The Eagle Eats First

Experienced employment lawyers know that getting both sides to say “yes” to settlement is a complicated task. The 1996 amendments to the tax code eliminating the previous exclusion of emotional harm damages from taxable income complicated the already difficult question of how to maximize the value of limited dollars to encourage settlement. With fewer options to maximize the value of limited settlement dollars, ultimately the tax consequence of the settlement becomes everyone's problem.

Until recently, it was widely believed in New York that attorneys' fees could be paid separately to the plaintiff's lawyer pursuant to a contingency fee agreement as a way of minimizing the plaintiff's tax liability. A recent decision by the Second Circuit casts considerable doubt on the continued viability of that approach. Since the complete labor lawyer must now dabble in tax advice, a few tips about understanding how the IRS interprets the tax code are in order.

The Eagle Eats First

Perhaps the most useful maxim is the general rule applied by the IRS: “The eagle eats first.” If you can digest that, the IRS position on taxable income is easier to understand. That overall principle aptly applies to the tax treatment for proceeds from employment litigation, including attorneys' fees.

The IRS's position is that attorneys' fees in employment litigation are an obligation of the taxpayer. Thus, a payment of attorneys' fees directly to the attorney for the taxpayer, whether pursuant to a contingency agreement, a written retainer agreement or otherwise, is taxable — first to the taxpayer (ie, plaintiff) and again to the attorney for the taxpayer. Thus, the phrase “The eagle eats first.”

The IRS position is that the taxpayer owns the cause of action seeking damages, including attorneys' fees. Under its view, if the taxpayer controls the cause of action and is obligated to pay fees, using the cause of action to pay the taxpayer's obligation is the equivalent of an assignment of income.

Judicial View Divided

The circuit courts have struggled with the IRS view when applied to employment litigation and contingency fee agreements. Not surprisingly, the circuits are split on this issue. The majority view is that recovered attorneys' fees are included in the taxpayer's (ie, plaintiff's) gross income. The Third, Fourth, Seventh, Tenth and Federal Circuits agree with the IRS. The Ninth Circuit holds that whether the attorneys' fees are includable depends on the state law's treatment of fees. If, under the state law, the attorney has a lien sufficient to create a property interest in favor of the attorney for fees, it is excludable from the plaintiff's income. The minority view is followed in the Fifth, Sixth and Eleventh Circuits. In most cases, the court's decision is driven by how the applicable state law treats attorneys' fees.

Second Circuit Decision in Raymond

The Second Circuit has now weighed in on the issue in Raymond v. United States. Although the Second Circuit agreed with the IRS and found that the attorneys' fees are included in the taxpayer's gross income, the case is based on Vermont law's treatment of attorneys' fees. There are differences between how Vermont and New York treat attorneys' fees. Whether those differences will matter is a close question.

First we look at the case: Raymond successfully obtained a judgment against his employer for wrongful termination. The employer satisfied the judgment with a single check payable to the plaintiff's law firm. Pursuant to a contingency fee agreement, the judgment proceeds were divided between the plaintiff and his lawyer with the lawyer retaining one-third of the judgment. The IRS took the position that 100% of the attorneys' fees were taxable to the plaintiff as income, and also taxable to the attorneys. Thus the phrase, “The eagle eats first, then eats again!”

The district court held that under Vermont law, the attorney had a charging lien on the proceeds of the judgment that created a property interest in the portion of the judgment paid to the attorney. The district court held that, consistent with the minority view of the Fifth, Sixth, Ninth and Eleventh Circuits, the attorney's fee portion was appropriately excludable from the plaintiff's income. On appeal, the Second Circuit reversed, siding instead with the IRS. In relevant part, the Second Circuit held that a charging lien under Vermont law created an insufficient property interest for the attorney to overcome the presumption that payments made on behalf of the taxpayer to satisfy the taxpayer's obligation are included in the gross income of the taxpayer.

The decision in Raymond, like the decisions in the majority of other circuits that have considered the question, turns on what level of control the client has in the proceeds of the judgment. The Second Circuit analysis includes a complete review of how Vermont law on attorneys' liens affects the all important control issue. Ultimately, the court held that in Vermont an attorney's lien is largely a security interest, not a property interest. The court also rejected the argument that the written retainer agreement created a property right. Instead, the court explained that the retainer agreement merely assigned future income.

We do not read Vermont Law as providing attorneys with a proprietary interest in their clients' claims. Further, determining to whom income flows depends in large part upon who controls the source of the income. When a tax payer is in sufficient control of the source of the income, federal principles of taxation deem him the recipient of gross income upon its disposition.

Applicability of Raymond to NY Law

The question remains whether the result is different in New York. State law on attorneys' liens is instructive. The New York Court of Appeals recently had occasion to discuss this question in LMWT Realty v. Davis, 85 N.Y.2d 462. In that case, New York's highest court held that “an attorney's charging lien is something more than a mere claim against either property or proceeds; an attorney's charging lien is a vested property right created by law and not a priority of payment.”

The case cites to older New York cases that held that an attorney obtains a “vested property right to the cause of action” once a retainer agreement is signed. That clear description suggests that if New York law is applied, a very different outcome may result when the taxability of attorneys' fees issue is considered. At least we can say that the New York Court of Appeals' language allows a taxpayer to make a good faith claim that attorneys' fees are excludable from gross income under New York law despite the Second Circuit decision applying Vermont law. The stakes involved virtually guarantee that this issue will be the subject of further litigation both in the circuits and before the Supreme Court.

Conclusion

Ultimately, the IRS's view cannot be good policy and certainly hurts all parties in litigation. The logical solution is comprehensive reform in Congress. Election-year politics, however, may render that solution a long- rather than a short-term one.

Editor's Note: At press time, the United States Supreme Court granted cert. to resolve the conflict between the circuits on whether a taxpayer's gross income includes that portion of the proceeds of litigation payable to an attorney pursuant to a contingency fee agreement. The two cases are, Commissioner of Internal Revenue v. Bank 2004 WL 602077 and Commissioner of Internal Revenue v. Banaitis 2004 WL 602078. In a related development, Congress is currently debating an amendment to the JOBS bill to include the Civil Rights Tax Relief Act (CRTRA). CRTRA provides a comprehensive solution allowing for income averaging and the exclusion of attorneys' fees from gross income in most employment litigation contexts.

Experienced employment lawyers know that getting both sides to say “yes” to settlement is a complicated task. The 1996 amendments to the tax code eliminating the previous exclusion of emotional harm damages from taxable income complicated the already difficult question of how to maximize the value of limited dollars to encourage settlement. With fewer options to maximize the value of limited settlement dollars, ultimately the tax consequence of the settlement becomes everyone's problem.

Until recently, it was widely believed in New York that attorneys' fees could be paid separately to the plaintiff's lawyer pursuant to a contingency fee agreement as a way of minimizing the plaintiff's tax liability. A recent decision by the Second Circuit casts considerable doubt on the continued viability of that approach. Since the complete labor lawyer must now dabble in tax advice, a few tips about understanding how the IRS interprets the tax code are in order.

The Eagle Eats First

Perhaps the most useful maxim is the general rule applied by the IRS: “The eagle eats first.” If you can digest that, the IRS position on taxable income is easier to understand. That overall principle aptly applies to the tax treatment for proceeds from employment litigation, including attorneys' fees.

The IRS's position is that attorneys' fees in employment litigation are an obligation of the taxpayer. Thus, a payment of attorneys' fees directly to the attorney for the taxpayer, whether pursuant to a contingency agreement, a written retainer agreement or otherwise, is taxable — first to the taxpayer (ie, plaintiff) and again to the attorney for the taxpayer. Thus, the phrase “The eagle eats first.”

The IRS position is that the taxpayer owns the cause of action seeking damages, including attorneys' fees. Under its view, if the taxpayer controls the cause of action and is obligated to pay fees, using the cause of action to pay the taxpayer's obligation is the equivalent of an assignment of income.

Judicial View Divided

The circuit courts have struggled with the IRS view when applied to employment litigation and contingency fee agreements. Not surprisingly, the circuits are split on this issue. The majority view is that recovered attorneys' fees are included in the taxpayer's (ie, plaintiff's) gross income. The Third, Fourth, Seventh, Tenth and Federal Circuits agree with the IRS. The Ninth Circuit holds that whether the attorneys' fees are includable depends on the state law's treatment of fees. If, under the state law, the attorney has a lien sufficient to create a property interest in favor of the attorney for fees, it is excludable from the plaintiff's income. The minority view is followed in the Fifth, Sixth and Eleventh Circuits. In most cases, the court's decision is driven by how the applicable state law treats attorneys' fees.

Second Circuit Decision in Raymond

The Second Circuit has now weighed in on the issue in Raymond v. United States. Although the Second Circuit agreed with the IRS and found that the attorneys' fees are included in the taxpayer's gross income, the case is based on Vermont law's treatment of attorneys' fees. There are differences between how Vermont and New York treat attorneys' fees. Whether those differences will matter is a close question.

First we look at the case: Raymond successfully obtained a judgment against his employer for wrongful termination. The employer satisfied the judgment with a single check payable to the plaintiff's law firm. Pursuant to a contingency fee agreement, the judgment proceeds were divided between the plaintiff and his lawyer with the lawyer retaining one-third of the judgment. The IRS took the position that 100% of the attorneys' fees were taxable to the plaintiff as income, and also taxable to the attorneys. Thus the phrase, “The eagle eats first, then eats again!”

The district court held that under Vermont law, the attorney had a charging lien on the proceeds of the judgment that created a property interest in the portion of the judgment paid to the attorney. The district court held that, consistent with the minority view of the Fifth, Sixth, Ninth and Eleventh Circuits, the attorney's fee portion was appropriately excludable from the plaintiff's income. On appeal, the Second Circuit reversed, siding instead with the IRS. In relevant part, the Second Circuit held that a charging lien under Vermont law created an insufficient property interest for the attorney to overcome the presumption that payments made on behalf of the taxpayer to satisfy the taxpayer's obligation are included in the gross income of the taxpayer.

The decision in Raymond, like the decisions in the majority of other circuits that have considered the question, turns on what level of control the client has in the proceeds of the judgment. The Second Circuit analysis includes a complete review of how Vermont law on attorneys' liens affects the all important control issue. Ultimately, the court held that in Vermont an attorney's lien is largely a security interest, not a property interest. The court also rejected the argument that the written retainer agreement created a property right. Instead, the court explained that the retainer agreement merely assigned future income.

We do not read Vermont Law as providing attorneys with a proprietary interest in their clients' claims. Further, determining to whom income flows depends in large part upon who controls the source of the income. When a tax payer is in sufficient control of the source of the income, federal principles of taxation deem him the recipient of gross income upon its disposition.

Applicability of Raymond to NY Law

The question remains whether the result is different in New York. State law on attorneys' liens is instructive. The New York Court of Appeals recently had occasion to discuss this question in LMWT Realty v. Davis , 85 N.Y.2d 462. In that case, New York's highest court held that “an attorney's charging lien is something more than a mere claim against either property or proceeds; an attorney's charging lien is a vested property right created by law and not a priority of payment.”

The case cites to older New York cases that held that an attorney obtains a “vested property right to the cause of action” once a retainer agreement is signed. That clear description suggests that if New York law is applied, a very different outcome may result when the taxability of attorneys' fees issue is considered. At least we can say that the New York Court of Appeals' language allows a taxpayer to make a good faith claim that attorneys' fees are excludable from gross income under New York law despite the Second Circuit decision applying Vermont law. The stakes involved virtually guarantee that this issue will be the subject of further litigation both in the circuits and before the Supreme Court.

Conclusion

Ultimately, the IRS's view cannot be good policy and certainly hurts all parties in litigation. The logical solution is comprehensive reform in Congress. Election-year politics, however, may render that solution a long- rather than a short-term one.

Editor's Note: At press time, the United States Supreme Court granted cert. to resolve the conflict between the circuits on whether a taxpayer's gross income includes that portion of the proceeds of litigation payable to an attorney pursuant to a contingency fee agreement. The two cases are, Commissioner of Internal Revenue v. Bank 2004 WL 602077 and Commissioner of Internal Revenue v. Banaitis 2004 WL 602078. In a related development, Congress is currently debating an amendment to the JOBS bill to include the Civil Rights Tax Relief Act (CRTRA). CRTRA provides a comprehensive solution allowing for income averaging and the exclusion of attorneys' fees from gross income in most employment litigation contexts.