Contingent Attorney Fee Is Income to Client
In today's litigious society, many class action lawsuits have contingent attorney fee arrangements. Although the reasons for the lawsuits differ--age discrimination, wrongful termination and the like--the tax issue is the same. Contingent fees are paid directly out of a taxpayer's judgment or settlement award. The IRS position is that the full amount of the award is includable in the taxpayer's gross income under IRC section 61 and legal fees are potential itemized deductions under IRC section 67. The courts are split on whether taxpayers should include contingent fees paid directly to attorneys in gross income. The difference between including the fees and taking them as an itemized deduction or excluding them may be significant because of the 2% floor on miscellaneous itemized deductions, the deduction phase-out for high income taxpayers and the disallowance of miscellaneous itemized deductions for alternative minimum tax purposes. James Sinyard, a division manager in the Mobile, Alabama, office of IDS Financial Services, Inc., was forced to resign in 1987 at age 49. Sinyard, along with 31 others, joined two class action lawsuits against IDS for age discrimination in violation of the Age Discrimination in Employment Act of 1967 (ADEA). The plaintiffs entered into a contingent fee arrangement with Winthrop & Weinstine that allocated one-third of any settlement or jury award to cover attorneys' fees. In 1992 IDS agreed to settle for $35 million, one-third of which went to the plaintiffs' lost wages, one-third to tort damages and one-third to attorneys' fees. On their 1992 joint federal income tax return, the Sinyards excluded from gross income the portion of the settlement ($252,608) attributable to attorneys' fees. Upon examination the IRS determined the fees were gross income to the Sinyards and deductible as a miscellaneous itemized deduction. The Sinyards petitioned the Tax Court. It agreed with the IRS that the contingent fees were gross income. Because the Sinyards would not fully benefit from the deduction due to the 2% floor and their exposure to the AMT, they turned to the Ninth Circuit Court of Appeals for help. Result. For the IRS. The Ninth Circuit, affirming the Tax Court, held the contingent fees were includable in the Sinyards' gross income and deductible only as a miscellaneous itemized deduction. The court determined the Sinyards were in constructive receipt of the money paid to Winthrop & Weinstine. …