Lead Opinion
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 thie 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. (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:
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:
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.
VIL 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.
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 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
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 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
EEOC had initially recommended that the members of the class settle their age discrimination suit for less than $1 million in 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 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
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 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
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 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
This controversy is driven by the substantial difference in the amount of tax burden that may result from the parties’ approaches.
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,
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
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,
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
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,
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,
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 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
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.
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.
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 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.
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.,
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 abide by a client’s decision whether to accept an offer of settlement of a matter. * * *
The assignment of income doctrine was originated by the Supreme Court and has evolved over the past 70 years. See Helvering v. Eubank,
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 attorney’s fees 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,
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 agreementfor 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.
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.,
Decision will be entered under Rule 155.
Reviewed by the Court.
Notes
This case was reassigned to Judge Robert P. Ruwe by order of the Chief Judge.
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 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.
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 Procedure.
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”,
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 t^payer. 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.
This view is based on the well-established assignment of income doctrine that was originated by the Supreme Court in Lucas v. Earl,
With the exception of situations where, under our holding in Golsen v. Commissioner,
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 Com-t 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.
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,
Dissenting Opinion
dissenting: The majority opinion sets forth supra note 3 and the accompanying text (majority op. p. 407) 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. 407, 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. 407, 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. 415) — Lucas v. Earl,
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. 411) from O’Brien v. Commissioner,
However, as the majority opinion notes (majority op. p. 407), continued application of the court-made rules in this era of minimum tax can raise effective tax rates to hardship levels 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,
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 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 prior decisions. But when experience and analysis show that we have departed
We should not declare ourselves incapable of self-correction, merely because we chose to follow a wrong path decades ago.
Respectfully, I dissent.
The statute referred to in O’Brien v. Commissioner,
In Teschner v. Commissioner,
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,
Cf. Cold Metal Process Co. v. Commissioner,
Dissenting Opinion
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.
Page
Findings and Resulting Inferences 422
Discussion . 42f?
425 1. Issue Is Ripe for Reexamination
427 2. Tax Court’s Jurisprudence on Tax Treatment of Contingent Fees — Dicta for Case at Hand .
431 3. Another Reason for Reexamination: Repeal of Statutory Spreadback and Averaging Provisions .
432 4. Cotnam and Estate of Clarks .
435 i. Narrow Ground — Significance of State Law .
438 ii. Broader Ground — Federal Standard .
441 5. Significance of Control in Supreme Court’s Assignment of Income Jurisprudence .
6. Substantial Reduction of Claimant’s Control by Contingent Fee Agreement . CO
i. “Contract of Adhesion”. ^
ii. American Bar Foundation Contingent Fee Study . 445
iii. “Two Keys” Simile. 447
7. Omissions and Distortions: the Majority Opinion. 448
8. Majority Opinion’s Handling of Authorities . 450
9. Preventing Tax Avoidance by Other Transferors. 452
10. Cropsharing as Alternative to Joint Venture/Partnership Analogy . 453
Conclusion . 457
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.
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
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.
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 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
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 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.
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,
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 repeal
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.]
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 distinguishable exception,
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,
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,
Although there may be considerable equity to the taxpayer’s position, that is not the way the statute is written. Without the benefit of section1303 [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 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,
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.”
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 theretoeven 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. [Id.]
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 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.
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 taxation
3. Another Reason for Reexamination: Repeal of Statutory Spreadback and Averaging Provisions
The history of the statutory spreadback provisions is instructive in another respect.
Contrarywise, the purpose of the AMT is to prevent individuals with substantial economic income from avoiding significant tax liability.
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,
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
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% 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 otherwise negligible income against which to deduct the fee, resulting in a deficiency of more than $36,000.
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 .]
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”,
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 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,
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. Commissioner,
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,
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.
The majority respond with two observations in support of respondent’s position: First, Wis. Stat. Ann. sec. 757.36 (1981) has been revised to give the attorney a lien “upon the proceeds or damages” as well as “upon the cause of action.”
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 cannot 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 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.
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.,
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.]
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,
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 recently adopted by the Court of Appeals for the Sixth Circuit in Estate of Clarks v. United States,
Judge Wisdom’s dissent was very much in the vein that the transaction was governed by the classic assignment of
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,
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 Estate of 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 Estate of Clarks also agree that the proper treatment is to divide the gross income
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,
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. 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,
The citation by the Court of Appeals for the Sixth Circuit of Wodehouse v. Commissioner,
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. Horst, supra — were intrafamily donative transfers.
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 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,
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 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.
My response is that Mr. Kenseth’s claim did not generate personal service income. Even though the loss of past earnings 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.
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.
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.
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”,
I’m not suggesting that the contingent fee agreement would be unenforceable;
ii. American Bar Foundation Contingent Fee Study
My ultimate finding in this case is not just the sympathetic response of a “romantic judge”
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).
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 contingent fee agreement. For all these reasons, the broader ground of the decisions of the Courts of Appeals in Cotnam v. Commissioner,
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 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 bal-anee
iii. “Two Keys” Simile
The contingent fee situation is much like that in Western Pac. R.R. Corp. v. Western Pac. R.R. Co.,
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, predetermined 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
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.
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.,
The majority opinion distorts the taxpayer’s position by stating, p. 414: “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 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 414, 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. 406.]
Further, Fox & Fox factored into the settlement an amount for their fee that was grossed up in the total, so that the
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 413, 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.
8. Majority Opinion’s Handling of Authorities
The majority misstate the Alexander, Baylin, Brewer, and O’Brien cases (majority op. pp. 407, 409, and 411, respectively) and what they stand for.
The majority opinion at page 407 creates a misleading impression about the significance of Alexander v. IRS,
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. 409. This language from Lucas v. Earl,
The majority opinion cites Brewer v. Commissioner,
The majority opinion’s quotations from O’Brien v. Commissioner,
9. Preventing Tax Avoidance by Other Transferors
The majority state at page 407: "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 conclusion would o^en the door to tax avoidance.
10. Cropsharing as Alternative to Joint Venture/Partnership Analogy
The suggestion of the Court of Appeals in Estate of Clarks v. United States,
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
Although I agree with our rejection in Bagley v. Commissioner,
One way to think of the contingent fee agreement, which brings us back to the metaphor about fruits and trees, is to
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.
The analogy of contingent fee agreements to cropsharing arrangements is suggestive and helpful. It solves the problem under the attorney’s ethics rule that says the attorney is not 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 nonactive owner or sublessor.
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.
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,
McKee et al., supra 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
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 fees 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 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
In Helvering v. Horst,
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,
See also Helvering v. Clifford,
On. occasion, the Commissioner has inadvertently taken this position. See Coblenz v. Commissioner,
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.
Exeluding the backpay 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.
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 backpay 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 backpay 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 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.
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,
Coady v. Commissioner,
The alternative provision for using the enhanced hourly rate schedule to calculate the legal fee under sec. Ill 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,
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 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,
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); 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).
See Kalinka, “A.L. Clarks Est. and the Taxation of Contingent Fees Paid to an Attorney”, 78 Taxes 16 (Apr. 2000).
See Brown, “The Growing ‘Common Law' of Taxation”, 1961 S. Cal. Tax Inst. 1, 13-21.
Bagley v. Commissioner,
See, e.g., Benci-Woodward v. Commissioner,
The taxpayer in O'Brien v. Commissioner,
It’s also noteworthy that the final paragraph of Judge Wisdom’s dissent in Cotnam v. Commissioner,
Estate of Gadlow v. Commissioner,
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.
See supra note 20.
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, backpay, breach of contract damages, income from inventions or artwork, antitrust damages) earned or received over specified periods of time.
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. 1964-1 C.B. (Part 2) at 644. Accordingly, the 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.
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. See 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. See 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).
In 1986, Congress repealed the income averaging provisions almost entirely (with an exception carved out for farming income). See 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, at 114 (1986), 1986-3 C.B. (Vol. 2) 114.
See S. Rept. 99-313, at 518 (1986), 1986-3 C.B. (Vol. 3) 1, 518.
See, e.g., Huntsberry v. Commissioner,
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.
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,
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, see Haserot v. Commissioner,
We recently followed the decision of the Court of Appeals in Cotnam v. Commissioner, supra, where Alabama law applied. See Davis v. Commissioner,
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,
See Smelker v. Chicago & N.W. Ry.,
Compare Estate of Newhouse v. Commissioner,
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).
Regarding the reliance of the Commissioner and Judge Wisdom on Old Colony Trust Co. v. Commissioner,
A recent case that illustrates the proposition is Meisner v. United States,
The statement of facts in the third Supreme Court decision relied on by the majority and the dissent of Judge Wisdom, Helvering v. Eubank,
3 Bittker & Lokken, Federal Taxation of Income, Estates, and Gifts 75-7 (2d ed. 1991).
The Court of Appeals in Estate of Clarks v. United States, supra, misstates Lucas v. Earl,
3 Bittker & Lokken, supra at 75-11; see also Chirelstein, Federal Income Taxation 194-195, 214-216 (8th ed. 1999).
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.
See discussions infra at 447-448 of the “two keys” simile and at 453-457 of the cropsharing analogy.
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.
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 2 Restatement, Contracts 2d, sec. 211 (1979), is “standardized agreement”. But see Corbin on Contracts, secs. 559A-559I (Cunningham & Jacobson, Cum. Supp. 1999).
Other than the uncertainty regarding enforceability of the provision in sec. Ill 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.
In a departure from traditional analysis, Rakoff, supra at 1178-1179, asserts that adhesion 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.
See Glendon, A Nation Under Lawyers 151-173 (1994).
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).
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.,
In so doing, the majority opinion creates a mismatch between findings of fact and opinion that is reminiscent of the centaur in Greek mythology.
Alexander v. IRS,
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,
The Justice Department in its brief on appeal to the Court of Appeals for the Eleventh Circuit in Davis v. Commissioner,
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 at 6-33:
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. * * -i!
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.
Kalinka, “A.L. Clarks’ Est and the Taxation of Contingent Fees Paid to an Attorney”, 78 Taxes 16,18-20 (Apr. 2000).
See, e.g., Canelo v. Commissioner,
Although secs. 1.721-1(a) and 1.707-1(a), Income Tax Regs., contemplate arrangements in which a partner maltes 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.
Other examples of unsuccessful efforts by assignment to transmute ordinary income into capital gain may be found in Commissioner v. P.G. Lake, Inc.,
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 unsucessful 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.
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”, at 203-204 (1998 ed.); ALI-ABA, Halstead, ed., Federal Income Taxation of Agriculture, ch. 2, “Social Security and the Farmer”, particularly 16-27 (3d. 1979).