Scott E. Vincent
Shughart, Thomson & Kilroy
Kansas City

A federal district court in Vermont recently held that fees paid directly to attorneys under a contingency fee agreement may be excluded from a client's gross income. Raymond v. United States, 2003-1 USTC par.50,196 (Dist. Ct. Vt. 2:01-CV-142). Raymond involved a wrongful termination recovery that was paid directly to attorneys pursuant to a contingent fee agreement. This case provides a good outline of the competing authorities on this issue, and highlights the split in authority on the issue.

In this case, the court likened a contingent fee to an assignment of income-producing property, rather than an assignment of future income from property. Having concluded that a contingency fee does not operate as an assignment of future income, the court then concluded that the contingency fee would not satisfy the substantial control test of the assignment of income doctrine, and the amounts received by the attorneys under the contingency agreement were not required to be included in the taxpayers' income.

Factual Background

The taxpayer in Raymond was terminated by his employer and then hired a law firm to pursue a wrongful termination suit. The law firm's fee agreement provided for a contingency fee of one-third of the net recovery, plus expenses. The taxpayer prevailed at trial, and the judgment was affirmed on appeal, ultimately resulting in a payment of more than $900,000 to the law firm. The firm retained more than $300,000 in fees and expenses, and the taxpayer received the balance of the recovery.

On his tax return for the year in question, the taxpayer reported the full amount of the recovery and claimed the attorney fees as a miscellaneous itemized deduction. Because of the effects of alternative minimum tax (eliminating the deduction for attorney's fees), the taxpayer initially paid taxes on the full amount of the recovery, with no reduction for the fees paid the law firm. The taxpayer later filed an amended return, excluding the attorney's fees from income and requesting a refund. The IRS denied the request for refund, and the taxpayer initiated the case in question.

Court's Analysis

The court focused the issue as follows: "whether fees paid directly to an attorney under a contingency fee agreement should be excluded from the client's gross income because it was income to the attorney and not to the client." The court also noted the split of authority on this issue, with the Fifth, Sixth and Eleventh Circuits excluding contingency fees from clients' gross incomes, and the Third, Fourth, Seventh, Ninth, Tenth and Federal Circuits including them. The Second Circuit has not decided the issue (it is also undecided in the Eighth Circuit).

The courts that include contingency fees paid directly to attorneys as gross income to their clients generally rely on the anticipatory assignment of income doctrine, which was devised to prevent a taxpayer from assigning income before it is realized in order to avoid the tax consequences of earning it. Traditionally, this doctrine was applied to gifts of income or property between family members. The essence of the doctrine is that income should be taxed to the person who earns it.

The Raymond court states that "the critical factor in determining whether a taxpayer has engaged in an anticipatory assignment of income is the degree of control over the asset that the taxpayer has retained." The court then analyzed how other courts have differed in their characterization of the degree of control that a taxpayer has retained over the fee portion of a judgment subject to a contingent fee arrangement. Some courts reject the concept that a taxpayer has relinquished control over a legal claim by executing a contingent fee agreement. However, other courts focus on state law, particularly state attorneys' liens, and often conclude that clients do relinquish control over a portion of their potential judgment by executing a contingent fee agreement.

The Raymond court took this latter approach. Concluding that state law determines the nature of a legal interest in property, even though federal law governs taxation of that interest, the court held for the taxpayer as follows:

"Because the contingency fee agreement is not a tax avoidance scheme, operates more like income-producing property than income from property, and in any event does not satisfy the substantial control test of the assignment of income doctrine, this court holds that the portion of Raymond's recovery that was paid directly to his attorneys under their contingent fee agreement was not income to Raymond. Because the IRS incorrectly required this amount to be included in the Raymonds' 1998 income, the Raymonds are entitled to a refund on their 1998 taxes."

Conclusion

The developing law on these issues certainly bears watching, and recipients of contingent fee awards should be counseled in terms of how the awards are paid, and how the fees should be reported.