Nos. 03-892 and 03-907, Supreme Court of the United States (filed Aug. 18, 2004)

In an 8-0 decision on Jan. 24, 2005, the Supreme Court upheld the double taxation of recoveries in certain cases, ruling that "as a general rule, when a litigant's recovery constituted income [for tax purposes], the litigant's income includes the portion of the recovery paid to the attorney as a contingency fee."

The Center for Constitutional Litigation filed an amicus brief on behalf of AAJ in the Banks case. AAJ's brief was acknowledged in the Court's opinion as providing a novel and intriguing approach to the taxability of the contingency fee portion of the claimant's recovery.

Still, the Court declined to consider the approach because it had not been presented by the parties below. Last year, Congress fixed the problem with respect to civil rights cases, and the decision will have no effect on compensation in physical injury cases. In other cases, attorneys will need to consider the possible tax consequences during settlement discussions.

Amicus Brief: Opportunity for Future Challenge

AAJ's amicus brief argued that the exchange of a plaintiff's cause of action for money (in the form of a judgment or settlement) ought to be treated like the sale or exchange of stock or a house. In other words, the taxpayer realizes income on the net proceeds after subtracting the fee paid to the broker or real estate agent.

Several Justices expressed some interest in this theory during oral argument, including Justice Scalia who asked the government attorney why counsel fees shouldn’t be treated like the real estate agent’s contingency fee.

Although the Justices declined to adopt a theory that had not been explored by lower courts, the honorable mention may be viewed as an open invitation to the lower federal courts to consider such theories.

Civil Rights Cases Not Affected

Many attorneys are interested in the impact of the Banks decision on their clients. Plaintiffs in malpractice, product liability, and automobile cases will not be affected because the recovery is not income. The ruling does impact recoveries for nonphysical injuries, particularly in civil rights and employment discrimination claims, which the IRS treats as income.

Last year Congress addressed this problem in the Civil Rights Tax Relief Act, which allows an above-the-line deduction for attorney fees in discrimination cases. The kinds of cases this applies to are listed in the statute and include:

Where Banks Applies

This ruling makes a difference in nonphysical injury, non civil rights cases. For example:

The decision will also affect recoveries of punitive damages, which the tax code treats as income even in personal injury actions. The IRS has previously disputed taxpayers’ allocation between compensatory and punitive damages. AAJ expects the Commissioner to go after plaintiffs who have won punitive damages to require them to make an allocation of the amount of the attorney’s fee that should be attributed to the punitive portion of the recovery.

Conclusions

In sum, the Banks decision will have little impact on most trial lawyers. Although the reported decisions have almost all involved attorney fees in employment discrimination cases, attorneys bringing economic loss cases should expect that the IRS will insist that the client include the attorney’s contingency fee as income. Those attorneys with punitive damage claims may seek to attribute attorney fees to the recovery of nontaxable compensatory damages, but should anticipate that the IRS may challenge that allocation.

AAJ's Amicus Curiae Brief: Commissioner of Internal Revenue v. Banks and Commissioner of Internal Revenue v. Banaitis