In C.I.R. v. Banks, — S.Ct. —, 2005 WL 123825 (S.Ct. Jan 24, 2005) the Supreme Court resolved a split among the circuits and reversed two pro-taxpayer appellate decisions, holding that contingent fees paid to attorneys as part of settlements of employment-related lawsuits must be included in gross income.
The Supreme Court made two preliminary observations why this issue is of consequence.
- Taking the legal expenses as miscellaneous itemized deductions results in a portion not allowed below a 2% adjustment gross income (AGI) floor, and amounts above the floor are generally disallowed entirely for alternative minimum tax (AMT) purposes.
- After these cases arose Congress enacted the American Jobs Creation Act of 2004, 118 Stat. 1418. Section 703 of the Act amended the Code by adding § 62(a)(19). Id., at 1546. The amendment allows a taxpayer to deduct “attorney fees and court costs paid by, or on behalf of, the taxpayer in connection with any action involving a claim of unlawful discrimination” in computing adjusted gross income, Ibid. The Act defines “unlawful discrimination” to include a number of specific federal statutes, § § 62(e)(1) to (16), any federal whistle-blower statute, § 62(e)(17), and any federal, state, or local law “providing for the enforcement of civil rights” or “regulating any aspect of the employment relationship … or prohibiting the discharge of an employee, the discrimination against an employee, or any other form of retaliation or reprisal against an employee for asserting rights or taking other actions permitted by law,” § 62(e)(18). Id., at 1547-1548. These deductions are permissible even when the AMT applies. Had the Act been in force for the transactions now under review, these cases likely would not have arisen. The Act is not retroactive.
In separate actions, two taxpayers petitioned for redetermination of taxability of litigation settlement proceeds. In both cases, the United States Tax Court upheld taxation of the portion of recovery paid to taxpayers’ attorneys as contingent fees. Taxpayers appealed, and the Sixth Circuit Courts of Appeals, 345 F.3d 373, and the Ninth Circuit, 340 F.3d 1074, reversed on the attorney fee issue. Certiorari was granted.
Banks filed an employment discrimination action after he was fired from his job as an educational consultant with the California Department of Education. After trial commenced in 1990, the parties settled. The Sixth Circuit held that the attorney’s fees were not an assignment of income (thus taxable to the taxpayer) reasoning that the arrangement was more like a partial assignment of income-producing property, whether or not state law gave the attorney any special property interest in the proceeds.
The jury awarded Banaitis compensatory and punitive damages based on a claim his employer attempted to induce him to breach his fiduciary duties to customers and discharged him when he refused. After resolution of all appeals and post-trial motions, the parties settled. The Ninth Circuit found that because Oregon law granting attorneys a superior lien in the contingent-fee portion of any recovery controlled, and that part of Banaitis’ settlement was not includable as gross income.
The Supreme Court, in an opinion by Justice Anthony Kennedy, found that the relationship between client and attorney is a quintessential principal-agent relationship, regardless of the variations in particular compensation agreements or the amount of skill and effort the attorney contributes. The client retains ultimate dominion and control over the underlying claim (the income-generating asset). That the client may rely on the attorney’s expertise and special skills to achieve a result the client could not achieve alone is true of most principal-agent relationships, and it does not alter the fact that the client retains ultimate dominion and control over the underlying claim. Although the attorney can make tactical decisions without consulting the client, the client still must determine whether to settle or proceed to judgment and make, as well, other critical decisions. Even where the attorney exercises independent judgment without supervision by or consultation with the client, the attorney as an agent is obligated to act solely on behalf of and for the exclusive benefit of the client-principal, rather than for the benefit of the attorney or any other party.
The Court noted Judge Posner’s observation: “[T]he contingent-fee lawyer [is not] a joint owner of his client’s claim in the legal sense any more than the commission salesman is a joint owner of his employer’s accounts receivable.” Kenseth, 259 F.3d, at 883. A principal relies on an agent to realize an economic gain, and the gain realized by the agent’s efforts is income to the principal. The portion paid to the agent may be deductible, but absent some other provision of law it is not excludable from the principal’s gross income. The Court found this to be whether or not the attorney-client contract or state law confers any special rights or protections on the attorney, so long as these protections do not alter the fundamental principal-agent character of the relationship, and that no state laws which the Court was aware, even those that purporting to give attorneys an “ownership” interest in their fees, converts the attorney from an agent to a partner.
The Court did not address Banks’ contention that application of the anticipatory assignment principle would be inconsistent with the purpose of statutory fee-shifting provisions, such as those applicable in his case brought under 42 U.S.C. § § 1981, 1983, and 2000(e) et seq. After Banks settled his case, the fee paid to his attorney was calculated solely based on the private contingent-fee contract. There was no court-ordered fee award, no indication in Banks’ contract with his attorney, and nothing in the settlement agreement with the defendant, indicating that the contingent fee paid to Banks’ attorney was in lieu of statutory fees Banks might otherwise have been entitled to recover.