Taxation of Contingency Fees after Banks and Banaitis
8 Pages Posted: 2 Jan 2010
Date Written: November 30, 2009
In 2004 the U.S. Supreme Court granted certiorari on two cases regarding inclusion in income of contingent attorney’s fees, Commissioner v. Banks and Commissioner v. Banaitis. 1) The courts of appeals were split on the issue of inclusion and had resolved their cases based on numerous theories, ranging from exclusion, derived from interpreting state attorney’s lien statutes, to includability because of the assignment of income doctrine. Some of the decisions were influenced by the courts’ belief that taxpayers should be treated equally, whether paying their fees on an hourly basis or a contingency basis. In Banks, the Supreme Court appears to have settled the issue. The Court held, as a general rule, that when a litigant’s recovery constitutes income, the litigant’s income includes any portion of the recovery paid as a contingent attorney’s fee. 2) A contrary holding would violate the assignment of income doctrine. The Court also held that the income-producing asset is the cause of action. That seemingly innocuous answer has presumably done away with the long-held belief that the origin of the claim determined the nature of the income recovered from a lawsuit.
As noted, the Court held in Banks that the taxpayer was taxed on the entire amount of the recovery - including the amount of the attorney’s fees paid. However, the Court did not stop at including the income, but continued with two inconsistent statements. First, the Court stated that the taxpayer retained control of the income-producing asset - which was the cause of action - and therefore, it would be an assignment of income if he were not taxed on the entire amount. The Court, however, added a descriptive phrase stating that ‘‘the income producing asset is the cause of action derived from the plaintiff’s injury.’’ That statement is confusing because it could imply that the nature of the income is derived from the nature of the plaintiff’s injury. Unfortunately, there is no classification for this new type of asset, if it exists. With those two statements, it is possible that the Court unintentionally changed the nature of income derived from a lawsuit.
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