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Regardless of whether they live in Texas or Alabama, taxpayers shouldn’t have to pay federal income tax on the portion of damage awards that goes to their lawyers under contingent-fee agreements, the 5th U.S. Circuit Court of Appeals has ruled. In a 2-1 ruling on July 19, the 5th Circuit reversed the U.S. Tax Court’s decision in Sudhir P. Srivastava and Elizabeth S. Pascual v. Commissioner of Internal Revenue. The tax court had counted contingent fees as gross income for taxing purposes. “It’s a major win for Texas plaintiff attorneys,” says Midland, Texas lawyer Michael Cropper, of the Law Offices of Michael D. Cropper, who represents Srivastava and Pascual in the case. “The tax court had garbled Texas law.” However, one Houston lawyer says the 5th Circuit failed to deal with an issue that has caused conflict among the federal circuit courts. “Frankly, what I think they did is punt,” says Henry Binder, an associate with Houston’s Porter & Hedges and author of an amicus brief filed on behalf of the Texas Trial Lawyers Association. Binder says the trial lawyers group was trying to get the federal courts to recognize the rights attorneys have under Texas law when there is a contingent-fee agreement in place. But the 5th Circuit held that it doesn’t matter what a state law says because the economic reality facing the taxpayer-plaintiff remains the same no matter where he resides. RULING ON THE PAST If the court were deciding the case as an issue of first impression, it might apply the anticipatory assignment doctrine to hold that contingent fees are gross income for the client, 5th Circuit Judge Jerry E. Smith wrote in the majority opinion. However, Smith said the court does not decide the case “on a clean slate,” but must instead follow the contrary approach that the 5th Circuit took in Cotnam v. Commissioner, decided in 1959. In Cotnam, which was based in part on Alabama law, the 5th Circuit held that the amount of a contingent fee paid out of a taxpayer’s recovery in a breach-of-contract suit was not income to the taxpayer. Because Alabama law governing contingent fees grants a lawyer the same ownership rights to claims being litigated as the client, those fees are excluded from taxation, the court ruled in Cotnam. The tax court had reached its conclusion in Srivastava by relying on a 1962 ruling in Dow Chemical Co. v. Benton. In that case, the Texas Supreme Court held that a lawyer couldn’t take a client to court to secure a contingent fee. Fred A. Simpson, a partner in the Houston office of Jackson Walker, says the 1962 ruling was in a different context and that Texas courts have long held that a lawyer’s lien in a contingent-fee contract creates an equitable assignment of claims in the client’s cause of action. “Texas law is significantly stronger than Alabama’s,” Binder says, adding that the lawyer owns the percentage of an award that is assigned in a contingent-fee agreement. A major concern, Binder says, is the impact that the alternative minimum tax (AMT) can have on damage awards and settlements a plaintiff might receive. The AMT limits most miscellaneous itemized deductions on federal income taxes to amounts exceeding 2 percent of gross income. An individual can be denied AMT deductions for attorneys’ fees if a court finds that the fee amount is initially income to the plaintiff. The 5th Circuit avoided the whole issue regarding the impact state law has on the tax question and, in keeping with its Cotnam ruling, concluded that contingent fees paid an attorney according to Texas law are also excludable. A HIGHER POWER In reaching its conclusion, the majority acknowledged the circuit split on this issue. While the 6th U.S. Circuit Court of Appeals in Cincinnati recently adopted Cotnam‘s reasoning, three other circuits have included contingent fees in gross income. Simpson says the 5th Circuit took into consideration the uniformity clause in the U.S. Constitution, which prohibits the government from treating taxpayers in one geographic area differently from taxpayers elsewhere. By acknowledging the circuit split on the issue, Simpson says, the 5th Circuit seems to be urging the nation’s highest court to wade into the issue. Simpson says the fact that there was a dissent in the case is another indication that the issue is ripe for review by the high court. Circuit Judge James L. Dennis, in a dissenting opinion, said Texas lawyers — unlike their Alabama counterparts — are not granted by state law the same right and power as the client over a cause of action and judgment. Dennis said the taxpayer-client received as income the portion of the settlement earmarked for payment of the attorney’s fees and should pay taxes on those proceeds. U.S. Justice Department attorney Kenneth W. Rosenberg, who represents the IRS, says it will be up to the U.S. solicitor general whether to appeal the 5th Circuit ruling. “It’s too early to say what his decision will be on it,” Rosenberg says. Rosenberg declines to discuss specifics of the case. “We generally don’t comment on matters that are in litigation,” says U.S. Justice Department spokeswoman Obern Rainey. DEFAMATION ALLEGED The case before the 5th Circuit stemmed from a decision by the IRS commissioner that Srivastava and his wife owed almost $1.5 million in taxes and penalties for 1991 and 1992 because they allegedly didn’t report the settlement monies they received as a result of a civil action. Srivastava, a cardiac surgeon, sued KENS-TV in San Antonio for defamation after the station broadcast a series of investigative reports in February 1985 questioning his medical practices, says San Antonio lawyer Jim Branton, who represented the physician in the suit. Branton, a partner in Branton & Hall, says Srivastava previously had not been sued for malpractice but was hit with a series of malpractice claims after KENS broadcast the series. Srivastava eventually had to move his practice to another city, Branton says. Following a 1990 trial, the jury awarded Srivastava $11.5 million in actual damages and $17.5 million in punitive damages, according to the 5th Circuit opinion. Branton, says the station’s insurance companies settled for $8.5 million the following year. Because two of the station’s carriers were insolvent, KENS had to pay a portion of the settlement, the opinion noted. The opinion said the plaintiffs received their settlement funds in 1991 but didn’t report the proceeds to the IRS as gross income, reasoning that the amount paid constituted nontaxable actual damages. However, the settlement did not separate the monies into various categories of recovery for nontaxable actual damages and taxable interest and punitive damages. Srivastava and his wife argued that the settlement represented actual damages because the award matched the amount they had sought in their complaint. That argument was not entirely factual, the opinion stated, because the plaintiffs had requested actual damages “in excess of $8.5 million.” Cropper says the 5th Circuit’s ruling “is not as big a win as we had hoped for our clients.” The 5th Circuit agreed with the tax court that “some portion of the settlement was attributable to something other than actual damages” and affirmed the tax court’s decision with regard to interest and punitive damages. If the tax court determines that the failure to pay tax on interest alone is a substantial underpayment, the IRS can recalculate and assess a new penalty against the plaintiffs, the 5th Circuit held.

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