Tax Aspects of Litigation Awards and Settlements - Philadelphia Bar ...

Until the United States Supreme Court decided Comm’r v. Banks,
Nos. 03-892 and 03-907 (U.S. Jan. 24, 2005), there had been a split
among the Circuits on the issue. The Tax Court and a majority of
the Courts of Appeal had held that a successful plaintiff in an
employment litigation case must include in income the gross
amount of an Award, including the portion paid to his or her
attorney pursuant to a contingent fee agreement. In Banks, the
Supreme Court sided with the Tax Court and the majority of the
Courts of Appeal (see discussion below).
B. Banks v. Comm’r. The Supreme Court consolidated two cases
from the Sixth and Ninth Circuits which dealt with the confusion
over the tax treatment of attorney contingent fees and the
importance of state attorney liens laws in determining the result.
In Comm’r v. Banks, 345 F.3d 373 (6th Cir. 2003), the Sixth
Circuit adhered to its position in Estate of Clarks (attorney fees not
includible in client’s income) and stated that its holding does not
rest on the rationale that state lien laws governing attorney rights
determine the correct tax result. Banks involved California lien
law under which no ownership interest is conferred to the attorney.
In Banaitis v. Comm’r, 340 F.3d 1074 (9th Cir. 2003), involving
an Oregon plaintiff, the Ninth Circuit distinguished Oregon’s
strong attorney lien law from the weak attorney lien laws in
California in holding that the plaintiff did not need to include on
his income contingent fees paid directly to his attorney. The
Supreme Court, in a unanimous decision, resolved the split by
holding, “[A]s 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.” Banks, Nos. 03-892 and
03-907 at 2. For an in depth discussion of Banks, see Robert B.
Wood, “Supreme Court Attorney Fees Decision Leaves Much
Unresolved,” Tax Notes, Feb. 14, 2005, at 792. Banks must be
read in conjunction with the American Jobs Creation Act of 2004,
P.L. 108-357, (see discussion below).
C. Related Issues
1. Class Action Suits. In PLR 200222001, the IRS held that
payment of attorney fees to class counsel resulting from the
settlement of an “opt-out” class action lawsuit should not
be included in the calculation of a class member’s gross
income because the class members have not personally
agreed to compensate class counsel. See also PLR
200518017 (attorney fees to class counsel not taxable to
class members and class members need not report fees
under 6041); PLR 200316040 and Rev. Rul. 80-364, 1980-
2 CB 294 (labor union suit brought on behalf of union
members). A different result may apply in “opt-in” class
action lawsuits. See Kenseth, infra, involving an ADEA
opt-in class action.
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