Attorney fees paid under contingency agreement may be excluded from gross income

Law Reporter, Mar 2004

DAMAGES

Banks v. Commissioner of Internal Revenue, 345 F.3d 373 (6th Cir. 2003).

The Sixth Circuit Court of Appeals held that attorney fees paid under a contingency fee arrangement should be excluded from a taxpayer's gross income.

Here, Banks filed suit after being terminated and agreed to a settlement amount, out of which money was deducted as a contingency fee to his attorney. When Banks filed his annual income tax return, he did not include any of the settlement money in his gross income.

Banks filed a petition in tax court when the Internal Revenue Service asserted he had understated his gross income. One of plaintiff's arguments was that, in the event portions of the settlement were considered gross income, the money paid to his attorney should be excluded. The tax court ruled that plaintiff could not exclude any of the settlement proceeds, including the attorney fees.

Reversing, the appellate court held that defendant's reliance on two U.S. Supreme Court cases was misplaced. Those cases, in which the taxpayers had deliberately moved some of their earnings to a relative's account to avoid paying taxes, are distinguishable from contingency fee cases, the court held. Rather, a case from the Fifth Circuit Court of Appeals, Cotnam v. Commissioner, 263 F.2d 119 (5th Cir. 1959), is controlling here.

In Cotnam, the court relied on an Alabama attorney's lien statute and held that contingency fees are excluded from a taxpayer's income because an attorney lien creates an equity interest in the judgment, and the client was never entitled to that money. The Sixth Circuit adopted this doctrine in Estate of Clarks v. United States, 202 F.3d 854 (6th Cir. 2000), 43 ATLA L. Rep. 125 (May 2000), holding that a contingency fee did not already exist but was simply "an intangible, contingent expectancy."

The court distinguished contingency fee cases on three additional grounds: (1) the motivation for the fee arrangement is not to avoid paying taxes; (2) contingency fee attorneys earn the income they receive instead of it being a gift; and (3) unlike in the Supreme Court cases, where the relative could claim the money as a gift, including contingency fees in gross income would result in double taxation.

Moreover, the court declined to make distinctions based on the particular state attorney's lien law involved in the action, saying that a "state-by-state" approach would give insufficient notice to taxpayers.

Accordingly, the court remanded on other issues.

Plaintiff's Counsel

James R. Carty, Roger J. Jones, and Russell R. Young, all of Chicago, Ill.