. The Act merely grants the employee a tax deduction. Banks makes clear that the employer is still responsible to report the entire settlement amount – including the amount paid to the attorneys – as income to the plaintiff, and to also prepare a Form 1099 reporting the amount paid to the attorneys as income to the attorneys. Failure to do so could result in an obligation to pay back withholding and penalties to the IRS.

In the wake of the Banks and Banaitis decision and the Civil Rights Relief Act, it is more important than ever to have experienced counsel involved in settling employment claims and preparing settlement agreements.

For more information, e-mail Michael J. Ranallo at michael.ranallo@hklaw.com or call toll free, 1-888-688-8500.