A. Background
Generally, each party to a lawsuit in the United States bears their own legal fees and costs including attorney’s fees. However, there are exceptions to this “American Rule.” For example, numerous federal and state statutes authorize courts to award legal fees and expenses to a party in certain instances, which are often referred to as “fee-shifting statutes.” See, e.g. 42 U.S.C. § 3613(c)(2) (Fair Housing Act); 29 U.S.C. § 216(b) (Fair Labor Standards Act); 29 U.S.C. § 626(b) (ADEA); see also Tex. Civ. & Rem. Code § 38.001 (permitting award of attorney’s fees if claim relates to, among other things, services rendered, furnished material, sworn accounts, and oral and written contracts).
Although fee-shifting statutes are nothing new, it may surprise you to learn that the federal tax consequences of these awards are not so clear. In 2005, the Supreme Court concluded that a plaintiff’s taxable income includes the portion of any recovery paid to the plaintiff’s attorney as a contingency fee to the extent that the recovery itself is taxable. See Commissioner v. Banks, 543 U.S. 426 (2005). But the Supreme Court in Banks specifically declined to address the issue of whether awards of attorney’s fees under a fee-shifting statute should share the same federal tax treatment.
Prior to the passage of the Tax Cuts and Jobs Act of 2017 (TCJA), the issue of taxability may not have mattered much to many plaintiffs. This was so because generally plaintiffs could claim offsetting deductions for their legal fees as miscellaneous itemized deductions, provided they also passed the additional hurdles of the Alternative Minimum Tax (AMT) limitations. Because the TCJA now disallows miscellaneous itemized deductions for tax years 2018 through 2025, however, the tax treatment of awards under fee-shifting statutes has taken on renewed interest.
This article discusses the Banks decision and the relevant federal tax authorities regarding the taxability of fee-shifting statutes. This article also offers some thoughts into potentially mitigating the adverse tax effects of fee-shifting statute awards.
B. Commissioner v. Banks
Before 2005, there was a split amongst the circuit courts on the issue of whether a plaintiff was required to include in gross income the portion of the recovery paid to the plaintiff’s attorney as a contingency fee. See Cotnam v. Commissioner, 263 F.2d 119 (5th Cir. 1959) (contingency fee portion of recovery not includible in the plaintiff’s gross income) with Raymond v. United States, 355 F.3d 107 (2d Cir. 2004) (entire recovery, including portion paid to an attorney as a contingency fee, income to the plaintiff). In 2005, the Supreme Court sought to resolve the circuit conflict by granting certiorari in the consolidated cases of Commissioner v. Banks and Commissioner v. Banaitis.
In the consolidated cases, Mr. Banks had sued his former employer in federal district court for violations of federal employment discrimination laws. Similarly, Mr. Banaitis had sued his former employer in state court for, among other things, interference with his employment contract. In both cases, the parties had hired attorneys to represent them on a contingency fee basis. Moreover, both argued that the contingency fees paid to their attorneys should not be includible in their gross income.
To fully understand the decision of Banks, it is important to first step back and analyze Mr. Banks and Mr. Banaitis’ motivations in contesting the IRS’ determinations. First, neither Mr. Banks nor Mr. Banaitis were able to deduct their legal fees as miscellaneous itemized deductions due to the limitations of the AMT. Second, although Congress had recently passed legislation aimed at permitting above-the-line deductions for certain types of legal expenses, see The American Jobs Creation Act of 2004, such legislation was not helpful to either Mr. Banks or Mr. Banaitis due to the legislation’s effective date. Thus, Mr. Banks and Mr. Banaitis were confronted with the unfortunate (and perhaps unfair) tax position of: (1) having to include in their gross incomes all of their damage recoveries, and (2) not being able to deduct any portion of their legal fees.
Notwithstanding this seemingly sympathetic set of facts, the Supreme Court held that the portion of Mr. Banks and Mr. Banaitis’ recoveries allocable to the contingency fees represented taxable income for federal income tax purposes. The Supreme Court reasoned that, as a general rule, federal tax law precluded taxpayers from making an anticipatory assignment of their income to other persons. Under this assignment of income doctrine, income and gains are “taxed to those who earned them . . . [which] is the first principle of income taxation.” Because Mr. Banks and Mr. Banaitis had dominion and control over their respective causes of action, i.e., their lawsuits, the Supreme Court held that each was required to include in their gross incomes the portion of their recoveries paid to their attorneys as contingency fees.
During the proceedings, Mr. Banks had raised an additional argument for why his legal fees should not be includible in his gross income. More specifically, he argued that he had filed a lawsuit under a federal statute permitting an award of attorney’s fees and that, under such circumstances, it would be anomalous for the Court to hold that his legal fees were includible in his gross income. Mr. Banks’ argument and the Court’s response follows:
Banks’ case, however, involves a further consideration. Banks brought his claims under federal statutes that authorize fee awards to prevailing plaintiffs’ attorneys. He contends that application of the anticipatory assignment principle would be inconsistent with the purpose of statutory fee-shifting provisions. See Venegas v. Mitchell, 495 U.S. 82, 86 (1990) (observing that statutory fees enable plaintiffs to employ reasonably competent lawyers without cost to themselves if they prevail). In the federal system statutory fees are typically awarded by the court under the lodestar approach, Hensley v. Eckerhart, 461 U.S. 424, 433 (1983), and the plaintiff usually has little control over the amount awarded. Sometimes, as when the plaintiff seeks only injunctive relief, or when the statute caps plaintiffs’ recoveries, or when for other reasons damages are substantially less than attorney’s fees, court-awarded attorney’s fees can exceed a plaintiff’s monetary recovery. See, e.g., Riverside v. Rivera, 477 U.S. 561, 564-565 (1986) (compensatory and punitive damages of $33,350; attorney’s fee award of $245,456.25). Treating the fee award as income to the plaintiff in such cases, it is argued, can lead to the perverse result that the plaintiff loses money by winning the suit. Furthermore, it is urged that treating statutory fee awards as income to plaintiffs would undermine the effectiveness of fee-shifting statutes in deputizing plaintiffs and their lawyers to act as private attorney generals.
We need not address these claims. After Banks settled his case, the fee paid to his attorney was calculated solely on the basis of the private contingent-fee contract. There was no court-ordered fee award, nor was there any indication in Banks’ contract with his attorney, or in the settlement agreement with the defendant, that the contingent fee paid to Banks’ attorney was in lieu of statutory fees Banks might otherwise have been entitled to recover. Also, the amendment added by the American Jobs Creation Act [of 2004] redresses the concern for many, perhaps most, claims governed by fee-shifting statutes.
Banks, 543 U.S. at 438-49. Thus, the Supreme Court declined to address the issue because Mr. Banks had not, in fact, been awarded attorney’s fees under a fee-shifting statute.
C. Additional Federal Tax Authority on the Taxability of Awards under Fee-Shifting Statutes
Since Banks, the Supreme Court has not revisited the issue of whether an award of attorney’s fees under a fee-shifting statute should be taxable to the plaintiff in all instances. However, the IRS and federal courts have addressed this issue, and these decisions are discussed more fully below.
- Sinyard v. Commissioner
Prior to the decision in Banks, the Tax Court had decided Sinyard v. Commissioner, T.C. Memo. 1998-364. In that case, Mr. Sinyard had filed a class action lawsuit against his former employer for violations of the ADEA. During the litigation, Mr. Sinyard entered into a contingency fee agreement with his attorney, which specified that: (1) the attorney would receive one-third of any recovery; and (2) in the event the court awarded Mr. Sinyard attorney’s fees, the award would be considered part of the recovery with Mr. Sinyard’s attorney receiving one-third and Mr. Sinyard receiving the remainder.
Mr. Sinyard settled his claims with a portion of the settlement payments being allocated to his attorney’s fees. Because the lawsuit was a class action suit, the court approved of the settlement terms. On his federal income tax return, Mr. Sinyard took the reporting position that the award of attorney’s fees was not taxable. The IRS disagreed, and Mr. Sinyard filed a petition with the United States Tax Court on this issue.
Mr. Sinyard lost at the Tax Court but appealed the decision to the Ninth Circuit Court of Appeals. See Sinyard v. Commissioner, 268 F.3d 756 (9th Cir. 2001). The Ninth Circuit affirmed the Tax Court’s decision over one dissent. The majority opinion concluded that the payment of attorney’s fees by the defendant in Mr. Sinyard’s case had relieved Mr. Sinyard of a contractual obligation to pay his attorney, resulting in taxable income. The majority further concluded that the award of attorney’s fees belonged to Mr. Sinyard under the fee-shifting statute because the statute authorized an award of fees to the prevailing plaintiff and not the lawyer. Because Mr. Sinyard could not claim an offsetting deduction for the legal fees under the AMT limitations, the Ninth Circuit recognized the potential unfairness of its decision. Specifically, it stated:
Without . . . [the AMT] limitation, the attorneys’ fees would be income to the Sinyards, and the income would be wiped out by deduction of the total received. It would be a wash. The anomalous result, no doubt unintended, arises when part of the deduction is blocked by the AMT. We do not think we can change the basic rules of income tax in order to correct this result.
The dissent strongly disagreed with the majority opinion. It reasoned that the award of attorney’s fees should not be taxable income to Mr. Sinyard because the purpose of the ADEA and the fee-shifting statute were to promote civil rights and to make the plaintiff whole again, both of which were thwarted by taxing the award.
- Vincent v. Commissioner
Vincent v. Commissioner, T.C. Memo. 2005-95, was decided only months after the Supreme Court issued its opinion in Banks. In Vincent, Ms. Vincent had filed a lawsuit against her former employer for violations of the California Fair Employment and Housing Act (CFEHA). During the litigation, Ms. Vincent and her attorney entered into a contingency fee agreement in which Ms. Vincent agreed to pay a percentage of the recovery to the attorney as compensation for legal services. However, the contingency fee agreement further provided that in the event attorney’s fees were awarded by the court, such award would constitute her attorney’s sole right to recovery pursuant to the agreement.
Ms. Vincent was eventually awarded $400,000 in damages and $184,350 of attorney’s fees under the CFEHA fee-shifting statute. After an appeal, the parties agreed to settle with Ms. Vincent receiving a lump sum of $510,000. Under the settlement agreement, the parties agreed to allocate $198,000 of the settlement payment to Ms. Vincent’s attorney’s fees. On her federal income tax return, Ms. Vincent took the position that her award of attorney’s fees was not taxable income. The IRS disagreed, and Ms. Vincent filed a petition with the United States Tax Court.
In holding for the IRS, the Tax Court noted that it was confronted “with the issue which the Court in Banks did not reach.” But the Tax Court reasoned that because Ms. Vincent’s case was appealable to the Ninth Circuit, it was “not without guidance” under Sinyard. Under Sinyard, the Tax Court found that Ms. Vincent’s award of attorney’s fees should be includible in her gross income. Significantly, Ms. Vincent did not appeal the Tax Court’s decision.
- Green v. Commissioner
Two years after Banks, the Tax Court rendered its decision in Green v. Commissioner, T.C. Memo. 2007-39. In that case, Ms. Green had filed a lawsuit against her former employer under the CFEHA. After a jury award for damages, the court awarded Ms. Green attorney’s fees under the CFEHA fee-shifting statute. Ms. Green did not report the award of attorney’s fees as gross income on her income tax return. The IRS challenged the reporting position, and Ms. Green filed a petition with the United States Tax Court.
Because of its prior decisions in Sinyard and Vincent, the Tax Court held that the award of attorney’s fees to Ms. Green was taxable income. On appeal, the Ninth Circuit agreed with the Tax Court. See Green v. Commissioner, 312 Fed. Appx. 929 (9th Cir. 2009). The Ninth Circuit reasoned that although the facts in Green were somewhat different than those in Sinyard, the reasoning of Sinyard controlled the outcome of the case. Notably, the Ninth Circuit reasoned that Ms. Green would have had gross income even accepting her argument that she had not entered into a contingency fee agreement with her attorney because there would have been an implied agreement under California law.
- Program Manager Technical Advice
On October 22, 2008, the IRS Office of Chief Counsel issued a Program Manager Technical Advice (PMTA). See PMTA 2009-0035. In the PMTA, Chief Counsel indicated that its general litigation position would be that “fees awarded to prevailing plaintiffs under federal and state fee-shifting statutes belong to the plaintiff and not the lawyer.” Id. In support of their position, Chief Counsel reasoned that Banks and the ACJA of 2004 had “endorsed” the IRS’ position that attorney’s fees awarded under a fee-shifting statute constituted gross income to the plaintiff. Curiously, Chief Counsel acknowledged that the issue had not been specifically addressed in Banks but concluded that other federal courts had agreed with the IRS’ position that such awards were taxable post-Banks. The PMTA referenced the court decisions of Vincent and Green.
- Letter Rulings
In 2010, the IRS issued a Letter Ruling on the taxability of fee-shifting statutes. See PLR 201015016. In the Letter Ruling, the taxpayer, one of several plaintiffs, had filed a lawsuit alleging improper practices under an unspecified Act. The taxpayer was represented on a pro bono basis by two legal aid organizations and a law firm.
The taxpayer had entered into an engagement agreement with one of the legal aid organizations, which stated that the organization would not charge the taxpayer a fee for its legal services. The taxpayer did not enter into engagement agreements with the other legal organization and the law firm although there was a mutual understanding between the parties that neither would charge for their legal services. Thus, the Letter Ruling noted that the taxpayer had “no obligation, contractual or otherwise, to pay any fees or other costs” to the legal organizations or law firms.
The taxpayer’s lawsuit was successful and he or she was awarded damages. In addition, the legal organizations and law firm filed motions under the Act’s fee-shifting statute for their costs including attorney’s fees. The court granted the motions and awarded attorneys’ fees. On these facts, the IRS concluded that the award of attorneys’ fees was not taxable to the taxpayer. Specifically, the Letter Ruling stated:
Attorney’s fees awarded to a successful litigant are generally includible in the litigant’s gross income under either the anticipatory assignment of income doctrine of Banks and Lucas v. Earl or under the payment of a liability doctrine enunciated in Old Colony Trust. Under both analyses, the litigant has an obligation, by express or implied agreement, to pay attorney’s fees. Taxpayer’s case is distinguishable because Taxpayer had no obligation to pay attorney’s fees. In fact, Taxpayer’s agreement (retainer contract) expressly provided that Legal Aid Organization 1 would not charge Taxpayer any fee for legal services. In addition, Taxpayer had no retainer contract with (and did not otherwise agree to pay any fees to) Legal Aid Organization 2 or Law Firm for their legal services. Rather, Legal Aid Organization 1 and Law Firm requested attorneys’ fees directly under the provisions of Section X of Act; they did not seek attorney’s fees on behalf of Taxpayer or in lieu of Taxpayer’s contingency fee obligation.
See also PLR 201552001 (same).
D. Analysis and Final Thoughts
Given the above federal tax authorities, plaintiffs who receive awards of attorney’s fees under fee-shifting statutes may be in a tough spot come tax reporting time. It is apparent that the IRS will continue to challenge almost any plaintiff’s assertion that an award of attorney’s fees under a fee-shifting statute is excludible from the plaintiff’s gross income. Moreover, because miscellaneous itemized deductions are no longer permitted for tax years 2018 through 2025, plaintiffs may find it difficult to claim offsetting deductions for the legal fees. In such instances, plaintiffs should carefully consider the following:
a. Whether the plaintiff’s underlying damages recovery is taxable? If the damages recovery is not taxable, the plaintiff may have an argument that any award of attorney’s fees under a fee-shifting statute is also not taxable.
b. Whether the legal fees are deductible as above-the-line deductions under Section 62? Section 62(a)(20) permits a deduction for legal fees and costs paid in connection with any action involving a claim of “unlawful discrimination” or other specified claims. For example, Section 62(e)(18) provides a deduction for legal fees for “[a]ny provision of Federal, State, or local law, or common law claims permitted under Federal, State, or local law . . . providing for the enforcement of civil rights . . .” Plaintiffs should carefully consider whether they qualify for any of the above-the-line deductions of Section 62, which may offset the inclusion of the award as income.
c. If the plaintiff’s recoveries are taxable and the plaintiff cannot claim an above-the-line deduction for the legal fees, the plaintiff may consider asserting alternative arguments for a reporting position that the award of attorney’s fees is not taxable income. Although impossible to provide all arguments here, some of these may include: (1) Banks never addressed the issue of whether an award of attorney’s fees should be taxable in all instances; and (2) the Tax Court’s post-Banks decisions on this issue are all memorandum opinions, which are generally not binding precedent. See, e.g., Nico v. Commissioner, 67 T.C. 647, 654 (1977). Plaintiffs who reside outside the Ninth Circuit Court of Appeals should bear in mind that they are not necessarily bound to the adverse decisions of that court on this issue.
Freeman Law aggressively represents clients in tax litigation at both the state and federal levels. When the stakes are high, clients rely on our experience, knowledge, and talent to help them navigate all levels of the tax dispute lifecycle—from audits and examinations to the courtroom and all levels of appeals. Schedule a consultation or call (214) 984-3000 to discuss your tax needs.
