Eldon R. Kenseth and Susan M. Kenseth v. Commissioner , 114 T.C. No. 26 ( 2000 )

114 T.C. No. 26UNITED STATES TAX COURT
ELDON R. KENSETH AND SUSAN M. KENSETH, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 2385-98. Filed May 24, 2000.
In 1993, P recovered a $229,501 settlement under
the Federal Age Discrimination in Employment Act of
1967, Pub. L. 90-202, sec. 2, 81 Stat. 602, current
version at 29 U.S.C. secs. 621-633a (1994). A portion
of the settlement proceeds was deposited in the trust
account of P’s attorney, X. In distributing the
settlement proceeds, X retained $91,800 in attorney’s
fees pursuant to a contingent fee agreement. The
remaining amount was paid to P. P excluded the
settlement proceeds designated as personal injury
damages under the settlement agreement. R determined
that the entire $229,501 recovered was includable in
gross income but allowed the attorney’s fees paid as a
miscellaneous itemized deduction. P concedes that the
settlement proceeds are not excludable in their
entirety but contends that the amount allocable to
attorney’s fees should be excluded from gross income.
Held, the amount retained by X for attorney’s fees
is includable in P’s gross income for 1993 under the
assignment of income doctrine. This Court respectfully
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declines to follow the reasoning of the Federal Courts
of Appeals in Estate of Clarks v. United States, 202
F.3d 854 (6th Cir. 2000), and Cotnam v. Commissioner,
263 F.2d 119 (5th Cir. 1959), revg. in part and affg.
in part 28 T.C. 947 (1957).
Cheryl R. Frank, Chaya Kundra, and Gerald W. Kelly, Jr., for
petitioners.
George W. Bezold, for respondent.
RUWE, Judge:* Respondent determined a deficiency of $55,037
in petitioners’ 1993 Federal income tax. The sole issue for
decision is whether petitioners’ gross income includes the
portion of the settlement proceeds of a Federal age
discrimination claim that was paid as the attorney’s fees of
Eldon R. Kenseth (petitioner) pursuant to a contingent fee
agreement.
FINDINGS OF FACT
The parties have stipulated some of the facts, and the
stipulations of facts and the attached exhibits are incorporated
in this opinion. At the time of filing their petition,
petitioners resided in Cambridge, Wisconsin.
In a complaint filed with the Wisconsin Department of
Industry, Labor, and Human Relations (DILHR) in October 1991,
petitioner alleged that on March 27, 1991, APV Crepaco, Inc.
*
This case was reassigned to Judge Robert P. Ruwe by order
of the Chief Judge.
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(APV), terminated his employment. The complaint also alleged
that, at the time of his discharge, petitioner was 45 years old,
held the position of master scheduler, was earning $33,480 per
year, and had been employed by APV for 21 years. It further
alleged that, around the time of petitioner’s discharge, APV did
not terminate younger employees also acting as master schedulers
but did terminate other employees over age 40.
Prior to filing the DILHR complaint, petitioner and 16 other
former employees of APV (the class) retained the law firm of
Fox & Fox, S.C. (Fox & Fox), to seek redress against APV. In
July 1991, petitioner executed a contingent fee agreement with
Fox & Fox that provided for legal representation in his case
against APV. Each member of the class entered into an identical
contingent fee agreement with Fox & Fox.
The contingent fee agreement was a form contract prepared
and routinely used by Fox & Fox; the client’s name was manually
typed in, but the names of Fox & Fox and APV had already been
included in preparing the form used for all the class members.
Fox & Fox would have declined to represent petitioner if he had
not entered into the contingent fee agreement and agreed to the
attorney’s lien provided therein.
The contingent fee agreement provided in relevant part:1
1
The portions of the Agreement not quoted are secs. “I.
INTRODUCTION”, “IV. THE ATTORNEYS’ FEES WHERE THERE IS A
SEPARATE PAYMENT OF ATTORNEYS’ FEES”, and “V. EXPLANATION OF FEE
(continued...)
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FOX & FOX, S.C.
CONTINGENT FEE AGREEMENT: (Case involving Statutory Fees)
* * * * * * *
II. CLIENT TO PAY LITIGATION EXPENSES
The client will pay all expenses incurred in
connection with the case, including charges for
transcripts, witness fees, mileage, service of process,
filing fees, long distance telephone calls,
reproduction costs, investigation fees, expert witness
fees and all other expenses and out-of-pocket
disbursements for these expenses according to the
billing policies and procedures of FOX & FOX, S.C. The
client agrees to make payments against these bills in
accordance with the firm’s billing policies.
III. THE ATTORNEYS’ FEES WHERE THERE IS NO SEPARATE
PAYMENT OF ATTORNEYS’ FEES
In the event that there is recovered in the case a
single sum of money or property including a job that
can be valued in monetary advantage to the client,
either by settlement or by litigation, the attorneys’
fees shall be the greater of:
A. A reasonable attorney’s fee in a contingent
case, which shall be defined as the
attorneys’ fees computed at their regular
hourly rates, plus accrued interest at their
regular rate, plus a risk enhancer of 100% of
the regular hourly rates (but in no event
greater than the total recovery), or:
B. A contingency fee, which shall be
defined as:
1
(...continued)
CONCEPTS”. Sec. V sets forth a justification for the provisions
of the agreement that is couched in terms of obviating the
potential for conflicts of interest between the attorneys and the
client by creating an identity of economic interests of attorneys
and client in the prosecution of the claim.
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Forty percent (40%) of the recovery if
it is recovered before any appeal is taken;
Forty-Six percent (46%) of the recovery
if it is recovered after an appeal is
taken.
Any settlement offer of a fixed sum which includes
a division proposed by the offeror between damages and
attorneys’ fees shall be treated by the client and the
attorneys as an offer of a single sum of money and, if
accepted, shall be treated as the recovery of a single
sum of money to be apportioned between the client and
the attorneys according to this section. Any division
of such an offer into damages and attorneys’ fees shall
be completely disregarded by the client and the
attorneys.
* * * * * * *
VI. CLIENT NOT TO SETTLE WITHOUT ATTORNEYS’ CONSENT
The client will not compromise or settle the case
without the written consent of the attorneys. The
client agrees not to waive the right to attorneys’ fees
as part of a settlement unless the client has reached
an agreement with the attorney for an alternative
method of payment that would compensate the attorneys
in accordance with Section III of this agreement.
VII. WIN OR LOSE RETAINER
The client agrees to pay a Five Hundred ($500.00)
Dollar win or lose retainer. This amount will be
credited to the attorney fees set forth in Section III
in the event a recovery is made. If no recovery is
made, this amount is non-refundable to the client.
VIII. LIEN
The client agrees that the attorney shall have a
lien against any damages, proceeds, costs and fees
recovered in the client’s action for the fees and costs
due the attorney under this agreement and said lien
shall be satisfied before or concurrent with the
dispersal of any such proceeds and fees.
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IX. CHANGE OF ATTORNEY
In the event the client chooses to terminate the
contract for legal services with Fox & Fox, S.C., said
firm will have a lien upon any recovery eventually
obtained. Said lien will be for the fees set forth in
Section III of this agreement.
In the event the client chooses to terminate the
contract for legal services with Fox & Fox, S.C., the
client will further make immediate payment of all
outstanding costs and disbursements to the firm of
Fox & Fox, S.C. and will do so within ten (10) days of
the termination of the contract.
In entering into this contract Fox & Fox, S.C. has
relied on the factual representations made to the firm
by the client. In the event such representations are
intentionally false, Fox & Fox, S.C. reserves the right
to unilaterally terminate this agreement and to charge
the client for services to the date of termination
rendered on an hourly basis plus all costs dispersed
and said amount shall be due within ten (10) days of
termination.
At the time of entering into the contingent fee agreement,
petitioner had paid only the $500 “win or lose” retainer to
Fox & Fox. This amount was to be credited against the contingent
fee that would be payable if there should be a recovery on the
claim; if there should be no recovery, this amount was
nonrefundable. Under section II of the agreement, petitioner
expressly agreed to reimburse Fox & Fox for out-of-pocket
expenses, in accordance with the firm’s normal billing policies
and procedures. In contrast, under section III of the agreement
(which set forth the contingent fee agreement), petitioner did
not expressly agree to pay anything. Instead, section III
provided how the amount of the contingent fee was to be
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calculated if there should be a recovery. Other sections of the
agreement summarized below provided for the attorney’s lien.
The contingent fee agreement required aggregation of the
elements of any settlement offer divided between damages and
attorney’s fees and provided that any division of such an offer
into damages and attorney’s fees would be disregarded by Fox &
Fox and petitioner. The contingent fee agreement provided that
petitioner could not settle his case against APV without the
consent of Fox & Fox. Under the contingent fee agreement,
petitioner agreed that Fox & Fox “shall have a lien” for its fees
and costs against any recovery in petitioner’s action against
APV. This lien by its terms was to be satisfied before or
concurrently with the disbursement of the recovery. The
contingent fee agreement further provided that, if petitioner
should terminate his representation by Fox & Fox, the firm would
have a lien for the fees set forth in section III of the
agreement, and all costs and disbursements that had been expended
by Fox & Fox would become due and payable by petitioner within 10
days of his termination of his representation by Fox & Fox.
APV had proposed that petitioner and the other members of
the class sign separation agreements in return for some severance
pay. Fox & Fox advised the class members that the form of
separation agreement used by APV did not comply with the Older
Workers Benefits Protection Act of 1990, Pub. L. 101-433, 104
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Stat. 978. As a result, petitioner and the class members who
signed the separation agreements and received severance pay were
able to file administrative discrimination complaints and bring
suit against APV, notwithstanding any purported release of their
claims against APV in the separation agreements.
On October 16, 1991, petitioner filed an administrative
complaint, using documents prepared by Fox & Fox, setting forth
the basis of his age discrimination claim against APV, with
DILHR. Around March 1992, DILHR sent a copy of petitioner’s
complaint to the U.S. Equal Employment Opportunity Commission
(EEOC). The initiation of these administrative discrimination
claims was a condition precedent to bringing suit against APV
under the Federal Age Discrimination in Employment Act of 1967
(ADEA), Pub. L. 90-202, sec. 2, 81 Stat. 602, current version at
29 U.S.C. secs. 621-633a (1994).
On June 16, 1992, Fox & Fox filed a complaint on behalf of
petitioner and the other class members against APV in the U.S.
District Court for the Western District of Wisconsin. The
complaint alleged a deprivation of their rights under ADEA and
sought back wages, liquidated damages, reinstatement or front pay
in lieu of reinstatement, and attorney’s fees and costs, and
demanded a trial by jury.
EEOC had initially recommended that the members of the class
settle their age discrimination suit for less than $1 million in
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the aggregate. The total settlement that Fox & Fox negotiated on
behalf of the claimants amounted to $2,650,000, which was
apportioned as follows pursuant to the contingent fee agreements:
Total recovery to class members $1,590,000
Total fee to Fox & Fox 1,060,000
Total settlement 2,650,000
On February 15, 1993, the dispute between petitioner and APV
was resolved by their execution of a “Settlement Agreement and
Full and Final Release of Claims” (settlement agreement). Each
member of the class entered into an identical settlement
agreement. The entire amount received by the members of the
class under their settlement agreements represented a recovery
under ADEA. However, the settlement agreements required
petitioner and the other members of the class to relinquish all
their claims against APV, including claims for attorney’s fees
and expenses but did not specifically allocate any amount of the
recovery to attorney’s fees. The settlement agreement required
petitioner to cause the administrative actions pending before
EEOC and DILHR to be dismissed with prejudice. The settlement
agreement provided that it was to be “interpreted, enforced and
governed by and under the laws of the State of Wisconsin”.
Petitioner’s allocated share of the gross settlement amount
of $2,650,000 was $229,501.37. Of this amount, $32,476.61 was
paid as lost wages by an APV check issued directly to petitioner.
APV withheld applicable Federal and State employment taxes from
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this portion of the settlement; the actual net amount of the
check to the order of petitioner was $21,246.20.
The portion of the settlement proceeds allocated to
petitioner and not designated as lost wages was $197,024.76,
which the settlement agreement characterized “as and for personal
injury damages which the parties intend as those types of damages
excludable from income under section 104(a)(2) of the Internal
Revenue Code as damages for personal injuries and the
corresponding provisions of the Tax Code of the State of
Wisconsin.” APV issued a check for this amount directly to the
Fox & Fox trust account. Fox & Fox calculated its fee, pursuant
to the contingent fee agreement, using 40 percent of the gross
settlement amount of $229,501.37 allocated to petitioner. After
deducting its fee of $91,800.54 and crediting petitioner with the
$500 “win or lose” retainer payment, Fox & Fox issued a check for
$105,724.22 from the Fox & Fox trust account to petitioner.
With the check that was received from Fox & Fox, petitioner
and every other class member received a settlement statement,
prepared by Fox & Fox, setting forth the recipient’s share of the
total settlement, the legal fee after credit for the retainer,
the net proceeds to the recipient, and the portion from which
taxes would be “deducted”. The recipient signed the settlement
statement, accepting and approving “the distribution of the
proceeds as set forth on this statement.” The recipient also
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acknowledged in the settlement statement that a portion of the
settlement proceeds had been characterized as personal injury
damages not subject to tax, but that this characterization was
not binding on taxing authorities, and agreed to pay any taxes
that might become due on the proceeds.
The settlement agreement provided that APV would be held
harmless for any taxes (other than on the amount allocated to
lost wages) “imposed on the amounts dispersed under this
agreement”.
On their 1993 income tax return, petitioners reported as
income only that portion of the settlement proceeds that was
allocated to wages--$32,476.61. They did not report or disclose
all or any part of the $197,024.76 that was allocated to personal
injury damages, nor did they claim or otherwise report a
deduction for all or any part of the attorney’s fees.
The notice of deficiency that was issued to petitioners made
an adjustment to their 1993 income to increase gross income in
respect of the settlement of petitioner’s ADEA claims by $197,024
(from $32,477 to $229,501). The notice also allowed $91,800 in
legal fees as an itemized deduction, reduced by $5,298 for the
2-percent floor on miscellaneous itemized deductions under
section 672 and by $4,694 for the overall limitation on itemized
2
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the year in issue, and
all Rule references are to the Tax Court Rules of Practice and
(continued...)
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deductions under section 68. The deficiency of $55,037 that was
determined by respondent included a liability of $17,198 for
alternative minimum tax arising from the disallowance of the
miscellaneous itemized deduction of the attorney’s fees for the
purpose of the alternative minimum tax under section
56(b)(1)(A)(i).
Petitioner and the other members of the class relied on the
guidance and expertise of Fox & Fox in signing the separation
agreements tendered to them by APV and then seeking redress
against APV. Commencing with the advice to petitioner that he
could sign the separation agreement with APV without giving up
his age discrimination claim, Fox & Fox made all strategic and
tactical decisions in the management and pursuit of the age
discrimination claims of petitioner and the other class members
against APV that led to the settlement agreement and the recovery
from APV.
Fox & Fox was aware of the relationship between any gross
settlement amount and the resulting fee that Fox & Fox would
receive. In the effort to ensure that the amounts ultimately
received by petitioner and the other class members would
approximate the full value of their claims, Fox & Fox factored in
an amount for the attorney’s fee portion of the settlement in
2
(...continued)
Procedure.
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preparing for and conducting their negotiations with APV and its attorneys.
Petitioner’s complaint filed with DILHR, his civil complaint
with the District Court for the Western District of Wisconsin,
and the settlement agreement were signed by Michael R. Fox or
Mary E. Kennelly of Fox & Fox. Fox & Fox’s office is in Madison,
Wisconsin; Mr. Fox and Ms. Kennelly are admitted to practice law
in Wisconsin.
OPINION
Petitioners concede that the proceeds from the settlement
are includable in gross income except for the portion of the
settlement used to pay Fox & Fox under the contingent fee
agreement. Specifically, petitioners argue that they exercised
insufficient control over the settlement proceeds used to pay Fox
& Fox and should, therefore, not be taxed on amounts to which
they had no “legal” right and could not, and did not, receive.
Conversely, respondent argues that (1) the amount petitioners
paid or incurred as attorney’s fees must be included in
petitioners’ gross income and (2) the contingent fee is
deductible as a miscellaneous itemized deduction, subject to the
2-percent floor under section 67 and the overall limitation under
section 68 and also nondeductible in computing the alternative
minimum tax (AMT) under section 56.
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This controversy is driven by the substantial difference in
the amount of tax burden that may result from the parties’
approaches.3 The difference, of course, is a consequence of the
plain language of sections 56, 67, and 68, so the
characterization of the attorney’s fees as excludable or
deductible becomes critical. There have been attempts to provide
relief from the resulting tax burden by creative approaches,
including attempts to modify long-standing tax principles. This
Court believes that it is Congress’ imposition of the AMT and
limitations on personal itemized deductions that cause the tax
burden here. We perceive dangers in the ad hoc modification of
established tax law principles or doctrines to counteract
hardship in specific cases, and, accordingly, we have not
acquiesced in such approaches. See Alexander v. IRS, 72 F.3d
938, 946 (1st Cir. 1995) (stating that the effect of the AMT on
3
Under respondent’s position in this case, the settlement
proceeds are included in petitioners’ gross income in full, but
the itemized deduction is subject to limitations and is not
available in computing the alternative minimum tax (AMT). Under
these circumstances, it is possible that the attorney’s fees and
tax burden could consume a substantial portion (possibly all) of
the damages received by a taxpayer. It is noted, however, that
if the recovery or income was received in a trade or business
setting, the attorney’s fees may be fully deductible in arriving
at adjusted gross income, thereby obviating the perceived
unfairness that may be occasioned in the circumstances we
consider in this case. Commentators and courts have long
observed this potential for unfairness in the operation of the
AMT in this and other areas of adjustments and tax preference
items. See, e.g., “State Bar of California Tax Section, Partial
Deduction of Attorneys’ Fees Proposed for Computing AMT”, 1999
TNT 125-45 (June 30, 1999); Wood, “The Plight of the Plaintiff:
The Tax Treatment of Legal Fees”, 98 TNT 220-101 (Nov. 16, 1998).
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an individual taxpayer’s deduction of legal expenses “smacks of
injustice” because the taxpayer is effectively robbed of any
benefit from the deductibility of legal expenses as miscellaneous
itemized deductions), affg. T.C. Memo. 1995-51. Despite this
potential for unfairness, however, these policy issues are in the
province of Congress, and we are not authorized to rewrite the
statute. See, e.g., Badaracco v. Commissioner, 464 U.S. 386, 398
(1984); Warfield v. Commissioner, 84 T.C. 179, 183 (1985).
There is a split of authority among the Federal Courts of
Appeals on this issue. The U.S. Court of Appeals for the Fifth
Circuit reversed this Court and held that amounts awarded in
Alabama litigation that were assigned and paid directly to cover
attorney’s fees pursuant to a contingent fee agreement are
excludable from gross income. See Cotnam v. Commissioner,
263 F.2d 119 (5th Cir. 1959), affg. in part and revg. in part 28
T.C. 947 (1957). In Cotnam, the taxpayer entered into a
contingent fee agreement to pay her attorney 40 percent of any
amount recovered on a claim prosecuted for the taxpayer’s behalf.
A judgment was obtained on the claim, and a check in the amount
of the judgment was made jointly payable to the taxpayer and her
attorney. The attorney retained his share of the proceeds and
remitted the balance to the taxpayer. The Commissioner treated
the total amount of the judgment as includable in the taxpayer’s
gross income and allowed the attorney’s fees as an itemized
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deduction. This Court agreed with the Commissioner, holding that
the taxpayer realized income in the full amount of the judgment,
even though the attorney received 40 percent in accordance with
the contingent fee agreement.
The U.S. Court of Appeals for the Fifth Circuit’s reversal
was based on two legal grounds. An opinion by Judge Wisdom on
behalf of the panel reasoned that, under the Alabama attorney
lien statute, an attorney has an equitable assignment or lien
enabling the attorney to hold an equity interest in the cause of
action to the extent of the contracted for fee. See id. at 125.
Under the Alabama statute, attorneys had the same right to
enforce their lien as clients have or had for the amount due the
clients. See id.The other judges in Cotnam, Rives and Brown, in a separate
opinion, stated that the claim involved was far from being
perfected and that it was the attorney’s efforts that perfected
or converted the claim into a judgment. Judge Wisdom, in the
second of his opinions, dissented, reasoning that the taxpayer
had a right to the already-earned income and that it could not be
assigned to the attorneys without tax consequence to the
assignor. The Cotnam holding with respect to the Alabama
attorney lien statutes has been distinguished by this Court from
cases interpreting the statutes of numerous other states.
Significantly, this Court has, for nearly 40 years, not followed
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Cotnam with respect to the analysis in the opinion of Judges
Rives and Brown that the attorney’s fee came within an exception
to the assignment of income doctrine. See, e.g., Estate of
Gadlow v. Commissioner, 50 T.C. 975, 979-980 (1968) (Pennsylvania
law); O’Brien v. Commissioner, 38 T.C. 707, 712 (1962), affd. per
curiam 319 F.2d 532 (3d Cir. 1963); Petersen v. Commissioner, 38
T.C. 137, 151-152 (1962) (Nebraska law and South Dakota law);
Srivastava v. Commissioner, T.C. Memo. 1998-362, on appeal (5th
Cir., June 14, 1998) (Texas law); Coady v. Commissioner, T.C.
Memo. 1998-291, on appeal (9th Cir., Nov. 3, 1998) (Alaska law).
Addressing the assignment of income question in similar
circumstances, the U.S. Court of Appeals for the Federal Circuit
reached a result opposite from that reached in Cotnam. See
Baylin v. United States, 43 F.3d 1451, 1454-1455 (Fed. Cir.
1995). In Baylin, a tax matters partner entered into a
contingent fee agreement with the partnership’s attorney in a
condemnation proceeding. When the litigants entered into a
settlement, the attorney received his one-third contingency fee
directly from the court in accordance with the fee agreement. On
its tax return, the partnership reduced the amount realized from
the condemnation by the amount of attorney’s fees attributable to
recovery of principal and deducted from ordinary income the
attorney’s fees attributed to the interest income portion of the
settlement. The Government challenged this classification of the
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attorney’s fees, determining that the attorney’s fees constituted
a capital expenditure and could, therefore, not reduce ordinary
income.
The Court of Federal Claims agreed with the Government. On
appeal, the taxpayer argued that the portion of the recovery used
to pay attorney’s fees was never a part of the partnership’s
gross income and should be excluded from gross income. The
Federal Circuit, rejecting the taxpayer’s argument, held that
even though the partnership did not take possession of the funds
that were paid to the attorney, it “received the benefit of those
funds in that the funds served to discharge the obligation of the
partnership owing to the attorney as a result of the attorney’s
efforts to increase the settlement amount.” Id. at 1454. The
Court of Appeals for the Federal Circuit sought to prohibit
taxpayers in contingency fee cases from avoiding Federal income
tax with “skillfully devised” fee agreements. See id.The U.S. Court of Appeals for the Ninth Circuit reached the
same result as the court in Baylin regarding the includability of
attorney’s fees in a taxpayer’s gross income. In Brewer v.
Commissioner, 172 F.3d 875 (9th Cir. 1999), affg. without
published opinion T.C. Memo. 1997-542, the Court of Appeals
affirmed the Tax Court decision holding that the portion of a
Title VII settlement that was paid directly to the taxpayer’s
attorney was not excludable from the taxpayer’s gross income.
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In a recent holding, the U.S. Court of Appeals for the Sixth
Circuit reached a result based on similar reasoning to that used
in Cotnam. See Estate of Clarks v. United States, 202 F.3d 854(6th Cir. 2000). In Estate of Clarks, after a jury awarded the
taxpayer personal injury damages and interest, the judgment
debtor paid the taxpayer’s lawyer the amount called for in the
contingent fee agreement. Because the portion of the attorney’s
fee that was attributable to the recovery of taxable interest was
paid directly to the attorney, the taxpayer excluded that amount
from gross income on the estate’s Federal income tax return. The
Commissioner determined that the portion of the attorney’s fees
attributable to interest was deductible as a miscellaneous
itemized deduction and was not excludable from gross income. The
taxpayer paid the deficiency and sued for a refund in Federal
District Court.
The District Court granted summary judgment in favor of the
Government. The U.S. Court of Appeals for the Sixth Circuit
reversed, employing reasoning similar to that used in Cotnam.
The Court of Appeals held that, under Michigan law, the
taxpayer’s contingent fee agreement with the lawyer operated as a
lien on the portion of the judgment to be recovered and
transferred ownership of that portion of the judgment to the
attorney. The court seemed to place greater emphasis on the fact
that the taxpayer’s claim was speculative and dependent upon the
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services of counsel when it was assigned. In that respect, the
court held that the assignment was no different from a joint
venture between the taxpayer and the attorney. The court
explained that this case was distinguishable from other
assignment of income cases in that there was “no vested interest,
only a hope to receive money from the lawyer’s efforts and the
client’s right, a right yet to be determined by judge and jury.”
Id. at 857. The court stated:
Here the client as assignor has transferred some of the
trees in his orchard, not merely the fruit from the
trees. The lawyer has become a tenant in common of the
orchard owner and must cultivate and care for and
harvest the fruit of the entire tract. Here the
lawyer’s income is the result of his own personal skill
and judgment, not the skill or largess of a family
member who wants to split his income to avoid taxation.
The income should be charged to the one who earned it
and received it, not as under the government’s theory
of the case, to one who neither received it nor earned
it. The situation is no different from the transfer of
a one-third interest in real estate that is thereafter
leased to a tenant. [Id. at 858.4]
This Court has, for an extended period of time, held the
view that taxable recoveries in lawsuits are gross income in
their entirety to the party-client and that associated legal
fees--contingent or otherwise--are to be treated as deductions.5
4
The Court of Appeals’ analogy is, to some extent,
inapposite because the transfer of trees in and of itself could
be consideration in kind and result in gains to the taxpayer.
More significantly, if the trees are analogous to the taxpayer’s
chose in action or compensatory rights, then the transfer
represents a classic anticipatory assignment of income.
5
This view is based on the well-established assignment of
(continued...)
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See Bagley v. Commissioner, 105 T.C. 396, 418-419 (1995), affd.
121 F.3d 393, 395-396 (8th Cir. 1997); O’Brien v. Commissioner,
38 T.C. 707, 712 (1962), affd. per curiam 319 F.2d 532 (3d Cir.
1963); Benci-Woodward v. Commissioner, T.C. Memo. 1998-395, on
appeal (9th Cir., Feb. 2, 1999). In O’Brien, we held that “even
if the taxpayer had made an irrevocable assignment of a portion
of his future recovery to his attorney to such an extent that he
never thereafter became entitled thereto even for a split second,
it would still be gross income to him under” assignment of income
principles. O’Brien v. Commissioner, supra at 712. “Although
there may be considerable equity to the taxpayer’s position, that
is not the way the statute is written.” Id. at 710. In reaching
this conclusion, we rejected the distinction made in Cotnam v.
Commissioner, supra, with respect to the Alabama attorney’s lien
statute, stating that it is “doubtful that the Internal Revenue
Code was intended to turn upon such refinements.” O’Brien v.
Commissioner, supra at 712. Numerous decisions of this Court
have reached the same result as O’Brien by distinguishing other
States’ attorney’s lien statutes from the Alabama statute
considered in Cotnam. See Estate of Gadlow v. Commissioner, 50
T.C. 975, 979-980 (1968) (Pennsylvania law); Petersen v.
5
(...continued)
income doctrine that was originated by the Supreme Court in Lucas
v. Earl, 281 U.S. 111 (1930). Lucas v. Earl, supra, has been
relied on by this Court for assignments of income involving both
related and unrelated taxpayers.
- 22 -
Commissioner, 38 T.C. 137, 151-152 (1962) (Nebraska law and South
Dakota law); Sinyard v. Commissioner, T.C. Memo. 1998-364, on
appeal (9th Cir., Oct. 15, 1999) (Arizona law); Srivastava v.
Commissioner, T.C. Memo. 1998-362, on appeal (5th Cir., June 14,
1999) (Texas law); Coady v. Commissioner, T.C. Memo. 1998-291(Alaska law).
After further reflection on Cotnam and now Estate of Clarks
v. United States, supra, we continue to adhere to our holding in
O’Brien that contingent fee agreements, such as the one we
consider here, come within the ambit of the assignment of income
doctrine and do not serve, for purposes of Federal taxation, to
exclude the fee from the assignor’s gross income. We also
decline to decide this case based on the possible effect of
various States’ attorney’s lien statutes.6
6
With the exception of situations where, under our holding
in Golsen v. Commissioner, 54 T.C. 742, 756-757 (1970), affd. 445
F.2d 985 (10th Cir. 1971), we feel compelled to follow the
holding of a Court of Appeals, we have consistently held that
attorney’s fees are not subtracted from taxpayers’ gross income
to arrive at adjusted gross income. In Davis v. Commissioner,
T.C. Memo. 1998-248, affd. per curiam ___ F.3d ___ (11th Cir.
2000), we followed Cotnam v. Commissioner, 263 F.2d 119 (5th Cir.
1959), affg. in part and revg. in part 28 T.C. 947 (1957),
because the appeal would lie to the Court of Appeals for the 11th
Circuit, which follows precedents of the Court of Appeals for the
5th Circuit for cases decided before Oct. 1, 1982. In a per
curiam opinion, the Court of Appeals for the 11th Circuit
affirmed our decision based on the binding Cotnam precedent and
declined to consider the Commissioner’s argument that Cotnam was
wrongly decided, noting that Cotnam can be overruled only by the
court sitting en banc. See Davis v. Commissioner, F.3d
2000 WL 491747 (11th Cir. 2000); see also Foster v. United
States, F. Supp. 2d (N.D. Ala., Mar. 13, 2000), on appeal
(continued...)
- 23 -
Section 61(a) provides that “gross income means all income
from whatever source derived,” and typically, all gains are taxed
unless specifically excluded. See James v. United States, 366
6
(...continued)
(11th Cir., Apr. 10, 2000), where the District Court generally
followed Cotnam as binding precedent, but denied litigation cost
explaining:
The court does not find, however, that under §
7430(c)(4)(A)(i) the position of the United States
(i.e., with respect to Cotnam) was not substantially
justified. Yes, the court does conclude that Cotnam
does control most of the issues respecting attorney’s
fees and, until the Court of Appeals or Supreme Court
rules otherwise, is binding on this court.
But there are serious and legitimate questions as
to whether the holding in Cotnam should continue to be
followed in this or other circuits. Strong arguments
can be made–-and presumably will be made by the
government in seeking en banc consideration of this
issue in the Davis case or on appeal of this case–-that
Cotnam is not consonant with Supreme Court decisions
like Horst and, indeed, is based on a misinterpretation
of Alabama law involving contingent fee contracts and
attorneys’ lien rights. In particular, Cotnam did not
give attention to the continuing control that, even
after entering into a contingent fee contract, the tort
plaintiff has with respect to settlement of the
entirety of the claim or to the continuing power of the
client to discharge an attorney and effectively cancel
the “assignment” of a share in later recoveries. The
1998 appeal by the government of Davis, filed before
this case was brought, indicated that its attack upon
Cotnam represents a fundamental disagreement with that
decision, and not some personal animus against Foster
in the present case. The rejection in January 2000 by
a second appellate court (the Sixth Circuit in the
Estate of Clarks case) does not support an assertion
that the government’s [sic] in this case was without
substantial foundation. This court determines that
Foster is not entitled to litigation costs under §
7430.
- 24 -
U.S. 213, 219 (1961). We can identify no specific exclusion from
gross income for the payment made to Fox & Fox. While it is true
that petitioner did not physically receive the portion of the
settlement proceeds used to pay the attorney’s fees, he did
receive the full benefit of those funds in the form of payment
for the services required to obtain the settlement. At the time
that petitioner entered into the contingent fee agreement, he had
already been discriminated against in the form of his wrongful
termination from employment. In other words, petitioner was owed
damages, and the attorney was willing to enter into a contingent
fee agreement to recover the damages owed to petitioner.
Therefore, petitioner must recognize as income the amount of the
judgment.
In coming to this conclusion, we reject the significance
placed by the U.S. Court of Appeals for the Sixth Circuit on the
speculative nature of the claim and/or that the claim was
dependent upon the assistance of counsel. Despite characterizing
petitioner’s right to recovery as speculative, his cause of
action had value in the very beginning; otherwise, it is unlikely
that Fox & Fox would have agreed to represent petitioner on a
contingent basis. We find no meaningful distinction in the fact
that the assistance of counsel was necessary to pursue the claim.
Attorney’s fees, contingent or otherwise, are merely a cost of
litigation in pursuing a client’s personal rights. Attorneys
- 25 -
represent the interests of clients in a fiduciary capacity. It
is difficult, in theory or fact, to convert that relationship
into a joint venture or partnership. The entire ADEA award was
“earned” by and owed to petitioner, and his attorney merely
provided a service and assisted in realizing the value already
inherent in the cause of action.
An anticipatory assignment of the proceeds of a cause of
action does not allow a taxpayer to avoid the inclusion of income
for the amount assigned.7 A taxpayer who enters into an agreement
for the rendering of services that assists in the recovery from a
third party must include the amount recovered (compensation) in
gross income, irrespective of whether it is received by the
taxpayer. See Hober v. Commissioner, T.C. Memo. 1984-491;
Loeffler v. Commissioner, T.C. Memo. 1983-503. This Court,
relying on Lucas v. Earl, 281 U.S. 111 (1930), has consistently
7
The assignment by a taxpayer of a right to collect a
doubtful and uncertain pending claim against the United States in
exchange for cash and other consideration did not constitute an
anticipatory assignment of income in Jones v. Commissioner, 306
F.2d 292 (5th Cir. 1962), revg. T.C. Memo. 1960-115, and thus the
taxpayer was not taxable on the amount ultimately recovered on
the claim. In Reffett v. Commissioner, 39 T.C. 869 (1963),
however, we distinguished Jones in a factual setting similar to
this case and held that proceeds from a taxpayer’s lawsuit that
were paid to witnesses for their services during the lawsuit were
includable in the taxpayer’s gross income. In addition, the U.S.
Court of Appeals for the Ninth Circuit has factually
distinguished Jones and held that an attorney’s transfer of part
of a contingent legal fee earned by him was an assignment of
income within the meaning of Lucas v. Earl, 281 U.S. 111 (1930).
Koshansky v. Commissioner, 92 F.3d 957, 958 (9th Cir. 1996),
affg. in part, revg. in part T.C. Memo. 1994-160.
- 26 -
held that a taxpayer cannot avoid taxation on his income by an
anticipatory assignment of that income to another. See id.Thus, any anticipatory assignment by the taxpayer of the proceeds
of the lawsuit must be included in the taxpayer’s gross income.
We reject petitioner’s contention that he had insufficient
control over his cause of action to be taxable on a recovery of a
portion of the settlement proceeds that was diverted to or paid
to Fox & Fox under the contingent fee agreement. There is no
evidence supporting petitioner’s contention that he had no
control over his claim. In Wisconsin, a lawyer cannot acquire a
proprietary interest that would enable the attorney to continue
to press a cause of action despite the client’s wish to settle.
Indeed, the Supreme Court of Wisconsin has stated that “The claim
belongs to the client and not the attorney, the client has the
right to compromise or even abandon his claim if he sees fit to
do so.” Goldman v. Home Mut. Ins. Co., 22 Wis. 2d 334, 341, 126
N.W.2d 1 (1964).
Likewise, petitioner has not waived his right to settle his
claim at any time, and it would be an ethical violation for his
attorney to press forward with such a case against the will of
the client. Wisconsin Supreme Court rule 20:1.2(a) provides:
A lawyer shall abide by a client’s decisions concerning
the objectives of representation, subject to paragraphs
(c), (d) and (e), and shall consult with the client as
to the means by which they are to be pursued. A lawyer
shall inform a client of all offers of settlement and
- 27 -
abide by a client’s decision whether to accept an offer
of settlement of a matter. * * *
Although petitioner may have entrusted Fox & Fox with the details
of his litigation, ultimate control was not relinquished. If
petitioner wanted to proceed without Fox & Fox, he could have
obtained new representation.
The assignment of income doctrine was originated by the
Supreme Court and has evolved over the past 70 years. See
Helvering v. Eubank, 311 U.S. 122 (1940); Helvering v. Horst, 311
U.S. 112 (1940); Lucas v. Earl, supra. Although legislation may
result in anomalous or inequitable results with respect to
particular taxpayers, we are not in a position to address those
policy questions. So, for example, if the AMT computation
effectively renders de minimis a taxpayer’s recovery due to the
nondeductibility of the attorney’s fees, we should not be tempted
to modify established assignment of income principles to remedy
the situation. That could result in a certain class of
taxpayer’s (those who receive reportable income from judgments)
being treated differently from all other taxpayers who are
subject to the AMT. These are matters within Congress’ authority
to decide. Congress, not the Courts, is the final arbiter of how
the tax burden is to be borne by taxpayers.
Even if we were willing to follow the Cotnam and/or Estate
of Clarks “attorney’s lien” rationale, our analysis of the
Wisconsin statutes and case law would not result in excluding the
- 28 -
attorney’s fee from petitioners’ gross income here. In Cotnam,
the Alabama statute provided that “attorneys at law shall 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.” Cotnam v. Commissioner, 263 F.2d
119, 125 n.5 (5th Cir. 1959) (quoting Ala. Code sec. 64 (1940)).
The relevant Wisconsin statute does not recognize the same right
and power in favor of attorneys that was identified in the
Alabama attorney’s lien statute. The Wisconsin statute provides:
Any person having or claiming a right of action,
sounding in tort or for unliquidated damages on
contract, may contract with any attorney to prosecute
the action and give the attorney a lien upon the cause
of action and upon the proceeds or damages derived in
any action brought for the enforcement of the cause of
action, as security for fees in the conduct of the
litigation; when such agreement is made and notice
thereof given to the opposite party or his or her
attorney, no settlement or adjustment of the action may
be valid as against the lien so created, provided the
agreement for fees is fair and reasonable. This
section shall not be construed as changing the law in
respect to champertous contracts. [Wis. Stat. Ann.
sec. 757.36 (West 1981).]
This statute provides for an attorney’s lien upon the cause of
action or upon the proceeds or damages from such cause of action
to secure compensation, but it does not give attorneys the same
rights as their clients over the proceeds of suits, judgments,
and decrees. Accordingly, the Wisconsin statute contains obvious
differences and is distinguishable from the Alabama statute.
- 29 -
A 100-year-old Wisconsin case contains an indication that at
one time, an attorney in Wisconsin may have had the type of
rights described in Cotnam. See Smelker v. Chicago & N.W. Ry.,
106 Wis. 135, 81 N.W. 994 (1900). In Smelker, the Wisconsin
Supreme Court held that an attorney could press the underlying
cause of action to enforce the attorney’s lien even after the
client had settled. While the Wisconsin court expressed doubt
about the propriety of such a policy, the statutory lien
provision in effect at the time appeared to the court to require
such a result. At the time of Smelker, the statute provided for
attorney’s liens only on the “cause of action”. As such, the
Wisconsin Supreme Court reasoned that the only way an attorney’s
lien could withstand settlement was if the cause of action could
continue at the behest of the attorney. This is no longer the
situation. The Wisconsin attorney’s lien statute was revised
after the decision in Smelker. The statute in effect for
purposes of this case provides for an attorney’s lien on the
cause of action as well as the proceeds or damages from the cause
of action and does not give the attorney the right to continue an
action after the client settles. See Wis. Stat. Ann. sec. 757.36
(1981). In light of the statement in Goldman v. Home Mut. Ins.
Co., supra, that a claim belongs to the client and not the
attorney, the fact that Smelker has only been cited by a
Wisconsin court once (in 1902 and even then not for the
- 30 -
proposition that attorneys have the same rights and power over
suits as their clients), and the fact that Wisconsin’s attorney’s
lien statute was revised, Smelker has not retained its vitality,
and we do not read it as standing for the proposition that
attorneys in Wisconsin have the same rights as their clients over
suits.
We conclude that petitioner’s award, undiminished by the
amount that he paid to Fox & Fox, is includable in his 1993 gross
income. The amount paid to Fox & Fox is deductible subject to
certain statutory limitations as determined by respondent. We
have also considered petitioners’ remaining arguments and, to the
extent not mentioned herein, find them to be without merit. To
reflect the foregoing,
Decision will be entered
under Rule 155.
Reviewed by the Court.
COHEN, WHALEN, CHIECHI, LARO, GALE, THORNTON, and MARVEL,
JJ., agree with this majority opinion.
HALPERN, FOLEY, and VASQUEZ, JJ., did not participate in
consideration of this opinion.
- 31 -
CHABOT, J., dissenting: The majority opinion sets forth
supra at note 3 and the accompanying text (majority op. pp. 13-
15) concerns as to the injustice resulting from the intersection
of court-made doctrine and statute law--in particular the minimum
tax. The majority opinion states that “these policy issues are
in the province of Congress” (majority op. p. 15) and refuses to
modify court-made doctrine. Although I agree with the majority
that “we are not authorized to rewrite the statute” (majority op.
p. 15), I reject the idea that we are disabled from correcting
court-made error, and so I dissent.
The assignment of income doctrine was created by the courts
to deal with situations where the taxpayer figuratively turned
his or her back on income that would have come to and been
taxable to the taxpayer, but for the taxpayer’s effort to shift
the receipt and taxability of the income. See the three seminal
opinions cited by the majority (majority op. p. 27)--Lucas v.
Earl, 281 U.S. 111 (1930) (husband assigned to wife half of
salary and fees that he earned; Federal taxing statute treats
assigned amounts as taxpayer’s income); Helvering v. Eubank, 311
U.S. 122 (1940) (taxpayer assigned to corporate trustees
insurance renewal commissions; taxpayer remains taxable on the
insurance renewal commissions he had earned); Helvering v. Horst,
311 U.S. 112 (1940) (taxpayer assigned to son negotiable bond
- 32 -
interest coupons; taxpayer remains taxable on the income that he
would have received but for the transfer). The Supreme Court
made clear that these results were based on the Court’s reading
of the statute as to what was income of the taxpayer rather than
income of another; the intended result was to tax the taxpayer on
the income the taxpayer would have had if he or she had acted to
“earn” the income but had not acted to deflect the income.
Those seminal cases did not present disputes about the
amount of the income, but they focused on whether the taxpayer
had succeeded in deflecting the taxation of it to others.
As the majority opinion notes, there is later case law
dealing with how to measure the amount of the income. This case
law is, in part, responding to needs to interpret and apply
intricate “spread-back” provisions and, in part, to fill in the
gaps in statutory text that become evident when a statute has to
be applied to the real world. The concepts developed by the
courts seemed to be reasonable and seemed to produce reasonable
results. However, the statutory background has changed over the
decades. For example the Congress repealed more than 30 years
ago the statute referred to in the majority opinion’s quotation
(majority op. p. 21) from O’Brien v. Commissioner, 38 T.C. 707,
710 (1962), affd. 319 F.2d 532 (3d Cir. 1963). Application of
court-made rules to the new background has exposed analytical
errors that were originally overlooked because the harm created
- 33 -
was not then regarded as serious. That is, we held that the
taxpayers in O’Brien v. Commissioner, supra, and in Cotnam v.
Commissioner, 28 T.C. 947 (1957), revd. on this issue and affd.
on other issues 263 F.2d 119 (5th Cir. 1959), were entitled to
some but not all of the relief they claimed from the general
application of the annual accounting period rules.8
However, as the majority opinion notes (majority op. pp. 13-
15), continued application of the court-made rules, in this era
of minimum tax can raise effective tax rates to hardship levels
8
The statute referred to in O’Brien v. Commissioner, 38 T.C.
707, 710 (1962), affd. 319 F.2d 532 (3d Cir. 1963), is sec. 1303,
I.R.C. 1954, which provided a “cap” on taxation of back-pay
awards, calculated by “spreading back” the award over the years
to which the awarded amounts were attributable. We held that the
gross award was to be spread back, unreduced by the taxpayer’s
costs of obtaining the award. We noted that the taxpayer merely
was being denied a special, limited relief from the normal
incidences of income taxation, and that he remained entitled to
deduct his legal fees for the year the award was made. See
O’Brien v. Commissioner, 38 T.C. at 710, 712. In O’Brien v.
Commissioner, 38 T.C. at 711, we relied on Smith v. Commissioner,
17 T.C. 135 (1951), revd. on another issue 203 F.2d 310 (2d Cir.
1953), in which we had ruled the same way under sec. 107(d),
I.R.C. 1939, the predecessor of sec. 1303, I.R.C. 1954. In Smith
v. Commissioner, 17 T.C. at 144, the taxpayer wanted the gross
award spread back and the expenses deducted for the year of the
award, while the Commissioner argued for spreading back the net
cost; we held for the taxpayer. In Cotnam v. Commissioner, 28
T.C. 947, 953-954 (1957), revd. on this issue and affd. on other
issues 263 F.2d 119 (5th Cir. 1959), we also held that the gross
award was to be spread back under sec. 107(d), I.R.C. 1939, and
the expenses deductible for the year of the award.
The spread-back provisions that were the foundations for
Smith, Cotnam, and O’Brien were repealed by the Revenue Act of
1964, Pub. L. 88-272, sec. 232(a), 78 Stat. 19, 105, effective
for taxable years beginning after Dec. 31, 1963. See Pub. L. 88-
272, sec. 232(g)(1), 78 Stat. 112.
- 34 -
in some real-world instances. The problem arises not from the
statute, but rather from the court-made elaboration of the
assignment of income doctrine and from our refusal to reexamine
the rules that we have devised. I agree with the majority that
the Congress has the power to revise the statute to reduce or
eliminate the effect of court-made errors, but the courts also
have the right and obligation to correct their own errors.
In Teschner v. Commissioner, 38 T.C. 1003 (1962), a majority
of this Court reexamined several of the seminal cases, rejected
respondent’s efforts to analyze by slogan,9 and determined that
9
In Teschner v. Commissioner, 38 T.C. 1003, 1007 (1962), we
explained as follows:
In his ruling, the respondent declared, “The basic
rule in determining to whom an item of income is
taxable is that income is taxable to the one who earns
it.” If by this statement the respondent means that
income is in all events includible in the gross income
of whomsoever generates or creates the income by virtue
of his own effort, the respondent is wrong. If this
were the law, agents, conduits, fiduciaries, and others
in a similar capacity would be personally taxable on
the proceeds of their efforts. The charity fund-raiser
would be taxable on sums contributed as the result of
his efforts. The employee would be taxable on income
generated for his employer by his efforts. Such
results, completely at variance with every accepted
concept of Federal income taxation, demonstrate the
fallacy of the premise.
If, on the other hand, the respondent used the
term “earn,” not in such a broad sense, but in the
commonly accepted usage of “to acquire by labor,
service, or performance; to deserve and receive
compensation” (Webster’s New International
Dictionary),4 then the rule is intelligible but does
not support the conclusion reached by the respondent
(continued...)
- 35 -
the taxpayer therein was not taxable on the prize that his
daughter received as a result of the taxpayer’s successful entry
in a contest. Under the rules of the contest, only persons under
the age of 17 years and 1 month were eligible to receive prizes.
See id. at 1004. Any contestant over that age was required to
designate a person below that age as the recipient of the prize.
See id. at 1004. The taxpayer designated his daughter as
recipient. See id. at 1005. The taxpayer did not play any part
in creating this restrictive rule. Although the contest was
described as a “Youth Scholarship Contest”, the contest rules did
not limit the daughter in her use of the prize, a fully paid-up
annuity policy. See id. at 1005. The prize was worth $1,287.12;
respondent included this amount in the taxpayer’s income and
determined a deficiency of $283.16. See id. at 1004, 1005. We
summarized our conclusion as follows, id. at 1009:
Granted that an individual cannot escape taxation
on income to which he is entitled by “turning his back”
upon that income, the fact remains that he must have
received the income or had a right to do so before he
is taxable thereon. As noted by the court in United
States v. Pierce, 137 F.2d 428, 431 (C.A. 8, 1943):
The sum of the holdings of all cases is that
for purposes of taxation income is
9
(...continued)
either in the ruling in question or in the case before
us. The taxpayer there, as here, acquired nothing
himself; he received nothing nor did he have a right to
receive anything.
_____________________
4
Cf. Cold Metal Process Co. v. Commissioner, 247
F.2d 864, 872 (C.A. 6, 1957).
- 36 -
attributable to the person entitled to
receive it, although he assigns his right in
advance of realization, and although, in the
case of income derived from the ownership of
property, he transfers the property producing
the income to another as trustee or agent, in
either case retaining all the practical
benefits of ownership.
Section 1(a) of the 1954 Code imposes a tax on the
“income of every individual.” Where an individual
neither receives nor has the right to receive income,
he is not the taxable individual within the
contemplation of the statute. There is no basis in the
statute or in the decided cases for a construction at
variance with this fundamental rule.
Reviewed by the Court.
Decision will be entered
for the petitioners.
The majority in the instant case tax to petitioners
substantial funds that petitioners did not receive, were never
entitled to receive, and never turned their backs on. They do so
in the name of the assignment of income doctrine. The majority
acknowledge that there may be injustice in so doing, and that the
injustice may well be even greater in other real-life settings
than in the instant case. They contend that precedents compel
them to this result and that relief can come only from the hills
(Psalm 121), or at least from Capitol Hill. But this Court has
shown in Teschner v. Commissioner, supra, that reexamination of
the origins of the assignment of income doctrine can sharpen our
understanding of the concepts and make more rational the
application of that doctrine. We do not lightly overrule our
- 37 -
prior decisions. But when experience and analysis show that we
have departed from the origins that we once thought to be the
foundations of those decisions, and when it is our judicial
interpretations and not the statute law that lead to results that
increasingly seem to be unjust, then we ought to reexamine the
foundations of the doctrine. See in this connection Phillips v.
Commissioner, 86 T.C. 433 (1986), affd on this issue and revd. on
another issue 851 F.2d 1492 (D.C. Cir. 1988).
We should not declare ourselves incapable of self-
correction, merely because we chose to follow a wrong path
decades ago.
Respectfully, I dissent.
PARR, WELLS, COLVIN, and BEGHE, JJ., agree with this
dissenting opinion.
- 38 -
BEGHE, J., dissenting: As presiding judge at the trial of
this case, my disagreement with the majority is neither a dispute
about evidentiary facts nor a doctrinal dispute as such. What
divides me from the majority--notwithstanding the majority have
adopted my proposed factual findings pretty much verbatim--is a
disagreement about the significance of those facts. In my view,
those facts do not call for application of the assignment of
income doctrine.
The recitals and reasoning in support of my efforts to
decide this case in favor of petitioners go on and on at such
length that I provide a Table of Contents.
Findings and Resulting Inferences . . . . . . . . . . . . . . 39
Discussion . . . . . . . . . . . . . . . . . . . . . . . . . . 44
1. Issue Is Ripe for Reexamination . . . . . . . . . . 44
2. Tax Court’s Jurisprudence on Tax Treatment of
Contingent Fees--Dicta for Case at Hand . . . . . 48
3. Another Reason for Reexamination: Repeal of
Statutory Spreadback and Averaging Provisions . . 54
4. Cotnam and Estate of Clarks . . . . . . . . . . . . 56
i. Narrow Ground--Significance of State Law . . 60
ii. Broader Ground--Federal Standard . . . . . . 66
5. Significance of Control in Supreme Court’s
Assignment of Income Jurisprudence . . . . . . . . 70
6. Substantial Reduction of Claimant’s Control
by Contingent Fee Agreement . . . . . . . . . . . 75
i. “Contract of Adhesion” . . . . . . . . . . . 76
ii. American Bar Foundation Contingent
Fee Study . . . . . . . . . . . . . . . . . 77
iii. “Two Keys” Simile . . . . . . . . . . . . . . 80
7. Omissions and Distortions: the Majority Opinion . . 82
8. Majority Opinion’s Handling of Authorities . . . . . 86
- 39 -
9. Preventing Tax Avoidance by Other Transferors . . . 89
10. Cropsharing as Alternative to Joint
Venture/Partnership Analogy . . . . . . . . . . . 90
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . 97
Findings and Resulting Inferences
I would find the ultimate fact that the elements of control
over the prosecution of the ADEA claims ceded by Mr. Kenseth and
assumed and exercised by Fox & Fox under the contingent fee
agreement make it reasonable to include in petitioners’ gross
income only Mr. Kenseth’s net share of the settlement proceeds,
$138,201.10 This means that, in computing Mr. Kenseth’s gross
income from the settlement, his share of the proceeds should be
offset by the $91,800 portion of Fox & Fox’s $1,060,000
contingent fee that reduced his share of such proceeds, not by
10
In Helvering v. Horst, 311 U.S. 112 (1940) (gift of bond
interest coupons to taxpayer’s son), Justice Stone pointed out
that the ultimate question in deciding whether the assignment of
income rule applies is a question of fact whose answer should be
informed by the perceptions and reactions of the trier of fact to
the total situation:
To say that one who has made a gift thus derived from
interest or earnings paid to his donee has never
enjoyed or realized the fruits of his investment or
labor because he has assigned them instead of
collecting them himself and then paying them over to
the donee, is to affront common understanding and to
deny the facts of common experience. Common
understanding and experience are the touchstones for
the interpretation of the revenue laws. [Helvering v.
Horst, 311 U.S. at 117-118; emphasis supplied.]
See also Helvering v. Clifford, 309 U.S. 331, 338 (1940),
discussed, cited, and quoted infra p. 47.
- 40 -
including $229,501 in his gross income and treating his share of
the fee as an itemized deduction, subject to the alternative
minimum tax (AMT).11
The following evidentiary facts and inferences therefrom
support this ultimate finding.
The contingent fee agreement was a standardized form
contract prepared by Fox & Fox. Fox & Fox would have declined to
represent Mr. Kenseth if he had not entered into the contingent
fee agreement and agreed to the attorney’s lien provided therein.
Mr. Kenseth and the 16 other members of the class had a
common grievance arising from APV’s terminations of their
employment. That grievance impelled them to retain the same law
firm to advise them and prosecute their claims for redress. Once
that law firm had entered an identical contingent fee agreement
with each claimant, there was a substantial additional practical
impediment--as compared with a sole plaintiff who enters into a
contingent fee agreement--to Mr. Kenseth or any other class
member firing Fox & Fox and hiring other attorneys. That
impediment became even more substantial as the prosecution of the
claims by Fox & Fox progressed, from the filing of the
administrative claims, to the commencement of the class action
11
On occasion, the Commissioner has inadvertently taken
this position. See Coblenz v. Commissioner, T.C. Memo. 2000-131.
- 41 -
lawsuit in the District Court, to settlement negotiations and
reaching of an agreement with APV and its attorneys.
In contrast to the unconditional personal liability Mr.
Kenseth assumed to pay his share of out-of-pocket expenses, he
did not agree to pay a fee, only to the modes of computation and
payment of the contingent fee to which Fox & Fox would be
entitled from the proceeds of any recovery. If there had been no
recovery, Fox & Fox would have received nothing.
The contingent fee agreement required aggregation of the
elements of any settlement offer divided between damages and
attorney’s fees and provided that any division of such an offer
into damages and attorney’s fees would be disregarded by Fox &
Fox and Mr. Kenseth. This means that, if either the defendant’s
settlement offer or the court’s decision had provided for a
separate award of attorney’s fees, the award of attorney’s fees
and the damages would have been grossed up to determine the fee
that Fox & Fox would be entitled to under the terms of the
contingent fee agreement.12
The contingent fee agreement provided that Mr. Kenseth could
not settle his case against APV without the consent of Fox & Fox.
Under Section VIII of the contingent fee agreement, Mr. Kenseth
12
Any issue presented by this provision became moot because
there was no agreement with APV or court award for the payment of
attorney’s fees.
- 42 -
agreed that Fox & Fox "shall have a lien" for its fees and costs
against any recovery in Mr. Kenseth's action against APV. This
lien by its terms was to be satisfied before or concurrently with
the disbursement of the recovery. The contingent fee agreement
further provided that if Mr. Kenseth should terminate his
representation by Fox & Fox, the firm would have a lien for the
fees set forth in Section III of the agreement, and all out-of-
pocket expenses that had been disbursed by Fox & Fox would become
due and payable by Mr. Kenseth within 10 days of his termination
of Fox & Fox as his attorneys.
Mr. Kenseth and the other members of the class relied on the
guidance and expertise of Fox & Fox in signing the separation
agreement tendered to them by APV and then seeking redress
against APV. Commencing with the advice to Mr. Kenseth that he
could sign the separation agreement without giving up his age
discrimination claim, and culminating with the obtaining by Fox &
Fox of an overall settlement and recovery that substantially
exceeded what EEOC had thought the case was worth, Fox & Fox made
all strategic and tactical decisions in the management and
pursuit of the age discrimination claims of Mr. Kenseth and the
other class members against APV.
Fox & Fox was well aware of the relationship between any
gross settlement amount and the resulting fee that Fox & Fox
would be entitled to. In preparing for and conducting
- 43 -
negotiations with APV and its attorneys, Fox & Fox tried to
ensure that the amounts actually received by Mr. Kenseth and the
other class members would approximate the full value of their
claims. Fox & Fox did this by including in their demands on
behalf of the claimants an amount for attorney’s fees that would
be included in and paid out of the settlement proceeds.
The bulk of the settlement proceeds was paid by APV directly
to the Fox & Fox trust account, by prearrangement between APV and
Fox & Fox.13 From the gross amount so paid, Fox & Fox paid itself
its agreed upon contingent fee of $1,060,000 and computed and
apportioned the remaining amount for distribution to Mr. Kenseth
and the other class members.14
13
Excluding the back pay portion--14.15 percent of the
total settlement proceeds and 23.58 percent of the total
distribution to class members--paid directly to Mr. Kenseth and
the other class members by APV, and from which employment taxes
were paid and withheld.
14
Mr. Kenseth had the largest share of the settlement of
any member of the class. The range of amounts distributed to
individual class members ranged from 2 percent of the total
amount distributed (Mr. Benisch) to 8.6 percent (Mr. Kenseth).
Although each class member’s back pay portion was the same
percentage of his share of the total settlement distributed to
class members (23.58 percent), the record does not disclose the
basis of the apportionment of the total settlement amount
distributed to each member of the class. The uniform
apportionment between back pay and the remainder of each
claimant’s share of the settlement proceeds seems inconsistent
with the way in which each claimant’s future earnings and
benefits were projected over estimated future work life and then
discounted back to present value by the economist retained by Fox
& Fox to assist in determining the amounts of the claimants’
claims. However, this lack of information and apparent
(continued...)
- 44 -
There is no evidence in the record that Mr. Kenseth or any
other class member ever expressed dissatisfaction with the
services of Fox & Fox or tried to bring in other attorneys to
participate in or take over the prosecution of any of the ADEA
claims.
Discussion
My task is to persuade the reader that the governing law
permits-–indeed compels--the ultimate finding that Mr. Kenseth
did not retain enough control over his claim to justify including
in his gross income any part of the contingent fee paid to his
attorneys.
1. Issue Is Ripe for Reexamination
My dissatisfaction with the results of recent cases,15
antedating publication of Estate of Clarks v. United States, 202
14
(...continued)
inconsistency have no bearing on the outcome of this case, other
than to indicate uniformity in the treatment of class members
consistent with their lack of individual control over the
outcome.
15
The unsatisfactory results of those cases (cited infra
notes 21-22), both absolutely and from a horizontal equity
standpoint, are highlighted by the treatment of legal fees paid
to prosecute claims arising out of the claimant’s business as an
independent contractor, which are allowed as above-the-line trade
or business expense deductions under sec. 162(a). See Guill v.
Commissioner, 112 T.C. 325 (1999). Kalinka, “A.L. Clarks Est.
and the Taxation of Contingent Fees Paid to an Attorney”, 78
Taxes 16, 23 (Apr. 2000), observes that adoption of the view
espoused in this dissent will still put in an unfavorable tax
position non-business claimants who obligate themselves to pay
attorney’s fees at hourly rates in order to obtain taxable
recoveries. I agree that congressional action would be necessary
to change the unfavorable tax result for such claimants.
- 45 -
F.3d 854 (6th Cir. 2000), revg. 98-2 USTC par. 50,868, 82 AFTR 2d
7068 (E.D. Mich. 1998), impelled me to ride the case at hand as
the vehicle to reexamine the Tax Court’s treatment of contingent
fees paid to obtain taxable recoveries. Although this case is
not the most egregious recent example, the mechanical interplay
of the itemized deduction rules with the AMT can result--in cases
in which the contingent fee exceeds 50 percent of the recovery--
in an overall effective rate of Federal income tax and AMT on the
net recovery exceeding 50 percent;16 in cases in which the
aggregate fees exceed 72-73 percent of the recovery, the tax can
exceed the net recovery, resulting in an overall effective rate
of tax that exceeds 100 percent of the net recovery.17
16
Coady v. Commissioner, T.C. Memo. 1998-291, on appeal
to the Court of Appeals for the Ninth Circuit, may be a case in
point. The contingent fee and costs approximated 60 percent of
the recovery.
The alternative provision for using the enhanced hourly rate
schedule to calculate the legal fee under Section III of Mr.
Kenseth’s contingent fee agreement could result, in a case in
which the recovery is small relative to the time spent on the
case by the attorneys, in a fee substantially greater than the
40-46 percent contingent fee provided by the agreement. It
should be kept in mind that the enhanced hourly rate provision
was an alternative method of computing the contingent fee, not a
provision for an hourly rate that was payable in all events for
which the client was personally liable, as in Bagley v.
Commissioner, 105 T.C. 396 (1995), affd. on other issues 121 F.3d
393 (8th Cir. 1997), and Estate of Gadlow v. Commissioner, 50
T.C. 975 (1968).
17
Because of the resulting exposure to two sets of fees,
the lien provisions of contingent fee agreements are a
substantial impediment to replacing original attorneys. These
situations contain the potential, if the total contingent fees
(continued...)
- 46 -
Even if Estate of Clarks v. United States, supra, had not
recently been decided in the taxpayer’s favor by the Court of
Appeals for the Sixth Circuit, it would be appropriate to revisit
this issue. That Congress has not yet responded to comments that
the itemized deduction and AMT provisions are working in
unanticipated and inappropriate ways that support revision or
repeal18 does not mean that courts are powerless to step in on a
17
(...continued)
should exceed approximately 72-73 percent of the gross recovery
and be treated as itemized deductions, of resulting in AMT
liability--assuming the taxpayer has no substantial other income
in the year of recovery--that would exceed the amount of the net
recovery. A case in point may be Jones v. Clinton, 57 F. Supp.
2d 719 (E.D. Ark. 1999) in which, after acrimonious dispute among
three sets of attorneys, $649,000 of the settlement proceeds of
$850,000 were divided among them (the settlement check was made
payable to plaintiff and two sets of attorneys), so as to leave
only $201,000 for the plaintiff. See “Attorneys For Jones
Escalate Fight Over Fees”, Washington Times A6 (1/17/99); “Jones’
Lawyers Battle Over Fees”, Washington Post A9 (1/20/99); “Sharing
Jones Settlement”, N.Y. Times A16 (3/5/99); see also Alexander v.
IRS, 72 F.3d 938, 946-947 (1st Cir. 1995), affg. T.C. Memo. 1995-
51, in which the allocated legal fee approximated 73-74 percent
of the total recovery, and the fee and the tax liability on it
appeared to exceed the net taxable recovery.
18
See, e.g., Gutman, “Reflections on the Process of
Enacting Tax Law”, Tax Notes 93, 94 (Jan. 3, 2000) (Woodworth
Lecture, delivered Dec. 3, 1999) (itemized deduction phaseouts);
IRS National Taxpayer Advocate’s Annual Report to Congress, BNA
Daily Tax Report GG-1, L-2 (AMT), L-9/10, L-22 (itemized
deductions) (Jan. 5, 2000); Meissner, “Repeal or Revamp the AMT:
The Time Has Come”, 86 Stand. Fed. Tax Rep. (CCH) Tax Focus (Aug
19, 1999); Testimony of Stefan F. Tucker on Behalf of Section of
Taxation, American Bar Association, before Subcommittee on
Oversight, U.S. House of Representatives, on Revenue Provisions
in the President’s FY 2000 Budget, Mar. 10, 1999, 52 Tax Law.
577, 580-581 (1999) (AMT and itemized deductions);
(continued...)
- 47 -
case-by-case basis. As Justice Douglas spoke for the Court in
Helvering v. Clifford, 309 U.S. 331, 338 (1940), responding to
the taxpayer’s argument that the then current statutory revocable
trust rules did not by their terms apply to the short-term trust
arrangement under review:
The failure of Congress to adopt any such rule of thumb
for that type of trust must be taken to do no more than
leave to the triers of facts the initial determination
of whether or not on the facts of each case the grantor
remains the owner for purposes of § 22(a). [Emphasis
supplied.]
What Justices Stone and Douglas said in Horst and Clifford
provides two reminders: First, the Supreme Court regards the
trial courts, including the Tax Court, as the proper arbiters of
the assignment of income doctrine; it’s the trial court’s job to
decide whether a taxpayer, who made an intrafamily or related
party transfer or other transfer of rights to future income or of
income producing property, retained sufficient control over what
was transferred to justify taxing the transferor on the income,
rather than the transferee. Second, the assignment of income
doctrine is judge-made law, not a rule of statutory
interpretation of the more recently enacted itemized deduction
and AMT provisions. Contrary to the claims of the majority and a
18
(...continued)
ABA/AICPA/TEI/release on 10 ways to simplify the tax code
(including repealing AMT and phasing out phaseouts) Doc. 2000-
5573 Highlights & Documents (Feb. 28, 2000).
- 48 -
recent commentator,19 we need not wait for Congress to change
those provisions. We’re dealing with a problem under the common
law of taxation;20 what the courts have created and applied,
courts can interpret, refine, and distinguish to determine
whether in changed circumstances the conditions for application
of the doctrine have been satisfied.
2. Tax Court’s Jurisprudence on Tax Treatment of Contingent
Fees--Dicta for Case at Hand
The inquiry begins with a reexamination of the original
cases--published as regular Tax Court opinions--cited by the
majority as originating and applying the rule that the Supreme
Court’s assignment of income opinions require that a contingent
fee be allowed only as a deduction, not as an offset in computing
gross income. All these cases were interpretations and
applications of the spreadback provisions of section 107 of the
1939 Code or its statutory successors in the 1954 Code. What the
Tax Court said in these cases about those Supreme Court opinions
was dictum. The Tax Court’s recent opinions on the subject,
concerning itemized deductions and the AMT, are, with one
19
See Kalinka, “A.L. Clarks Est. and the Taxation of
Contingent Fees Paid to an Attorney”, 78 Taxes 16 (Apr. 2000).
20
See Brown, “The Growing ‘Common Law’ of Taxation”, 1961
S. Cal. Tax Inst. 1, 13-21.
- 49 -
distinguishable exception,21 memorandum opinions, not properly
regarded as binding precedent.22
The regular opinions of the Tax Court on which the majority
rely are not directly in point. There is another ground on which
Smith v. Commissioner, 17 T.C. 135 (1951), revd. on another issue
203 F.2d 310 (2d Cir. 1953); Cotnam v. Commissioner, 28 T.C. 947(1957), affd. in part and revd. in part 263 F.2d 119 (5th Cir.
1959); Petersen v. Commissioner, 38 T.C. 137 (1962); O'Brien v.
Commissioner, 38 T.C. 707 (1962), affd. per curiam 319 F.2d 532(3d Cir. 1963); and Estate of Gadlow v. Commissioner, 50 T.C. 975(1968), were decided that distinguishes them from the case at
hand. Each of these earlier cases applied section 107 of the
1939 Code or a similar provision for relief from high marginal
rates of income tax on bunched receipts in one year (or a
relatively short period) of back pay, compensation from an
21
Bagley v. Commissioner, 105 T.C. 396, 418-419 (1995),
affd. on other issues 121 F.3d 393 (8th Cir. 1997), which was not
appealed on this issue, held, among numerous other things, that
hybrid attorney’s fees (fixed $50-hourly rate and 25-percent
contingency fee), to extent allocable to taxable portion of
awards, were deductible as itemized deductions under sec. 67(a),
rather than as offsets in computing gross income. Stated ground
of decision on this issue, not appealed by the taxpayers, was
that fee agreement did not create partnership or joint venture
within meaning of sec. 7701(a)(2) between plaintiff-taxpayer and
attorney. See infra pp. 70, 90-97.
22
See, e.g., Benci-Woodward v. Commissioner, T.C. Memo.
1998-395; Sinyard v. Commissioner, T.C. Memo. 1998-364;
Srivastava v. Commissioner, T.C. Memo. 1998-362; Coady v.
Commissioner, supra; Brewer v. Commissioner, T.C. Memo. 1997-542,
affd. without published opinion 172 F.3d 875 (9th Cir. 1999).
- 50 -
employment, etc., attributable to services rendered over a number
of years. The statutory mechanism allowed the taxpayer to
compute income tax for the year of receipt as if the back pay or
other compensation had been ratably received during the years
earned. The theme of those cases, without regard to assignment
of income principles, was this Court’s unwillingness to provide
relief beyond the express terms of what was felt to be a generous
statutory relief provision.
In each of those cases, this Court treated the problem as
one of statutory interpretation, before wrapping itself in the
mantle of Lucas v. Earl, 281 U.S. 111 (1930), and the Supreme
Court’s other landmark cases on assignment of income. So said
Judge Raum, speaking for the Court in O’Brien v. Commissioner, 38
T.C. at 710:23
Although there may be considerable equity to the
taxpayer’s position, that is not the way the statute is
written. Without the benefit of section 1303 [the 1954
Code equivalent of 1939 Code section 107], there would
be no relief whatever, and the relief granted cannot go
beyond these very provisions. They provide merely for
a computation of tax based upon “the inclusion of the
respective portions of such back pay in the gross
income for the taxable years to which such portions are
23
The taxpayer in O’Brien v. Commissioner, 38 T.C. 707(1962), affd. per curiam 319 F.2d 532 (3d Cir. 1963), had not
claimed on his return that the fee should offset the recovery,
with the resulting reduced amount to be spread back. The
taxpayer had reported on his 1957 income tax return the receipt
of a backpay award, had spread back the gross amount of the award
over the years of service (1952-1955), and then had apportioned
and spread back the legal fees over the same years. This, the
Court held, the statutory spreadback provision did not permit.
- 51 -
respectively attributable.” There is no provision
whatever for spreading back any related expenses as was
done in petitioner’s returns.
Judge Raum saw the situation as identical with that in Smith
v. Commissioner, 17 T.C. at 144, quoting what the Court said in
that case in upholding the taxpayer’s claim of entitlement to the
deduction in the year of receipt, notwithstanding that the
Commissioner had computed his tax liability by spreading the back
pay award over the years of service:
Without this section, the entire $212,000 would be
income in 1945. Section 107 is silent as to expenses
incurred in connection with any collection of back pay,
and there are no regulations or decisions which we have
been able to find on the question. To limit
application of section 107 to amounts received less
expenses connected with collection is not a function
for the Court, but rather is a task for Congress if
that is the result which they wish. We therefore hold
that petitioner is entitled to deduct the $25,000 legal
expense in 1945.
Judge Raum then discussed the opinions of the Tax Court and
the Court of Appeals for the Fifth Circuit in Cotnam v.
Commissioner, supra, concluding: “In reaching that conclusion
the majority [in the Fifth Circuit] placed considerable stress
upon certain provisions of an Alabama statute relating to
attorney’s liens.”24 O’Brien v. Commissioner, supra at 712.
24
It’s also noteworthy that the final paragraph of Judge
Wisdom’s dissent in Cotnam v. Commissioner, 263 F.2d 119, 127
(5th Cir. 1959), revg. 28 T.C. 947 (1957), like the opinion of
Judge Turner in the Tax Court, and the Tax Court’s prior opinion
in Smith v. Commissioner, 17 T.C. 135 (1951), revd. on another
issue 203 F.2d 310 (2d Cir. 1953), relied upon the lack in sec.
(continued...)
- 52 -
Turning back to the case before him, Judge Raum found that there
were no such provisions in Pennsylvania law. Judge Raum then
questioned whether State law had any bearing on the matter,
inasmuch as the underlying claim had been prosecuted in the
United States Court of Claims under Federal law. What followed,
Judge Raum’s ipse dixit on assignment of income, is dictum. Id.:
However, we think it doubtful that the Internal Revenue
Code was intended to turn upon such refinements. For,
even if the taxpayer had made an irrevocable assignment
of a portion of his future recovery to his attorney to
such an extent that he never thereafter became entitled
thereto even for a split second, it would still be
gross income to him under the familiar principles of
Lucas v. Earl * * *, Helvering v. Horst * * *, and
Helvering v. Eubank * * *. The fee, of course, would
be deductible, just as it was held to be in Weldon D.
Smith. Cf. Walter Petersen * * *. We reach the same
result here. Petitioner is entitled to the benefit of
section 1303 with respect to his $16,173.05 recovery in
1957 and may deduct the $8,243.10 legal expenses in
that year; such legal expenses may not be spread back
over earlier years, nor may the same result be achieved
indirectly by subtracting the expenses from the
recovery and then applying section 1303 to the reduced
amount.
Estate of Gadlow v. Commissioner, supra, is the last regular
Tax Court opinion in this series. Estate of Gadlow is similarly
distinguishable from the case at hand. Like the earlier cases,
Estate of Gadlow concerned the application of a provision for
computing income tax liability upon the receipt of damages for
breach of contract by prorating the recovery over the earlier
24
(...continued)
107 of any express provision for allocating expenses against the
prorated compensation.
- 53 -
years that the income would have been received but for the
breach, section 1305 of the 1954 Code. One of the grounds
advanced by the Court in Estate of Gadlow for refusing to follow
the Court of Appeals for the Fifth Circuit in Cotnam was that the
applicable Pennsylvania law did not contain the Alabama
provision.25
The Court’s opinion in Estate of Gadlow summarized and
quoted O’Brien v. Commissioner, supra, and concluded that the
spread back provisions under review:
did not make provision for spreading back related
expenses incurred in the collection of back pay. We
concluded [in O’Brien] that without specific statutory
authority this Court could not allow this treatment.
We reach the same conclusion here. [Estate of Gadlow
v. Commissioner, supra at 981.]
In the case at hand there is no analogous question of
statutory interpretation of a relief provision, only the
application of the Federal common law of taxation26 to determine
25
Estate of Gadlow v. Commissioner, 50 T.C. 975, 980
(1968), is also distinguishable from Cotnam v. Commissioner, 25
T.C. 947 (1957), affd. in part and revd. in part 263 F.2d 119(5th Cir. 1959), on another ground, not present in the case at
hand:
because Gadlow did not employ the attorneys on a
contingent-fee basis as Mrs. Cotnam did, but rather,
their fee was fixed solely by the number of hours they
worked on Gadlow’s case. Therefore, the fee was
Gadlow’s debt due and owing from Gadlow to his
attorneys without regard to the outcome of the
litigation.
26
See supra note 20.
- 54 -
whether the Tax Court can and should apportion the respective
gross incomes of client and attorney pursuant to a contingent fee
agreement under which the client gives up substantial control
over the prosecution and recovery of his claim.
3. Another Reason for Reexamination: Repeal of Statutory
Spreadback and Averaging Provisions
The history of the statutory spreadback provisions is
instructive in another respect.27 In 1964, those provisions were
repealed in favor of general income averaging.28 In 1970,
Congress enacted the 50-percent maximum tax on earned income,
which was in turn repealed in 1981, when the top income tax rate
27
Under the 1954 Code, taxpayers were afforded six targeted
spreadback (or averaging) provisions that were intended to
mitigate the harsh effects of progressive tax rates on income
earned unevenly over the years. See secs. 1301-1307 (1954 Code).
These relief provisions applied only to particular types of
income (e.g., employment compensation, back pay, breach of
contract damages, income from inventions or artwork, antitrust
damages) earned or received over specified periods of time.
28
Congress amended the targeted averaging provisions in the
Revenue Act of 1964, stating that “A general averaging provision
is needed to accord those whose incomes fluctuate widely from
year to year the same treatment accorded those with relatively
stable incomes.” S. Rept. 830, 88th Cong., 2d Sess. (1964),
1964-1 C.B. (Part 2) 505, 643, 644. Congress explained that the
former targeted averaging provisions were inadequate because they
were (1) limited to a relatively small proportion of situations
and (2) unduly complicated. See id. at 644. Accordingly,
Revenue Act of 1964, Pub. L. 88-272, sec. 232(a), 78 Stat. 19,
105 replaced the old provisions (subject to transitional relief)
with an averaging device that was available to individual
taxpayers generally, regardless of the source of income. See id.- 55 -
was reduced to 50 percent.29 In 1986, Congress repealed general
income averaging.30 All these provisions were tools Congress had
used to ameliorate the top marginal income tax rates that went as
high as or higher than 70 percent during most of the relevant
periods. After 1986, under the new flatter rate structure, with
a top rate of substantially less than 50 percent, these
provisions were no longer needed. Against the background of
Congressional concerns about ameliorating a high and steeply
progressive rate structure, I don’t believe Congress expected or
intended that the interplay of the newly enacted itemized
deduction and AMT provisions could result in effective rates of
tax substantially exceeding 50 percent up to more than 100
percent of a net recovery.
29
Congress granted another type of relief from the punitive
effects of historically high marginal rates when it enacted the
50 percent maximum tax on personal service income for tax years
beginning after Dec. 31, 1970. Tax Reform Act of 1969, Pub. L.
91-172, sec. 804(a), 83 Stat. 487, 685 (codified as sec. 1348).
However, such relief subsequently was considered no longer
necessary when Congress reduced the highest marginal tax rate on
all types of income to 50 percent, for taxable years beginning
after Dec. 31, 1981. Economic Recovery Tax Act of 1981, Pub. L.
97-34, sec. 101(c)(1), 95 Stat. 172, 183. (repealing sec. 804(a)
of the Tax Reform Act of 1969).
30
In 1986, Congress repealed the income averaging
provisions almost entirely (exception carved out for farming
income). Tax Reform Act of 1986, Pub. L. 99-514, sec. 141(a),
100 Stat. 2085, 2117. Congress believed that changes to the
individual income tax provisions, which provided wider brackets,
fewer rates, and a flatter rate structure with a top marginal
rate substantially less than 50 percent, reduced the need for
complicated income averaging. See H. Rept. 99-426 (1986), 1986-3
C.B. (Vol. 2) 114.
- 56 -
Contrarywise, the purpose of the AMT is to prevent
individuals with substantial economic income from avoiding
significant tax liability.31 Although we have held that the
itemized deduction limitations and the AMT can apply to low and
middle-income taxpayers,32 that doesn’t mean that Congress
expected or intended that these provisions could result in
effective tax rates exceeding 50 percent. Where their interplay
with contingent fees has that potential, courts are entitled to
ask whether the plaintiff-claimant’s retained control--vis-a-vis
the control acquired and exercised by the attorney--is sufficient
to justify including in the claimant’s gross income the
contingent fee the attorney pays himself out of the recovery
proceeds.
4. Cotnam and Estate of Clarks
The inquiry continues with a review of the opinions of the
Court of Appeals for the Fifth Circuit in Cotnam v. Commissioner,
263 F.2d 119 (5th Cir. 1959), affg. in part and revg. in part 28
T.C. 947 (1957). The handling of the matter by the Court of
Appeals discloses both a narrow ground and a broader ground for
its decision. The numerous occasions we have distinguished
Cotnam on the narrow ground have obscured the broader ground and
31
See S. Rept. 99-313, at 518, 1986-3 C.B. (Vol. 3) 1, 518.
32
See, e.g., Huntsberry v. Commissioner, 83 T.C. 742(1984); Lickiss v. Commissioner, T.C. Memo. 1994-103.
- 57 -
contributed to our failure to grapple with the issue in a broad-
gauged, principled way under the Federal common law of taxation
as adopted by the Supreme Court. Instead, we’ve been beguiled by
“attenuated subtleties” and “refinements” into treating the
problem as one of determining the claimant’s retained legal
rights in his cause of action under State law.
The taxpayer in Cotnam had rendered housekeeping services to
an elderly individual during the years 1940-44 in consideration
of his promise to bequeath her one-fifth of his estate.
Following his death without a will, she entered a contingent fee
agreement with attorneys who successfully prosecuted her claim to
judgment against the estate. The check for the $120,000 recovery
(plus approximately $5,000 in interest), which was received in
1948, was made payable to the taxpayer and her attorneys. After
endorsement by the payees, the check was deposited in the
attorneys’ bank account. Retaining their fee of $50,000, the
attorneys gave the taxpayer their check of $75,000 for the
balance (amounts rounded off).
The Commissioner determined that the recovery was
compensation income rather than a nontaxable bequest and
apportioned the gross recovery under section 107 of the 1939 Code
over the 4-1/2-years the services were rendered. In applying
section 107, the Commissioner allowed the legal fee as a
deduction only in the year paid, in which the taxpayer had
- 58 -
otherwise negligible income against which to deduct the fee,
resulting in a deficiency of more than $36,000.33
The Tax Court first held that the recovery was compensation
income rather than a nontaxable bequest; on this issue the Court
of Appeals for the Fifth Circuit unanimously affirmed. On the
second question, whether the contingent legal fee was excluded
from the compensation to be spread back or merely a useless
deduction in the year of receipt by the attorneys, Judge Wisdom,
writing for the panel, made clear that he disagreed with the
outcome in the taxpayer’s favor, stating as follows:
A majority of the Court, Judges Rives and Brown,
hold that the $50,365.83 paid Mrs. Cotnam’s attorneys
should not be included in her gross income. This sum
was income to the attorneys but not to Mrs. Cotnam.
* * * * * * *
The facts in this unusual case, taken with the
Alabama statute, put the taxpayer in a position where
she did not realize income as to her attorneys’
interests of 40% in her cause of action and judgment.
[Cotnam v. Commissioner, 263 F.2d at 125.]
33
Because of the high marginal rates of Federal income tax
in effect in 1940-44 and 1948, inclusion of the gross recovery in
1948 income and allowance of the deduction in that year would
have resulted in a greater deficiency than that arising under the
apportionment of the gross income over the prior years under 1939
Code sec. 107, even if the fee were treated as a deduction or
offset for 1948. The taxpayer was arguing for even greater
relief, that the compensation received in 1948 and apportioned
under sec. 107 over the earlier years should be reduced by the
legal fee.
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This is the narrow holding of the Court of Appeals’ decision
in Cotnam, discussed below in subpart i.34
There then followed a statement of the broader ground of the
panel’s decision, introduced by the following statement: “Judges
RIVES and BROWN add to the foregoing, the following”, 263 F.2d at
125, and concluding: “Accordingly, the attorneys’ fee of
$50,365.83 should not have been included in the taxpayer’s gross
income”, 263 F.2d at 126. Then came the dissenting opinion of
Judge Wisdom, who had written the opinion for the panel embodying
the narrow holding.35 The disagreement between the additional
34
Although the Tax Court noted that the attorneys “only had
a lien on the fund” payable to Mrs. Cotnam and that the attorneys
“had no right in or title to” Mrs. Cotnam’s recovery sufficient
to justify treating them as the owners for tax purposes of any
portion of that recovery, it is not clear that the peculiar
provisions of Alabama law that provided the narrow holding of the
Court of Appeals decision were brought to the attention of the
Tax Court. See Cotnam v. Commissioner, 28 T.C. 947, 954 (1957),
affd. in part and revd. in part 263 F.2d 119 (5th Cir. 1959).
The Tax Court, in sustaining the Commissioner’s treatment of the
fee as a deduction, did not address the significance (or even
advert to the existence) of those provisions (discussed infra pp.
60-66).
35
Cotnam is a close-to-home example of a judge (Wisdom, J.)
writing both the majority opinion and a dissent. Although only
rarely does the judge who writes the majority opinion also write
separately in concurrence or dissent, it has happened in this
Court, Haserot v. Commissioner, 46 T.C. 864, 872-878 (1966)
(Tannenwald, J., “speaking separately”), affd. sub nom.
Commissioner v. Stickney, 399 F.2d 828 (6th Cir. 1968), and in
other courts, see, e.g. City of Baton Rouge v. Ross, 654 So.2d
1311, 1326 (La. 1995) (Calogero, C.J., concurring); Santa Clara
County Local Transp. Auth. v. Guardino, 902 P.2d 225, 256 (Cal.
1995) (Werdegar, J. dissenting); Dawkins v. Dawkins, 328 P.2d
346, 353 (Kan. 1958) (Jackson, J., concurring), no less than the
(continued...)
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statement of Judges Rives and Brown and Judge Wisdom’s dissent is
a disagreement about the application of traditional assignment of
income principles. The broader holding, which, the majority and
I agree, frames the issue on which the case at hand and other
contingent fee cases should be decided, is discussed below in
subpart ii. Of course, the majority agree with Judge Wisdom and
I agree with Judges Rives and Brown.
i. Narrow Ground--Significance of State Law
In deciding Cotnam v. Commissioner, supra, the majority of
the Court of Appeals, in the portion of the panel’s opinion
written by Judge Wisdom (hereinafter majority opinion), relied
heavily on two unusual characteristics of attorney’s liens under
Alabama law. The majority opinion noted that the Alabama
35
(...continued)
Supreme Court of the United States, see, e.g., Logan v. Zimmerman
Brush Co., 455 U.S. 422, 438-442 (1982) (separate opinion of
Blackmun, J.); Abbate v. United States, 359 U.S. 187, 196-201
(1959) (separate opinion of Brennan, J.); Wheeling Steel Corp. v.
Glander, 337 U.S. 562, 574-576 (1949) (separate opinion of
Jackson, J.); cf. Helvering v. Davis, 301 U.S. 619, 639-640
(1937) (opinion of Cardozo, J.); Andrew Crispo Gallery, Inc. v.
Commissioner, 16 F.3d 1336, 1343-1344 (2d Cir. 1994) (opinion of
Van Graafeiland, J.), affg., vacating and remanding in part T.C.
Memo. 1992-106; In re Estate of Sayre, 279 A.2d 51, 52 n.2 (Pa.
1971) (opinion of Bell, C.J.). As Justice Jackson said in
Wheeling Steel Corp. v. Glander, supra at 576: “It cannot be
suggested that in cases where the author is the mere instrument
of the Court he must forego expression of his own convictions.
Mr. Justice Cardozo taught us how justices may write for the
Court and still reserve their own positions, though overruled.
Helvering v. Davis, 301 U.S. 619, 639.” For discussions of the
practice, see Aldisert, Opinion Writing, 168-170 (1990);
Llewellyn, The Common Law Tradition: Deciding Appeals 494 (1960).
- 61 -
attorney’s lien statute gave an attorney an interest in the
client's suit or cause of action, as well as the usual security
interest in any judgment or settlement the client might
eventually win or receive. See Cotnam v. Commissioner, 263 F.2d
at 125; United States Fidelity & Guar. Co. v. Levy, 77 F.2d 972,
975 (5th Cir. 1935) (cited by the majority opinion in Cotnam).
The majority opinion also noted that under the Alabama statute
"Attorneys have the same rights as their clients." Cotnam v.
Commissioner, 263 F.2d at 125. The majority opinion did not
explain in detail the sense in which attorneys' and clients'
rights were the same. However, the cases cited to support this
point make clear the majority opinion was referring to an
attorney's right, under Alabama law, to prosecute his client's
suit to a final judgment, even after the client has settled the
suit with the adverse party. See Denson v. Alabama Fuel & Iron
Co., 73 So. 525 (Ala. 1916); Western Ry. v. Foshee, 62 So. 500(Ala. 1913).36
When we have not followed Cotnam, we have usually relied on
differences between the attorney’s lien law for the State in
issue and Alabama law. See, e.g., Estate of Gadlow v.
36
We recently followed the decision of the Court of Appeals
in Cotnam v. Commissioner, supra, where Alabama law applied. See
Davis v. Commissioner, T.C. Memo. 1998-248 (Tax Court constrained
to follow Court of Appeals’ Cotnam decision under rule of Golsen
v. Commissioner, 54 T.C. 742 (1970), affd. 445 F.2d 985 (10th
Cir. 1971)), affd. per curiam F.3d (11th Cir. 2000). See
also Foster v. United States, F. Supp.2d (N.D. Ala. 2000).
- 62 -
Commissioner, 50 T.C. 975 (1968) (distinguishing Pennsylvania
law); Petersen v. Commissioner, 38 T.C. 137 (1962) (Nebraska and
South Dakota law); Benci-Woodward v. Commissioner, T.C. Memo.
1998-395 (California law); Sinyard v. Commissioner, T.C. Memo.
1998-364 (Arizona law); Srivastava v. Commissioner, T.C. Memo.
1998-362 (Texas law); Coady v. Commissioner, T.C. Memo. 1998-291(Alaska law). But see O'Brien v. Commissioner, 38 T.C. 707(1962) (dictum that State law makes no difference), affd. per
curiam 319 F.2d 532 (3d Cir. 1963).37
Wisconsin law governed the attorney-client relationship
between Fox & Fox and Mr. Kenseth. Wisconsin law arguably gives
attorneys the two unusual interests in their clients' lawsuits
relied on by the majority opinion in Cotnam v. Commissioner, 263
37
Other Federal courts, in concluding that taxpayer-
plaintiffs are taxable on contingent fees paid to their
attorneys, have also noted that the State laws in issue do not
give attorneys proprietary or equitable interests in their
clients’ recoveries or causes of action. See Baylin v. United
States, 43 F.3d 1451, 1455 (Fed. Cir. 1995) (commenting on
Maryland attorney’s lien statute); Estate of Clarks v. United
States, 98-2 USTC par. 50,868, 82 AFTR 2d 7068 (E.D. Mich. 1998)
(distinguishing Cotnam v. Commissioner, supra, on the ground of
differences between Michigan and Alabama law), revd. 202 F.3d 854(6th Cir. 2000)). My view that the tax effects of contingent fee
agreements should be decided on the broader ground makes it
unnecessary for me to take a position on the view of the Court of
Appeals for the Sixth Circuit that the Michigan common law
attorney’s lien is the equivalent of the proprietary interest of
the attorney in the cause of action under Alabama law.
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F.2d 119 (5th Cir. 1959).38 Although the narrow ground issue need
not detain us indefinitely, a few observations are in order.
Respondent argues that Wisconsin ethical rules prohibit an
attorney from acquiring a "proprietary interest" in a cause of
action he is pursuing for his client. See Wis. Sup. Ct. R.
20:1.8(j) (1998). That rule actually states, however, that "A
lawyer shall not acquire a proprietary interest * * * except that
the lawyer may: (1) acquire a lien granted by law to secure the
lawyer's fee or expenses; and (2) contract with a client for a
reasonable contingent fee in a civil case." Id. (Emphasis
added.) Therefore, the rule clearly permits an attorney to
acquire the interests in his client's cause of action
contemplated by the Wisconsin attorney’s lien laws; it also
suggests that those interests are proprietary interests.
38
See Smelker v. Chicago & N. W. Ry., 81 N.W. 994, 994
(Wis. 1900), which quoted the Wisconsin attorney’s lien statute
as originally enacted in 1891. Although Smelker is an old case,
diligent research has not disclosed any authority reversing it or
declaring it obsolete. It is cited and summarized as standing
for the propositions described in the text in 146 A.L.R. 67, 69
(1943) (“ANNOTATION. Merits of client’s cause of action or
counterclaim as affecting attorney’s lien or claim for his
compensation against adverse party, in case of compromise without
attorney’s consent”) and 7 Am. Jur. 2d, Attorneys at Law, sec.
323 (1997) (“Right to continue action client has settled”). Our
opinions distinguishing the decision of the Court of Appeals in
Cotnam v. Commissioner, supra, on the basis of differences in
State law have relied on Pennsylvania cases from 1852 and 1919,
and on Texas cases from 1913 and 1920. See Estate of Gadlow v.
Commissioner, 50 T.C. 975, 980 (1968) (distinguishing
Pennsylvania law); Srivastava v. Commissioner, T.C. Memo. 1998-
362 (Texas law).
- 64 -
The majority respond with two observations in support of
respondent’s position: First, Wis. Stat. 757.36 has been revised
to give the attorney a lien “upon the proceeds or damages” as
well as “upon the cause of action.” The majority suggest that it
is no longer necessary to keep the underlying cause of action
alive in order effectively to assert an attorney’s lien under
Wisconsin law.
The majority also point to Wis. Sup. Ct. R. 20.1.16 and
20.1.2(a) (1998), which include the ethical rules that a client
may discharge an attorney at any time and that “a lawyer shall
inform a client of all offers of settlement and abide by a
client’s decision whether to accept an offer of settlement of a
matter.” The majority suggest that these rules mean that a
Wisconsin attorney cannot acquire an interest in a lawsuit that
would enable the attorney to continue to press it in the face of
the client’s expressed desire to settle, or at least that it
would be an ethical violation for the attorney to continue to
press a case that the client had settled or desired to settle.
Admittedly, the matter is unclear, bearing in mind that Section
III of the contingent fee agreement entered by Mr. Kenseth and
other class members with Fox & Fox provide that the client can
not settle his case without the consent of Fox & Fox, and that
the Preamble to the Rules of the Wisconsin Supreme Court
governing professional conduct for attorneys says that the rules
- 65 -
are for disciplinary purposes; they are not supposed to affect
the substantive legal rights of lawyers and are not designed to
be a basis for civil liability.39
The Wisconsin courts have recognized the tension between the
client’s rights to terminate representation and the attorney’s
rights under contingent fee agreements and the statutory lien.
See Goldman v. Home Mut. Ins. Co., 126 N.W.2d 1 (Wis. 1964),
cited by respondent and the majority for the proposition that the
claim belongs to the client, not the attorney. However, what
Goldman actually said was more balanced:
it is not against public policy for a client to settle
his claim with the tortfeasor or his insurer without
participation and consent of the attorney before action
is commenced even though the client has retained
counsel. * * * The claim belongs to the client and
not the attorney; the client has the right to
compromise or even abandon his claim if he sees fit to
do so. * * *
We do not hold by inference that a contract
between client and attorney whereby the attorney is to
control the procedure of the prosecution of the claim,
nor that an agreement for a lien upon the cause of
action for attorney’s fees is against public policy
and, therefore, void. On the contrary, by virtue of
the attorney lien statutes and the common law we
recognize their validity. [Id. at 5.]
39
Compare Estate of Newhouse v. Commissioner, 94 T.C. 193,
232-233 (1990), regarding effect on valuation of a right of the
necessity of bringing a lawsuit to enforce it; presence of such
uncertainty equates with a reduction in claimant-assignor’s
degree of control; see also Estate of Mueller v. Commissioner,
T.C. Memo. 1992-284, on effects of threatened litigation on
possible nonconsumation of a stock acquisition as affecting value
of the stock.
- 66 -
The Wisconsin courts have also recognized that although a
client may have the ultimate power to discharge an attorney or
settle a claim, the attorney has rights and remedies when the
client breaches or terminates a contingent fee agreement. For
example, in Tonn v. Reuter, 95 N.W.2d 261 (Wis. 1959), the
Wisconsin Supreme Court held that an attorney who had been
discharged without cause could sue his client for breach of
contract; the measure of damages was the contingent fee
percentage applied to the client’s ultimate recovery, less the
value of the services the attorney was not required to perform as
a result of the breach. And in Goldman v. Home Mut. Ins. Co.,
supra, the Wisconsin Supreme Court held that a plaintiff’s
attorney could sue the defendant for third-party interference
with contract rights, where the defendant settled with the
plaintiff, without the knowledge of the attorney.40
ii. Broader Ground--Federal Standard
I now turn to the broader ground of the decision of the
Court of Appeals in Cotnam v. Commissioner, supra, as announced
by Judges Rives and Brown, and as opposed by Judge Wisdom, and
40
If, on appeal of the case at hand to the Court of Appeals
for the Seventh Circuit, the Court of Appeals should wish to
obtain answers to any questions of Wisconsin law that the parties
have not resolved to its satisfaction, and which it regards as
bearing on the outcome, the Wisconsin Supreme Court has power
(not obligation) to entertain any such questions put to it by the
Court of Appeals under Wis. Stat. sec. 821.01 (1999) (Uniform
Certification of Questions of Law Rule).
- 67 -
recently adopted by the Court of Appeals for the Sixth Circuit in
Estate of Clarks v. United States, supra. The primary point made
by Judges Rives and Brown was that in a practical sense the
taxpayer never had control over the portion of the recovery that
was retained by her attorneys. In my view, this broader ground
disposes of the case at hand in petitioners’ favor, independently
of the narrow ground.
Judge Wisdom’s dissent was very much in the vein that the
transaction was governed by the classic assignment of income
cases that he cited and relied upon: Helvering v. Eubank, 311
U.S. 122 (1940); Helvering v. Horst, 311 U.S. 112 (1940); and
Lucas v. Earl, 281 U.S. 111 (1930). After quoting at length from
Helvering v. Horst, supra, Judge Wisdom concluded:
This case is stronger than Horst or Eubank, since
Mrs. Cotnam assigned the right to income already
earned. She controlled the disposition of the entire
amount and diverted part of the payment from herself to
the attorneys. By virtue of the assignment Mrs. Cotnam
enjoyed the economic benefit of being able to fight her
case through the courts and discharged her obligation
to her attorneys (in itself equivalent to receipt of
income, under Old Colony Trust Co. v. Commissioner,
1929, 279 U.S. 716 * * *. [Cotnam v. Commissioner, 263
F.2d at 127.]
The majority in Cotnam also rejected the Commissioner’s and
Judge Wisdom’s reliance on Old Colony Trust Co. v. Commissioner,
279 U.S. 716 (1929), because a contingent fee agreement creates
no personal obligation. The only source of payment is the
recovery; if there is no recovery, the client pays nothing and
- 68 -
the attorney receives nothing. I agree with this additional
point of the Court of Appeals majority in Cotnam.41
The points made by the Courts of Appeals in Cotnam and
Estate of Clarks v. Commissioner, supra, are not in complete
agreement, but their differences don’t invalidate the essential
on which they do agree. The Courts of Appeals in Cotnam and
Clarks agree that the value of the claim was speculative and
dependent on the services of counsel who was willing to take it
on a contingent fee basis to try to bring it to fruition. They
also agree that the only benefit the taxpayer could obtain from
his or her claim was to assign the right to receive a portion of
it (the contingent fee percentage) to an attorney in an effort to
collect the remainder and that such benefit does not amount to
full enjoyment that justifies including the fee portion in the
assignor’s gross income. The Courts of Appeals in Cotnam and
Clarks also agree that the proper treatment is to divide the
gross income between the client and the attorney, rather than to
41
Regarding the reliance of the Commissioner and Judge
Wisdom on Old Colony Trust Co. v. Commissioner, 279 U.S. 716(1929), I observe, as did Judges Rives and Brown, that the
contingent fee was not one that the claimant (Mr. Kenseth) was
ever personally obligated to pay, even if there should be a
recovery. Under Sections IV and VIII of the contingent fee
agreement (unlike Section II, which personally obligated the
client to pay litigation expenses, as defined), the attorneys’
right to receive the fee was secured solely by the lien that
would attach to any recovery, which was the sole contemplated and
actual source of payment of the fee.
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include the entire recovery in the client’s income and to
relegate the client to a deduction that is not fully usable.
I am in complete agreement with Judges Rives and Brown and
the panel in Estate of Clarks that the assignment of income
doctrine should not apply to contingent fee agreements. A
contingent fee agreement is not an intrafamily donative
transaction, or even a transaction within an economic family,
such as parent-subsidiary, see United Parcel Serv. of Am., Inc.
v. Commissioner, T.C. Memo. 1999-268, or the doctors’ service
partnership and related HMO in United States v. Basye, 410 U.S.
441 (1973). Notwithstanding the attorneys’ fiduciary
responsibilities to their client, a contingent fee agreement is a
commercial transaction between parties with no preexisting common
interest that sharply reduces or eliminates the client’s dominion
and control over both the cause of action and any recovery. Our
decisions distinguishing (or just not following) the decision of
the Court of Appeals in Cotnam v. Commissioner, supra, have not
adequately considered the characteristics of contingent fee
agreements or the effect those characteristics should have in
deciding whether such agreements should be treated as assignments
of income to be disregarded for Federal income tax purposes.
I now address the points of the Court of Appeals for the
Sixth Circuit in Estate of Clarks v. United States, supra, that
go beyond the points of Judges Rives and Brown in Cotnam v.
- 70 -
Commissioner, supra: that the contingent fee arrangement is (1)
like a partnership or joint venture or (2) a division of property
or transfer of a one-third interest in real estate, thereafter
leased to a tenant.
We rejected the first point in Bagley v. Commissioner, 105
T.C. 396, 418-419 (1995), affd. on other issues 121 F.2d 393 (8th
Cir. 1997), in holding that a contingent fee agreement does not
create a partnership or joint venture under section 7701(a)(2)
(see further discussion infra part 10).
The citation by the Court of Appeals for the Sixth Circuit
of Wodehouse v. Commissioner, 177 F.2d 881, 884 (2d Cir. 1949),
raises doubts about the second point. Wodehouse is just another
case that illustrates the proposition, see Chirelstein, Federal
Income Taxation 203 (8th ed. 1999), that interests in self-
created property rights, such as paintings, patents, and
copyrights, “are effectively assignable for tax purposes despite
the elements of personal services on the part of the assignor.”
Id.42
5. Significance of Control in Supreme Court’s
Assignment of Income Jurisprudence
The transfers of income or property at issue in the classic
cases on which the dissent of Judge Wisdom and this Court have
relied–-cases such as Lucas v. Earl, supra, and Helvering v.
42
A recent case that illustrates the proposition is Meisner
v. United States, 133 F.3d 654 (8th Cir. 1998).
- 71 -
Horst, supra–-were intrafamily donative transfers.43 If given
effect for tax purposes, such intrafamily transfers would permit
family members to “split” their incomes and avoid the progressive
rate structure (a less pressing concern these days). In
addition, because the transferred item never leaves the family
group, the transferor may continue to enjoy the economic benefits
of the item as though the transfer had never occurred. See
Commissioner v. Sunnen, 333 U.S. 591, 608-610 (1948) (husband
transferred patent licencing contracts to wife; husband’s
indirect post-transfer enjoyment of royalty payments and other
benefits received by wife a factor favoring decision that
transfer was an invalid assignment of income); Helvering v.
Clifford, 309 U.S. 331 (1940) (husband created short-term trust
for wife’s benefit; intrafamily income-splitting possibilities
required special scrutiny of arrangement, and husband’s continued
43
The statement of facts in the third Supreme Court
decision relied on by the majority and the dissent of Judge
Wisdom, Helvering v. Eubank, 311 U.S. 122 (1940), does not reveal
whether the transfer at issue was intrafamily. However, the
majority opinion in Eubank contains no independent analysis; it
rests entirely on the reasoning of the Supreme Court’s opinion in
the intrafamily transfer companion case of Helvering v. Horst,
311 U.S. 112 (1940). In addition, in Commissioner v. Sunnen, 333
U.S. 591, 602-603 (1948), the Supreme Court described Eubank,
along with several other classic assignment of income cases, as
part of the “Clifford-Horst line of cases”, all involving
transfers within the family group. The Supreme Court in Sunnen
further stated that “It is in the realm of intra-family
assignments and transfers that the Clifford-Horst line of cases
has peculiar applicability.” Commissioner v. Sunnen, 333 U.S. at
605.
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indirect enjoyment of wife’s benefit a factor in decision to
treat husband as owner of trust). Contingent fee agreements
between client and attorney do not present these problems.
Equally importantly, in Lucas v. Earl, supra, and Helvering
v. Horst, supra, the transferor–-in part due to the family
relationship–-was found to have retained a substantial and
significant measure of control after the transfer over the income
rights or property transferred. The presence of such continuing
control is undoubtedly important in deciding whether a transfer
should be treated as an invalid assignment of income. As the
Supreme Court stated in Commissioner v. Sunnen, 333 U.S. at 604:
The crucial question remains whether the assignor
retains sufficient power and control over the assigned
property or over receipt of the income to make it
reasonable to treat him as the recipient of the income
for tax purposes. * * *
Or, as the Supreme Court wrote in Corliss v. Bowers, 281 U.S.
376, 378 (1930) (revocable trust created by husband for benefit
of wife and children treated as invalid assignment of income):
taxation is not so much concerned with the refinements
of title as it is with actual command over the property
taxed * * *. * * * The income that is subject to a
man’s unfettered command and that he is free to enjoy
at his own option may be taxed to him as his income,
whether he sees fit to enjoy it or not. * * *
I acknowledge, with 3 Bittker & Lokken, Federal Taxation of
Income, Estates, and Gifts 75-2 (2d ed. 1991), that efforts to
shift income have extended beyond the family to other economic
units. Courts have been alert, whatever the motivation of the
taxpayers before them, to forestall the tax success of
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arrangements that, if successful, would be exploited by others.
As a result, legislative and judicial countermeasures “have come
to permeate the tax law so completely that they sometimes
determine which of several parties to an ordinary business
transaction must report a particular receipt or can deduct a
liability.” Id. However, those observations don’t answer the
question. They just remind us that the taxpayer’s arguments
deserve strict scrutiny.
I also acknowledge that the assignor’s lack of retained
control may be trumped if the subject of the assignment is
personal service income.44 Unlike the trust and property cases,
Lucas v. Earl, supra, can be rationalized not so much on the
service provider’s retained control over whether or not he
works,45 “but on the more basic policy to ‘tax salaries to those
who earned them’”.46
My response is that Mr. Kenseth’s claim did not generate
personal service income. Even though the loss of past earnings
44
3 Bittker & Lokken, Federal Taxation of Income, Estates,
and Gifts 75-7 (2d ed. 1991).
45
The Court of Appeals in Estate of Clarks v. United
States, supra, misstates Lucas v. Earl, 281 U.S. 111 (1930), in
saying that in that case, as in Helvering v. Horst, supra, “the
income assigned to the assignee was already earned, vested and
relatively certain to be paid to the assignor”. As a matter of
fact, the assignment document in Lucas v. Earl had been executed
in 1901, long before the effective date of the 16th Amendment;
the taxable years in issue were 1920 and 1921. See Lucas v.
Earl, supra at 113.
46
Bittker & Lokken, supra, at 75-11; see also Chirelstein,
Federal Income Taxation 194-195, 214-216 (8th ed. 1999).
- 74 -
as well as future income and benefits were taken into account in
computing his settlement recovery, Mr. Kenseth’s claim had its
origin in the rights inhering in a constitutionally or
statutorily protected status (e.g., age, sex, race, disability)
rather than a free bargain for services under an ongoing
employment relationship or personal service contract. Such
rights are no less alienable than other types of property rights
that may be bought and sold and otherwise compromised by payments
of money.47 Indeed, where a claim based on status, such as an
ADEA claim, is the subject of a contingent fee agreement, the
amount paid the attorney as a result of his successful
prosecution of the claim is much more personal service income of
the attorney than personal service income of the claimant,
however the claimant’s share of the income might be characterized
for tax purposes. Again, quoting Bittker & Lokken, supra at 75-
13, in a slightly different context: “If a metaphor is needed,
one could say that the pooled income is the fruit of a single
grafted tree, owned jointly by the parties to the agreement.”48
47
Perhaps, contrary to Maine, Ancient Law 100 (Everyman ed.
1931), more recent developments, which, in “progressive societies
has hitherto been a movement from Status to Contract,” have
shifted back to a greater emphasis on status as a source of
personal and property rights.
48
See discussions infra at 80-81 of the “two keys” simile
and at 90-97 of the cropsharing analogy.
- 75 -
6. Substantial Reduction of Claimant’s Control by
Contingent Fee Agreement
When Mr. Kenseth executed the contingent fee agreement, he
gave up substantial control over the conduct of his age
discrimination claim. He also gave up total control of the
portion of the recovery that was ultimately received and retained
by Fox & Fox.
The contingent fee agreement provided that Mr. Kenseth could
not settle his case without the consent of Fox & Fox. It further
provided that, if Mr. Kenseth had terminated his representation
by Fox & Fox, that firm would still have a lien for the
contingent fee called for by the agreement, and all costs and
disbursements would become due and payable within 10 days.
Moreover, Mr. Kenseth was just one member of the class of
claimants represented by Fox & Fox. All these factors
contributed, as a practical matter, to the creation of
substantial barriers to Mr. Kenseth’s ability to fire Fox & Fox
and to hire other attorneys or to try to settle his case
himself.
Mr. Kenseth instead relied on the guidance and expertise of
Fox & Fox, and Fox & Fox made all strategic and tactical
decisions in the management and pursuit of Mr. Kenseth’s age
discrimination claim. Fox & Fox negotiated a net recovery (after
reduction by the contingent fee) that substantially exceeded the
settlement that the EEOC had recommended.
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i. “Contract of Adhesion”
For all these reasons it is clear, when Mr. Kenseth signed
the contingent fee agreement, that he gave up substantial
control-–perhaps all effective control–-over the future conduct
of his age discrimination claim. This is not surprising; a
contingent fee agreement in all significant respects amounts to a
“contract of adhesion”,49 defined by Black’s Law Dictionary 318-
319 (7th ed. 1999) as: “A standard-form contract prepared by one
party, to be signed by the party in a weaker position, usu. a
consumer, who has little choice about the terms”.50
I’m not suggesting that the contingent fee agreement would
be unenforceable;51 contracts of adhesion are prima facie
enforceable as written. See Rakoff, “Contracts of Adhesion: An
49
See Rakoff, “Contracts of Adhesion: An Essay in
Reconstruction”, 96 Harv. L. Rev. 1174, 1176-1177 (1983), which
sets forth seven characteristics that define a “contract of
adhesion”; all these characteristics are present in the
contingent fee agreement between Mr. Kenseth and Fox & Fox.
50
The landmark article that coined and gave currency to the
appellation “contract of adhesion” is, of course, Kessler,
“Contracts of Adhesion–-Some Thoughts About Freedom of Contract”,
43 Colum. L. Rev. 629 (1943). The less inflammatory term found
and used in Restatement, Contracts Second, sec. 211 (1979), is
“standardized agreement”. But see Corbin on Contracts, secs.
559A-559I (Cunningham & Jacobson, Cum. Supp. 1999).
51
Other than the uncertainty regarding enforceability of
the provision in Section III of the agreement that Mr. Kenseth
and the other claimants in the class action could not settle
their cases without the consent of Fox & Fox.
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Essay in Reconstruction”, 96 Harv. L. Rev. 1174, 1176 (1983).52
Nor do I suggest that the contingent fee agreement in the case at
hand operated unfairly so as to make it unenforceable. I do
suggest that the character of the agreement as a contract of
adhesion supports my ultimate finding that Mr. Kenseth as the
adhering party gave up substantial control over his claim, which
was the subject matter of the agreement.
ii. American Bar Foundation Contingent Fee Study
My ultimate finding in this case is not just the sympathetic
response of a “romantic judge”53 or an idiosyncratic reaction
divorced from the practical realities of the operation of
contingent fee agreements. My findings on Mr. Kenseth’s reduced
control over the prosecution and recovery of his claim are
supported by the recurring comments to the same effect in the
study by MacKinnon, Contingent Fees for Legal Services: A Study
of Professional Economics and Liabilities (American Bar
Foundation 1964). What is striking about the MacKinnon study,
which makes no mention of any tax questions, are its repeated
52
In a departure from traditional analysis, Rakoff, supra
at 1178-1179, asserts that adhesive contracts may exist in
otherwise competitive markets. This would appear to be the case
with respect to that segment of the market for legal services in
which contingent fee agreements are customarily used. There is
no reason to believe that much if any bargaining occurs with
respect to the other terms of contingent fee agreements
concerning the attorney’s lien and the contractual provisions for
its enforcement. So it appears in the case at hand.
53
See Glendon, A Nation Under Lawyers 151-173 (1994).
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references54 to the high degree of practical control that
attorneys acquire under contingent fee agreements over the
prosecution, settlement, and recovery of plaintiffs’ claims.
After Mr. Kenseth signed the contingent fee agreement, he
had absolutely no control over the portion of the recovery from
his claim that was assigned to and received by Fox & Fox as its
legal fee. The agreement provided that, even if Mr. Kenseth
fired Fox & Fox, Fox & Fox would receive the greater of 40
percent of any recovery on Mr. Kenseth’s claim or their regular
hourly time charges, plus accrued interest of 1 percent per
month, plus a risk enhancer of 100 percent of their regular
hourly charges (not exceeding the total recovery). The agreement
also stated that Mr. Kenseth gave Fox & Fox a lien on any
recovery or settlement. The agreement also provided that Mr.
Kenseth would not settle the claim without first obtaining the
approval of Fox & Fox.
As noted above, the contingent fee agreement between Mr.
Kenseth and Fox & Fox was not an intrafamily donative transaction
and did not occur within an economic group of related parties.
In addition, Mr. Kenseth’s control of his claim (and of any
recovery therefrom) was sharply reduced or eliminated by the
54
See MacKinnon, Contingent Fees for Legal Services: A
Study of Professional Economics and Liabilities 5, 21-22, 29, 62,
63, 64, 70, 73, 77, 78-79, 80, 196, 197, 211 (American Bar
Foundation 1964).
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contingent fee agreement. For all these reasons, the broader
ground of the decisions of the Courts of Appeals in Cotnam v.
Commissioner, 263 F.2d 119 (5th Cir. 1959), and Estate of Clarks
v. United States, 202 F.3d 854 (6th Cir. 2000), applies to the
case at hand. The contingent fee agreement did not effect an
assignment of income that must be disregarded for income tax
purposes under Helvering v. Eubank, 311 U.S. 122 (1940),
Helvering v. Horst, 311 U.S. 112 (1940), and Lucas v. Earl, 281
U.S. 111 (1930).
This conclusion provides an independent and sufficient
ground for the holding, decoupled from the narrow ground of
Cotnam and Estate of Clarks regarding attorneys’ ownership
interests in lawsuits under State law, that Mr. Kenseth’s gross
income in the case at hand does not include any part of the
settlement proceeds paid to the Fox & Fox trust account and
retained by Fox & Fox as its contingent fee.
The application of the decisions of the Courts of Appeals in
Cotnam and Estate of Clarks is not limited to situations in which
local law allows a transfer of a “proprietary” interest in the
claim to the attorney. These holdings apply to situations in
which the attorney obtains only the usual security interest in
the claim and its proceeds that is provided in most States.
It is noteworthy that neither the additional statement of
the Cotnam majority nor the dissent of Judge Wisdom referred to
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the Alabama law that provides for the transfer of a proprietary
interest in the claim to the attorney. The language of the
additional statement supports the offset approach in all
contingent fee situations in which the proceeds of the settlement
or judgment are pursuant to prearrangement paid directly to the
attorney (or to attorney and client as joint payees) with the
understanding that the attorney will calculate and pay himself
the fee and pay the balance to the client. To make the result
depend upon whether a technical ownership interest was
transferred under State law would make the outcome depend on
“attenuated subtleties” and “refinements” that, as Justice Holmes
said in Lucas v. Earl, supra at 114, and Judge Raum said in
O’Brien v. Commissioner, supra at 712, should be disregarded.55
iii. “Two Keys” Simile
The contingent fee situation is much like that in Western
Pac. R.R. Corp. v. Western Pac. R.R. Co., 345 U.S. 247, 277
(1953) (Jackson, J. dissenting), which concerned the respective
interests of former parent corporation and subsidiary in the tax
55
It also appears, notwithstanding that petitioners did not
argue the point in the case at hand, that plaintiffs in a class
action, such as Mr. Kenseth, in a legal and practical sense have
less control over the prosecution of their claims than a sole
plaintiff who has signed a contingent fee agreement. See Newberg
on Class Actions, sec. 5.25--Individual Settlements More
Difficult after Commencement of Class Action (3d ed. 1992).
Compare Eirhart v. Libbey-Owens-Ford Co., 726 F. Supp. 700 (N.D.
Ill. 1989), with Sinyard v. Commissioner, T.C. Memo. 1998-364,
and Brewer v. Commissioner, T.C. Memo. 1997-542, affd. without
published opinion 172 F.3d 875 (9th Cir. 1999).
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benefits of net operating losses arising in consolidated return
periods:
Each corporation then had a bargaining position.
The stakes were high. Neither could win them alone,
although each had an indispensable something that the
other was without. It was as if a treasure of
seventeen million dollars were offered * * * to whoever
might have two keys that would unlock it. Each of
these parties had but one key, and how can it be said
that the holder of the other key had nothing worth
bargaining for?
The tax position of Mr. Kenseth is stronger than that of
either claimant in the Western Pac. R.R. case. Justice Jackson’s
reference to the “treasure” is to a static, fixed, pre-determined
amount, the tax benefit from the net operating losses. When
attorney and client enter a contingent fee agreement, the amount
of the ultimate recovery is unknown; the recovery is determined
in a dynamic process in which the exercise of the experience and
skill of the attorney results both in some recovery and in an
increase in the value of that recovery. The attorney creates and
adds value; the efforts of the attorney contribute to--indeed he
may be solely responsible for--both the recovery and its
augmentation. Attenuated subtleties and refinements of title
have nothing to do with the practical realities of contingent fee
agreements and the relative interests of attorney and client in
any recovery that may ultimately be realized.
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7. Omissions and Distortions: the Majority Opinion
The majority opinion makes a caricature of the findings it
purports to adopt by ignoring some and distorting others.56
Some examples:
First, on the meaning and application of the term “control”:
neither “control” nor “lack of control” is a monolithic concept,
nor do they occupy opposite sides of the same coin. Many
elements or strands are braided into the ownership and control of
a claim or cause of action. The question is whether enough
elements of control over all or part of the claim are given up by
the client who enters into a contingent fee agreement to make it
inappropriate to include the entire amount of the recovery in the
client’s gross income. The correct answer is to allocate the
recovery in the first instance between attorney and client as
their interests may appear in accordance with the terms of the
contingent fee agreement.
Petitioner gave up substantial control over his claim, and
all control over the portion attributable to the contingent fee.
Even if Smelker v. Chicago & N.W. Ry., 81 N.W. 994, 994 (Wis.
1900) is no longer good law under the Wisconsin attorney’s lien
law and the Wisconsin ethical rules require an attorney to abide
by a client’s decision to accept an offer of settlement, the
56
In so doing, the majority opinion creates a mismatch
between findings of fact and opinion that is reminiscent of the
centaur in Greek mythology.
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contrary provision in the contingent fee agreement substantially
dilutes the control retained by the client, as shown by Tonn v.
Reuter, 95 N.W.2d 261 (Wis. 1959), and Goldman v. Home Mut. Ins.
Co., 126 N.W.2d 1 (Wis. 1964). Even if that provision of the fee
agreement should not be enforced in strict accordance with its
terms if it came to a lawsuit between the client and the first
attorney, that provision of the agreement creates considerable
uncertainty. That uncertainty means the client has far less
retained control over the prosecution of the claim than the
assignor of an interest in the income from his own future
services to third parties. Further, the client’s ability to fire
the attorney and hire another is severely limited by the
likelihood that liability for two sets of fees will result. So
much for the practical substance of the “ultimate control”
retained by the client who signs a contingent fee agreement.
The majority opinion distorts the taxpayer’s position by
stating, p. 26: “There is no evidence supporting petitioner’s
contention that he had no control over his claim.” First, there
is substantial evidence that petitioner suffered a substantial
reduction in his control over his claim; it’s right there in the
findings. Second, petitioners aren’t arguing that they had no
control; they’re just saying that their control was substantially
reduced. We’re not called upon to come up with relative
percentages of control; that would be a sterile exercise in
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trying to create an unnecessary appearance of certainty. The
substantial impediments petitioners subjected themselves to in
entering into the contingent fee agreement are enough to take
this case out of the traditional assignment of income situation,
where the assignor’s retained control is absolute and unfettered.
On page 27, the majority opinion uses the gross misnomer
“details” to characterize what Mr. Kenseth entrusted to Fox &
Fox. How can it be accurate to say that Fox & Fox was only
responsible for the “details of his [Mr. Kenseth’s] litigation”?
Mr. Kenseth and the other class members were able with the advice
of Fox & Fox to sign the severance agreement and receive
severance pay, as well as press their ADEA claims; this is
because APV and its attorneys had made a mistake in preparing the
severance agreement that was spotted by Fox & Fox. The findings
also note that EEOC had recommended that the claims be settled
for an amount 2.5 times smaller than what Fox & Fox was able to
negotiate. To quote from the findings:
Petitioner and the other members of the class
relied on the guidance and expertise of Fox & Fox in
signing the separation agreements tendered to them by
APV and then seeking redress against APV. Commencing
with the advice to petitioner that he could sign the
separation agreement with APV without giving up his age
discrimination claim, Fox & Fox made all strategic and
tactical decisions in the management and pursuit of the
age discrimination claims of petitioner and the other
class members against APV that led to the settlement
agreement and the recovery from APV. [Majority op. p.
12.]
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Further, Fox & Fox factored into the settlement an amount for
their fee that was grossed up in the total, so that the total net
recovery was still $1.9 million, almost twice EEOC’s original
valuation of the claim.
All this supports my conclusions that Fox & Fox added
substantial value to the raw claim as it existed immediately
prior to execution of the contingent fee agreement(s) and that
Fox & Fox was responsible for much more than mere “details”.
At page 25, the majority opinion says: “The entire ADEA
award was ‘earned’ by and owed to petitioner, and his attorney
merely provided a service and assisted in realizing the value
already inherent in the cause of action.” Is the majority
opinion saying that, at the time immediately prior to
petitioner’s entry into the contingent fee agreement, the claim
had the same value as the amount ultimately recovered? Of course
not; the uncertain speculative front end value had to be
discounted to reflect the time value of money and the risks of
litigation. Fox & Fox added substantial value to the claims of
Mr. Kenseth and his colleagues. Under the terms of the
contingent fee agreement, Fox & Fox’s shares of the recovery
should be taxed to them directly and not run through petitioner
and the other members of the class who never even had the chance
to kiss goodbye what they never became entitled to receive.
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8. Majority Opinion’s Handling of Authorities
The majority misstate the Alexander, Baylin, Brewer, and
O’Brien cases (majority op. pp. 14, 17-18, and 21, respectively)
and what they stand for.
The majority opinion at page 14 creates a misleading
impression about the significance of Alexander v. IRS, 72 F.3d
938, 948 (1st Cir. 1995), affg. T.C. Memo. 1995-51. The Court of
Appeals for the First Circuit did affirm the Tax Court, and the
Court of Appeals did say that applying the AMT to the itemized
deductions “smacks of injustice”, as indeed it did--the sum of
the legal fees and the additional tax liability exceeded the
taxpayers’ net taxable recovery. What the majority opinion omits
is that the taxpayer in Alexander did not argue, as petitioners
argue in the case at hand, that the legal fee should be excluded
from petitioner’s gross income because the assignment of income
rules don’t properly apply.57 There was both a taxable recovery–-
$250,000–-and a concededly non-taxable recovery–-$100,000–-and
the taxpayer deducted an allocable part of his legal fees
(computed on a disproportionate time basis, which the
Commissioner did not dispute) from the taxable recovery. The Tax
Court and the Court of Appeals for the First Circuit held,
57
Alexander v. IRS, 72 F.3d 938, 948 (1st Cir. 1995), affg.
T.C. Memo. 1995-51, lacked any findings as to whether the legal
fee in question was a contingent fee or a fee based on hourly
rates for which the taxpayer was personally liable.
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because the recoveries related to taxpayer’s wrongful termination
as an employee, that the fees so deducted by the taxpayer were
employee business expenses properly treated as itemized
deductions subject to the 2-percent floor and the AMT. In so
doing, the courts rejected the taxpayer’s argument that the
deductible legal fees were Schedule C expenses because,
notwithstanding his wrongful termination as an employee, he had
thereafter gone into the management consulting business as an
independent contractor. The settlement proceeds were
compensation ordinary income and did not represent amounts
received on the disposition of intangible assets. Consequently,
the legal fees were not incurred in a disposition and could not
be netted against the settlement proceeds received.58
58
Respondent argues in the alternative in the case at hand
that if Mr. Kenseth was able to assign an interest in his cause
of action to Fox & Fox, that assignment was itself a taxable
transaction. Mr. Kenseth entered into the contingent fee
agreement in 1991; that year is not before us. Therefore, we are
not required to consider the tax consequences, if any, of the
signing of the contingent fee agreement. See Schulze v.
Commissioner, T.C. Memo. 1983-263 (assignment of claim in 1975 by
husband to wife in connection with divorce shifted burden of
taxation on amounts recovered on that claim in 1976; we found it
unnecessary to consider the Commissioner's alternative argument
that the assignment was a taxable event in the earlier year,
because that year was not before us).
The Justice Department in its brief on appeal to the Court
of Appeals for the Eleventh Circuit in Davis v. Commissioner,
T.C. Memo. 1998-248, affd. per curiam F.3d (11th Cir.
2000) (see supra note 36), also made the alternative argument--
not raised by the Commissioner in the Tax Court--that the
contingent fee agreement is a transfer of an interest in the fee
(continued...)
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With respect to Baylin, the majority opinion says: “The
Court of Appeals for the Federal Circuit sought to prohibit
taxpayers in contingency fee cases from avoiding Federal income
tax with ‘skillfully devised’ fee agreements.” Majority op. p.
18. This language from Lucas v. Earl, which had to do with
protecting the progressive rate structure, obviously has no
bearing on latter-day contingent fee arrangements. I also
disagree with Baylin’s in effect applying Old Colony Trust Co. to
treat the fee, which becomes the lawyer’s share of the realized
claim, as an amount realized by the client that is properly
included in the sum of satisfactions procured by the client.
Even though the lawyer may not obtain legal ownership of the
claim, there is no denying that the lawyer acquires a substantial
economic interest in the ultimate recovery.
The majority opinion cites Brewer v. Commissioner, 172 F.3d
875 (9th Cir. 1999), affg. without published opinion T.C. Memo.
1997-542, as if it were substantial authority. Both the
unpublished opinion of the Court of Appeals and this Court’s
58
(...continued)
with a zero basis on which the taxpayer realized deferred income
or gain in the year of the recovery under the open transaction
theory. This argument really is nothing more than a restatement
of the anti-assignment of income argument that begs the question.
The question unanswered by the Justice Department and the
Commissioner is whether the taxpayer is entitled to treat the
contingent fee as a cost of obtaining the total recovery or an
offset that must be taken into account in computing gross income,
rather than including the entire recovery in gross income and
taking a separate deduction for the fee.
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memorandum opinion--the taxpayer was pro se--provide no more than
a lick and a promise on this point. The taxpayer in Brewer was a
member of a class of hundreds (women who had been discriminated
against in the recruiting, hiring, and training of sales agents
by the State Farm insurance companies). I find it incredible
that those claimants were all required to gross up their
recoveries and then deduct their respective shares of the legal
fees. I doubt that any member of such a large class had a
scintilla of control over the conduct of the class action.
The majority opinion’s quotations from O’Brien v.
Commissioner, 38 T.C. at 710, particularly, “Although there may
be considerable equity to the taxpayer’s position, that is not
the way the statute is written” (majority op. p. 21), ignore that
O’Brien and its antecedents and descendants were construing
statutory spreadback provisions, not applying the assignment of
income doctrine under section 22 of the 1939 Code, section 61 of
the 1954 or 1986 Code, or the 16th Amendment.
9. Preventing Tax Avoidance by Other Transferors
The majority state at page 14: “We perceive dangers in the
ad hoc modification of established tax law principles or
doctrines to counteract hardship in specific cases, and,
accordingly, we have not acquiesced in such approaches”.
Although the majority opinion does not spell out those dangers,
concerns have been expressed that adoption of my findings and
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conclusion would open the door to tax avoidance. My response to
such concerns is that the contingent fee agreement is a peculiar
situation, far removed from the intrafamily and other related
party transfers, including commercial assignments within economic
units, that generated and continue to sustain the assignment of
income doctrine. The result I espouse can be confined to the
contingent fee situation; the tools of legal reasoning remain
alive and well to enable the Commissioner and the courts to
defend the fisc against transferors who in other contexts might
seize upon my proposed result in this case to try to extend it
beyond its proper limits.
10. Cropsharing as Alternative to Joint
Venture/Partnership Analogy
The suggestion of the Court of Appeals in Estate of Clarks
v. United States, supra, that the contingent fee arrangement is
like a partnership or joint venture has intuitive appeal.
Posner, Economic Analysis of Law 624-626 (5th ed. 1998),
describes the contingent fee agreement not only as a high
interest rate loan that compensates the lawyer for the risk he
assumes of not being paid at all if the claim is unsuccessful and
for the postponement in payment,59 but also as a kind of joint
59
See also Garlock, Federal Income Taxation of Debt
Instruments 6-10 (1998 Supp.): “Thus, rights to wholly
contingent payments would be treated in accordance with their
economic substance”. Garlock also comments p. 6-33:
(continued...)
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ownership “(and a contingent fee contract makes the lawyer in
effect a cotenant of the property represented by the plaintiff’s
claim)”, id. at 625, which could also lead to partnership/joint
venture characterization.
Adoption of the partnership/joint venture analogy could
create problems that would require attention. It has been
suggested that partnership or joint venture characterization
would open the door to tax avoidance by attorneys who enter into
contingent fee agreements.60 Examples include the possibility
that attorneys would contend that partnership characterization
entitles them to distributive shares of the tax-free recoveries
in personal injury actions and to current deductions for the
59
(...continued)
Because many contracts for the sale of property that
call for contingent payments involve principal payments
that are wholly contingent, it is doubtful that these
contracts would be viewed as debt instruments and
accordingly would be subject to section 483 rather than
section 1274. * * *
It seems likely that a contingent fee contract would be treated
under a debt analysis as contingent as to both principal and
interest; both the principal and interest amounts could be
determined only when and if the claim is satisfied so as to give
rise to the lawyer’s entitlement to a fee, see Garlock supra at
4-21 and 22, and would not satisfy the form or substance
requirements of debt. As a result, there is obvious similarity
in substance if not in form to a partnership or joint venture
between attorney and client.
60
Kalinka, “A.L. Clarks’ Est. and the Taxation of
Contingent Fees Paid to an Attorney”, 78 Taxes 16, 18-20 (Apr.
2000).
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advances of costs they make to their clients.61 In addition,
local law and ethical rules prohibiting the assignment of claims
to attorneys would be obstacles to the making of the capital
contribution that is the prerequisite to the formation of a
partnership.62 See Luna v. Commissioner, 42 T.C. 1067 (1964), and
Estate of Smith v. Commissioner, 313 F.2d 724 (8th Cir. 1963),
affg. in part, revg. in part, and remanding 33 T.C. 465 (1959),
which rejected arguments by service providers that they had
entered into partnership agreements that entitled them to capital
gain treatment of what was held to be compensation income.63
Although I agree with our rejection in Bagley v.
Commissioner, 105 T.C. 396 (1995), of the partnership/joint
venture analogy, we did not go far enough in exploring the
consequences of other arrangements that don’t amount to
partnerships or joint ventures and yet result in the division of
61
See, e.g., Canelo v. Commissioner, 53 T.C. 217 (1969),
affd. 447 F.2d 484 (9th Cir. 1971).
62
Although secs. 1.721-1(a) and 1.707-1(a), Income Tax
Regs., contemplate arrangements in which a partner makes property
available for use by the partnership without contributing it to
the partnership, such arrangements are considered to be
transactions between the partnership and a partner who is not
acting in his capacity as a partner. If this were the only
transaction between the putative capital partner and the putative
partnership, it would appear that no contribution of property to
the partnership would have occurred.
63
Other examples of unsuccessful efforts by assignment to
transmute ordinary income into capital gain may be found in
Commissioner v. P.G. Lake, Inc., 356 U.S. 260 (1958), and Hort v.
Commissioner, 313 U.S. 28 (1941).
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the proceeds or income from an activity. Although section
301.7701-1(a)(2), Proced. & Admin. Regs., provides that certain
joint undertakings may give rise to entities for federal tax
purposes “if the participants carry on a trade, business,
financial operation, or venture and divide the profits
therefrom,” the examples that follow illustrating such
arrangements, also distinguish them from mere joint undertakings
to share expenses or arrangements by sole owners or tenants in
common to rent or lease property, such as cropsharing
arrangements.
One way to think of the contingent fee agreement, which
brings us back to the metaphor about fruits and trees, is to
analogize it to a cropsharing arrangement.64 Cropsharing is
strikingly similar to the contingent fee agreement. The attorney
is in the position of the tenant farmer, who bears all his direct
and overhead expenses incurred in earning the contingent fee (and
64
To adopt another agricultural metaphor, a claim, lawsuit,
or cause of action is, see Compact Oxford English Dictionary 1838
(1971), a “monocarp”, “a plant that bears fruit but once * * *.
Annuals and biennials, which flower the first or second year and
die, as well as the Agave, and some palms which flower only once
in 40 or 50 years and perish, are monocarpic. * * * The plant
itself is also completely exhausted, all its disposable formative
substances are given up to the seed and the fruit, and it dies
off (monocarpous plants)”. So the unsuccessful lawsuit dies off
without bearing fruit, but, with the successful husbandry of an
attorney who has entered into a contingent fee agreement with the
client, the lawsuit may come to fruition in a recovery, which is
shared by the client and attorney under the terms of the
agreement.
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the contingent fees under all such arrangements to which he is a
party with other clients). The client is in the position of the
landowner (lessee-sublessor), who bears none of the operating
expenses, but is responsible for paying the carrying charges on
his land, such as mortgage interest and real estate taxes. These
charges are analogous to court costs, which the client under a
contingent fee agreement is usually responsible for, and which
the attorney can only advance to or on behalf of the client.
It is apparently so clear that there is no direct authority
that cropsharing arrangements result in a division of the crops
and the total gross revenue from their sale in the agreed upon
percentages. See IRS Publication 225, Farmer’s Tax Guide 15-16
(1999). This income is characterized as rental income to the
owner or lessee of the land and farm income to the tenant-farmer.
See id.65
The analogy of contingent fee agreements to crop sharing
arrangements is suggestive and helpful. It solves the problem
under the attorney’s ethics rule that says the attorney is not
65
Probably the most litigated issue has been whether, under
the facts of each particular case, there has been “material
participation” by the owner or lessee so as to obligate him or
her to pay self-employment tax and to be entitled to Social
Security benefits. See, e.g., Davenport, Farm Income Tax Manual
sec. 303, “Rents Received in Crop Shares”, particularly “Material
Participation Trade-off”, pages 203-204 (1998 ed.); ALI-ABA,
Halstead, ed., Federal Income Taxation of Agriculture, ch. 2
Social Security and the Farmer, particularly 16-27 (3d ed. 1979).
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supposed to acquire an ownership interest in the cause of action
that is the subject of such an agreement. The client, like the
owner or lessee of farmland who rents it to the tenant farmer,
transfers to the attorney an interest in the recovery that is
analogous to the tenant farmer’s share of the crop generated by
his farming activities on the land leased or made available to
him by the non-active owner or sublessor.
1 McKee et al., Federal Taxation of Partnerships and
Partners, par. 3.02[5], at 3-15-16 (3d ed. 1997), cites Smith v.
Commissioner, supra, and Luna v. Commissioner, supra, among
others, for the following propositions:
A profit-oriented business arrangement is not a
partnership unless two or more of the participants have
an interest in the partnership as proprietors. Thus an
agreement to share profits is not a partnership if only
one party has a proprietary interest in the profit-
producing activity. For example, the owner of a
business may agree to compensate a hired manager with a
percentage of the income of the business, or a broker
may be retained to sell property for a commission based
on the net or gross sales price. Even though both
arrangements culminate in the division of profits,
neither constitutes a partnership unless the
arrangement results in the parties becoming
coproprietors.
The Culbertson intent test has its greatest
continuing viability in connection with the elusive
distinction between coproprietorship arrangements and
other arrangements for the division of profits. A
number of objective factors may be taken into account
in determining whether participants intend to operate
as coproprietors or to share profits as third parties
dealing at arm’s length.
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McKee et al. go on to discuss the characteristics of proprietary
profits interests, and other factors evidencing proprietary
interests, such as agreement to share losses, ownership of a
capital interest, participation in management, performance of
substantial services, and the intention to be a partnership,
which includes not only the intention to share profits as
coproprietors, but can also be evidenced by more mundane factors,
such as entry into a partnership agreement and the filing of
partnership returns. See Commissioner v. Culbertson, 337 U.S.
733 (1949); Luna v. Commissioner, supra at 1077-1078; Estate of
Smith v. Commissioner, supra.
McKee et al. at par. 5.03[2] n.120 again cite Estate of
Smith and other cases for the proposition that, if a service
provider obtains only an interest in future profits, the courts
have been reluctant to recognize the service provider as a
partner; instead they treat him as an employee or independent
contractor who has received nothing more than a promise of
contingent compensation in the future. Given the nature of the
attorney-client relationship, independent contractor is the
relationship that obtains under the contingent fee agreement.
Under this arrangement, as in Estate of Smith v. Commissioner,
supra, the profits are divided between the parties in the agreed
upon percentages. But the decision not to treat the arrangement
as a partnership assures that the income of the service provider
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retains its character as compensation ordinary income. The
service provider’s income does not take its character from the
property that belongs to the other party who made it available to
be worked on by the service provider.
Conclusion
The assignment of income cases decided by the Supreme Court
for the most part have arisen in intrafamily donative transfers.
Assignment of income cases arising in commercial contexts have
concerned attempts at income tax avoidance between related
parties. The touchstone of these cases has been the retained
control over the subject matter of the assignment by the
assignor.
The control retained by Mr. Kenseth in this case was much
less than the control retained by the assignor in any of the
cases in which the assignment of income doctrine has been
properly applied. Indeed, the control retained by Mr. Kenseth
was so much less as to make it unreasonable to charge him with
the full amount of his share of the total settlement, without
offset of the attorney’s fee apportioned against his share. From
the inception of the contingent fee agreement, a substantial
portion of any recovery that might be obtained was dedicated to
Fox & Fox, who through the mixture of their labor with the claims
of Mr. Kenseth and his colleagues, first, caused the claims to be
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realized under a settlement agreement, and, second, added
substantially to whatever speculative value those claims might
have had when the contingent fee agreements were entered into.
The Bankruptcy Court for the Middle District of Alabama said
it very well in recently applying Cotnam in Hamilton v. United
States, 212 Bankr. 212 (Bankr. M.D. Ala. 1997), a case that would
have been appealable to the Court of Appeals for the Eleventh
Circuit: “This decision does not limit taxation of the total
amount of the judgment as income. It merely apportions the
income to the proper entities”.
In conclusion, there should be no concern that giving effect
to my findings and conclusion will open the door to tax
avoidance. They are confined to a peculiar situation, far
removed from the intrafamily and other related party transfers
that generated and sustain the assignment of income doctrine.
The case at hand is not an appropriate occasion for application
of that doctrine. The gross income realized and received by Mr.
Kenseth and his colleagues should not be inflated to include the
contingent fee paid to their attorneys.