The netting of costs against income receipts produced by such costs, without barring Congress from disallowing such costs

Virginia Tax Review, Fall, 2007 by Joseph M. Dodge

I. INTRODUCTION

This article principally argues that, under the federal income tax, costs of obtaining specific sums of money should be capitalized (as opposed to being treated as expenses), just as costs of obtaining property should be capitalized. (1) Insofar as a right or claim to money is itself "property," this thesis should be wholly noncontroversial. The result of capitalization is the creation of basis, (2) and basis is netted against the "amount realized" (3) (the proceeds of disposition), (4) to produce "gain" (includible in gross income) (5) or "loss" (potentially deductible in arriving at taxable income). (6) Since this article deals with costs of obtaining or receiving specific cash amounts, it propounds what can be referred to as a "netting" or "offset" rule, principle, or thesis. (7) The netting thesis is a straightforward application of the capitalization principle that would operate (notwithstanding perceived current tax accounting conventions) outside the arbitrary confines of the taxable year.

Although the netting of costs against receipts would seem to be a routine application of settled principle, it is generally opposed by the Internal Revenue Service (Service), most conspicuously in the case of legal fees incurred by successful litigation plaintiffs (typically under contingency-fee arrangements) in obtaining nonexcludible damages and settlement awards. (8) The Service claims that such litigation costs are deductible under section 212(1) as "ordinary and necessary expenses paid or incurred during the taxable year ... for the production or collection of income," or (in the case of employment-related claims) unreimbursed employee business expenses. (9) It happens that such costs, viewed as expenses, are "miscellaneous itemized deductions" (MIDs), (10) except when incurred (after October 22, 2004) in obtaining a recovery under certain claims relating to employment and civil rights. (11) MIDs are disallowed under the regular income tax up to an amount equal to two percent of the taxpayer's adjusted gross income, (12) and wholly disallowed under the Alternative Minimum Tax. (13) Thus, treatment of a cost as an MID is much more unfavorable to taxpayers (14) than would be the treatment of the same cost as a basis offset. (15)

On the issue of plaintiff litigation costs, the commentators usually assume that such costs are indeed expenses, but argue that inclusion in the MID category was accidental (not specifically intended by Congress). (16) Commentators have thus offered doctrinal theories that would avoid the consequences of MID treatment by treating the portion of the includible award that is equal to the contingency fee as being the gross income of the attorney (rather than income of the plaintiff out of which an expense is paid). (17) These theories were considered and rejected in the recent case of Commissioner v. Banks. (18) In Banks the taxpayer was a personal injury plaintiff who incurred contingent attorney fees in connection with obtaining an includible recovery. According to the nature of contingent fee arrangements, an amount equal to the fees was paid over to the attorney and never actually received by the plaintiff. The Supreme Court decision rejected the taxpayer's claim that the attorney fees were the income of the attorney and not the plaintiff.

The quite different netting thesis advanced here was raised in an amicus brief in Banks, (19) but the Court declined to entertain it on the grounds that the argument was not ripe for consideration unless having been vetted by the Court of Appeals. Adoption of the netting thesis would render Banks irrelevant, because all of the parties in Banks, as well as the decision therein, assumed that the litigation costs were expenses. The essence of the argument for the netting thesis is that the costs relating to a specific item of (cash) income are capital expenditures, taking the form either of "acquisition costs" or "transaction costs," that are netted against gross receipts in arriving at gross income, (20) rather than expenses that are separately deducted, after having been subject to "expense" dilution and disallowance rules, in arriving at taxable income. (21) Furthermore, there is no difference in constitutional status among capital expenditures and expenses, with the consequence that Congress has the power to disallow them equally. (22)

This article is not motivated by any particular concern (one way or another) with advancing the interests of plaintiffs (or any class thereof) and their attorneys. Hence, the merits of the Banks decision as to the issues that it actually decided are not contested here. (23) By the same token, the enactment into law of section 62(a)(20) in 2004, (24) which grants tax relief to successful plaintiffs in anti-discrimination and civil rights actions by conferring above-the-line deduction status on litigation costs, is not a satisfactory substitute for adoption of the netting principle. (25) On its face, section 62(a)(20) only covers attorney fees and court costs, incurred after October 22, 2004, of obtaining certain kinds of recoveries (26) and only allows the deduction to be above-the-line to the extent of the recovery. My interest here is in the structure of the income tax.