Tax
Feb. 1, 2003
Taxation of Attorney Fees Will Depend on Issue of Ownership
Focus Column - Tax Law - By R. Duane Westup, Mark Van Buskirk and Donald J. Winkler - In a contingency case involving a $1 million recovery, the client may end up with a net recovery of only $250,000 after paying attorney fees and taxes. Both plaintiff and defense counsel will find it beneficial to understand the tax implications of attorney fees that are paid out of damage awards to nonbusiness plaintiffs.
R. Duane Westrup
Westrup & Associates
444 W Ocean Blvd #1614
Long Beach , CA 90802
Email: jveloff@waklaw.com
Mark L. Van Buskirk
Donald J. Winkler
Tax Law
By R. Duane Westup, Mark Van Buskirk and Donald J. Winkler
In a contingency case involving a $1 million recovery, the client may end up with a net recovery of only $250,000 after paying attorney fees and taxes. Both plaintiff and defense counsel will find it beneficial to understand the tax implications of attorney fees that are paid out of damage awards to nonbusiness plaintiffs.
On the plaintiff's side, this can help the attorney educate the client regarding tax issues that will affect how much ends up in the client's pocket. If the plaintiff understands the tax implications, it may be easier to obtain agreement on a settlement and avoid the problems associated with a client who belatedly learns about the adverse tax consequences when a return is prepared.
From the defense perspective, a settlement that puts the same amount of "after-tax" dollars in the plaintiff's hands may be less costly. Accordingly, this may give defense counsel an additional tool that will encourage a reasonable settlement.
The Internal Revenue Service and 9th U.S. Circuit Court of Appeals position in a contingency case requires a successful plaintiff to pay income taxes not only on the portion of the recovery actually received after the deduction of attorney fees but also on the portion of the recovery received by the lawyer under the contingency fee agreement. The client may pay income tax regardless of whether he or she ever received, or had any right to receive, the portion of the recovery used to satisfy the lawyer's contingency fee. However, new developments may relieve the client of the obligation to pay these additional income taxes.
(Note that recoveries relating to physical injuries are not taxable to plaintiffs. Thus, the attorney fee issue is not applicable to physical injury awards.)
The IRS and 9th Circuit take the position that the portion of the recovery designated as attorney fees is taxable to both the attorney and to the plaintiff. For example, in a $1 million taxable damage recovery with a 40 percent contingency fee, the plaintiff is required to report as income the entire $1 million, instead of just the $600,000 net recovery that he or she receives. Of course, the lawyer also must report as income the $400,000 provided for by the contingent fee arrangement.
The IRS and 9th Circuit position is based on the assumption that the client is entitled to deduct the $400,000 of attorney fees as a miscellaneous itemized deduction on Schedule A of his or her tax return.
However, the client will not always receive a deduction for that amount. Tax law requires that the taxpayer compute his or her tax liability under the regular tax system and the Alternative Minimum Tax system and pay the higher of the two computed taxes. Due to certain income phase-outs, only $354,000 of the $400,000 of legal fees in this example would be allowed as a deduction under the regular tax system. In addition, no portion of the legal fees can be deducted for Alternative Minimum Tax purposes. In this example, the disallowed legal fees for Alternative Minimum Tax purposes results in a higher tax.
There is a substantial tax difference between reporting a $1 million recovery and $400,000 of legal fees ("gross reporting") and reporting a net recovery of $600,000 ("net reporting"). If the tax return reflects gross reporting and these items are the only items on the return, the client can expect to pay almost $100,000 more in taxes than would result from net reporting. Under that scenario, gross reporting would create tax of $350,000, resulting in an effective tax rate of 58 percent. However, net reporting would create tax of $250,000 and a 42 percent effective tax rate.
The client's reporting the same $400,000 of income as the attorney represents a form of double taxation. This result is based on the tax rule that provides that the entire amount received is the "property" of the prevailing party; i.e., the client. Even if the fees paid to the attorney are secured by an attorney's lien, the lien does not convert the fees to a property interest held by the attorney. Similarly, preparing a separate check for the attorney does not change how the recovery will be taxed to the plaintiff.
The important lesson to be learned is that federal tax law will follow the determination of property rights under applicable state law.
In Coady v. Commissioner of Internal Revenue, 213 F.3d 1187 (9th Cir. 2000), the court reviewed the issue of whether a plaintiff could exclude from gross income costs and contingent legal fees incurred in securing a judgment in connection with a wrongful termination claim. The court held that under Alaska's attorney lien statute, the lawyer did not have a superior lien or an ownership interest in the cause of action and, as a result, 100 percent of the proceeds of the judgment had to be included in the client's gross income.
Coady declined to follow cases from other circuits because the court in Coady found that Alaska's attorney lien statute did not create an ownership interest in the cause of action, as did the statutes in those other circuits.
The 9th Circuit reached the same result in Benci-Woodward v. Commissioner of Internal Revenue, 219 F.3d 941 (9th Cir. 2000), as it did in Coady. In Benci-Woodward, the court, citing various authorities including Coady, concluded that in California, a contingency fee agreement does not confer any ownership interest in the client's claim but only operates to give the lawyer a lien upon the client's recovery. As a result, the entire amount of the recovery was includable in income.
However, there is a bright spot emerging in California. In a recent nontax case, the California Supreme Court ruled that an award of attorney fees under the Fair Employment and Housing Act belongs to the lawyer and not to the client. In Flannery v. Prentice, 26 Cal.4th 572 (2001), the court held that absent a fee agreement disposing of proceeds of an attorney fee award under the FEHA, the fees belong to the attorneys for whose work they are awarded.
In Flannery, the former client sued her former lawyer on various causes of action concerning a prior representation. The plaintiff's complaint included a request for declaratory relief with regard to whether the statutory attorney fees awarded in the earlier action belonged to her or to her lawyer.
After an extensive analysis of the issue of who "owns" the statutorily awarded attorney fees, the court concluded that the "ownership" of attorney fees provided by statute, if not otherwise disposed of pursuant to a fee agreement, "vested" in the lawyer, not the prevailing litigant. While Flannery did not address any tax issues, it provides a critical element necessary to make a persuasive argument in favor of relieving the client from reporting as income the attorney-fee portion of a judgment or settlement in certain circumstances.
As a result of Flannery, there is a reasonable basis to expect that in a tax case relating to attorney fees, the 9th Circuit will hold that statutory fees deemed to be the property of the attorney may be excluded from the client's gross income. Such a result can be distinguished from Coady and Benci-Woodward because Flannery holds that the attorney, rather than the client, owns the attorney fees.
Until the 9th Circuit applies Flannery to this tax issue, there will continue to be uncertainty as to whether clients must include in their gross income the statutory awards of attorney fees. However, for certain cases, Flannery provides a reasonable basis upon which to exclude the attorney fees from gross income.
In addition, clients who previously filed returns and included statutory attorney fees in gross income may decide to file amended returns requesting refunds. While the IRS likely will oppose such a position, clients should be made aware of the option to file original or amended returns on this basis. A favorable decision on the tax effect of Flannery likely will extend to other statutory fees (such as those under the Labor Code) that include similar provisions with respect to the ownership of the attorney fees.
In the event that a client does pursue judicial resolution of this issue, an additional point should be kept in mind. In Coady, the taxpayer raised, for the first time on appeal, the argument that the arrangement between the client and the lawyer, for federal income tax purposes, was one of a joint venture or partnership. The court declined to consider the argument because it was not raised below.
R. Duane Westrup is the managing partner of Westrup, Klick & Associates in Long Beach. Mark Van Buskirk is an associate with that firm. Donald Winkler is a certified public accountant and a principal with Green, Hasson & Janks in Westwood.
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