Kenseth, Eldon R. v. CIR ( 2001 )

In the
United States Court of Appeals
For the Seventh Circuit
No. 00-3705
Eldon R. Kenseth and Susan M. Kenseth,
Petitioners-Appellants,
v.
Commissioner of Internal Revenue,
Respondent-Appellee.
Appeal from the United States Tax Court.
No. 2385-98.
Argued April 3, 2001--Decided August 7, 2001
Before Posner, Kanne and Rovner, Circuit
Judges.
Posner, Circuit Judge. Some years ago
Mr. Kenseth filed an age-discrimination
suit against his former employer. He had
a contingent-fee contract with the law
firm that represented him, pursuant to
which the firm deducted 40 percent of the
proceeds of the settlement that it
obtained for him, remitting the balance
to him. The Tax Court ruled that the
entire proceeds, including the $91,800
deducted by the law firm as its fee, were
part of Kenseth’s gross income. The fee
was (most of it anyway, as we’ll see in
a moment) a deductible expense--but only
for purposes of the regular federal
income tax; it is one of a long list of
expenses ("miscellaneous expenses") that
are not deductible from gross income in
computing the alternative minimum tax, 26
U.S.C. sec. 56(b)(1)(A)(i); see Benci-
Woodward v. Commissioner, 219 F.3d 941,
944 (9th Cir. 2000), the purpose of which
is "to make sure that the aggregating of
tax-preference items [and of other
expenses specified in 26 U.S.C. sec.sec.
56, 58] does not result in the taxpayer’s
paying a shockingly low percent-age of
his income as tax." First Chicago Corp.
v. Commissioner, 842 F.2d 180, 181 (7th
Cir. 1988). As a result of not being able
to deduct the law firm’s fee, Kenseth
owed some $17,000 in alternative minimum
tax that he would not have owed had the
contingent fee been excludable from his
gross income in computing his alternative
minimum tax liability. He took a further
hit because his deduction from gross
income of the $91,800 pocketed by the law
firm was reduced by $5,298 by reason of
the 2 percent minimum for miscellaneous
itemized deductions and by $4,694 because
of the overall limitation on itemized
deductions. 26 U.S.C. sec.sec. 67, 68.
In an effort to avoid these tax bites,
Kenseth points out that under Wisconsin
law (as under that of every other state,
as far as we know), which is the law that
governed his contract with the law firm,
the firm had a lien on the proceeds of
any settlement or judgment to the extent
of the contingent fee. And the firm could
even have enforced the lien if Kenseth
had terminated the firm before the case
went to judgment or settlement, provided
the termination was not for cause. These
facts show, he argues, that the part of
the proceeds that went to pay the law
firm’s fee should not have been treated
as income to him--in which event he would
not have had to pay any alternative
minimum tax on it.
The circuits are split on whether a
contingent fee is, as the Tax Court held
in this case, a part of the client’s
taxable income. Compare Foster v. United
States, 249 F.3d 1275, 1279-80 (11th Cir.
2001); Srivastava v. Commissioner, 220
F.3d 353, 364-65 (5th Cir. 2000); Davis
v. Commissioner, 210 F.3d 1346 (11th Cir.
2000) (per curiam); Estate of Clarks v.
United States, 202 F.3d 854 (6th Cir.
2000); Cotnam v. Commissioner, 263 F.2d
119, 125-26 (5th Cir. 1959), all
rejecting the Tax Court’s position, with
Young v. Commissioner, 240 F.3d 369, 376-
79 (4th Cir. 2001); Benci-Woodward v.
Commissioner, supra; Coady v.
Commissioner, 213 F.3d 1187 (9th Cir.
2000), and Baylin v. United States, 43
F.3d 1451, 1454-55 (Fed. Cir. 1995), all
accepting it. We have not yet had
occasion to take sides in the
controversy. But with all due respect to
those who disagree, we think the Tax
Court’s resolution of the issue is
clearly correct. Taxable income is gross
income minus allowable deductions. 29
U.S.C. sec. 63(a); United States v.
Whyte, 699 F.2d 375, 378 (7th Cir. 1983).
If a taxpayer obtains income of $100 at a
cost in generating that income of $25, he
has gross income of $100 and a deduction
of $25, see sec. 162(a), yielding taxable
income of $75; he does not have gross
income of $75. If, therefore, for some
reason the cost of generating the income
is not deductible, he has taxable income
of $100. See sec. 62(a)(1) and, with
specific reference to legal fees incurred
for the production of income, Alexander
v. IRS, 72 F.3d 938, 944-46 (1st Cir.
1995). That is Kenseth’s situation under
the alternative minimum tax.
He concedes as he must that had he paid
the law firm on an hourly basis, the fee
would have been an expense. It would have
been a deduction from, not a reduction
of, his gross income, as held in the
Alexander case. We cannot see what
difference it makes that the expense
happened to be contingent rather than
fixed. If a firm pays a salesman on a
commission basis, the sales income he
generates is income to the firm and his
commissions are a deductible expense,
even though they were contingent on his
making sales. Of course there is a sense
in which contingent compensation
constitutes the recipient a kind of joint
venturer of the payor. But the plaintiff
concedes, as again he must, that
Wisconsin law does not make the
contingent-fee lawyer a joint owner of
his client’s claim in the legal sense any
more than the commission salesman is a
joint owner of his employer’s accounts
receivable. The lawyer has a lien, that
is, a security interest. Wis. Stat. sec.
757.36. But the ownership of a security
interest is not ownership of the
security. A firm whose assets are secured
by a mortgage can deduct the interest
from its income, but it is not allowed to
reduce its income by the amount of the
interest. Interest on a secured
obligation is just another expense. And,
though this is just the icing on the
cake, Wisconsin now (the rule may once
have been different, see Mohr v. Harris,
348 N.W.2d 599, 600-02 (Wis. App. 1984);
Wallach v. Rabinowitz, 200 N.W. 646, 647
(Wis. 1924)) prohibits lawyers from
acquiring "a proprietary interest in the
cause of action or subject matter of
litigation the lawyer is conducting for a
client." Wisconsin State Rules of
Professional Conduct, Supreme Court Rule
20:1.8(j). The rule allows the lawyer to
acquire a lien and to make a contingent-
fee contract, but neither a lien nor a
contractual right is "proprietary."
It is true that if a contingent-fee
lawyer expends effort on behalf of his
client, who then terminates the
contingent-fee contract, in effect
confiscating the lawyer’s work, the
lawyer has a claim against the client;
but he is no different in this respect
from any other trade creditor stiffed by
his debtor. In essence, Kenseth wants us
to recharacterize this as a case in which
he assigned 40 percent of his tort claim
to the law firm. But he didn’t. A
contingent-fee contract is not an
assignment, Young v. Commissioner, supra,
240 F.3d at 378; and in Wisconsin the
lawyer is prohibited from acquiring
ownership of his client’s claim. So what
Kenseth really is asking us to do is to
assign a portion of his income to the law
firm, but of course an assignment of
income (as distinct from the assignment
of a contract or an asset that generates
income) by a taxpayer is ineffective to
shift his tax liability. Lucas v. Earl,
281 U.S. 111, 114-15 (1930); United
States v. Newell, 239 F.3d 917, 919-20
(7th Cir. 2001).
There is nothing exotic about this
analysis--nothing, indeed, that depends
on the particular contractual setting,
that of a contingent-fee contract with a
lawyer, out of which this case arises.
The settlement of Kenseth’s age-
discrimination suit against his former
employer presumably replaced lost income,
which would have been taxable; and many
of the expenses of producing that income,
such as the cost of commuting, would not
have been deductible. So incomplete
deductibility here is not surprising or
anomalous or inappropriate. We mentioned
the commissioned salesman; consider now
the operation of a construction business.
All receipts are counted as gross income,
and outlays to subcontractors and
materialmen are deductible, even though
these subcontractors have liens on the
work and even though the general
contractor could say that he just
"assigns" a part of the job to the sub.
Kenseth says that he relinquished
control over his income-producing asset,
namely the age-discrimination claim. The
relevance of this point to his tax
liability is obscure, since owners of
income-producing property frequently
relinquish control over the property, for
example to a tenant, receiving income
that is taxable; and the point itself is
incorrect. Kenseth no more relinquished
control of the claim to his contingent-
fee lawyer than he would have to a fixed-
fee lawyer. He could fire either one and
would owe either one for work done but
not paid for. The principal effect of the
rule for which Kenseth contends would be
to create an artificial, a purely tax-
motivated, incentive to substitute
contingent for hourly legal fees.
He argues that his position would
eliminate an inequity created by the
much-criticized alternative minimum tax.
As an original matter, in taxation’s
Garden of Eden, it would indeed be
difficult to think of a reason why
Kenseth should have been denied the
normal privilege of deducting from his
gross income 100 percent of an expense
reasonably incurred for the production of
taxable income. And nothing in the
background of the alternative minimum tax
law indicates why attorneys’ fees were,
along with other "miscellaneous
expenses," lumped in with tax-preference
items and denied the normal privilege.
See generally Laura Sager & Stephen
Cohen, "How the Income Tax Undermines
Civil Rights Law," 73 So. Calif. L. Rev.
1075, 1090-93 (2000). But the idea behind
the tax is of course to limit otherwise
allowable deductions, so that, to put it
crudely, everybody who has income pays
some federal income tax. So rather than
ask why attorneys’ fees are not
deductible for purposes of the
alternative minimum tax, we should ask
why those fees should be distinguished
from other miscellaneous deductions that
the tax disallows; no answer comes to
mind.
Enough; for in any event it is not a
feasible judicial undertaking to achieve
global equity in taxation, see Benci-
Woodward v. Commissioner, supra, 219 F.3d
at 944, and cases cited there, especially
when the means suggested for eliminating
one inequity (that which Kenseth argues
is created by the alternative minimum
income tax) consists of creating another
inequity (differential treatment for
purposes of that tax of fixed and
contingent legal fees). And if it were a
feasible judicial undertaking, it still
would not be a proper one, equity in
taxation being a political rather than a
jural concept. Indeed the cases that
reject the Tax Court’s position seem
based on little more than sympathy for
taxpayers. The granddaddy of those cases,
Cotnam v. Commissioner, supra, a 2-1
opinion (so far as relates to the issue
in our case) with Judge Wisdom
dissenting, states its rationale as
follows: "The amount of the contingent
fee was earned, and well earned, by the
attorneys. True, in a remote rather than
a proximate sense, the entire amount of
the judgment had also been earned by Mrs.
Cotnam, but she could never have
collected anything or have enjoyed any
economic benefit unless she had employed
attorneys, and to do so, she had to part
with forty per cent of her claim long
before the realization of any income from
it." 263 F.2d at 126. This rationale
badly flunks the test of neutral
principles. It is often the case that to
obtain income from an asset one must hire
a skilled agent and pay him up front;
that expense is a deductible expense, not
an exclusion from income.
Affirmed.