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We call ourselves “litigators,” but, let’s face it: What we really are are “settlers.” Settlements are the staple of our profession. Without them, the system would quickly break down under the weight of trial work.

Judges do all that they can to encourage settlements, and “resolutions” (a much more palatable word to defense counsel) are discussed from the very start of almost every case.

Taxation of the amount received by the plaintiff is at the core of every settlement. After all, at the end of the day, the principal force driving the settlement is how much the plaintiff will pocket to make him or her (at least feel) “whole.” All that the employer cares about is paying as little as possible to make the case go away. Whether and how the money is taxed only becomes relevant if the plaintiff insists on an after-tax amount and taxes are to be withheld.

Of course, a plaintiff doesn’t clear the entire settlement amount. Rather, his or her attorney needs to be paid out of the settlement as well. While the law in the 3rd Circuit has been settled for more than 40 years, the 6th U.S. Circuit Court of Appeals just highlighted the issue of whether the full amount of the settlement, including the amount of the contingency fee paid to the attorney, should be taxed to the plaintiff.

In Banks v. Comm’r of Internal Revenue, the 6th Circuit in a decision in September highlighted a split with the 3rd U.S. Circuit Court of Appeals, as well as four other appellate courts, in finding that contingency fees are to be taxed only to the attorney but not to the plaintiff.


John Banks worked for the California Department of Education from 1972 to 1986. He was terminated and brought suit, claiming violations of Title VII Sections 1981 and 1983 and various state law tort claims. He withdrew the state law claims before trial but continued to pursue the discrimination actions. Nine days into trial, the case was settled for $464,000. Out of this amount, Banks paid $150,000 to his attorney. He did not include any of the settlement amount on his income tax return.

The tax court held that the contingency fees that Banks, who had moved to Michigan, paid to his attorney were income to Banks and were not excludable. Banks appealed this decision, along with the tax court’s decision that the entire award was not excludable as a “personal injury.”

Initially, the 6th Circuit noted that there is a split among the federal appellate courts on this issue. The 5th, 9th (in a very narrow decision that may be limited only to cases resolved in Oregon) and 11th U.S. Circuit Courts of Appeals have all previously held that contingency fees are taxable only to the attorney but not to the plaintiff. The 4th, 7th, 10th and Federal U.S. Circuit Courts of Appeals have joined the 3rd Circuit in finding that contingency fees are taxed to a plaintiff in a settlement.

The 6th Circuit addressed this issue in an earlier decision, Estate of Clarks v. United States in 2000. In Estate of Clarks, the court held that the fees were taxable only to the attorney and should not be taxed to the plaintiff, thus aligning itself with the latter group of courts.

The Banks court acknowledged that the tax commissioner had always taken the position that contingency fees should be included in income to the plaintiff on the basis of a theory of “anticipatory assignment of income.” That is, the plaintiff cannot escape the income by passing it off to a third party – in this case, his or her attorney. Because the plaintiff/taxpayer created the right to receive and enjoy the income, he should be taxed on the entire amount. The U.S. Supreme Court adopted this approach in a different context by declining to attribute fruits “to a different tree from that on which they grew.” This is the core theory on which amounts paid to an attorney in a settlement have been taxed to the plaintiff.

Tenancy in common

The 6th Circuit distinguished the “fruits from the tree” analogy from cases involving contingency fees by finding in the Estate of Clarks decision that “the client as assignor has transferred some of the trees in his orchard, not merely the fruit from the trees. The lawyer has become a tenant in common of the orchard owner and must cultivate and care for and harvest fruit of the entire tract. The lawyer’s income is the result of his own personal skill and judgment, not the skill or largesse of a family member who wants to split his income to avoid taxation.”

Thus, the 6th Circuit applied the Estate of Clarks decision to find that the $150,000 contingency fee was taxable only to the attorney and not to the plaintiff. The court declined to base its decision on Michigan’s “attorney lien law,” which, in each state, governs the rights of the attorney to claim a lien against their client’s judgment. The various state attorney lien laws have been cited in discussions on both sides of the issue and have controlled some of the decisions on the basis of whether the attorney essentially has an “ownership interest” in the judgment. The 6th Circuit held that having federal tax issues controlled on a “state-by-state” approach would be unreliable for taxpayers.

3rd CIRCUIT holding

The law in the 3rd Circuit has been settled for more than 40 years, since the court affirmed, without opinion, the U.S. Tax Court’s decision in O’Brien v. Commissioner in 1963 . Although the decision predates even Title VII, the issues presented will sound quite familiar to today’s attorneys.

O’Brien brought a claim for wrongful discharge from his position as a deputy director with the IRS. He was reinstated and recovered his lost wages. He received back pay in a lump sum and paid his attorney out of the recovery, paying taxes only on the amount that he retained. The Tax Court rejected this approach, finding that the entire amount of the recovery was income to the plaintiff/employee. “Even if the taxpayer had made an irrevocable assignment of a portion of his future recovery to his attorney to such an extent that he never thereafter became entitled thereto even for a split second, it would still be gross income to him. . . . ” The 3rd Circuit affirmed the Tax Court’s decision in what it called “ an excellent opinion.”

O’Brien, of course, preceded Churchill v. Star Enterprises, (E.D. Pa. 1998), in which the U.S. District Court for the Eastern District of Pennsylvania held that regardless of the amount of taxes to be paid, an employer need not withhold taxes from a back-pay award in an employment case.

Whether it is the Banks decision or a future decision along these lines, the taxation of contingency fees will almost certainly be decided finally by the Supreme Court. In the meantime, it is important for counsel in the 3rd Circuit to know and understand exactly how settlement amounts in each circuit are taxed to protect both plaintiffs and employers when issuing 1099 forms.

SIDNEY STEINBERG is a partner in Post & Schell’s business law and litigation department. He concentrates his national litigation and consulting practice in the field of employment and employee relations law. Steinberg has lectured extensively on all aspects of employment law, including Title VII, the FMLA and the ADA.

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