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Contingent Fees Paid to Attorneys is Taxable Income

April 1, 2005

By: Pamela J. Marantz

On January 24, 2005, the U.S. Supreme Court, ruled that all damages recovered in litigation are taxable income, including contingent fees paid directly to attorneys. Commissioner of Internal Revenue vs. Banks, 2005 U.S. Lexis 1370, 73 U.S.L.W. 4117 (2005).

The Supreme Court concluded that attorney’s fees paid out of a judgment or settlement under a contingent fee agreement are includable in a claimant’s gross income for federal tax purposes.

This ruling effectively ends a conflict among the federal appeals courts over whether the position taken by the Internal Revenue Service regarding the tax treatment of such contingency fees was correct.The unanimous decision held that the attorney’s fees portion of any judgment or settlement is taxable income to the recipient whether the fees have been paid directly to the claimant or to the attorney, and whether the fees are pursuant to a contingent fee or different arrangement.

The court upheld the government’s position on the strength of a doctrine that says, “A taxpayer cannot exclude economic gain from gross income by assigning the gain in advance to another party.”

The opinion addresses two consolidated cases. In the first case, John W. Banks, worked as an educational consultant for the California Department of Education from 1972 to 1986, when he was terminated. After his termination, he sued the state for employment discrimination and eventually agreed to a $464,000 settlement. The settlement characterized the entire amount as payment for personal injury damages, which are excluded from gross income under the tax code. Banks paid $150,000 of the settlement amount to his attorney, pursuant to their contingency fee arrangement. Banks did not include any of the $464,000 as gross income on his 1990 Federal Income Tax return.

In the second case, plaintiff Sigitas Banaitis was a Vice President and Loan Officer with the Bank of California and Mitsubishi Bank. During his employment Banaitis developed stress-related medical problems and alleged that he was pressured to resign. He sued Bank of California for wrongful discharge in violation of public policy and Mitsubishi Bank for intentional interference with employment and economic expectations.

In 1991, a jury awarded Banaitis compensatory and punitive damages. After resolution of all appeals, the parties settled. The defendants paid approximately $8.7 million in damages. Following the formula set out in the contingency fee arrangement, the defendants paid an approximately $4.8 million to Banaitis and an additional $3.8 directly to Banaitis’ attorney. The plaintiff excluded the $8.7 Million settlement from gross income on his Federal Income Tax return, attaching a statement of explanation to his return.

The Court’s decision reaffirms one of the oldest principles in income tax juris-prudence, namely, that income is taxed to the one who earned it regardless of any attempts at anticipatory assignment of the income or damages to someone else. The Court stated that a contingent fee agreement constituted an anticipatory assignment to the attorney of a portion of the client’s income from the litigation recovery.

Thus, as a general rule, when a litigant’s recovery constitutes income, the litigant’s income includes the portion of the recovery paid to the attorney as a contingent fee.