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We call ourselves “litigators” but we’re really “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 make sure that 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 in order to make him or her 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, since his or her attorney needs to be paid out of the settlement as well. Whether the full amount of the settlement — including the amount of the contingency fee paid to the attorney — should be taxed to the plaintiff was at the heart of the 6th Circuit’s recent decision in Banks v. Comm’r of Internal Revenue. John Banks worked for the California Department of Education from 1972 to 1986. He was terminated and brought suit claiming violations of Title VII, Secs. 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 Banks 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 circuits on this issue. The 3rd, 4th, 7th and 10th Circuit courts, along with the Federal Circuit court have held that contingency fees are taxed to the plaintiff in a settlement. The 5th, 9th (in a very narrow decision that may be limited only to cases resolved in Oregon) and 11th Circuits have all previously held that contingency fees are taxable only to the attorney, but not to the plaintiff. The 6th Circuit also noted that it had addressed this issue in an earlier decision, Estate of Clarks v. United States. 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 has always taken the position that contingency fees should be included in income to the plaintiff, based on 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 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. 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. [T]he lawyer’s income is the result of his own personal skill and judgment, not the skill or largess 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 lien against their client’s judgment. The various state attorney lien laws have been cited in almost all of the decisions on both sides of the issue and have controlled some of the decisions based upon 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. 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 throughout the country to know and understand exactly how settlement amounts in each circuit are taxed to protect both plaintiffs and employers (when issuing 1099 Forms). Sidney R. Steinberg is a shareholder in the business law and litigation department of Post & Schell, (www.postschell.com). He concentrates his national litigation and consulting practice in the field of employment and employee relations law and may be reached at [email protected].

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