Young v. Commissioner IRS , 240 F.3d 369 ( 2001 )

PUBLISHED
UNITED STATES COURT OF APPEALS
FOR THE FOURTH CIRCUIT
LOUISE F. YOUNG, a/k/a Louise Y.
Ausman; JAMES R. AUSMAN,
Petitioners-Appellants,
No. 00-1244
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent-Appellee.
JOHN B. YOUNG; MARTHA H. YOUNG,
Petitioners-Appellees,
v. No. 00-1261
COMMISSIONER OF INTERNAL REVENUE,
Respondent-Appellant.
Appeals from the United States Tax Court.
(Tax Ct. Nos. 97-21489, 97-20435)
Argued: December 7, 2000
Decided: February 16, 2001
Before WILKINS, MICHAEL, and MOTZ, Circuit Judges.
_________________________________________________________________
Affirmed by published opinion. Judge Motz wrote the opinion in
which Judge Michael joined. Judge Wilkins wrote an opinion concur-
ring in part and dissenting in part.
_________________________________________________________________
COUNSEL
ARGUED: Frank Hilton Lancaster, ROBINSON, BRADSHAW &
HINSON, P.A., Charlotte, North Carolina, for Appellants. Jonathan
Samuel Cohen, Tax Division, UNITED STATES DEPARTMENT
OF JUSTICE, Washington, D.C.; William Mimms Claytor, BAU-
COM, CLAYTOR, BENTON, MORGAN & WOOD, P.A., Charlotte,
North Carolina, for Appellees. ON BRIEF: Robert W. Fuller, III,
ROBINSON, BRADSHAW & HINSON, P.A., Charlotte, North Car-
olina, for Appellants. Paula M. Junghans, Acting Assistant Attorney
General, Michelle C. France, Tax Division, UNITED STATES
DEPARTMENT OF JUSTICE, Washington, D.C., for Appellee Com-
missioner.
_________________________________________________________________
OPINION
DIANA GRIBBON MOTZ, Circuit Judge:
This case presents two tax questions arising from the settlement of
a property dispute between former spouses. The first is whether a
1992 transfer of land from a husband to his former wife constitutes
a transfer "incident to" their 1988 divorce for purposes of the non-
recognition of gain rules. The second is whether the wife must include
within her gross income the contingent fees paid directly to her attor-
neys from the proceeds of her subsequent sale of that land. We agree
with the Tax Court's holding that both questions must be answered
in the affirmative.
I.
Louise Young1 1 and John Young married in 1969 and divorced in
_________________________________________________________________
1 After her divorce from John Young, Louise married James Ausman,
another appellant, and became Louise Ausman. Although it is not
reflected in the caption of the case, Louise has since divorced and remar-
ried and is now named Louise Rice. To remain consistent with the par-
ties' stipulated facts before the Tax Court, however, we continue to refer
to Louise Young.
2
1988. The following year they entered into a Mutual Release and
Acknowledgment of Settlement Agreement ("1989 Settlement Agree-
ment") to resolve "their Equitable Distribution [of] Property claim
and all other claims arising out of the marital relationship." Pursuant
to this agreement, Mr. Young delivered to Mrs. Young a promissory
note for $1.5 million, payable in five annual installments plus interest,
which was secured by a deed of trust on 71 acres of property that Mr.
Young received as part of the same 1989 Settlement Agreement.
In October 1990, Mr. Young defaulted on his obligations under the
1989 Settlement Agreement; the next month Mrs. Young brought a
collection action in state court in North Carolina. On May 1, 1991,
that court entered judgment for Mrs. Young, awarding her principal,
interest, and reasonable attorneys' fees. Mr. Young paid only
$160,000 toward satisfaction of that judgment, thus prompting Mrs.
Young to initiate steps to execute the judgment. Before execution,
however, Mr. and Mrs. Young entered into a Settlement Agreement
and Release ("1992 Agreement"), which provided that Mr. Young
would transfer to Mrs. Young, in full settlement of his obligations, a
59-acre tract of land (42.3 of the 71 acres that had collaterized his
$1.5 million note and 16.7 acres adjoining that tract). Pursuant to the
1992 Agreement, Mr. Young retained an option to repurchase the land
for $2.2 million before December 1992. Mr. Young assigned the
option to a third party, who exercised the option and bought the land
from Mrs. Young for $2.2 million.
On her 1992 and 1993 federal income tax returns, Mrs. Young
reported no capital gain from the sale of the property nor the
$300,606 portion of the $2.2 million that went directly to pay her
attorneys' fees. At the same time, Mr. Young did not report any gain
from his transfer of property, in which he had a $130,794 basis, to sat-
isfy his then almost $2.2 million obligation to Mrs. Young. Thus, the
appreciation of this property went untaxed despite the occurrence of
a taxable event, i.e., the transfer or the sale.
The Commissioner asserted deficiencies against both Mr. Young
and Mrs. Young. Each then petitioned the Tax Court, which consoli-
dated the two cases. After trial, the Tax Court ruled that the capital
gain was properly taxable to Mrs. Young under 26 U.S.C.
§ 1041(a)(2) (1994), which provides that "[n]o gain or loss shall be
3
recognized on a transfer of property . . . to . . . a former spouse, . . .
if the transfer is incident to the divorce." See Young v. Commissioner,
113 T.C. 152, 156 (1999). Because the Tax Court held that the 1992
property transfer was "incident to the divorce," it concluded that Mr.
Young realized no gain through his transfer of this property to his for-
mer spouse. Id. Rather, according to the Tax Court, Mrs. Young took
Mr. Young's adjusted basis in the land and should have recognized
a taxable gain upon the subsequent sale of that property. In addition,
the Tax Court held that the portion of the proceeds from the sale,
which was paid directly to her attorneys, must be included in Mrs.
Young's gross income. As a result of these holdings, the Tax Court
ruled that Louise Young and her then husband, James Ausman, owed
$206,323 in additional income tax in 1992, and Louise alone owed
$262,657 in additional income tax in 1993.
Mrs. Young and James Ausman appeal both rulings. The Commis-
sioner files a protective cross-appeal on the § 1041 issue, urging that
if we do not agree with the Tax Court's conclusion that Mrs. Young
(and Mr. Ausman) realized taxable capital gains, we also reverse its
holding with respect to Mr. Young so that he is required to recognize
the gain.
II.
We first consider the Tax Court's ruling involving§ 1041, which
provides that no taxable gain or loss results from a transfer of prop-
erty to a former spouse if the transfer is "incident to the divorce." 26
U.S.C. § 1041(a)(2). Section 1041 further provides that "a transfer of
property is incident to the divorce" if it is"related to the cessation of
the marriage." 26 U.S.C. § 1041(c)(2). The statute does not further
define the term "related to the cessation of the marriage," but tempo-
rary Treasury regulations provide some guidance. Those regulations
extend a safe harbor to transfers made within six years of divorce if
also "pursuant to a divorce or separation instrument, as defined in
§ 71(b)(2)." Temp. Treas. Reg. § 1.1041-1T(b) (2000). Section
71(b)(2) defines a "divorce or separation instrument" as a "decree of
divorce or separate maintenance or a written instrument incident to
such a decree." 26 U.S.C. § 71(b)(2) (1994). A property transfer not
made pursuant to a divorce instrument "is presumed to be not related
to the cessation of the marriage." Temp. Treas. Reg. § 1.1041-1T(b).
4
This presumption may be rebutted "by showing that the transfer was
made to effect the division of property owned by the former spouses
at the time of the cessation of the marriage." Id.The Tax Court held that the 1992 transfer from Mr. Young to Mrs.
Young was "related to the cessation of the marriage," thus neither
party recognized a gain or loss on the transfer, and Mrs. Young took
the same basis in the land that the couple had when they were mar-
ried. Young, 113 T.C. at 156. The court applied the regulatory safe
harbor provision, but also found that the transfer"completed the divi-
sion of marital property" and, regardless of the safe harbor provision,
it "satisfied the statutory requirement that the transfer be `related to
the cessation of the marriage.'" Id. We agree with the Tax Court that
the 1992 land transfer was "related to the cessation of the marriage,"
finding that it "effect[ed] the division of[marital] property." Temp.
Treas. Reg. § 1.1041-1T(b).
The factual underpinnings of this case are not questioned. It is
undisputed that the parties formulated and entered into the 1989 Set-
tlement Agreement to resolve their "respective claims for equitable
distribution of property" and "all other claims arising out of the mari-
tal relationship." The parties also agree that the 1992 Agreement was
to resolve disputes arising from that 1989 Settlement Agreement. In
fact, an entire section of the 1992 Agreement details the marital back-
ground of the dispute, beginning with the Youngs' divorce and subse-
quent execution of the 1989 Settlement Agreement, and expressly
provides that the 1992 Agreement was to "fully settle all claims under
the Judgment and Deed of Trust" that arose out of the 1989 Settle-
ment Agreement. Not surprisingly then, the Tax Court explicitly
found that the 1992 transfer "completed the division of marital prop-
erty." Young, 113 T.C. at 156.2 2
_________________________________________________________________
2 Whether the transfer effected the division of marital property is an
issue of fact, and we cannot reverse the Tax Court's"subsidiary and ulti-
mate findings on this factual issue" unless they are clearly erroneous.
Rice's Toyota World, Inc. v. Commissioner, 752 F.2d 89, 92 (4th Cir.
1985). Cf. Riley v. Commissioner, 649 F.2d 768, 773 (10th Cir. 1981)
(finding no clear error in Tax Court's holding that payments were made
in accordance with property settlement and thus were"legal obligation[s]
. . . aris[ing] out of a family or marital relationship"). The dissent ignores
5
Nonetheless, Mrs. Young challenges the Tax Court's finding and
argues that the 1992 transfer did not "effect the division of [marital]
property." In support of her contention, Mrs. Young notes that she
was a judgment creditor when she entered into the 1992 Agreement.
But the only status relevant for § 1041 purposes is "spouse" or "for-
mer spouse." Beyond her position as a former spouse, Mrs. Young's
status makes no difference when determining whether the transfer is
taxable; § 1041 looks to the character of and reason for the transfer,
not to the status of the transferee as a creditor, lien-holder, devisee,
trust beneficiary, or otherwise.3 3 Indeed, in Barnum v. Commissioner,
19 T.C. 401, 407-08 (1952), although the former wife had obtained
a judgment against her husband for alimony arrearage, the Tax Court
found the resulting settlement to be "incident to a divorce" because,
like the 1992 Agreement in this case, it settled the"dispute over obli-
gations arising from a divorce decree." Id._________________________________________________________________
this deferential standard of review in concluding that the transfer of mari-
tal property was completed when Mr. Young delivered the promissory
note to Mrs. Young. See post at 17. There is no reason to hold the Tax
Court inappropriately assessed the evidence, certainly no basis for find-
ing the court clearly erred in doing so. That Mr. Young transferred a
promissory note to Mrs. Young in 1989 does not change the fact that his
1992 land transfer was also "related to the cessation of marriage." Nei-
ther the statute nor the regulations limit § 1041 to only one post-divorce
transfer if two or more are "incident to divorce" or necessary to complete
the transfer of marital property. Moreover, no gain or loss would have
been recognized on Mr. Young's annual payment of his note, nor is there
reason to recognize a gain or loss simply because the parties agreed that
Mr. Young could satisfy his outstanding obligation in a single transfer.
As the Tax Court correctly found, the transfer was not "completed" until
Mr. Young paid his obligation in full.
3 That the 1992 transfer satisfied a judgment does not support the dis-
sent's contention that it was therefore made for"reasons bearing no rela-
tionship to the fact that the parties were previously married." Post at 18.
This assertion completely overlooks the context in which the judgment
was settled and satisfied. The 1992 Agreement itself details the marital
"reasons" behind the settlement. Mr. Young did not simply satisfy a
judgment, he finally gave "effect" to the"division of [the marital] prop-
erty." Temp. Treas. Reg. § 1.1041-1T(b).
6
Additionally, Mrs. Young's reliance on a private letter ruling
issued to another taxpayer is misplaced. P.L.R. 9306015 (Feb. 12,
1993).4
4 In that case, the divorce decree contemplated a sale of the for-
mer marital house, in which each spouse owned a one-half interest,
to a third party. The IRS ruled that the husband's subsequent sale of
his one-half interest in the house to his former wife instead of a third
party was an "arm's-length transaction between two parties that hap-
pen to be former spouses," and thus did not"effect the division" of
marital property pursuant to § 1041 and its regulations. Id. (emphasis
added). Because the husband in the private letter ruling had no obliga-
tion stemming from the divorce decree to sell his half interest in the
home to his wife, the fact that the parties were former spouses truly
had no bearing on the sale except as the means of their association.
In contrast, Mr. Young transferred the 59 acres to satisfy an obliga-
tion that originated from the dissolution of the Youngs' marriage. Mr.
Young's transfer of this land was not an independent decision
"[un]related to the cessation of the marriage." And Mrs. Young did
not just "happen" to be Mr. Young's "former spouse." Instead, the
transaction occurred only because she was his former spouse enforc-
ing her rights growing out of the dissolution of their marriage.
Mrs. Young's argument based on state court jurisdiction is no more
persuasive. She asserts that the 1992 Agreement could not have effec-
tuated the division of marital property, because the judgment that pre-
cipitated the 1992 Agreement was rendered by a North Carolina
Superior Court, and not a North Carolina District Court, which "is the
proper division . . . for . . . the enforcement of separation or property
settlement agreements between spouses, or recovery for the breach
thereof." N.C. Gen Stat. § 7A-244. Whatever the merits of this argu-
ment as to the jurisdiction of North Carolina courts, it cannot be the
basis for a decision as to the federal tax consequences of a transfer
of property. The Commissioner does not contend that the suit upon
which the 1992 Agreement was based was for "recovery for the
breach" of a property settlement agreement under North Carolina law,
but only that the 1992 Agreement completed "the division" of marital
property under § 1041 of the Internal Revenue Code.
_________________________________________________________________
4 We note that Congress has mandated that a private letter ruling, which
by its terms is directed only to the taxpayer who requested it, has no pre-
cedential value. See 26 U.S.C. § 6110(j)(3)(1994).
7
Nor do we find Mrs. Young's "fairness" argument compelling. She
points out that under the 1989 Settlement Agreement she was to
receive $1.5 million plus interest, but if forced to pay the capital gains
tax she will receive a lesser amount. For this reason, she argues that
application of § 1041 to the 59-acre transfer would "result in a radical
and unfair re-division of the Young's [sic] marital property." Brief of
Appellant at 29. But, this argument overlooks the fact that Mrs.
Young agreed to accept the 59 acres in lieu of enforcing her judgment
against Mr. Young and receiving a cash payment. For whatever rea-
son -- and the record is silent as to Mrs. Young's motivations -- she
chose not to follow the latter route. In addition, if Mrs. Young had
agreed to accept land in 1989, as she ultimately did in 1992, the
resulting transfer would unquestionably have "effect[ed] the division
of [marital] property" and been within§ 1041. That the transfer
occurred three years later does not alter its "effect," or its treatment
under § 1041.
The sole reason for the 1992 Agreement was to resolve the disputes
that arose from the Youngs' divorce and subsequent property settle-
ment. Had the Youngs reached this settlement at the time of their
divorce, there is no question that this transaction would have fallen
under § 1041. There is no reason for the holding to differ here where
the same result occurred through two transactions instead of one.
The policy animating § 1041 is clear. Congress has chosen to "treat
a husband and wife [and former husband and wife acting incident to
divorce] as one economic unit, and to defer, but not eliminate, the rec-
ognition of any gain or loss on interspousal property transfers until
the property is conveyed to a third party outside the economic unit."
Blatt v. Commissioner, 102 T.C. 77, 80 (1994) (emphasis added).55
See also H.R. Rep. No. 98-432, at 1491 (1984), reprinted in 1984
U.S.C.C.A.N. 1134. Thus, no taxable event occurred and no gain was
realized by either Mr. or Mrs. Young until Mrs. Young sold the 59
acres to a third party.
_________________________________________________________________
5 There are of course exceptions in which transfers to third parties "on
behalf of" a former spouse are treated as § 1041 transfers, see Arnes v.
United States, 981 F.2d 456, 458 (9th Cir. 1992), but this is not such a
case.
8
Indeed, holding otherwise would contradict the very purpose of
§ 1041. Congress enacted that statute to "correct the[ ] problems"
caused by United States v. Davis, 370 U.S. 65 (1962), in which "[t]he
Supreme Court ha[d] ruled that a transfer of appreciated property to
a spouse (or former spouse) in exchange for the release of marital
claims results in the recognition of gain to the transferor." H.R. Rep.
No. 98-432, at 1491-92 (1984), reprinted in 1984 U.S.C.C.A.N. 1134-
35. Congress found this result "inappropriate," id., and thus amended
the tax code in 1984 to add § 1041. Given this history, to impute a
gain to Mr. Young on his transfer of "appreciated property . . . in
exchange for the release of [Mrs. Young's] marital claims" would
abrogate clear congressional policy. Id.
The dissent's contention that the result we reach here is not sup-
ported by equitable considerations misses the point. Congress has
already weighed the equities and established a policy that no gain or
loss will be recognized on a transfer between former spouses incident
to their divorce. Thus anytime former spouses transfer appreciated
property incident to their divorce, the transferee spouse will bear the
tax burden of the property's appreciated value after selling it and
receiving the proceeds. Although this rule will undoubtedly work a
hardship in some cases, the legislature has clearly set and codified this
policy. We cannot disregard that choice to satisfy our own notions of
equity.
In so concluding, we do not suggest that the boundaries defining
when a transfer is "related to the cessation of the marriage" or made
"to effect the division of [marital] property" are always clear. We can-
not, however, on the facts of this case hold that Mr. Young's "inter-
spousal property transfer" was a taxable event, when the purpose
behind Mr. Young's transfer was to satisfy his obligations arising
from the "cessation of the marriage." To do so would, we believe,
contravene the language, purpose, and policy of§ 1041 and the regu-
lations promulgated pursuant thereto.
III.
The Commissioner also determined that to the extent Mr. Young's
transfer of land to Mrs. Young discharged a $300,606 debt to her for
legal expenses, it should be included in her gross income. In the Tax
9
Court, Mrs. Young contended that Mr. Young owed the $300,606 in
attorneys' fees directly to her attorneys, not to Mrs. Young herself,
and so maintained that this amount should not be included in her
gross income, regardless of § 1041. The Tax Court found to the con-
trary. On appeal, Mrs. Young does not challenge this factual finding
but nonetheless maintains that the Tax Court erred when it concluded
that this $300,606 must be included within her gross income. Mrs.
Young argues that, even if this amount was owed to her, she never
realized this income and so it should for this reason not be included
in her gross income.
Resolution of this question centers on the meaning of "gross
income." The Internal Revenue Code provides a very general defini-
tion: "[e]xcept as otherwise provided . . . gross income means all
income from whatever source derived." 26 U.S.C.§ 61(a) (1994).
Moreover, the Supreme Court has given a "liberal construction" to the
term "gross income . . . in recognition of the intention of Congress to
tax all gains except those specifically exempted." James v. United
States, 366 U.S. 213, 219 (1961) (emphasis added); see also Commis-
sioner v. Glenshaw Glass Co., 348 U.S. 426, 430 (1955).
The Court has long held that the assignment to another of income
not yet received does not relieve the assignor of tax liability on that
income. See Lucas v. Earl, 281 U.S. 111 (1930). In Earl, Justice
Holmes reasoned that the Internal Revenue Code "tax[es] salaries to
those who earned them" and does not allow a party to escape taxes
through "anticipatory arrangements and contracts however skillfully
devised to prevent the salary . . . from vesting even for a second in
the man who earned it." Id. at 114-15. Similarly in Helvering v. Horst,
311 U.S. 112, 114 (1940), the Supreme Court held that a father could
not escape taxation on future interest income by assigning it to his
son. In Horst, the father owned negotiable bonds but detached their
interest coupons, giving them to his son before they came due. The
Court held that the father's gift was an anticipatory assignment of his
income because he had earned and enjoyed the benefit of the coupons
by directing them to his son. Thus, the father was properly taxed even
though the son ultimately collected the interest income.
Under the reasoning of Earl and Horst , Mrs. Young's anticipatory
assignment of a portion of her settlement proceeds to her attorneys
10
does not foreclose taxation of those proceeds, i.e., they are nonethe-
less includible within Mrs. Young's gross income. Mrs. Young asks
us, however, to adopt the contingent attorney fee exception to this
rule established by the Fifth Circuit in Cotnam v. Commissioner, 263
F.2d 119 (5th Cir. 1959).
Over Judge Wisdom's dissent, the Cotnam court held that, unlike
the situation in Earl, a contingent fee was not income to the client but
rather income earned directly by her attorneys, because the client's
claim was uncertain to be paid at all and thus "worthless without the
aid of skillful attorneys." Cotnam, 263 F.2d at 125. Applying this rea-
soning, the court ruled that the client did not assign "income," but
instead "assigned to her attorneys forty per cent of the claim in order
that she might collect the remaining sixty per cent." Id. Furthermore,
the Cotnam court found that in contrast to the father in Horst, "the
only economic benefit to the [client] was an aid to the collection of
a part of an otherwise worthless claim." Id. at 126. The Cotnam court
also relied on the Alabama Code, which provided that"attorneys . . .
have the same right and power over said suits, judgments and decrees,
to enforce their liens, as their clients had or may have for the amount
due thereon to them." Id. at 125. Because Alabama attorneys have the
"same right" over the suit as the client, the court reasoned, the client
could never have realized the fee as income to her.
Only one circuit has independently reached the same outcome as
Cotnam. See Estate of Clarks v. United States, 202 F.3d 854 (6th Cir.
2000).66 In that case, the Sixth Circuit similarly reasoned that while the
income at issue in Earl and Horst was "already earned, vested and rel-
atively certain to be paid to the assignor," a contingent fee is more
similar to a "division of property than an assignment of income," and
the "income should be charged to the one who earned it and received
it, not . . . to one who neither received it nor earned it." Id. at 857-58.
Like Cotnam, Clarks also looked to state law. Under the applicable
Michigan law, an attorney only had a lien on a judgment (as opposed
to the property "right" provided under the Alabama law in Cotnam),
_________________________________________________________________
6 Since the former Fifth Circuit split, the Eleventh Circuit and the new
Fifth Circuit have followed Cotnam on stare decisis grounds. See
Srivastava v. Commissioner, 220 F.3d 353, 357-58 (5th Cir. 2000); Davis
v. Commissioner, 210 F.3d 1346, 1347 (11th Cir. 2000).
11
nonetheless, the Clarks court concluded that"[a]lthough the underly-
ing claim . . . was originally owned by the client, the client lost his
right to receive payment for the lawyer's portion of the judgment." Id.
at 856.
Mrs. Young urges us to follow Cotnam and Clarks. But to do so
would permit a client to avoid taxation by "skillfully devis[ing]" the
method for paying her attorneys' fees, the precise danger the Supreme
Court warned against in Earl, 281 U.S. at 115. If her attorneys
charged an hourly rate, Mrs. Young would certainly have to include
within her gross income any income used to pay her legal fees,
whether the income came from the settlement proceeds or otherwise.
We see no reason to allow her to escape taxation on a portion of the
settlement proceeds simply because she arranged to compensate her
attorneys directly from the proceeds through a contingent fee arrange-
ment. Indeed, the Fifth Circuit itself, although following Cotnam on
grounds of stare decisis, has recently recognized that a client with a
contingent fee arrangement:
[O]ught not receive preferential tax treatment from the sim-
ple fortuity that he hired counsel on a contingent basis, for
his attorney's method of compensation did not meaningfully
affect the gain he was able to enjoy from a favorable resolu-
tion of the litigation.
Srivastava v. Commissioner, 220 F.3d 353, 363 (5th Cir. 2000)(foot-
note omitted).
In addition, Cotnam's holding that the contingent fee was "income
to the attorneys but not to [the client]" was based in part on the notion
that the client's claim was "worthless without the aid of skillful attor-
neys." Cotnam, 263 F.2d at 125. That rationale overlooks the fact that
an attorney paid by the hour adds just as much "worth" to a claim as
a contingent fee attorney. Moreover, it is undisputed that satisfaction
of Mrs. Young's obligation to her attorneys provided her an economic
benefit. See Baylin v. United States, 43 F.3d 1451, 1454 (Fed. Cir.
1995). See also Old Colony Trust Co. v. Commissioner, 279 U.S. 716,
729 (1929) ("The discharge by a third person of an obligation to him
is equivalent to receipt by the person taxed."). That an assignment of
income involves a contingent or undetermined amount does not
12
exempt it from taxation to the assignor. See Coady v. Commissioner,
213 F.3d 1187, 1191 (9th Cir. 2000); Baylin, 43 F.3d at 1455 ("That
the [client] assigned a portion of its . . . recovery to its attorney before
it knew the exact amount of the recovery does not mean that this
amount never belonged to the [client].").
We also do not accept the suggestion in Cotnam and Clarks that
a contingent fee arrangement gives an attorney a portion of a client's
cause of action, see Cotnam, 263 F.2d at 125, or "property." See
Clarks, 202 F.3d at 857-58. The client still controls the claim (or
property) and ultimately decides to forego, pursue, or settle that
claim. The attorney simply provides a service and receives compensa-
tion for that service, whether by an hourly rate or through a contin-
gent fee. Indeed, the idea that the attorney merely helps the client earn
income from her claim is reinforced by the Tax Court's holding in
this case that Mrs. Young could deduct the portion of her legal fees
that were "allocable to the recovery of taxable income." Young, 113
T.C. at 157 (emphasis added) (citing Kelly v. Commissioner, 23 T.C.
682, 688 (1955), aff'd 228 F.2d 512 (7th Cir. 1956)).
Nor do we agree with Cotnam and Clarks 's (and Mrs. Young's)
reliance on state law to settle this federal tax issue. Indeed, there is
no relevant distinction between the state common law discussed in
Clarks and Baylin, yet those courts reached opposite conclusions.7 7 As
the Fifth Circuit itself has now recognized, whether amounts paid
directly to attorneys under a contingent fee agreement should be
included within the client's gross income should be resolved by
proper application of federal income tax law, not the amount of con-
_________________________________________________________________
7 Under the law of both Michigan, which was assertedly relevant in
Clarks, and Maryland, which was assertedly relevant in Baylin, attorneys
have no "right" to the client's income-producing claim but just a lien on
the judgment. See Aetna Cas. & Sur. Co. v. Starkey, 116 Mich. App. 640,
645, 323 N.W.2d 325, 328 (1982) ("An attorney's lien is not an assign-
ment but is a specific encumbrance on a fund or judgment which the cli-
ent has recovered through the professional services of the attorney.");
Chanticleer Skyline Room, Inc. v. Greer, 271 Md. 693, 319 A.2d 802,
806 (1974) ("Like any other lien, this lien does not create an ownership
interest in the attorney, but merely places a charge upon the fund as
security for the debt which is owed to the attorney by his client.").
13
trol state law grants to an attorney over the client's cause of action.
See Srivastava, 220 F.3d at 363-64 & n.33. 8
But, even if we adopted the contingent fee exception established in
Cotnam and the view that state law was determinative -- and we do
not -- North Carolina law is easily distinguishable from the Alabama
statute on which Cotnam relied. The Alabama statute gave the attor-
ney the "same right" over the cause of action as the client, thus argu-
ably providing a right over the income-producing claim. By contrast,
the North Carolina common law provides an attorney with a charging
lien, which "attaches only to a judgment, not to a cause of action."
Dillon v. Consolidated Delivery, Inc., 43 N.C. App. 395, 396, 258
S.E.2d 829, 830 (1979). Consequently, an attorney's right to contin-
gent income matures at the same time the judgment is rendered or set-
tlement achieved -- i.e., when the client's income is earned. And
Justice Holmes teaches us that a taxpayer cannot escape taxation by
"prevent[ing] the [income] when paid from vesting even for a second
in the man who earned it." Earl, 281 U.S. at 115 (emphasis added).
There is no indication that a North Carolina attorney paid by contin-
gent fee has acquired rights to the cause of action or a right equal to
that of the client. Until judgment, or in this case settlement, the attor-
ney has the right to recover fees for services rendered, but not to
obtain a share of the income produced by the client's claim. See Cov-
ington v. Rhodes, 38 N.C. App. 61, 64, 247 S.E.2d 305, 308 (1978).
The attorney does not, as Mrs. Young suggests, own the claim itself.
Accordingly, we join the majority of those circuits to have
addressed this issue and decline to adopt the Cotnam exception. See
Coady v. Commissioner, 213 F.3d 1187 (9th Cir. 2000); Alexander v.
IRS, 72 F.3d 938 (1st Cir. 1995); Baylin, 43 F.3d 1451 (Fed. Cir.
1995); O'Brien v. Commissioner, 38 T.C. 707 (1962), aff'd 319 F.2d
532 (3d Cir. 1963). See also Bagley v. Commissioner, 105 T.C. 396,
418-19 (1995) (holding, without mentioning Cotnam, that settlement
portion paid to attorneys pursuant to contingent fee was income to cli-
_________________________________________________________________
8 Moreover, Congress amended the tax code in 1984 in part to "carry
out the congressional purpose of avoiding different tax consequences
because of differences in state laws." Kitch v. Commissioner, 103 F.3d
104, 107 (10th Cir. 1996) (citing H.R. Rep. No. 98-432, at 1491-92,
1495, reprinted in 1984 U.S.C.C.A.N. 697, 1134-35, 1137).
14
ent), aff'd 121 F.3d 393 (8th Cir. 1997). Rather, the $300,606,
although directly paid to Mrs. Young's attorneys under a contingent
fee agreement was, as the Tax Court held, properly includible in her
gross income.
IV.
Therefore, the Tax Court's judgment is in all respects
AFFIRMED.
WILKINS, Circuit Judge, concurring in part and dissenting in part:
The majority affirms the determination of the Tax Court that the
1992 property transfer from John Young to his former wife Louise
was "incident to" the Young's divorce and that Louise must include
as her income the contingent fees paid directly to her attorneys from
the sale of the land transferred. I concur regarding the contingency fee
issue but respectfully dissent regarding whether the 1992 property
transfer was incident to the Young's divorce. I would conclude that
a property transfer made between former spouses to satisfy a judg-
ment is not made "incident to" the parties' divorce merely because the
lawsuit that produced the judgment was for default on a promissory
note obtained in the parties' divorce property settlement.
I.
The issue in dispute here is which former spouse is responsible for
paying capital gains taxes as a result of the substantial appreciation
of the transferred property that occurred prior to the time John used
the property to satisfy his debt to Louise.11 The answer to that question
depends on whether the 1992 transfer was a taxable event. If it was,
_________________________________________________________________
1 John's basis in the property was $130,794. He transferred the land to
Louise to satisfy a debt totaling $2,153,845, including $1,500,000 in
principal, $344,938 in interest, $300,606.08 in attorney's fees, and
$8,300 in collection costs. John reported no capital gain from his use of
the appreciated property to satisfy his debt. Louise sold the property for
$2,265,000 and reported a $100,000 short-term capital gain and
$356,500 in interest income.
15
then John owed capital gains taxes and Louise received a basis that
reflected the fact that the property had appreciated substantially prior
to her receiving it. If it was not, then John owed no capital gains taxes
and Louise took the property at John's previous, much lower basis.
I believe the applicable law demonstrates that the 1992 transfer was
a taxable event and therefore capital gains taxes were due and payable
by John as a result of this transaction.
The parties agree that the 1992 property transfer was a taxable
event unless 26 U.S.C.A. § 1041 applies. That section provides that
"[n]o gain or loss shall be recognized on a transfer of property . . .
to . . . a former spouse . . . if the transfer is incident to the divorce."
26 U.S.C.A. § 1041(a)(2) (West Supp. 2000). A transfer is "incident
to the divorce" if it either "occurs within 1 year after the date on
which the marriage ceases" or "is related to the cessation of the mar-
riage." Id. § 1041(c). A temporary Treasury regulation interpreting
§ 1041 in turn provides, in pertinent part, that a transfer is deemed
"related to the cessation of the marriage" when made within six years
of the divorce and "pursuant to a divorce or separation agreement."
Temp. Treas. Reg. § 1.1041-1T(b) (2000). On the other hand, "[a]ny
transfer not pursuant to a divorce or separation instrument . . . is pre-
sumed to be not related to the cessation of the marriage." Id. The reg-
ulation further states that "[t]his presumption may be rebutted only by
showing that the transfer was made to effect the division of property
owned by the former spouses at the time of the cessation of the mar-
riage." Id.The majority does not address the question of whether the 1992
agreement to satisfy the judgment was a "divorce or separation instru-
ment," but concludes that the Government met its burden of proving
that the property transfer "was made to effect the division of [marital]
property." I will briefly explain why I believe the property transfer
was not a "divorce or separation instrument" and then explain why I
believe it is incorrect to conclude that the property transfer "was made
to effect the division of [marital] property."
A.
The term "divorce or separation instrument" appears in
26 U.S.C.A. § 71, which pertains to alimony and separate mainte-
16
nance payments. That section defines "divorce or separation instru-
ment," as pertinent here, as "a decree of divorce or separate
maintenance or a written instrument incident to such a decree."
26 U.S.C.A. § 71(b)(2)(A) (West 1988). It is undisputed that the set-
tlement agreement is not a decree of divorce or separate maintenance.
Accordingly, it qualifies as a "divorce or separation instrument" only
if it is "a written instrument incident to""a decree of divorce or sepa-
rate maintenance."
Words not defined in a statute are given their ordinary meaning.
See Scrimgeour v. Internal Revenue, 149 F.3d 318, 327 (4th Cir.
1998). "Incident" means "dependent upon, appertaining or subordi-
nate to, or accompanying something else of greater or principal
importance." Black's Law Dictionary 762 (6th ed. 1990). Here, the
1992 agreement did not bear such a close relationship to the divorce
decree. Instead, the 1988 divorce decree and the 1992 agreement were
connected only indirectly: The 1992 agreement settled a dispute that
arose out of the 1989 division of property that occurred as a result of
the parties' 1988 divorce. Nothing in the divorce decree or the prop-
erty division compelled the land transfer contemplated in the 1992
agreement. Accordingly, the settlement document does not fit the def-
inition of a "divorce or separation instrument."
B.
The determination that the 1992 settlement agreement is not a "di-
vorce or separation instrument," as that term is defined in § 71, gives
rise to a presumption that the property transfer was not related to the
cessation of the marriage. In order to rebut that presumption, the Gov-
ernment was required to show "that the transfer was made to effect
the division of [marital] property." Temp. Treas. Reg. § 1.1041-1T(b).
Because the division of marital property was completed years before
the property transfer--when the parties released their marital claims
against one another and Louise accepted the promissory note--I
would hold that the Government failed to make the necessary show-
ing.
A property transfer is not made for the purpose of effecting a mari-
tal property division when the marital property division has already
17
been completed.22 The Youngs completed this division when John
delivered the promissory note to Louise. His payments on the note did
not transfer marital property; the note itself accomplished that. Nei-
ther were the payments inherently marital, as alimony is. Instead,
John's obligations on the note were the obligations of a debtor to a
creditor and were no more intimate than a mortgage. Accordingly,
although the judgment arising from John's default on the note was
causally related to the marital property division, that division had
been completed and the marital economic ties between the Youngs
had been severed before the 1992 transfer occurred. 3 The 1992 prop-
erty transfer was made simply to satisfy a judgment between them, for
reasons bearing no relationship to the fact that the parties were pre-
viously married. In other words, John owed a debt to Louise because
of the marriage, but they did not agree to settle the debt by a land
transfer because of the marriage.
Indeed, the fact that the parties' status as former spouses did not
affect their decision to make the transfer in question was also the
_________________________________________________________________
2 The majority states that the statement made by the Tax Court that the
1992 transfer "completed the division of marital property" was a finding
of fact that we must accept unless clearly erroneous. See ante at 5-6 n.2.
Clearly, however, the statement was a conclusion of law, not a finding
of fact. The Tax Court specifically set out its"FINDINGS OF FACT" at
the beginning of its opinion, Young v. Comm'r , 113 T.C. 152, 154-55
(1999); the statement cited by the majority appears in the section of the
opinion labeled "OPINION." Id. at 156. And, even without this delinea-
tion, it is apparent that the statement is no finding of fact. This case was
decided on stipulated facts, and the determination that "[t]he 1992 Agree-
ment resolved a dispute arising under the 1989 Property Settlement and
completed the division of marital property" simply described how the
1992 agreement related to the property division. Id. There is no reason
for us to give deference to this analysis by the Tax Court of stipulated
facts. Because the statement is a conclusion of law, our standard of
review is de novo. See Waterman v. Comm'r, 179 F.3d 123, 126 (4th Cir.
1999).
3 This factor distinguishes Barnum v. Commissioner, 19 T.C. 401(1952), cited by the majority. In that case, the agreement addressed exist-
ing alimony rights of the parties. See Barnum , 19 T.C. at 407. Further-
more, it is important to note that the Barnum court was not guided by the
temporary Treasury regulation that guides our decision today.
18
basis for private letter ruling 9306015. See Priv. Ltr. Rul. 9306015
(Feb. 12, 1993). There, the divorce decree contemplated a sale to a
third party of the former marital house, in which each spouse owned
an interest. Nevertheless, eight years after the parties' divorce, the
husband sold his interest in the home to his former wife. The IRS
ruled that because the sale was simply "an arm's-length transaction
between two parties that happen to be former spouses," the transfer
was not made to effect the division of marital property. Id. The major-
ity attempts to distinguish this ruling by asserting that, unlike the par-
ties in the private letter ruling, the Youngs were not simply "two
parties that happen to be former spouses" because the circumstances
that led John to make the 1992 transfer were created by the marital
property division. See ante, at 7. Clearly, however, the IRS' charac-
terization of the parties in the private letter ruling as "happen[ing] to
be former spouses" did not refer to the history of the circumstances
leading to the sale; indeed, the sale was the direct result of circum-
stances arising from the marriage. Rather, the characterization
referred to the husband's purpose in making the transfer. Regardless
of whether the husband's shared interest in the house arose from his
prior marriage, that history did not affect his decision to sell his inter-
est to his joint owner. The same principle applies here. Regardless of
the fact that John's status as a judgment debtor arose from his prior
marriage, that history did not affect his decision to satisfy the judg-
ment by making the 1992 transfer. Accordingly, as in the private let-
ter ruling, the 1992 transfer was simply "an arm's-length transaction
between two parties that happen to be former spouses," and it cannot
be said that the 1992 transfer was "made to effect the division of
[marital] property."
The majority concludes that the 1992 property transfer should not
be treated as a taxable event because that would have been the result
had Louise agreed to the property transfer as part of the 1989 divorce
settlement.4 4 See id. at 8. Although like transactions should indeed
receive like treatment under the tax code, the hypothetical transaction
offered by the majority and the transaction that actually occurred are
not alike. In fact, they differ in the most critical way: In the hypotheti-
cal, Louise would have obtained the property as a means of severing
_________________________________________________________________
4 Of course, Louise did not agree to this. She agreed to receive from
John $1.5 million tax free to her over a five-year period.
19
her economic union with her former spouse, thereby justifying treat-
ment of the transfer as if it were made within a single economic unit,
whereas in the actual transaction, the property was transferred after
the Youngs' economic union had already been completely severed.
See H.R. Rep. No. 98-432, at 1491-92 (1984), reprinted in 1984
U.S.C.C.A.N. 697, 1134 (noting that the reason that transfers between
spouses are not taxed is "that a husband and wife are a single eco-
nomic unit"). Accordingly, the hypothetical transfer would have been
"made to effect the division of [marital] property," while the actual
transaction was not. In contrast, John's transfer of the property to
Louise to satisfy a judgment should not be treated differently from a
sale by John to Louise of the property. Each property transfer is sim-
ply an arm's-length exchange of property for valuable consideration
between people who happen to be former spouses, and no valid tax
policy would justify treating these like transactions differently.5 5
If the words "made to effect the division of[marital] property"
were interpreted in a vacuum, the majority's interpretation might be
plausible, but when one considers the anomolous results produced by
the majority's interpretation, its incorrectness becomes apparent. It is
wrong to conclude that the Treasury Department intended to treat dif-
ferently two arm's-length property transfers between former spouses
based on the fact that in one the transferee pays cash for the property
and in the other she allows the transfer to satisfy a judgment. It is
therefore just as wrong to conclude that the Treasury Department
intended that the line between tranfers "made to effect the division of
[marital] property" and transfers not made to effect such a division
would be drawn where the majority draws it today.
One final aspect of this case deserves mention. From the majority's
decision to interpret the applicable regulation in a manner that is sup-
ported neither by the language of the regulation nor by any valid tax
policy, one might infer that unmentioned equitable considerations
_________________________________________________________________
5 Indeed, the premise that the sale of the property to Louise would have
been a taxable event but the transfer of the property in satisfaction of the
judgment was not leads to the strange result that the tax treatment of the
1992 transaction could have been changed simply by structuring the
transaction as a sale of the property to Louise, with the proceeds to be
used to satisfy the judgment.
20
weigh in favor of the majority's result. Just the opposite is true, how-
ever. By holding that the 1992 transfer was a § 1041 transaction, the
majority provides a substantial windfall of several hundred thousand
dollars to a defaulting debtor while at the same time punishing a cred-
itor who accepted a settlement instead of litigating her claims (which
would have resulted in a satisfaction of the judgment without the tax
burden she now faces).66
For all of these reasons, I believe that the 1992 transfer was not "in-
cident to the divorce," and thus the transfer of the property was a tax-
able event to John. I respectfully dissent from the majority's
conclusion to the contrary.
_________________________________________________________________
6 The majority misunderstands my discussion of fairness. I do not sug-
gest that equitable considerations should trump the language of § 1041
or the applicable regulation. Rather, I only point out that in addition to
the fact that the majority's holding appears unguided by any coherent tax
principle and produces anomolous results, it yields a tremendously unfair
result for Louise Young.
21