Contingency Agreement Attorney Fees Paid in Settlement Are Taxable as Gross Income of the Client Regardless of State Law

Employees ?in ?two ?consolidated ?cases ?from? the Sixth and Ninth Circuits settled discrimination lawsuits for substantial damages and payment of their attorney fees in accordance with contingent fee agreements.?? The IRS took the position that the? attorneys?? fees? paid? were? taxable? to? the clients as ?gross income,? which because of the alternative minimum tax would be quite significant.?? Both courts of appeals rejected the IRS ?argument.???? A ?unanimous ?U.S. ?Supreme Court reversed (8-0), holding that the fee agreements amount to an anticipatory assignment to the attorney of a portion of the clients? income from any litigation recovery.?? ?In litigation recovery, the income-generating asset is the legal claim.?? The plaintiff retains dominion over this asset throughout the litigation; the relationship with the attorney is quintessential principal-agent so ?it is appropriate to treat the full recovery amount as income to the principal.? ?This is true ?regardless? of ?whether ?the ?attorney-client contract or state law confers any special rights or protections on the attorney, so long as such protections do not alter the relationship?s fundamental principal-agent character.?? ?The Court declined to address the contention that the anticipatory assignment principle is inconsistent with the purpose of statutory fee-shifting provisions, such as 42 U.S.C. ? 1988, because the attorneys? fees were calculated based solely on the contingent-fee contract pursuant to settlement.?? ?Importantly,? the? Court? noted? that ?the American Jobs Creation Act redresses the concern? for? many,? perhaps? most,? claims governed by fee-shifting statutes.? ?Likewise, the Court did not consider other tax theories raised for the first time on appeal including that the contract establishes a Subchapter K partnership or ?that ?the ?fees ?are ?deductible ?as ?a ?capital ?or business expense. Comm?r of IRS v. Banks, Nos. 03-892 and 03-907 (J. Kennedy; C.J. Rehnquist not participating; 01/24/05).