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Tricia Schultz* I. INTRODUCTION Suppose you file suit against your employer for sexual discrimination and harassment in the workplace and you retain your attorney pursuant to a contingent fee agreement.' After the jury awards you over $3 million, the judgment, deemed excessive by the judge, is reduced to nearly $300,000 plus payment of attorneys' fees and cost of nearly $1 million.2 After preparing your tax returns for the year of the settlement, you learn that your tax liability amounts to nearly $400,000, almost $100,000 in excess of the amount you actually received. The $1 million paid directly to your attorneys constitutes income not only to the attorneys, but to yourself as well, resulting in double taxation of those fees.4 The benefit of any deduction allowed for the fees is reduced as a result of the two percent floor on and phase-outs of miscellaneous itemized deductions, as well as the alternative minimum tax ("AMT"). Ultimately, you have been penalized for being a successful non-physical personal injury plaintiff. This situation has continued throughout the United States for over a decade, causing increased litigation on the contingent fee tax issue and inconsistent results among the circuits.6 A minority of circuits, recognizing the unequal treatment of non-physical personal injury plaintiffs, have allowed taxpayers an above the line deduction for fees paid pursuant to a contingent fee agreement, usually resting their conclusion on application of state attorney lien law. 7 The majority, however, including the Tax Court, have required the taxpayer to include the full award received as gross income under the anticipatory
* J.D. Candidate, University of Missouri-Kansas City, 2005; L.L.M. Candidate, University of Missouri-Kansas City, 2006. The author would like to thank Professor Robert Downs for his guidance and insight in writing this Note and Luke Bland for his much appreciated patience and support. 1 This hypothetical represents the real life story of Cynthia Spina. See Adam Liptak, Tax Bill Exceeds Award to Officer in Sex Bias Suit, N.Y. TIMES, Aug. 11, 2002, at 18, col. 5. 2
5 See generally Richard E. Sympson, Taxation of ContingentLegal Fees on Settlements or Awards, 3 Hous. Bus. & TAX L.J. 170, 178-83 (2003) (detailing the applicable code provisions affecting the contingent fee tax issue and illustrating the adverse effects of the AMT). 6 See Banks v. Comm'r, 2003 FED App. 0347P (6th Cir.) ("There is a circuit split on the issue of whether contingency fees must be included in gross income."); Banaitis v. Comm'r, 83 T.C.M. (CCH) 1053 (2002), available at 2002 T.C.M. LEXIS 4, *16 ("We recognize that there is a split among the Courts of Appeals on this question."). 7 See, e.g., Banaitis v. Comm'r, 340 F.3d 1074 (9th Cir. 2003); Banks, 2003 FED App. 0347P (6th Cir.); Foster v. United States, 249 F.3d 1275 (11th Cir. 2001); Estate of Clarks v. United States, 2000 FED App. 0020P (6th Cir.); Cotnam v. Comm'r, 263 F.2d 119 (5th Cir. 1959); see discussion infra Part II.C.
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assignment of income doctrine. 8 In 2003, after five denials of certiorari, 9 the Supreme Court finally recognized the ensuing need for a uniform federal law and granted certiorari on the contingent fee tax issue by accepting the combined cases of Commissionerv. Banks' and Commissioner v. Banaitis.1 One month prior to oral arguments for Banks and Banaitis, taxpayers who were forced to include amounts paid pursuant to a contingent fee in gross income were given hope for favorable relief when Congress enacted section 703, titled Civil Rights Tax Relief, of the American Jobs Creation Act of 2004 ("Jobs Creation Act").' 2 The Jobs Creation Act allowed taxpayers to exclude from income those amounts paid to attorneys that were incurred in certain unlawful discrimination cases. 13 Unfortunately for the taxpayers in Banks and Banaitis, they did not qualify for relief under the new code provisions because the effective date of the Jobs Creation Act was not retroactive. 14 The taxpayers asked the Court in Banks not to decide the cases under the Jobs Creation Act so that oral arguments, which were scheduled to be made the following week, could be heard on the issue.' 5 The Supreme Court retained the taxpayers' cases, but deciding in favor of the Internal Revenue Service ("IRS"), held that all attorneys' fees paid pursuant to a contingent fee agreement prior to the effective date of the Act are includable in gross income.' 6 The Court stated that since the effective date of the Jobs Creation Act was not retroactive, it could not provide relief for taxpayers whose cases were settled prior to that date. 17 Thus, in the situation above, if you settled your case on October 23, 2004, your gross income would not include fees paid to
See, e.g., Raymond v. United States, 355 F.3d 107 (2nd Cir. 2004); Hukkanen-Campbell v.
Comm'r, 274 F.3d 1312 (10th Cir. 2001); Kenseth v. Comm'r, 259 F.3d 881 (7th Cir. 2001); Young v. Comm'r, 240 F.3d 369 (4th Cir. 2001); Benci-Woodward v. Comm'r, 219 F.3d 941 (9th Cir. 2000); Baylin v. United States, 43 F.3d 1451 (Fed. Cir. 1995); Alexander v. IRS, 72 F.3d 938 (1st Cir. 1995); O'Brien v. Comm'r, 319 F.2d 532 (3d Cir. 1963), aff'g, 38 T.C. 707 (1962); see discussion infra Part II.B. 9 Hukkanen-Campbell, 274 F.3d at 1312, cert. denied, 535 U.S. 1056 (2002); Sinyard v. Comm'r, 268 F.3d 756 (9th Cir. 2001), cert. denied, 536 U.S. 904 (2002); Benci-Woodward, 219 F.3d at 941, cert. denied, 531 U.S. 1112 (2001); Coady v. Comm'r, 213 F.3d 1187 (9th Cir. 2000), cert. denied, 532 U.S. 972 (2001); O'Brien,319 F.2d at 532, cert. denied, 375 U.S. 931 (1963). 1o Banks, 2003 FED App. 0347P, cert. granted,541 U.S. 958 (2004) (No. 03-0892). " Banaitis, 340 F.3d at 1074, cert. granted,541 U.S. 958 (2004) (No. 03-0907). 12 American Jobs Creation Act of 2004, Pub. L. No. 108-357, § 703, 118 Stat. 1418, 1546 (2004) (codified at 26 U.S.C.A. § 62(a)(18), (e) (2005)). 13American Jobs Creation Act § 703. 14 Id. ("The amendments made by this section shall apply to fees and costs paid after the date of the enactment of this Act with respect to any judgment or settlement occurring after such date.") 15 Joint Supplemental Brief for the Respondents at 1-4, Banks v. Com'r, 541 U.S. 958 (2004), (No.03-0892). 16 Comm'r v. Banks, 125 S. Ct. 826, 829 (2005) (together with Banaitis, No. 03-0907) ("We hold that, as a general rule, when a litigant's recovery constitutes income, the litigant's income includes the portion of the recovery paid to the attorney as a contingent fee.") 7 Banks, 125 S. Ct. at 831.
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your attorneys; however, if you settled just one day earlier, .you could end up owing the government more'than your net award received. In its decision, the Court eliminated the disparity that adversely affected taxpayers prior to the Jobs Creation Act due to application of state attorney lien law and created a new disparity based on the time the judgment was rendered or settlement agreed. In addition, because the Jobs Creation Act covers only those lawsuits defined as a claim of unlawful discrimination, certain non-physical personal injury plaintiffs do not qualify for exclusionary treatment, and are thereby subject to the same unfair treatment as that inflicted upon Banks and 8 Banaitis.1 Therefore, although it appears from both recent legislation and the decision in Banks that the contingent fee tax issue is settled, the debate will most 9 likely continue.' This Note will discuss the reasoning behind the Supreme Court's decision in Banks and Banaitis and propose a possible solution to the unjust treatment of plaintiffs awarded a money judgment or settlement in a non-physical personal injury cause of action. Part II of this Note gives a histoiical view of the taxation of damage awards, as well as the following split among the circuits and the proposed legislation addressing the contingent fee tax issue. Part III of this Note will discuss the Supreme Court's reasoning underlying the conclusion that all attorneys' fees are includable in a taxpayer's gross income and the rejection of the taxpayers' argument that a contingent fee agreement creates a partnership between the taxpayer and his attorney. Part IV will attempt to offer a solution to the contingent fee tax issue, despite the ruling of Banks, suggesting that Congress should amend the Internal Revenue Code so as to treat the contingent fee as a transaction cost incurred in the disposition of property, allowing a non-physical personal injury plaintiff to exclude from gross income the entire amount of fees paid to their attorneys and avoid application of the AMT. II. THE SPLIT AMONG CIRCUITS AND RESPONSIVE LEGISLATION A. Historical Taxation of Damages and Unfairness Historically, awards in both physical and non-physical personal injury cases were excludable from a taxpayer's gross income. 20 Effective in 1997, however, Congress enacted the Small Business Protection Act of 199621 and created a distinction between physical and non-physical personal injury; only those awards attributable to physical injury or sickness could be excluded from a taxpayer's
Robert W. Wood, Jobs Act Attorney Fee Provision:Is It Enough?, 105 TAX NOTES 961,963
(2004), availableat 2004 LEXIS TNT 215-27. 19 See Robert W. Wood, Supreme Court Attorney Fees Decision Leaves Much Unresolved, 106 TAX NOTES 792 (2005), availableat 2005 LEXIS TNT 24-67. 20 26 U.S.C.S. § 104(a)(2) (Matthew Bender & Co., Inc. 1995). 21 Small Business Protection Act of 1996, Pub. L. No. 104-188, § 1605, 110 Stat. 1755, 1838-39 (1996).
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gross income. 22 A non-physical personal injury plaintiff, such as one in an unlawful discrimination case, must include in their gross income the amount of the award received, including attorneys' fees and court costs. 23 This harsh bright line rule negatively affected many non-physical personal injury plaintiffs.2 4 To offset this disparity, if the plaintiff qualified, they were allowed to deduct their expenses as a trade or business miscellaneous itemized deduction. 25 These deductions, however, may be frequently limited or phased-out and deductible only to the extent they exceed two percent of the taxpayer's adjusted gross income. 6 In addition, in many cases where a taxpayer has a higher level of income, the deductions may be reduced or disallowed in their entirety by the AMT. 27 After applying the AMT, an unlawful discrimination plaintiff who paid a significant portion of their award to their lawyers on a contingent basis may have a tax liability that exceeds the net award actually received. Critics have suggested that this unfairness may substantially affect a non-physical personal injury plaintiff from going forward with their case.29 Shocked by this dilemma, a bill was submitted to Congress in 199830 addressing a possible resolution to this issue, but taxpayers would have to wait five more years until a similar, but much revised solution would be enacted. 3' The issue remained among the circuits whether attorneys' contingent fees were excludable from a taxpayer's gross income until the Supreme Court ruled in Banks that all fees paid to an attorney are includable in the taxpayer's gross income.
26 U.S.C.S. § 104(a)(2). See Marisa J. Mead, Taxing the Victims: Compensatory Damage Awards and Attorneys'Fees in
Sexual HarassmentLawsuits, 11 J.L. & POL'Y 801, 815-31 (2003) (discussing the development of tax law concerning the historical taxation of damage awards). 24 See National Employment Lawyers Association, Advocacy: CRTRA, http://www.nela.org/advocacy/crtra.cfin (last visited June 29, 2005). 25 Alexander v. Comm'r, 72 F.3d 938, 944 (1st Cir. 1995). No code section specifically authorized deduction of attorneys' fees in non-physical personal injury cases, but taxpayers are allowed to deduct lawyer's fees related to business expenses or the production of income. See 26 U.S.C. § 162 (2005); 26 U.S.C. § 212 (2005). 26 I.R.C. §§ 67-68 (2004). 27 I.R.C. §§ 55, 56(b)(l)(A)(i) (2004). See Sympson, supra note 5, at 177-81 (discussing in detail the application of the AMT as to contingent fees). 28 Jennifer S. Neumann, The Discrimination Created by the Tax Treatment of Attorney's Fees in FederalCivil Rights Cases, 51 KAN. L. REv. 595, 609-11 (2003) (comparing AMT tax treatment of an unlawful discrimination plaintiff to a typical income earner with the same taxable income). 29 Mead, supra note 23, at 841-47. 30 Civil Rights Tax Fairness Act of 1999, H.R. 1997, 106th Cong. (1999). 31 Creation Act of 2004, Pub. L. No. 108-357, § 703, 118 Stat. 1418 (2004) (codified at 26 U.S.C.A. § 62(a)(18), (e) (2005)).
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B. The Anticipatory Assignment of Income Doctrine and Inclusion of Contingent Fees in Gross Income As circuits, passed on the question of whether attorneys' fees pursuant to a contingent fee agreement are excludable from gross income, a majority of the circuits held that attorneys' fees received on a contingent fee basis must be included in the gross income of a non-physical personal injury plaintiff.32 The Commissioner has always taken the view that such fees fall under the "anticipatory assignment of income" doctrine.33 This doctrine, as enunciated in Lucas v. Earl,34 provides that the making of an assignment of future income directly to a creditor does not avoid the income from "vesting even for a second in the man who earned it" nor prevent any realization of income. 35 In Lucas, a husband attempted to contribute half of his salary as an attorney to his wife under a contractual agreement.36 Despite the fact that the wife held a fifty percent proprietary interest under joint property law, the Court emphasized that the husband was the only party to the contract from which the income was derived. 37 That portion of income assigned to the wife constituted income to the husband.3 8 Similarly, in Helvering v. Horst, the Court further stated that a father who gifted negotiable bonds to his son realized interest income on the bonds even though the father never physically received that portion of the income.39 Courts view the contingent fee arrangement as anticipatory assignment of income from the plaintiff to his attorney. 40 At the close of the action, the entire amount awarded to plaintiff attributable to a non-physical personal injury cause of action is gross income to the plaintiff, irrespective of any contingent fee agreement which grants an attorney an interest in the lawsuit. 41 The fact that the
See, e.g., Raymond v. United States, 355 F.3d 107 (2nd Cir. 2004); Hukkanen-Campbell v.
Comm'r, 274 F.3d 1312 (10th Cir. 2001), cert. denied, 535 U.S. 1056 (2002); Kenseth v. Comm'r, 259 F.3d 881 (7th Cir. 2001); Young v. Comm'r, 240 F.3d 369 (4th Cir. 2001); Benci-Woodward v. Comm'r, 219 F.3d 941 (9th Cir. 2000); Baylin v. United States, 43 F.3d 1451 (Fed. Cir. 1995); Alexander v. IRS, 72 F.3d 938 ,944-946 (1st Cir. 1995); O'Brien v. Comm'r, 319 F.2d 532 (3d Cir. 1963), affg, 38 T.C. 707 (1962). 33 See Kenseth v. Comm'r, 114 T.C. 399, 412 (2000). 34281 U.S. 111 (1930). 35 Id. at 114-15; accord Helvering v. Horst, 311 U.S. 112, 116-17 (1940) (holding assignment of income that was never physically received by the taxpayer who earned it still falls under the anticipatory assignment of income doctrine). 36281 U.S. at 113. 37 1d. at 114.
" 311 U.S. at 120 ("When, by the gift of the coupons, [the owner of a negotiable bond] has separated his right to interest payments from his investment and procured the payment of the interest to his donee, he has enjoyed the economic benefits of the income in the same manner and to the same extent as though the transfer were of earnings .... "). 40 See Young v. Comm'r, 240 F.3d 369, 376-77 (4th Cir. 2001); Baylin v. United States, 43 F.3d 1451, 1454-55 (Fed. Cir. 1995); O'Brien v. Comm'r, 38 T.C. 707, 712 (1962). 41 Young, 240 F.3d at 376-77.
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plaintiff never physically received any amount of the contingent fee does not foreclose a conclusion that the income is taxable. 2 The plaintiff is liable for tax on the gross amount and allowed a miscellaneous itemized deduction of their expenses incurred.4 3 C. Tax Treatment as Determined by Applicable State Attorney Lien Law As an alternative to the assignment of income doctrine, circuits often looked to the nature of the attorneys' interests in the cause of action as determined by state attorney lien law to determine whether contingent fees are excludable from gross income." This reliance on state law caused the split among the circuits and the need for Supreme Court review of the issue in the combined cases of Banks and Banaitis. If state law, as interpreted by the courts, failed to afford an attorney a proprietary interest in the lawsuit, or merely granted a security interest, most circuits agreed with the Commissioner that those contingent fees were part of the plaintiffs income. 4 In fact, the Fourth Circuit expressly refused to acknowledge that state attorney lien law is determinative of the contingent fee tax issue.46 A minority of circuits, relying on the applicable state attorney lien law, rejected the anticipatory assignment of income doctrine and held that where an attorney had a superior lien or propriety interest in a plaintiffs cause of action, the taxpayer was allowed an above the line deduction for attorneys' fees paid on a contingent basis.47 As presented in the landmark case of Cotnam v. 48 Commissioner, the court, interpreting an Alabama attorney lien law, decided that an attorney had a present equitable interest in the settlement or award of the plaintiff's case.4 9 The client had, in effect, transferred a part of the case to the attorney and never realized the income equal to the fee.5 ° To support their conclusion that an attorney had an intangible contingent expectation, many courts focused on the speculative nature of the contingent fee as well as the dependency of the outcome of the suit on the skill and knowledge
43See Alexander v. Comm'r, 72 F.3d 938, 944-46 (1st Cir. 1995); Kenseth v. Comm'r, 259 F.3d
881, 883 (7th Cir. 2001).
44See Neumann, supranote 28, at 601-05. 45See Hukkanen-Campbell v. Comm'r, 274 F.3d 1312, 1314 (10th Cir. 2001); Kenseth, 259 F.3d at
883-84; Benci-Woodward v. Comm'r, 219 F.3d 941, 943 (9th Cir. 2000); Baylin, 43 F.3d at 1455.
46Young v. Comm'r, 240 F.3d 369, 379 (4th Cir. 2001) ("But, even if we adopted the contingent fee
exception established in Cotnam and the view that state law was determinative-and we do notNorth Carolina law is easily distinguishable from the Alabama statute on which Cotnamn relied.") 47 See, e.g., Banaitis v. Comm'r, 340 F.3d 1074 (9th Cir. 2003), revd, 125 S. Ct. 826; Banks v. Comm'r, 2003 FED App. 0347P (6th Cir.), revd, 125 S. Ct. 826; Foster v. United States, 249 F.3d 1275 (11th Cir. 2001); Estate of Clarks v. United States, 202 F.3d 854 (6th Cir. 2000); Cotnam v. Comm'r, 263 F.2d 119 (5th Cir. 1959). 48 263 F.2d 119. 49Id. at 125. 50 Id.; see also Banaitis, 340 F.3d at 1083.
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of the attorney. 5' In distinguishing the contingent fee agreement from the anticipatory assignment of income doctrine, courts typically characterized this intangible, contingent expectation as a division of property and concluded that the income paid to the attorney pursuant to the agreement was never realized by the plaintiff of the case.52 Prior to the Supreme Court's decision in Banks, which made all fees includable in gross income, this analysis caused serious problems for several of the circuits when they were asked to pass upon a case whose state attorney lien law differed from that on which the court had already decided the contingent fee issue.53 Bound by the doctrine of stare decisis, some courts found that excludability of contingent fees from gross income was not distinguishable by the amount of ownership interest conferred to the attorney under applicable state attorney lien law.54 The Ninth Circuit had surprisingly split within itself, granting exclusionary status to those cases where state attorney lien law conferred a propriet~ar5 interest to the attorney, but requiring inclusion in those states which did not.5 It held that contingent fees must be included in gross income when Alaska or California attorney lien law applied, but may be 56 excluded from income under Oregon law. The Fifth Circuit in Srivastava v. Commissioner57 reluctantly allowed a taxpayer to exclude their contingent attorneys' fees, pointing out that the tax treatment of a contingent attorneys' fee "does not depend on the intricacies of an attorney's bundle of rights against the opposing party under the law of the governing state. 5 8 Bound by the precedent of Cotnam as well as the principles of consistency, the court gave no emphasis to the fact that Texas law conferred substantially less to the attorney than under Alabama law.5 9 The court went further to make clear that had the case been one of first impression, the fees paid would have been included in the taxpayer's gross income.6 Notably, the court in Srivastava agreed with the position of the Commissioner, but refused to accept the challenge of the Cotnam doctrine and to support a clear disregard for the long standing rule of stare decisis.
See Estateof Clarks, 202 F.3d at 857-58.
52 Id. at 858. 53See Banaitis, 340 F.3d 1074 (creating a split within the Ninth Circuit by holding that under
Oregon law, but not Alaska or California law, attorneys' fees are excludable from gross income); Banks v. Comm'r, 345 F.3d 373, 382-85 (6th Cir. 2003) (declining to take a state by state approach to the tax treatment of a contingent fee by distinctions between applicable state attorney lien law); Srivastava v. Comm'r, 220 F.3d 353, 363-365 (5th Cir. 2000) (bound by Cotnan v. Comm'r, 263 F.2d 119 (5th Cir. 1959), irrespective of the differences in applicable state attorney lien law). 5 4 Banks, 345 F.3d at 386; Srivastava, 220 F.3d at 357. F.3d 1187, 1190-91 (9th Cir. 2000), and Benci-Woodward v. Comm'r, 219 F.3d 941, 943 (9th Cir. 2000), with Banaitis,340 F.3d at 1082-83. 17Srivastava, 220 F.3d 353.
58 220 F.3d. at 364. 59 Id. 60 '5 Banaitis, 340 F.3d at 1082-83. 56 Compare Coady v. Comm'r, 213
Id. at 363.
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The Sixth Circuit was faced by a situation similar to that of Srivastava in Banks.6 1 Applying California attorney lien law to the contingent fee agreement, which grants merely a security interest the lawsuit, Banks was bound by the previous decision of Estate of Clarks v. United States. 62 The court agreed with the Fifth Circuit that the tax treatment of contingent fee agreements should not depend on application of state attorney lien law. 63 Attempting to distinguish contingent fee arrangements from those covered by the anticipatory assignment of income doctrine, the court in Banks put forth three grounds for why the fees should be deducted above the line. 64 First, a true business purpose existed between the client and the attorney; there was no tax avoidance motive present in the contingent fee agreement. 65 Second, the attorneys in a contingent fee arrangement, unlike the assignee in Earl and other assignment of income cases performed services for the plaintiff, relying on their own skill and judgment. 6 Finally, the court noted that applying the anticipatory assignment of income doctrine to the case at bar would result in double taxation to the plaintiff.67 Under Srivastava and Banks, a plaintiff could circumvent the applicable attorney lien law by filing suit in a court that follows the doctrine of stare decisis and is favorable to their position, irrespective of the fact that their attorney has no ownership right in the cause of action. It became evident that "[t]he lack of uniformity and injustice of the rule prevailing in the majority of circuits led to forum shopping and frequent gerrymandering of attorney fees arrangements...,68 There was a clear need for a uniform federal law to apply to issues of federal income taxation. In March 7 2004, the Supreme Court accepted the combined cases of Banks69 and Banaitis ° and several months later ultimately resolved this offensive confusion among the courts and denied exclusionary treatment for both taxpayers. 7' As discussed below, in the months leading up to the date of oral arguments for Banks and Banaitis,Congress too created its own remedy to the contingent fee issue.
61 345 F.3d 373, 385 (6th Cir. 2003). 62 202 F.3d at 857.
345 F.3d at 385.
68 Wood, 69
supra note 19. Banks, 345 F.3d 373. 70 Commn'r v. Banaitis, 340 F.3d 1074 (9th Cir. 2003). 71 Compare Banks, 125 S. Ct. at 826, with Banaitis, 340 F.3d at 1074. For a discussion of the decision in Banks, see infra Part III.
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D. Civil Rights Tax Relief and the Jobs Creation Act of 200472
Congress acted quickly in response to the circuit court split, introducing legislation that addressed the contingent fee issue called the Civil Rights Tax Following the lead of the District of Fairness Act of 1999 ("CRTFA"). Columbia, Congress sought to eliminate the unfair tax treatment of unlawful discrimination awards and settlements.74 Many lawyers, supported by the National Employment Lawyers Association and the American Small Business Alliance, felt that the impact of the law affected all the parties to the transaction. 75 "Because of the tax bite, businesses have to pay more or individuals have to take less to get settlements, or there are no settlements. A lot of cases are on the docket longer, and there are more trials., 76 However, it was years before any relief from the unintended consequences of the Small Business Job Protection Act of 1996 would be passed.77 Aimed at eliminating double taxation on attorneys' fees, early legislation favored equal treatment of unlawful discrimination cases and physical personal injury cases. 78 Congress proposed a new section to the Internal Revenue Code of 1986 that would exclude from gross income amounts received, other than backpay, frontay, or punitive damages, on account of certain unlawful discrimination." The CRTFA of 1999 went further to list the types of cases that qualified as an unlawful discrimination claim.80 For two years following the introduction of the CRTFA, both the House and the Senate reintroduced the bill for consideration; each attempt resulted in failure. 8 1 The penalty of double taxation of successful civil rights plaintiffs continued.8 2
American Jobs Creation Act of 2004, Pub. L. No. 108-357, § 703, 118 Stat. 1418, 1546-48 (2004) (codified at 26 U.S.C.A. § 62(a)(18), (e) (2005)). 73 Civil Rights Tax Fairness Act of 1999, H.R. 1997, 106th Cong. § 1 (1999). 74 See NELA Applauds District'sAdoption of Nation's First Civil Rights Tax FairnessAct; Asks Congress to Follow, U.S. NEWSWiRE, Aug. 2, 2002, availableat 2002 WL 22070164. 75 See Marcia Coyle, U.S. Tax on Damages Under Fire: Bill to Repeal '96 Levy Has Backing of
Both Business, PlaintiffBar,21 NAT. L.J. 50, Aug. 9, 1999, at Al. 76 Id. (quoting Frederick M. Gittes, employment lawyer and partner at Columbus, Ohio's Spater, Gittes, Schulte & Kolman). 77 American Jobs Creation Act § 703. 78 146 CONG. REC. S7160, 7163 (daily ed. July 18, 2000) (statement of Sen. Grassley). "The result of this taxation is that the attorneys and government make out better than the victims who had their rights violated." Id. 79 Civil Rights Tax Fairness Act of 1999, H.R. 1997, 106th Cong. § 2(a) (1999). The House proposed a new section to the Internal Revenue Code of 1986, § 139, entitled "Amounts Received on Account of Certain Unlawful Discrimination." 80 H.R. 1997 § 2(a) 8' H.R. 4570, 106th Cong. § 2(a) (2000); S. 2887, 106th Cong. § 2(a) (2000); H.R. 840, 107th Cong. § 2(a) (2001); S. 917, 107th Cong. § 2(a) (2001). 82 See 147 CONG. REc. S5273 (daily ed. May 21, 2001) (statement of Sen. Collins).
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After the letdown of the CRTFA, Congress amended its position to resolve the unfairness circumscribed on unlawful discrimination plaintiffs. The provisions of the CRTFA were unnecessarily broad and would reduce the amount of revenue to federal income too significantly.83 In 2003, Congress introduced a new solution by allowing for an above the line deduction of attorne ys' fees and court costs paid with respect to a claim of unlawful discrimination. Similar to the CRTFA, the proposed bill listed the types of cases in which relief would be granted including various federal and state civil rights and employment claims. 85 Although the bill, re-titled the Jobs and Growth Tax Relief Reconciliation Act of 2003, eventually passed, the section addressing the contingent fee issue was dropped from the bill by the House Committee on Ways and Means in the early stages of consideration. 6 Congress then returned to its original position that all amounts received on account of an unlawful discrimination claim, excluding frontpay, backpay, and punitive damages, should be excluded from gross income, but did not succeed. 7 It was not until the Jumpstart Our Business Strength ("JOBS") Act that Congress began to see a light at the end of the tunnel for resolution of the contingent fee tax issue. 88 The Senate agreed to the JOBS Act, as amended, allowing for an exclusion from gross income of attorneys' fees paid in connection with a claim of unlawful discrimination. 89 This Act was ultimately incorporated into the Jobs Creation Act, passed by Congress and signed by the president on October 22, 2004.90 The text of the Act amended the redefined gross income to exclude those amounts paid in connection with an unlawful discrimination lawsuit. 9' It defined "unlawful discrimination" to include a
83 See Coyle, supra note 75, at Al; Mead, supra note 23, at 853. 84 Jobs and Growth Tax Relief Reconciliation Act of 2003, S. 1054, 108th Cong. § 521 (2003); Jobs and Growth Tax Relief Reconciliation Act of 2003, H.R. 2, 108th Cong. § 52 1(a) (2003) (as engrossed by the Senate, as amended, S. Vote 179, 108th Cong., 149 CONG. REC. S6451, S6474 (daily ed. May 15, 2003)) (proposing a new section to the Internal Revenue Code of 1986, § 223). 85 S. 1054, § 521(a). 86 Jobs and Growth Tax Relief Reconciliation Act of 2003, Pub. L. No. 108-27, 117 Stat. 752 (2003); H.R. REP. No. 108-94, pt. U (2003). 87 Civil Rights Tax Relief Act of 2003, S. 557, 108th Cong. § 2(a) (2003); Civil Rights Tax Relief Act of 2003, H.R. 1155, 108th Cong. § 2(a) (2003). 88 Jumpstart Our Business Strength Act, S. 1637, 108th Cong. § 643 (2003) (as engrossed by the Senate, as amended). 89 S. 1637, § 643. For text of the bill as amended, see 150 CONG. REc. S5622 (daily ed. May 18, 2004). 90 American Jobs Creation Act of 2004, Pub. L. No. 108-357, § 703, 118 Stat. 1418, 1546-48 (2004) (codified at 26 U.S.C.A. § 62(a)(18), (e) (2005)). R. CONF. REP. No. 108-755, pt. E, at 2 (2004), reprintedin 150 CONG. REC. H8411,8536-37 (Oct. 7, 2004). 91 Section 62(a)(19) provides: (a) General rule. For purposes of this subtitle, the term "adjusted gross income" means, in the case of an individual, gross income minus the following deductions:
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number of specific statutes, including Title VII and ERISA claims, employment claims, including those brought under any federal whistle-blower statute, and Federal False Claims Act claims.92 Although the Senate had originally hoped to
(19) Costs involving discrimination suits, etc. Any deduction allowable under this chapter for attorney fees and court costs paid by, or on behalf of, the taxpayer in connection with any action involving a claim of unlawful discrimination (as defined in subsection (e)) or a claim of a violation of subchapter III of chapter 37 of title 31, United States Code [31 USCS §§ 3721 et seq.] or a claim made under section 1862(b)(3)(A) of the Social Security Act (42 U.S.C. 1395y(b)(3)(A)). The preceding sentence shall not apply to any deduction in excess of the amount includible in the taxpayer's gross income for the taxable year on account of a judgment or settlement (whether by suit or agreement and whether as lump sum or periodic payments) resulting from such claim. 26 U.S.C.S. § 62(a)(19) (2005).
Section 62(e) provides: (e) Unlawful discrimination defined. For purposes of subsection (a)(19), the term "unlawful discrimination" means an act that is unlawful under any of the following: (1) Section 302 of the Civil Rights Act of 1991 (2 U.S.C. 1202). (2) Section 201, 202, 203, 204, 205, 206, or 207 of the Congressional Accountability Act of 1995 (2 U.S.C. 1311, 1312, 1313, 1314, 1315, 1316, or 1317). (3) The National Labor Relations Act (29 U.S.C. 151 et seq.). (4) The Fair Labor Standards Act of 1938 (29 U.S.C. 201 et seq.). (5) Section 4 or 15 of the Age Discrimination in Employment Act of 1967 (29 U.S.C. 623 or 633a). (6) Section 501 or 504 of the Rehabilitation Act of 1973 (29 U.S.C. 791 or 794). (7) Section 510 of the Employee Retirement Income Security Act of 1974 (29 U.S.C. 1140). (8) Title IX of the Education Amendments of 1972 (20 U.S.C. 1681 et seq.). (9) The Employee Polygraph Protection Act of 1988 (29 U.S.C. 2001 et seq.). (10) The Worker Adjustment and Retraining Notification Act (29 U.S.C. 2102 et seq.). (11) Section 105 of the Family and Medical Leave Act of 1993 (29 U.S.C. 2615). (12) Chapter 43 of title 38, United States Code [38 USCS §§ 4301 et seq.] (relating to employment and reemployment rights of members of the uniformed services). (13) Section 1977, 1979, or 1980 of the Revised Statutes (42 U.S.C. 1981, 1983, or 1985). (14) Section 703, 704, or 717 of the Civil Rights Act of 1964 (42 U.S.C. 2000e-2, 2000e-3, or 2000e- 16). (15) Section 804, 805, 806, 808, or 818 of the Fair Housing Act (42 U.S.C. 3604, 3605, 3606, 3608, or 3617). (16) Section 102, 202, 302, or 503 of the Americans with Disabilities Act of 1990 (42 U.S.C. 12112, 12132, 12182, or 12203). (17) Any provision of Federal law (popularly known as whistleblower protection provisions) 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 under Federal law.
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apply a retroactive effective date, starting December 31, 2002, it was agreed that section 703, Civil Rights Tax Relief, would be effective as of the date of enactment. 93 This legislation, however, does not address the full impact of the contingent fee tax issue.9 4 Some plaintiffs, however broad the definition of unlawful discrimination, do not fall within the "catchall" provision of sections 62(e)(18) and (19) and may still subject the plaintiff to disproportionate tax treatment. 95 The Supreme Court in Banks and Banaitis recognized that had the Civil Rights Tax Provision been retroactive, "these cases likely would not have arisen." 9 The Court declined, however, to judicially create retroactive relief for plaintiffs who received their judgment award or settlement prior to the effective date of the legislation.9 7 III. BANKS AND BANAITIS: RESPONDENTS' ARGUMENTS FOR EXCLUSION OF ATTORNEYS' FEES FROM GROSS INCOME AND WHY THEY FAILED In its unanimous opinion (Chief Rehnquist did not participate due to illness), the Supreme Court reversed the decisions of both the Sixth and the Ninth Circuits and concluded that "when a litigant's recovery constitutes income, the litigant's income includes the portion of the recovery paid to the attorney as a contingent fee.",98 Siding with the IRS in his opinion, Justice Anthony M. Kennedy concluded that the long-standing anticipatory assignment of income doctrine appropriately governs the contingent attorney fee agreements. 99 Justice Kennedy also disposed of the taxpayers' arguments that the contingent fee agreement should be treated as a partnership for tax purposes regardless of applicable state attorney lien law and that the fees were speculative at the time of
(18) Any provision of Federal, State, or local law, or common law claims permitted under Federal, State, or local law(i) providing for the enforcement of civil rights, or (ii) regulating any aspect of the employment relationship, including claims for wages, compensation, or benefits, 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. I.R.C. § 62(e) (2004). 9' H.R. CONF. REP. No. 108-755, pt. E, at 2 (2004). 94 Wood, supra note 18, at 964 ("Congress was clearly right to pass this provision, even if it does not solve everything."). 9' See id. at 962-63 (stating that certain claims outside the employment context such as defamation, negligent or intentional infliction of emotional distress, or invasion of privacy claims would not be allowed exclusionary treatment for attorneys' fees under the Jobs Creation Act of 2004). 96 Comm'r v. Banks, 125 S. Ct. 826, 831 (2005).
Id. at 829. 99 Id. at 826 ("The court agrees with the Commissioner that a contingent-fee agreement should be viewed as an anticipatory assignment to the attorney of a portion of the client's income from any litigation recovery.").
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assignment. 00 The opinion failed to address, however, many of the arguments supporting the taxpayers, including those presented by multiple amici.'' Though the Court remedied the split among and within the circuits, and eliminated the disparity created by varying degrees of attorney lien laws, it created a new disparity, negatively impacting only those who settled their case or received a judgment award prior to the enactment of the Jobs Creation Act. A. The Attorney-Client Contingent Fee Agreement as a Joint Venture: Subchapter K of the Internal Revenue Code Cannot Apply In his brief for the respondent, attorney Phillip N. Jones stated, "This case is governed by Subchapter K'02 of the Internal Revenue Code."' 1 3 Suggesting that a contingent fee agreement between a client and attorney should properly be classified as a partnership for income tax purposes °4 respondents relied on dicta from previous contingent fee tax cases that excluded from gross income those fees paid on a contingent basis. 0 5 They argued that under section 702 of the Internal Revenue Code, as co-partners, both the attorney and the client should be taxed only on the amount that each actually received.1' 6 It was apparent, however, by the time oral arguments were made that this creative classification
'00 Id. at 832-33. 'o' Banks, 125 S. Ct. at 833. See Sheryl Stratton, Justices Side with Government in Contingent Attorney Fee Cases, 106 TAX NOTES 511, 512 (2005) ("The opinion.., is shallow, one-sided, and disappointing because it never discusses or considers the array of arguments that would result in a finding for taxpayers.") (as asserted by Stephen Cohen, author of one of the amicus brief mentioned by the Supreme Court). 102 I.R.C. §§ 701-720 (2004). 103 Brief for the Respondent at 1, Comm'r v. Banaitis, 541 U.S. 958 (2004) (No. 03-0907), available at http://supreme.1p.findlaw.com/supreme-court/briefs/03-907/03-907.mer.resp.pdf (last visited June 29, 2005). 104 Respondent's Brief at 5-18, Banaitis (No. 03-0907); Brief for the Respondent at 15-16, Comm'r v. Banks, 541 U.S. 958 (2004) (No. 03-0892), available at http://supreme.1p.findlaw.com/supremecourtbriefs/03-892/03-892.mer.resp.pdf (last visited June 29, 2004) (citing I.R.C. §§ 761 (a), 7701(a)(2) (2005) ("[T]he term 'partnership' includes a... joint venture ... through or by means of which any business, financial operation or venture is carried on.")). 105 See Estate of Clarks v. United States, 202 F.3d 854, 857 (6th Cir. 2000) ("Like an interest in a partnership agreement or joint venture, Clarks contracted for services and assigned his lawyer a one-third interest in the venture in order that he might have a chance to recover the remaining twothirds."); Srivastava v. Comm'r, 220 F.3d 353, 360 (5th Cir. 2000) ("[Tlhe claim is subject to a sort of virtual co-ownership--'like an interest in a partnership agreement or joint venture.') (quoting Estate of Clarks, 202 F.3d at 857). But see Kenseth v. Comm'r, 114 T.C. 399, 413 (2000) ("Attorneys represent the interests of clients in a fiduciary capacity. It is difficult, in theory or fact, to convert that relationship into ajoint venture or partnership."). 106 I.R.C. § 702(a) (2005) ("In determining his income tax, each partner shall take into account separately his distributive share of the partnership's ... income.").
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of an attorney-client relationship would ultimately fail.'0 7 The Supreme Court "reject[ed] the suggestion to treat the attorney-client relationship as a sort of business partnership or joint venture for tax purposes.' ' 8 1. The Attorney-Client Relationship Is That of Principal-Agent, Not CoPartners In its decision, the Court primarily relied on the fact that attorneys have historically been described as an agent of their client. 0 9 Where an agent is bound to act solely for the benefit of his principal, and not for the benefit of himself, that income generated by the agent is properly characterized as income to the principal."l 0 Logically, where the relationship is that of principal and agent, it cannot simultaneously be classified as a joint business undertaking."' Actually, all fifty states have adopted some form of the American Bar Association's Model Rules of Professional Conduct, Rule 5.4(b), which provides that a "lawyer shall not form a partnership with a nonlawyer if any of the activities of the partnership consist of the practice of law." ' 1 2 Clearly, a partnership between an attorney and
Oral Argument of Philip N. Jones on Behalf of Respondent Banaitis, Banks (No. 03-0892) ("Our
first choice, our preference for this Court to rule is-is not the partnership or joint venture theory. Our first choice is for this Court to simply look at the application of the assignment of income doctrine and ask it-if it is being misapplied"). See Gregg D. Polsky; Contingent Fees: Why the PartnershipTheory Doesn't Work, 104 TAx NOTES 1089 (2004), 2004 LEXIS TNT 174-39. 108 Comm'r v. Banks, 125 S. Ct. 826, 832 (2005). 109 Id. at 832-33; RESTATEMENT (SECOND) OF AGENCY § 1 cmt. E (1957) ("Thus, the attorney-at-law . . . and other similar persons employed either for a single transaction or for a series of ). See NAACP v. Button, 371 U.S. 415, 460-61' (1963) ('The transactions, are agents .... ) relation of attorney and client is that of master. and servant in a limited and dignified sense .... (quoting In re Co-operative Law Co., 92 N.E. 15, 16 (N.Y. 1910)). "0 Banks, 125 S. Ct. at 832-33 (citing RESTATEMENT (SECOND) OF AGENCY §§ 13, 39, 387 (1957)). 111 Reply Brief for the Petitioner at 4, Banks (No. 03-0892), Banaitis (No. 03-0907). (2003) available at R. 5.4(b) OF PROF'L CONDUCT 112 MODEL RULES http://www.abanet.org/cpr/mrp/rule-5-4.html (last visited June 29, 2005). See ALA. R. PROF'L CONDUCT R. 5.4(b) (2004); ALASKA R. PROF'L CONDUCT R. 5.4(b) (2004); ARiz. R. PROF'L
CONDUCT ER 5.4(b) (2004); ARK. MODEL R. PROF'L CONDUCT R. 5.4(b) (2004); CAL. BAR. R. PROF'L CONDUCT R. 1.310 (2004); COLO. R. PROF'L CONDUCT R. 5.4(b) (2004); CONN. R. PROF'L
5.4(b) (2004); DEL. LAWS R. PROF'L CONDUCT R. 5.4(b) (2004); FLA. BAR REG. R. 45.4(c) (2005); GA. R. & REGS. ST. BAR 4-102(d), R. 5.4(b) (2004); HAw. PROF'L CONDUCT R. 5.4(b) (2004); IDAHO R. PROF'L CONDUCT R. 5.4(b) (2004); ILL. SUP. CT. R. PROF'L CONDUCT, R 5.4(b) (2004); BuRNS IND. R. PROF'L CONDUCT R 5.4 (2005); IOWA CODE OF PROF'L RESPONSIBILITY DR 3-103 (2003); KAN. R. PROF'L CONDUCT R. 5.4 (2003); KY. SUP. CT. R. 3.130, R. 5.4(b) (2004); LA. R. OF PROF'L CONDUCT 5.4(b) (2004); ME. R BAR 3.12(c) (2003); MD. R. PROF'L CONDUCT 5.4(b) (2004); ANN. L. MASS. SUP. JUD. CT. R. 3:07, R. PROF'L CONDUCT R. 5.4(B) (2004); MICH. R. PROF'L CONDUCT R. 5.4(b) (2004); MINN. R. PROF'L CONDUCT R. 5.4(b) (2003); Miss. R. PROF'L CONDUCT R. 5.4(b) (2005); MO. SUP. CT. R. 4-5.4(b) (2004); MONT. PROF'L CONDUCT R. 5.4(b) (2003); NEB. CT. R., CODE PROF'L RESPONSIBILITY DR 3-103 (2004); NEV. SUP. CT. R. 188.2 (2004); N.H. R. OF PROF'L CONDUCT R. 5.4(b) (2004); N.J. R. PROF'L CONDUCT R. 5.4(b) (2004); N.M. R. PROF'L CONDUCT 16-504(B) (2004); N.Y. CODE PROF'L RESPONSIBILITY DR 3-103 (2004);
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his client cannot exist for federal tax law purposes where state law precludes such an entity. In addition, consistent with the principle that federal, not state law, should apply to federal income tax issues, the Court further refused to acknowledge that under state attorney lien law an attorney holds an "ownership" interest in their fees, thus taking the contingent attorney fee arrangement out of the doctrine of anticipatory assignment of income and placing it under the taxation principles of a partnership. 2. The Partnership Requirement of a Reciprocal Fiduciary Duty Reasons other than that of the principal-agent relationship as discussed by the Court exist to support the conclusion that an attorney and client cannot form a partnership under a contingent fee agreement. For example, a contingent fee agreement cannot be a partnership unless each co-partner acts in a reciprocal fiduciary duty to each and every other partner.' 4 Were a contingent fee agreement between an attorney and his client to be classified as a partnership, the client must then owe some fiduciary duty to the attorney. This cannot be so, as the only duty a client owes to his attorney is merely contractual, in the form of payment of fees115 In addition, consider the possible ramifications of allowing a client to be an attorney's co-partner. A client, faced with an outcome in litigation that was not to his liking, could potentially sue his attorney under a breach of fiduciary theory. As state tort law provides dissatisfied clients with a remedy against attorneys for negligence, certainly courts should not venture into the vague arena of corporate law to address the issue of practitioner malpractice.
N.C. PROF'L CONDUCT R. 5.4(b) (2004); N.D. R. PROF'L CONDUCT R. 5.4(b) (2004); OHIO CODE PROF'L RESPONSIBILITY DR 3-103 (2004); 5 OKLA. ST. CHAP. 1, APPx. 3-A, R. 5.4(b) (2004); OR.
CODE PROF'L RESPONSIBILITY R. 5.4(b) (2004); PA. R. PROF'L CONDUCT R. 5.4(b) (2004); RI Sup. CT. ART. V, R. 5.4(b) (2004); S.C. APP. CT. R. 5.4(b) (2004); S.D. R. PROF'L CONDUCT R. 5.4(b) (2003); TENN. SuP. CT. R. 8, CANON 5.4(b) (2004); TEx. R. PROF'L CONDUCT R. 5.04(b) (2004); UTAH CODE JuD. ADmiN. R. 5.4(b) (2004); VT. R. PROF'L CONDUCT R. 5.4(b) (2004); VA. SUP. CT. R. PT. 6, SEC. II, R. 5.4(b) (2004); WASH. R. PROF'L CONDUCT R. 5.4(b) (2004); W. VA. R. PROF'L CONDUCT R. 5.4(b) (2004); WIS. SUP. CT. R. 20:5.4(b) (2004); Wyo. R. PROF'L CONDUCT R. 5.4(b) (2003).
113 Banks, 125 S. Ct. at 833. 114 UNIF. P'SHtIP ACT § 21(a)
(2003) ("Every partner must account to the partnership for any benefit, and hold as trustee for it any profits derived by him without the consent of the other partners from any transaction connected with the formation, conduct, or liquidation of the partnership or from any use by him of its property."). See generally Meinhard v. Salmon, 164 N.E. 545 (N.Y. 1928).
115See RESTATEMENT (THIRD) OF THE LAW GOVERNING LAWYERS § 17 (2000). "The duties of
clients to lawyers are less extensive than those of lawyers to clients. Lawyers owe special duties because clients entrust them with important and sensitive matters, and because the legal system requires diligent and devoted performance of that trust." Id. § 17 cmt. a.
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3. Application of Section 83 to the Attorney-Client Partnership Results in Taxation of the Full Award or Settlement Finally, if the contingent fee arrangement could be considered a partnership under Subchapter K, allowing a plaintiff to effectively transfer an interest in the underlying cause of action to his attorney in exchange for professional services, the plaintiff would not be able to escape tax liability for that portion attributable to the attorneys' fees.' 1 6 Section 83 of the Internal Revenue Code, covering transfers of property with respect to the performance of services, would apply, 7 resulting in taxable income to the client of an amount equal to the full award." The Tax Court decision of McDougal v. Commissioner"8 effectively illustrates the impact of section 83 on the attorney-client contingent fee arrangement." 19 In McDougal, the taxpayer, a racehorse owner, created an agreement with his trainer whereby the taxpayer transferred to the trainer a 50 percent capital interest in the horse in exchange for his prior training services. 20 Addressing the issue of whether McDougal realized a gain on his capital contribution (the horse), the court held that the parties had created a partnership and that the transaction constituted a two step process. 2 In the first step, where McDougal transferred an undivided interest in the horse to the trainer in exchange for his prior services, the court concluded that McDougal "realized a gain to the extent the value of the horse exceeded its basis, as well as a deduction equal to the horse's value.' 22 In the second step, each party then transferred their undivided interest in the horse in exchange for a partnership interest, resulting in an additional gain to the racehorse owner upon distribution of profits. 23 Just like the racehorse owner in McDougal, if a plaintiff who enters into a contingent fee agreement with his attorney for his services creates a partnership, the plaintiff recognizes a gain equal to that of the attorneys' interests under the agreement at the resolution of the case.124 When the case is settled, the plaintiff has an additional gain equal to that amount remaining after distribution to the attorney. 25 The end result is the same as the Supreme Court's ruling: a taxpayer must include in gross income 26 those amounts paid to an attorney under a contingent fee basis. 1
116 See supra note 107; Brief of Amici Curiae Professor Gregg D. Polsky and Professor Brant J.
Hellwig in Support of Petitioner, Banks (No. 03-0892). ... I.R.C. § 83 (2004); see supra note 107. 18 McDougal v. Comm'r, 62 T.C. 720 (1974). 119 See supra note 107 (assuming that unless a plaintiff's claim has no value at the time of the contingent fee agreement, an attorney's interest is characterized as a capital interest, and is properly subject to section 83). 20 McDougal, 62 T.C. at 721-22. 121See supra note 107. 22 1 See McDougal, 62 T.C. at 727. 123 McDougal, 62 T.C. at 725-26. 124 See Polsky, supra note 107, for a detailed illustration of the McDougal analysis with respect to a contingent fee agreement. 25 1 id. 126 Comm'r v. Banks, 125 S. Ct. 826, 829 (2005).
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B. The Assignment of Income Doctrine Is Not Misapplied as to the Attorney-Client Contingent Fee Arrangement As an alternative to the partnership theory above, attorneys for the respondents and multiple amici curiae argued that the anticipatory assignment of income doctrine is misapplied as to the attorney-client contingent fee agreement.27 The Supreme Court disagreed, specifically rejecting the taxpayers' argument that because the plaintiff lacks the requisite dominion and control over the income and because of the speculative value of the interest at the moment of assignment, the doctrine is inapplicable. 28 The Court chose not to pass upon additional arguments put forth by the taxpayers in their briefs proposing that the anticipatory assignment of income doctrine is misapplied. 29 In addition, although the assignment of income doctrine is understood by many to be a judicially created anti-abuse rule, 130 the Court refused to question whether the doctrine is inapplicable in situations such as the contingent fee agreement where 3 no identifiable tax avoidance motive is present.1 ' Under the law then applicable, the Court probably made the proper conclusion, but left open the possibility for 132 further litigation on the tax treatment of contingent attorney fee agreements. 1. Requisite Control of the Income: Plaintiff's Legal Injury as the Source of the Income-Generating Asset Specifically, the Supreme Court relied on well settled precedent that the question of "dominion and control" under the assignment of income doctrine is not whether the taxpayer had control of the income at the moment of receipt, but whether taxpayer had adequate control over the income-generating asset.' 33 This "preserves the principle that income should be taxed to the party who earns the
Brief for the Respondent at 23-39, Banks (No. 03-0892); Brief for the Respondent at 21-30,
Banaitis (No. 03-0907). See, e.g., Brief of Amici Curiae Kenneth W. Gideon et al. in Support of Respondents at 6-11; Brief of Amicus Curiae Taxpayers Against Fraud Education Fund in Support of Respondents at 4-10; Brief of Amicus Curiae Association of Trial Lawyers of America in Support of Respondents at 17-20, Banks (No. 03-0892). 128 Banks, 125 S. Ct. at 831-32. 129 See Respondents' Brief at 23-39, Banks (No. 03-892) (proposing additional arguments that the assignment of income doctrine does not apply, including the lack of a family relationship between the assignor and assignee, the impact of double taxation, and a comparison of a fixed fee relationship to that of a contingent fee relationship); Respondents' Brief at 21-30, Banaitis (No. 030907) (arguing that the assignment of income doctrine is misapplied because the agreements were not between family members, the income was separated from the source of the income and that Congress could not have intended the resulting double taxation). 30 1 See Respondents' Brief at 28-30, Banks (No. 03-0892). 13 Banks, 125 S. Ct. at 831 ("The [assignment of income doctrine] is preventative and motivated by administrative [and] substantive concerns, so [this Court does] not inquire whether any particular assignment has a discernible tax avoidance purpose."). 132 Stratton, supra note 101, at 513. 133 Comm'r v. Banks, 125 S. 826, 831-32 (2005). Ct.
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income and enjoys the consequent benefits.' 34 In the context of a contingent fee agreement, the Court agreed with the Internal Revenue Service that "the source of the right to receive and enjoy the income"' 135 stems from the injury suffered which created the cause of action. 36 While it is true that the attorney controls a part of the cause of action, it is ultimately the plaintiff who retains the final disposition of the case (including his representation) and is the sole source of the right to that income under the assignment of income doctrine.' 3 7 As the source of the income, the Court concluded that the plaintiff retained sufficient control over the income for the assignment of income doctrine to apply, and the taxpayer is 138 liable for the full amount of the award. 2. The Speculative Value of the Plaintiff's Claim Does Not Limit the Applicability of the Assignment of Income Doctrine In their briefs, respondents urged that because the value of the plaintiff's claim was speculative and not relatively certain to be earned, it was not income 1 39 to the taxpayer but "simply amounted to an intangible, contingent expectancy.', However, the Court had a much different view, stating that "the anticipatory assignment doctrine is not limited to instances when the precise dollar value of 0 the assigned income is known in advance."' 14 Taking note that in Horst,14' a principal assignment of income case where the assignment involved a specified sum, the Court pointed out that a ruling that the assignment of income doctrine applies is not dependent on identifiable value at the time of the assignment. 142
134 Id. at 832. 135 Comm'r v. Sunnen,
125 S. Ct. at 832 ("In the case of a litigation recovery the income-generating asset is the
333 U.S. 591, 604 (1948).
cause of action that derives from the plaintiffs legal injury."). See also Reply Brief for Petitioner at 9-11, Banks (No. 03-0892). 13' Banks, 125 S. Ct. at 832-33 ("[T]he attorney can make tactical decisions without consulting the client, [but the client] still must determine whether to settle or proceed to judgment and make, as well, other critical decisions."). See Raymond v. United States, 355 F.3d 107, 116 (2d Cir. 2004) ("[T]he taxpayer controlled the source of the income.... He could have fired his attorney. He could have dropped the case. He, and only he, had the power to authorize a settlement of the claim."). 13'Banks, 125 S. Ct. at 832-33. 139 Brief for the Respondent at 24, Banaitis, (No. 03-0907) (quoting Estate of Clarks v. United States, 202 F.3d 854, 857 (6th Cir. 2000)).
140 Banks, 125 S. Ct. at 832. 14 Helvering v. Horst, 311 U.S. 112 (1940)
125 S. Ct. at 832 ("That the amount of income the asset would produce was uncertain at the moment of assignment is of no consequence."). The court made clear that in both situations, those where the value is identifiable and those where the value is speculative, "the taxpayer retained control over the income-generating asset, diverted some of the income produced to another party, and realized a benefit by doing so." Id.
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As suggested by the respondents, however, this conclusion can be contradicted by the Commissioner himself in a recent private letter ruling. 143 In that ruling, where an assigned claim is doubtful or contingent at the time of assignment and the assignment of the claim has a legitimate business purpose, then, so long as the assignment was not gratuitous or made prior to the tax year 44 the income was received, the assignment of income doctrine does not apply.' Unfortunately for the respondents, although private letter rulings have been cited by the Court to show inconsistencies of treatment by the Commissioner or that 45 the Commissioner has accepted the position advanced in similar situations,1 private letter rulings may not be cited as precedent. 146 Thus, the private letter ruling provides no assistance to the taxpayer in his argument that the assignment of income doctrine does not apply to the attorney-client contingent fee arrangement. n fact, the Court did not address the substance of the private letter or ruling in its opinion147 multiple other arguments supporting exclusion of the fees from gross income. 3. Left Stranded: The High Court Fails to Discuss Alternative Theories of Relief In its opinion, although the Supreme Court recognized the impact of the AMT on taxpayers such as the respondent, 48 they gave little or no discussion to alternative theories of relief offered by the taxpayers showing the distinction between the contingent attorney fee arrangement and previous assignment of income cases. 49 Particularly, the opinion summarily dismisses in one sentence the argument that the contingent attorney fee arrangement lacks any tax avoidance motive under the assignment of income doctrine: "[This] rule is preventative and motivated by administrative as well as substantive concerns, so we do not inquire whether any particular assignment has a discernible tax avoidance purpose." "0 Although the taxpayers are correct that the assignment of
Priv. Ltr. Rul. 200427009 (July 2, 2004), available at 2004 PLR LEXIS 342.
'44 Id. at *7-11 (In this ruling, a personal injury defendant was allowed to exclude from income amounts assigned to the personal injury plaintiff-a portion of defendant's interest in a claim against the defendant's insurer- in return for the personal injury plaintiff's agreement to forgo his remedies against the defendant.) (citing Jones v. Comm'r, 306 F.2d 292 (5th Cir. 1962) and Schulze v. Comm'r, T.C. Memo 1983-263). See Respondents' Brief at 31-41, Banks (No. 03-0892). 145 Respondents' Brief at 26 n.1, Banaitis (No. 03-0907); see Rowan Cos., Inc. v. U.S., 452 U.S. 247, 261 (1981); Hanover Bank v. Comm'r, 369 U.S. 672, 686 (1962). 146 26 U.S.C. § 61 10(k)(3) (2005). 147 Stratton, supra note 101, at 511-12. 148 Comm'r v. Banks, 125 S. 826, 830 (2005) ("For the tax years in question the legal expenses Ct. in these cases could have been taken as miscellaneous itemized deductions subject to the ordinary requirements, but doing so would have been of no help to respondents because of the operation of the [AMT].") (internal citations omitted). 149 Stratton, supra note 101, at 512. ISo Banks, 125 S. Ct. at 831. HeinOnline -- 74 UMKC L. Rev. 257 2005-2006
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income doctrine is understood to address tax motivated transfers, 5 ' at oral argument the Court correctly pointed out that the rule was not originatedas an anti-abuse rule since no income tax existed at its adoption. 52 The Court took the view as originated in Lucas, "no distinction can be taken according to the motives leading to the arrangement by which the fruits are attributed to a ' 53 different tree from that on which they grew."' As with the Court's view on the speculative value of plaintiff's cause of action,' 54 the Court's decision that the motivation of the taxpayer is irrelevant is inconsistent with one of the Commissioner's recent private letter rulings.' 55 That ruling, allowing exclusion of proceeds from a claim of litigation transferred to156 ' a third party, is based partly on the presence of a "genuine business purpose." Clearly the contingent attorney fee arrangement could be characterized as possessing some business purpose and should bear some weight in the determination of the tax treatment of the fees.1 57 "As the Commissioner recognized in his own ruling, the taxpayer's motivation is a58significant factor in determining whether a transfer is an assignment of income."' The Supreme Court also fails to address the distinction that previous assignment of income cases involve gratuitous transfers and that the contingent fee arrangement does not. 9 The respondents characterized the contingent attorney fee arrangement as "a commercial, arms-length transaction pursuant to 0 which both parties provided valuable consideration."' 6 Multiple other amici curiaebriefs pointed out that the assignments of income under the contingent fee arrangement were not gratuitous, but rather bargained for transactions, and that
151 Brief for the Respondent at 28-30, Banks (No. 03-0892) ("The assignment of income doctrine developed as, and is universally understood to be, a judicial doctrine crafted for the purpose of preventing taxpayers from planning ploys designed to defeat the progressive tax system."). Id. at 28. 152 Oral Argument of James R. Carty on Behalf of Respondent Banks, Banks (No. 03-0892) ("It[the assignment of income doctrine] originated in a case where there could not possibly have been an-an intent to abuse because the-the transfer had occurred before there was any income tax.") (quoting Justice Antonin Scalia); Oral Argument of Philip N. Jones on Behalf of Respondent Banaitis, Banks (No. 03-0892) ("So--so our holding could hardly be based upon-upon the existence of an avoidance motive.") (quoting Justice Scalia). 113 Banks, 125 S. Ct. at 831 (quoting Lucas v. Earl, 281 U.S. 111, 115 (1930)). 154 See discussion supra Part III.B.2. 155 Priv. Ltr. Rul. 200427009 (Mar. 19, 2004), available at 2004 PLR LEXIS 342. See Respondents' Brief at 28-30, Banks (No. 03-0892). 5 1 6 Priv. Ltr. Rul.200427009 (July 2, 2004), available at 2004 PLR LEXIS 342, at **10, 12. 17 Respondents' Brief at 30, Banks (No. 03-0892). As discussed supra Part III.B.2, private letter rulings have no weight as precedent. 158 Respondents' Brief at 30, Banks (No. 03-0892). 159 Stratton, supra note 101, at 512 ("It is unfortunate that the Court did not address the argument that all previous assignment of income cases decided by the Supreme Court had involved gratuitous transfers, and this case did not. ) (as observed by Philip Jones, counsel for Respondent Banaitis). 160 Brief for the Respondent at 22, Banaitis (2004) (No. 03-0907).
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each party should be taxed on the respective shares they earned. 161 Under Charles Davenport's theory, the assignment for consideration in a contingent fee agreement is a "vertical slice" of the income, whereas a gratuitous assignment is more likely a "carved out" assignment of an interest, subject to the assignment of income doctrine. 62 Davenport agreed that "[t]he Court will be sorry for having adopted rules that app to gratuitous transactions in what are essentially commercial situations."' ° The rule created by the Court remains unfair and unjust to contingent attorney fee plaintiffs who are not eligible for exclusion under Jobs Creation Act, and will probably be met with further litigation and 16 congressional activity to address the issue. IV. A SOLUTION TO THE CONTINUING CONTINGENT FEE ISSUE: 165 LEGAL FEES AS TRANSACTION COSTS The decision in Banks settled the split among the circuits, putting an end to any forum shopping due for exclusionary treatment of fees paid pursuant to a contingent fee arrangement.' 66 While the Supreme Court noted that the Jobs Creation Act now affords relief to cases involving unlawful discrimination analogous to those of both Banks and Banaitis, 67 the contingent fee tax issue still remains due to gaps in the legislation. 68 Some non-physical personal injur19 plaintiffs do not fall within the definition of "unlawful discrimination. Examples include invasion of privacy, defamation, and negligent and intentional infliction of emotional distress cases. The effect on those plaintiffs is the same unfair treatment afforded to Banks and Banaitis, sometimes resulting in taxation at an effective rate which exceeds 100 percent. 17' As Justice Sandra Day O'Connor clearly acknowledged, "[T]his is an appalling situation.' 72 Litigation regarding the tax treatment of contingent
Brief of Amicus Curiae Professor Charles Davenport in Support of Respondents at 13-15,
Banks (No. 03-0892); Brief of Amici Curiae of the Lawyers' Committee for Civil Rights Under Law et al. at 7-11, Banks (No. 03-0892); Brief of Amici Curiae the Association of Trial Lawyers of America in Support of Respondents at 18-19, Banks (No. 03-0892). 162 Davenport Brief at 13-15, n.21, Banks (No 03-0892). Compare Hort v. Comm'r, 313 U.S. 28 (1941), and Comm'r v. P.G. Lake, Inc., 356 U.S. 260 (1958) (for an example of a "carved-out" interest), with Blair v. Comm'r, 300 U.S. 5 (1937) (for an example of a "vertical slice" interest). 163 Stratton, supra note 101, at 512.
Davenport Brief at 4-13, Banks (No 03-0892). Comm'r v. Banks, 125 S.Ct. 826 (2005). 167 Id. at 831 ("Had the Act been in force for the transactions now under review, these cases likely would not have arisen. The Act is not retroactive, however, so while it may cover future taxpayers in respondents' position, it does not pertain here."). 168 Wood, supra note 18, at 962-63. 169 id. 170 Id. 171Id. 172 Oral Argument of David B. Salmons on Behalf of the Petitioner, Banks (No. 03-0892).
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fee agreements will most likely continue, despite the new legislation and the Supreme Court's decision in Banks.173 "[T]he proper result is to go to Congress," and devise legislation which provides full and complete relief to4 the taxpayers 17 confronted with the contingent fee tax issue created by the AMT. Clearly, Congress could embrace the contingent fee tax issue and amend the provisions of the AMT, either by phasing out the tax altogether, allowing miscellaneous itemized deductions under the tax, or indexing the tax for inflation. 175 This action is unlikely, as Congress has eliminated a great majority of the injustice through the Jobs Creation Act. 176 Congress could also expand the scope of cases allowed exclusion under section 61(a)(19) to include all nonphysical personal injury plaintiffs affected by the AMT tax trap. This too would provide complete relief and equal treatment of taxpayers. But Congress should take note of the alternative solution proposed by Charles Davenport as amicus curiae in support of respondents, suggesting that the contingent fee arrangement should be treated as a transaction cost under the Code, not a deduction. 77 This theory was discussed during oral arguments for the consolidated cases of Banks and Banaitis178 as well as mentioned in the opinion, 179 but was ultimately denied consideration as a "novel proposition of law with broad implications for the tax system that were not advanced in earlier stages of the litigation."' 80 The Court simply stated, "We decline comment on these supplementary theories.'' Perhaps the Court was suggesting a possible solution to future taxpayers affected by the contingent fee tax issue. In his theory, Davenport, a professor of law at Rutgers University, proposes that the legal fees are excludable from gross income as transaction costs, or capital expenditures, incurred in the future disposition of property.' 82 Under current tax law, "[i]f the transaction costs are related to the disposition of property, they are subtracted from the proceeds of the disposition with only the
Wood, supra note 18, at 964. Oral Argument of David B. Salmons on Behalf of the Petitioner, Banks (No. 03-0892). For a discussion of alternative solutions through amendment to the AMT provisions, see Aaron
C. Charrier, Note, Taxing Contingency Fees: Examining the Alternative Minimum Tax and Common Law Tax Principles, 50 DRAKE L. REv. 315, 354-56 (2002). 176 See Wood, supra note 18, at 961 ("[E]mployment cases have served as the poster child of inequity."). 177 Brief for Amicus Curiae Professor Charles Davenport in Support of Respondents at 3-10, Banks (No 03-0892). See Robert W. Wood, Davenport's Solution for the Attorney's Fees Mess: A Capital Idea, 97 TAX NoTEs 969 (Nov. 18, 2002), available at 2002 LEXIS TNT 223-60; Deborah A. Geier, Attorney's Fees: Davenport Has the Right Idea, 97 TAx NoTEs 1627 (Dec. 23, 2002), available at 2002 LEXIS TNT 247-26. 178 Oral Argument of David B. Salmons on Behalf of the Petitioner, Banks (No. 03-0892); Oral Argument of Philip N. Jones on Behalf of Respondent Banaitis, Banks (No. 03-0892). 179 Comm'r v. Banks, 125 S.Ct. 826, 833 (2005). 180 Id.
181Id. 182 Davenport
Brief at 3-10, Banks (No. 03-0892); accord Charles Davenport, Why Tort Legal Fees
Are Not Deductible, 97 TAx NoTEs 703 (2002).
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remaining amount being realized as income"' 183 or "are first added to basis and then subtracted as basis from the proceeds to reach the amount of income to be reported by the taxpayer."' 184 Either way the result is the same: if a taxpayer acquires a piece of real estate and incurs legal fees in connection with that acquisition, the amount of those fees is added to the taxpayer's basis and never recognized by the plaintiff taxpayer as income. 185 Thus, assuming that tort claims are properly recognized as property 186 and that the legal fees qualify as a transaction cost under the Code, 8 7 a taxpayer would be able to subtract from the litigation proceeds the amount of the fees paid pursuant to the contingent fee agreement. 8 8 But for the fact that disposition of personal injury cases results in ordinary income, not capital gains as produced in the disposition of property,' 89 Davenport's transactional cost theory provides a logical solution to the confusing tax fee issue which continues to affect taxpayers. V. CONCLUSION Although the Jobs Creation Act of 2004 creates a remedy to the contingent fee tax issue in cases of unlawful discrimination, the Supreme Court ruled in Banks that taxpayers whose cases were settled or reduced to judgment prior to effective date of the Act, remain subject to the unjust AMT tax trap and are not allowed to exclude from gross income amounts paid pursuant to a contingent fee agreement. In some cases, tax liability exceeded the amount beneficially received by the taxpayer. Thus, the disparity of tax treatment among taxpayers which existed in the circuit split based on varying degrees of state attorney lien law has been eliminated, but a new disparity has been created based on whether the case was disposed of before or after the enactment date of the Jobs Creation Act. Also, the Civil Rights Tax Relief provided by the Jobs Creation Act is incomplete; certain non-physical personal injuries fall outside the broad
183 Davenport Brief at 6, Banks (No. 03-0892) (citing Helvering v. Union Pac., 293 U.S. 282 (1934), reh 'g denied, 293 U.S. 630 (1934) and Spreckels v. Comm'r, 315 U.S. 626 (1942)). 184 Davenport Brief at 6 n.14, Banks (No. 03-0892). 185 Oral Argument of David B. Salmons on Behalf of the Petitioner, Banks (No. 03-0892). See 186 See Davenport Brief at 3-5, Banks (No. 03-0892). Davenport characterizes a tort cause of action as property, stating that the Court has held a tort cause of action may not be taken without compensation or due process. Id. (quoting Dames & Moore v. Regan, 453 U.S. 654 (1981) and N.Y.Cent. R.R. Co. v. White, 243 U.S. 188 (1916)). "Even wispier intangibles are readily accepted as property in the tax law." Id. at 4. 187 Davenport Brief at 9-10, Banks (No. 03-0892) ("These fees were costs. They are directly traceable to a discrete, recognizable transaction."). Davenport also assumes that since legal fees facilitated the disposition of the causes of action, they would qualify as acquisition costs under Treasury Regulation § 1.263(a)-4(e)(1) (2004), even though the cases involve a disposition of property, not an acquisition. Id. at 9, n. 15. 188 Davenport Brief at 9-10, Banks (No. 03-0892). 189 Brant J. Hellwig, Tax Treatment of Legal Fees: The Debate Continues, 97 TAX NOTES 1235, See 1235-36 (2002), available at 2002 LEXIS TNT 232-44 (stating that since recovery of litigation is regarded as ordinary income, it cannot therefore be property).
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definition of unlawful discrimination and do not qualify for exclusion. For those taxpayers, the fees paid are includible in gross income, and possibly subject to the AMT tax trap. It is time for Congress to provide taxpayers with whole relief by eliminating the double taxation that results from inclusion of attorneys' fees in gross income.
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