Assume that you're a plaintiff in a lawsuit. To prosecute the lawsuit, you hire an attorney on a contingent fee basis. That is, if there is a recovery, either through a judgment that is collectible or a settlement, the attorney gets paid. Otherwise, he or she does not.
Assume further that any recovery with respect to the lawsuit is taxable, as would be the case, for instance, in an ex-employee's recovery for a claim for wrongful discharge. Certainly, you reason, only the net amount received by the plaintiff would be subject to taxation, with the amount paid to the attorney either being deductible or not included into income in the first instance. That conclusion may not be correct.
In 1993, Raymond was terminated as an employee by IBM. He retained a law firm to file a wrongful termination lawsuit against IBM. Under the fee arrangement between Raymond and the law firm, the law firm was to receive a contingent fee of 1/3 of any amount recovered from IBM, plus its expenses. In the event of an appeal, the law firm was to be paid its standard hourly rate.
A jury trial resulted in a judgment of over $860,000 for Raymond. Due to post-judgment interest, IBM ultimately paid Raymond about $930,000. From that amount, Raymond paid the law firm that represented him about $340,000.
The conundrum faced by Raymond was succinctly stated by the district court as follows: "Because of the amount of [his] income for that year, [Raymond's] income tax was determined by the Alternative Minimum Tax ('AMT'). Ordinarily [he] would have been able to take a miscellaneous deduction for [his] attorneys' fees to the extent those fees exceeded 2% of [his] adjusted gross income, but miscellaneous deductions are not allowed under the AMT. The effect of the inclusion of the entire amount of the judgment as income and the operation of the AMT was to require [Raymond] to pay income tax on the full $929,585.90, although $306,898.01 of that amount went directly to [his] attorneys." Stated even more succinctly, Raymond had to pay income tax on the fees that he paid to his attorneys.
The good news for Raymond is that he lives in Vermont. Vermont is in the Second Circuit which had not previously addressed this issue. Eight of the other eleven circuit courts of appeal and the Federal Circuit have addressed the question and the score is currently six to three in favor of the IRS. (The Fourth Circuit currently is on the side of the Service.)
In Raymond's case, the U.S. District Court in Vermont found that "the portion of Raymond's recovery that was paid directly to his attorneys under [his] contingent fee agreement was not income to Raymond." The court reasoned that the attorneys had a property interest in the settlement equal to their contingent fee. Thus, the payment to the attorneys was not an anticipatory assignment of income by Raymond. In some measure, the result turned on legal principles under Vermont law pertaining to attorneys' fees and the ability of the attorneys to assert a lien on any recovery. Although I've not research this point closely, it appears that Vermont law is substantially the same as that of Maryland in this area.
The bad news for Raymond is that the case will certainly be appealed. Given the division of opinion among the circuits, the case would seem to be a good candidate for ultimate resolution by the Supreme Court. Due to the uncertain state of the law in this area, any taxpayer faced with the issue should be prepared to file a protective refund claim with respect to any taxes paid as a result of the application of the AMT to a contingent attorneys' fee paid on a taxable settlement.
Because the opinion has not been publicly posted, I cannot yet provide a hyperlink. But I will e-mail a copy upon request.