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Uncertainty over who has to pay income tax on a lawyer’s fee has long vexed employment litigation. But U.S. District Senior Judge Peter C. Dorsey has concluded that both client and lawyer must fork over income tax on the attorney’s fee component of an award or settlement. Even if the employer, by contract, must write the check to the lawyer directly, Dorsey’s seven-page analysis in Parmanand v. Capewell Components, LLC determines that payment is really being made first to the client, and is also taxable as client income. “I’m grateful for guidance that we as practitioners can rely on,” said Shipman & Goodwin tax lawyer Alan E. Lieberman, who represented Capewell in the dispute over the terms of an employment settlement. Dorsey’s Sept. 10 ruling is a departure from federal appellate courts in the 5th, 6th and 11th circuits. It agrees with five others — the 1st, 3rd, 4th, 9th and Federal circuits, which all conclude that attorneys’ fees in employment cases are really income to both client and counsel, and should be taxed twice. The client-income rule for employment cases doesn’t apply to personal-injury payments for medical costs or pain and suffering. A separate tax rule holds that awards and settlements designed to “make a person whole” after physical injury are not taxable as income. Mary E. Kelly and Henry F. Murray, of Hartford’s Livingston, Adler, Pulda, Meiklejohn & Kelly, represented plaintiff Richard Parmanand. They are filing a motion for reconsideration, urging Dorsey to certify the question as an issue for the Connecticut Supreme Court, since his rationale centers on a concept defined by state law — the nature of the property interest of a lawyer’s fee lien. 1883 PRECEDENT Dorsey’s ruling reverses the recommendation of U.S. Magistrate Joan G. Margolis, who found that only the lawyer should be taxed with the lawyer’s fee component of an employment settlement or judgment. Lieberman, on behalf of Capewell, made four objections to Margolis’ recommendations, three based on federal tax law interpretations, and one on the state law issue of whether a lawyer’s lien for fees creates a property interest for the lawyer akin to ownership. Dorsey, citing the 120-year-old state Supreme Court case of Cooke v. Thresher, determined that the lawyer’s fee interest in a judgment is a charging lien or “incumbrance,” as the Cooke case put it. In Dorsey’s reading, the lawyer’s property interest in the fee is not greater than the client’s. He rejected the 2000 Superior Court case, Kubeck v. Cossette, which held otherwise, but was indirectly based on New York law. In ambiguous areas of the law, a federal judge must predict how the state’s own appellate courts would rule, Dorsey noted. In a paragraph of thinking out loud, Dorsey said the property interest of a legal case, including the fee component, belongs primarily to the client: “If the attorney has an ownership interest in the cause of action, the attorney would seemingly have the right to participate in the decision to settle, for which there is no known authority.” Similarly, he continued, there’s no right of the lawyer to refuse to settle, or to pursue the case without the client. In an interview, Kelly and Murray said they believe Dorsey is not viewing the rights correctly. The lawyer’s right to a fractional fee is established from the outset, by contract, and the client never has a superior right to that fraction, Kelly said. Once a settlement is reached or a judgment is awarded, the lawyer’s fee becomes a fixed figure — and far more the lawyer’s than the client’s — based on the contract. LAW FIX NEEDED Kelly said the IRS practice of taxing the client for attorneys’ fees creates a dramatic injustice in civil rights discrimination cases, where the client’s damages may be small, but the court awards substantial attorney fees. “Say the plaintiff wins a $5,000 judgment in a housing discrimination case, where the damages are small. If the attorneys are awarded a $150,000 fee, the IRS’s position is that the client should pay income tax on the whole $155,000.” Kelly said. Murray called it “off the wall.” Kelly noted that both pro-business groups, like the Connecticut Business and Industry Association, and employment lawyers nationwide agree that the double taxation policy should be changed, and back the federal Civil Rights and Tax Fairness Act, which Congress failed to enact last year. Lieberman said Dorsey’s decision in Connecticut is the second of two decisions within the 2nd Circuit, which has no controlling precedent. “In a federal decision in Vermont, they determined that Vermont lien law gave attorneys sufficient property rights in a plaintiff’s cause of action, so that it was inappropriate to tax to a plaintiff the portion of the award allocable to the attorney,” he said. A continuing drawback in settlement calculations, Lieberman added, arises through the alternative minimum tax calculation. It counts the attorney fee award as income and a tax preference item, not subject to write-off as a cost. Since settlement dollars are worth less to the parties, cases are harder to resolve, he noted.

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