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Although it seems unfair to require taxpayers to pay taxes on lawyer contingency fees paid out of a court award or settlement, the law may not be on their side, some justices suggested during U.S. Supreme Court arguments last week. The high court on Nov. 1 took up two consolidated appeals by the government on an issue that has split the circuit courts: whether taxpayers are required to include in their gross income the portion of damages recovery that is used to pay an attorney under a contingency fee agreement. Commissioner of Internal Revenue v. Banks, No. 03-892; Commissioner of Internal Revenue v. Banaitis, No. 03-907. An unusual coalition of business, trial lawyers and civil rights groups is urging the justices to rule against the Internal Revenue Service (IRS), which argued — and lost in the courts below — that the entire recovery must be included in a taxpayer’s gross income. In Banks, John W. Banks settled an employment discrimination lawsuit for $464,000 and paid $150,000 of that settlement to his lawyer. In Banaitis, Sigitas Banaitis and his former bank employers settled his job-related claims for nearly $9 million, about $4 million of which went to Banaitis’ lawyers. The IRS said the entire recovery must be included in gross income and the legal fees could be an itemized deduction. But the alternative minimum tax, which generally kicks in with higher awards, applied to the Banks and Banaitis recoveries. The attorney fees were not deductible, and the alternative tax resulted in a significantly higher tax assessment for each man. A ‘SWEEPING’ DEFINITION During arguments, Assistant to the Solicitor General David B. Salmons told the justices that the law’s definition of gross income is “sweeping.” He argued that income is taxed to the person who earns it, and here the client was at all relevant times in control of the underlying source of income. Justice Sandra Day O’Connor called “appalling” the situation where a plaintiff may end up paying more in taxes than he or she received in a recovery. Salmons conceded such situations occur, but he added, “The proper result is to go to Congress.” Banaitis’ counsel, Philip N. Jones of Portland, Ore.’s Duffy Kekel, and Banks’ attorney, James R. Carty of Los Angeles, offered the court several alternatives to the government’s position. They argued that a contingency fee arrangement is similar to a joint venture in which each party is taxed on only his or her share of the resulting income. They also argued, among other things, that Oregon law gives lawyers a strong property interest in contingent fees But Justice Stephen G. Breyer, voicing the dissatisfaction that some of his colleagues also expressed with those arguments, said: “Your problem is that maybe the equities are there, but what is the theory of law?” He pressed for “precise form of words” that would govern the contingency fee relationship.

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