Contingency Payment Considered Part of Taxpayer's Gross Income

A taxpayer who won a recovery of backpay and paid his attorneys on a contingency fee basis must include the contingency payment figure in his gross income for tax purposes, the 2nd Circuit has ruled in an issue that has split other appeals courts. The man argued that he never received the funds and had no right to them due to a lien under state law, but the court found no reason to treat contingent fee arrangements differently than other arrangements.

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A taxpayer who won a recovery of backpay and paid his attorneys on a contingency fee basis must include the amount of the contingency payment in his gross income for tax purposes, the 2nd U.S. Circuit Court of Appeals ruled Tuesday. “When a taxpayer is in sufficient control of the source of income, federal principles of taxation deem him the recipient of gross income upon its disposition,” the court said in Raymond v. United States. “This is such a case.” The court made its decision on an issue that has divided its fellow circuits and, in so ruling, joined the majority. David A. Raymond was awarded $900,000 from his former employer, IBM, following a jury trial in which he was represented by the firm of Ouimette & Runcie on a contingency basis. He initially included the full amount in his gross income on his 1998 tax return, but later sought a refund on an amended tax return filed the following year. When the Internal Revenue Service rejected his application, Raymond and his wife filed suit in U.S. District Court in Vermont. Chief Judge William K. Sessions III granted the Raymonds’ motion for summary judgment, finding that the contingency payment of $300,000 to the firm was not part of the Raymonds’ gross income. On the appeal, 2nd Circuit Judge Richard Wesley said, “Whether contingent fees are includable in the gross income of a client recovering on a judgment is the subject of much debate among the circuit courts.” Noting that the U.S. Supreme Court has “long asserted” that substance rather than form determines tax consequences, Judge Wesley said the Raymond appeal presented the court “with an issue in which the line between substance and form has blurred.” Courts, he said, have generally looked first to state law in determining the nature of legal interests in property. “Where the attorney’s interest in the fee is sufficiently strong, some courts — those in the minority — have held that the attorney has a ‘property’ interest in it exclusive of the client’s interest; from this, these courts conclude the fee was never income to the client, but only to the attorney,” he said. But for the majority of courts, Judge Wesley said, “the interest is merely a ‘security’ interest,” where the fee is “plainly income to the client, albeit income upon which the attorney has a lien.” Raymond had argued that he never received the funds and had no right to them because of the lien placed on them under Vermont law. But Judge Wesley said that “it makes little sense to distinguish between circumstances in which an attorney is paid on a hourly basis and those in which the client and attorney have agreed to a contingent fee arrangement.” When a client pays an attorney on an hourly basis, the same fund generates gross income for each; the fund simply passes through the client’s hands first, he said. “There seems no reason to treat contingent fee arrangements differently.” Judges James Oakes and Rosemary Pooler joined in the opinion. James W. Runcie of Ouimette & Runcie represented the Raymonds. Kenneth W. Rosenberg of the Department of Justice’s Tax Division, and Assistant Attorney General Eileen J. O’Connor represented the government.

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