IRS Hits the Jackpot on Recent Supreme Court Ruling on Contingent Fee Arrangements

The Supreme Court unanimously ruled on January 24, 2005 that a taxpayer's gross income from the proceeds of litigation includes that portion of the award or settlement that is paid to attorneys pursuant to a contingent fee agreement (Commissioner v. Banks, U.S., No. 03-892, 1/24/05; Commissioner v. Banaitis, U.S., No. 03-907, 1/24/05). The decision, written by Justice Anthony Kennedy, specifically states, "[A]s a general rule, when a litigant's recovery constitutes income, the litigant's income includes the portion of the recovery paid to the attorney as a contingent fee". This decision upholds a doctrine that a taxpayer cannot exclude an economic gain from gross income by assigning the gain in advance to another party. The theory behind this doctrine, often referred to as the "anticipatory assignment of income doctrine", is that gains should be taxed to those who earn them. The doctrine is intended to prevent taxpayers from avoiding taxation by assigning income under the dominion of the first party to a party who did not earn it.

The court also rejected the argument that the attorney-client relationship is a sort of business partnership or joint venture for tax purposes. Instead, the court stated that the attorney-client relationship is a "quintessential principal-agent relationship". In other words, while the contingent fee may be deductible, the gain realized by the agent's efforts is income solely to the principal. The ruling does not address the issue of "fee shifting statutes" where attorneys' fees awarded by the court pursuant to such statues can exceed a plaintiff's monetary recovery, with the possible result that taxing the fee award to the plaintiff will cause the plaintiff to lose money by winning the suit.

The ruling does not apply to unlawful discrimination and is limited to only punitive damages in personal injury cases, as other statutory provisions specifically allow a deduction for the fees paid to the attorney for regular and alternative minimum tax purposes or exclude the award from taxable income altogether.

The practical effect of the ruling is that an individual plaintiff in commercial litigation matters will recognize taxable income equal to the total award or settlement and likely be subject to the alternative minimum tax (AMT) as the attorneys fees are not deductible for AMT purposes. This will dilute the after-tax cash value of client recoveries by raising the effective federal income tax rate by over 11% and subjecting the attorney’s fee to double taxation. Accordingly, the IRS will have a greater stake in the outcome of commercial litigation matters to the detriment of the plaintiff. Firms that are mindful of this adverse tax impact may consider disclosing this in fee arrangements with clients to avoid potential misunderstandings.

Law firms will want to evaluate their contingent fee agreements and consider disclosure to clients of these adverse tax consequences to avoid future disputes. If you any questions regarding this new ruling, please contact Allen Wendler at 713-659-5080.

Twice recently we have assisted with motions to compel production of financial data kept in electronic form. In the first instance, most of the general ledger files had been deleted from the production. The other time, no general ledger files were produced. Fortunately, in both cases clear documentary trails exist of requests, motions, court hearings and orders as well as repeated examples of incomplete or no production of data ordered to be produced.

One of the cases has gone to a hearing where a skillful PowerPoint presentation was made by counsel organizing the long history of efforts to obtain the missing general ledger accounts. We testified as to the missing accounts and the evidence in prior financial statements that such accounts existed. But, we observed the demeanor of the judge changed when we described our electronic discovery efforts proving the alteration of the hard drive the night before the computer was produced to us during the most recent round of discovery. Upon hearing of this alteration and seeing the proof, the court imposed a large sanction on the party altering the hard drive; counsel for our client believes the judge will instruct the jury adversely as to the missing data.

In the other case, we traveled to the opposing party's offices at the court's order to copy not only the general ledger, but all the files on the company's server. This task was complicated by the requirement it be done at night to minimize disruption and the mistaken description of the server by the owner as containing mirror drives when in fact it held separate drives with a dynamic partition.

Mike Howard of our firm competently and carefully obtained the electronic evidence in both cases.

We observe with regard to problems with electronic discovery (i) the importance of a clear trail of efforts to obtain the data, succinct presentation and (ii) the "tipping point" can be proof of malfeasance, e.g. alteration of the data immediately before it is produced.

As discussed in the November 2004 issue of the Journal of Accountancy, the IRS assesses a trust fund recovery penalty (TFRP) against individuals it holds personally liable for an employer’s unpaid payroll taxes. This is a civil penalty imposed on anyone required to collect, account for or pay the tax and who willfully fails to do so.

When an employer distributes payroll checks to employees, the employer becomes a trustee for the U.S. government in regards to the employee's payroll taxes withheld. Withheld payroll taxes are also known as "trust fund taxes," and because they are held on behalf of the Unites States, they should not be used to pay salaries, expenses or for any other purpose. If the employer uses the trust fund for other purposes, officers and other company employees may have to pay a civil penalty of 100% of the employer’s delinquent trust fund taxes. The IRS imposes this TFRP on "responsible persons" under IRC section 6672, distinct from the employer’s responsibility to pay the taxes it withholds from employees.

According to the article, the concept "innocent until proven guilty" that applies in criminal cases does not apply here. Since the TFRP is civil, the IRS may treat individuals as "guilty until proven innocent." Criminal penalties also may apply for failing to deposit payroll taxes, and a person can be subject to both civil and criminal action. According to the IRS Chief Financial Officer’s Office of Unpaid Assessment Analysis, about 128,000 individuals have outstanding trust fund recovery penalties as a result of their failure to pay payroll taxes. Including accumulated interest, these penalties average $93,750 a person and total about $12 billion.

If you have a client that is in need of assistance with payroll tax issues, we can help. Please contact Allen Wendler at 713-659-5080.

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