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David a. raymond, a former IBM employee who recovered $900,000 from the company for wrongful termination, must declare the entire amount as income, notwithstanding the fact that his attorney pocketed $300,000 pursuant to a contingency-fee agreement, the 2d U.S. Circuit Court of Appeals ruled last month. Raymond v. U.S., No. 03-6037. The tax treatment of contingent attorney fees seems ripe for Supreme Court review. In December, Solicitor General Theodore B. Olson asked the high court to reverse a 2003 decision by the 6th Circuit, Banks v. Comm’r, 345 F.3d 353, that held just the opposite-that a taxpayer need not declare as income the portion of a judgment that satisfies a contingent fee agreement. The issue is nettlesome to taxpayers because of the alternative minimum tax. Ordinarily, Raymond could have declared his entire award as income and then deducted the contingent fee as an income-generating expense. However, the size of the reward kicked him up out of the ordinary and into the realm of the alternative minimum tax, a sort of backstop tax regime designed to capture relatively wealthy taxpayers who would slip through with little liability under the ordinary scheme. One way the alternative minimum tax achieves that goal is by disallowing certain classes of deductions, including attorney fees. Had Raymond been able to exclude his attorney’s $300,000 fee from income, his total earnings wouldn’t have been high enough to make him subject to the alternative minimum tax and his check to the Internal Revenue Service would have been $55,000 smaller. A majority of circuit courts that have looked at the issue in recent years-the 4th, 7th, 10th, Federal, and now the 2d-have said that contingent fees must be declared as income. The minority position was first staked out by the 5th Circuit in 1959′s Cotnam v. Comm’r, 263 F.2d 119. Both the 5th and the 11th circuits (the 11th used to be a part of the 5th) have adhered to Cotnam in recent years as a matter of stare decisis, though sometimes grumbling that the majority view is the better one. But both the 6th Circuit, in Banks, and the 9th Circuit, in last year’s Banaitis v. Comm’r, 340 F.3d 1074, have put the minority view on a modern-day footing. Actually, the 9th Circuit has adopted both the majority and the minority positions. In Banaitis, the court held that a contingency fee was not income because Oregon law gave the attorney a property interest in his client’s recovery. In two decisions from 2000, on the other hand, the court ruled that Alaska and California law did not confer a property interest on lawyers and thus did not justify excluding contingency fees from the income of their clients. That points to an additional split among the circuits. Some courts start their analyses with an examination of state property law. However, two courts have said that the issue should be decided purely as a matter of federal law. In 2001′s Young v. Comm’r, 240 F.3d 369, the 4th Circuit said the issue “should be resolved by proper application of federal income tax law, not the amount of control state law grants to an attorney over the client’s cause of action.” The 6th Circuit agreed on that point in Banks (though it disagreed on the ultimate question), citing the need for uniformity throughout the country instead of a state-by-state patchwork. The 2d Circuit in the case at hand analyzed the law of Vermont, where Raymond resided, and “decline[d] to conclude that Vermont law provides attorneys with a proprietary interest in their clients’ claims.” In addition, the court cautioned, “we should remember we are interpreting federal tax law.” Under that law, the contingent fee was income because Raymond controlled its source, namely, his claim against IBM, which his attorney prosecuted only at his direction. The only bone the court threw to Raymond was the observation that his predicament was “unfortunate.” Young’s e-mail address is gyoungnlj.com.

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