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In a pair of cases with potential pocketbook impact on lawyers and their clients, the Supreme Court ruled on Monday that the contingent fee portion of lawsuit settlements and awards is taxable to the client, even if the money goes directly to the attorney. But initial reaction to the 8-0 decision was more muted than expected because a law passed by Congress last fall limits the ruling’s implications, and the decision won’t doom the contingent fee system, which fuels a broad range of private litigation. While the cases — Commissioner of Internal Revenue v. Banks and Commissioner of Internal Revenue v. Banaitis — were pending last fall, Congress passed a provision allowing taxpayers who win awards in employment, whistleblower and civil rights litigation not to count attorney fees and court costs as taxable income. Congress already allows this for lawyer fees in personal injury cases. In addition, Justice Anthony Kennedy, in his opinion for the Court, explicitly said he was not ruling on the tax implications of other federal laws that provide attorney fees, some of which exceed the award the plaintiff receives. But in other types of commercial litigation under federal and state law, experts forecast more costly settlements in light of Monday’s ruling because winning plaintiffs may insist that the extra tax they have to pay be tacked onto the settlement. “Congress pre-empted the worst possible impact of today’s rulings,” said Jennifer Brown, legal director of Legal Momentum (formerly the NOW Legal Defense and Education Fund), which worried that a ruling against the taxpayer would discourage public interest litigation. “But we are still concerned about other cases in which the contingency fee offers the only means of access to the courts for people of ordinary means.” Jeffrey White, lawyer for the Association of Trial Lawyers of America, said, “Now, in some cases, when both sides sit down to discuss settlement, you’ll have to evaluate the tax consequences on the individual plaintiff and maybe hire a tax consultant. It will get a lot more complicated.” William Perry Pendley of Mountain States Legal Foundation, who filed a brief in the case on behalf of several public interest law firms, was disappointed that Justice Kennedy sidestepped the tax issue as it relates to fee awards mandated by federal fee-shifting statutes. Often, Pendley said, clients of his organization and similar groups are seeking injunctive relief or small awards, not huge sums. If those clients are forced to pay taxes on the attorney fees that go to the public interest law firm, they would in effect be penalized for winning. “It’s a shame that the Court punted on the fee-shifting issue,” said Pendley, who predicted that litigation with the Internal Revenue Service over this issue will now resume. The issue of whether or not contingent fees count as income to the client has been simmering in the courts for years, mainly for taxpayers using the Alternative Minimum Tax, which does not allow for the deduction of attorney fees. Taxpayers have complained that the tax amounts to double taxation because the lawyer pays taxes on the fees, whether or not the client does. The IRS claims that an entire award or settlement counts as income to the plaintiff, no matter what happens to any part of it. The issue went into the courts, most often in the employment law setting, and usually the IRS won. But with adverse rulings in the 2nd, 4th, 6th, 9th and 11th circuits in recent years, the IRS appealed to the Supreme Court for resolution. Kennedy complied, stating that “as a general rule, when a litigant’s recovery constitutes income, the litigant’s income includes the portion of the recovery paid to the attorney as a contingent fee.” Kennedy said the plaintiff in a lawsuit at all times “retains dominion” over the income-generating asset — namely the cause of action stemming from a legal injury. The Court also rejected an argument advanced by some taxpayers that the attorney-client relationship is a sort of partnership or joint venture for tax purposes. Rather, Kennedy said it is a “quintessential principal-agent relationship.” The fact that the client relies on the lawyer to achieve a result the client could not reach alone “does not alter the fact that the client retains ultimate dominion and control over the underlying claim.” As a result, the resulting award counts as income to the client, Kennedy ruled. Kennedy also said that the ruling does not affect qui tam actions under the federal False Claims Act, in which private citizens, acting on behalf of the United States, can recover awards for government fraud they uncover. Chief Justice William Rehnquist, who did not attend the Nov. 1 argument in the tax cases, did not participate in the decision.

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