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The U.S. Supreme Court has concluded that when a defendant pays a plaintiff’s fees as part of a settlement, the fees cannot be excluded from the taxable income of the settling plaintiff simply because the plaintiff had a contingency agreement with his or her lawyer. CIR v. Banks, No. 03-982, 73 U.S.L.W. 4117 (Jan. 24, 2005). The Court phrased the issue before it as “whether the portion of a money judgment or settlement paid to a plaintiff’s attorney under a contingent-fee agreement is income to the plaintiff under the Internal Revenue Code � [The Court held] 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.” The decision resolves what had been a division among the federal courts of appeals, and would have been of considerably greater practical importance for employment law matters had it come before passage of the American Jobs Creation Act of 2004 (P.L. 108-357). Section 703 of that act generally gives individuals settling an employment law matter a so-called “above-the-line” deduction from income for attorneys fees paid to the plaintiff’s lawyer as part of a settlement (i.e., the plaintiff usually will pay no federal income tax on that money). Although the AJCA may make it easier, as a practical matter, to settle a given case by putting more money in the plaintiff’s pocket, neither the AJCA nor the Banks decision changes the general rule of thumb for employers settling employment law matters: when an employer pays a plaintiff’s lawyer’s fees on behalf of a settling plaintiff, the employer is generally well advised, and may well be obligated, to issue an IRS Form 1099-MISC reporting the payment as income to the plaintiff’s lawyer, and a second such form reporting the payment as income to the settling plaintiff. THE BANKS DECISION When a defendant in an employment case pays a plaintiff’s attorneys fees, three analytically distinct, but economically interrelated, tax issues frequently arise: (i) is the defendant’s payment includable in the income of the plaintiff? (ii) if it is, to what extent is the plaintiff able to deduct those fees? (iii) is the defendant required to file an IRS Form 1099-MISC reporting that payment as income to the plaintiff? These three issues have been of particular concern to plaintiffs and defendants in employment cases, because some courts and the IRS have taken the position in such cases that when a defendant pays a plaintiff’s attorneys fees as part of a settlement, the money received by the lawyer is generally income to plaintiff and has to be included on the plaintiff’s tax return. Further, the IRS has issued regulations providing that, when the defendant’s payment of attorneys fees is income to plaintiff, the defendant must file one Form 1099-MISC showing the payment of attorneys fees as income to plaintiff, and another showing the fees as income to the lawyer. This is true whether the defendant has made such a payment solely to plaintiff’s counsel or jointly to plaintiff and plaintiff’s counsel. Some employee plaintiffs who have contingency fee arrangements with their counsel had taken the position prior to Banks that, because the payment of attorneys fees is contingent on success in the litigation, the defendant’s payment of plaintiff’s attorneys fees is not income to plaintiff (thus sidestepping any limits on plaintiff’s deductibility of attorneys fees). The federal courts of appeal were divided on the effect of a contingency fee arrangement on this income inclusion question. In its decision on Jan. 24, 2005, in CIR v. Banks, No. 03-982, 73 U.S.L.W. 4117, the U.S. Supreme Court resolved that difference of opinion. Framing the issue narrowly, the Court concluded that the existence of a contingent fee arrangement does not by itself affect the issue of inclusion of income by plaintiff. As a result, the amount of fees paid was considered income both as to the lawyer and as to the settling plaintiff. The rule enunciated in Banks will apply to cases to which the AJCA does not apply, that is (a) to cases that do not satisfy the complicated effective date of the AJCA (which has components related to the settlement date and the date on which the payments are made); and (b) to cases that do not involve the causes of action, which means it applies mostly to non-employment cases). The Banks decision expressly leaves a number of income inclusion issues open. The Court expressly noted Banks’ additional argument that he should not have to include amounts in income because of the effect of a fee-shifting statute, but it declined to rule on that question because no such statute was said to be at issue in the case. The Court also noted that various amici had asserted additional theories under which a defendant’s payment of plaintiff’s attorneys fees might not be income to the plaintiff, but expressly declined to rule on them as well. SECTION 703 OF AJCA The practical implications of the Banks decision for employment law cases were materially diminished by passage late last year of the American Jobs Creation Act of 2004 (P.L. 108-357). Section 703 of that act dealt with question whether a plaintiff in a piece of employment litigation could deduct from his or her taxes fees paid on his or her behalf to the plaintiff’s lawyer. The issue affected both employers and the plaintiffs’ bar because the preexisting limits on a plaintiff’s ability to deduct fees had made it more difficult to settle many cases. Thus, the legislation had significant support from both employers and plaintiffs’ bar alike. Section 703 amended IRC Section 62 to provide generally, and subject to certain limitations and exceptions beyond the scope of this article, that, if payments are made after October 22, 2004 (the section’s specific effective date) with respect to certain, specially defined causes of action (including actions for “unlawful discrimination”), the plaintiff can deduct those legal fees “above the line,” typically making them income-tax-free to the plaintiff. For these purposes, it does not matter whether the plaintiff had a contingency fee arrangement with plaintiff’s counsel. COMBINED EFFECT OF BANKS DECISION AND SECTION 703 OF THE AJCA In the wake of Banks, a settling plaintiff can’t avoid including in income the amount of plaintiff’s attorneys fees paid by the defendant, just because the plaintiff and plaintiff’s counsel had a contingency fee arrangement. Having included that amount in income, however, a plaintiff may well be able to deduct those fees “above the line,” so long as those fees were incurred in connection with one of the actions set forth in IRC Section 62 and paid after the effective date of Section 703 of the AJCA. IRS FORM 1099-MISC In a situation where Banks applies, if a business defendant makes a specifically-identified payment of attorneys fees on behalf of a settling plaintiff (whether directly to the plaintiff’s attorney or jointly to the attorney and the settling plaintiff), then ordinarily the defendant will have to report that payment on IRS Form 1099-MISC with respect to the plaintiff, in addition to any requirement that may apply with respect to filing IRS Form 1099-MISC with respect to the plaintiff’s attorney. Julian B. Decyk is of counsel in the tax department at Paul Hastings’ Los Angeles office and Neal Mollen is partner in the employment department in the Washington, DC office.

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