A Win-Lose Situation
Plaintiffs who file a lawsuit know that they might win or lose. But there also may be a new “third category”: a winner who ends up losing.
In the case of Commissioner of Internal Revenue v. Banks, No. 03-892, scheduled to be heard this month before the U.S. Supreme Court, the loss involves money for the plaintiff. The court will decide whether a winning plaintiff must count as taxable income the portion of a verdict or settlement that goes to his lawyer.
The Internal Revenue Service says the answer is unquestionably yes. “It is a fundamental rule of taxation that income is to be taxed to the person who earns it, even when it is paid at that person’s direction to someone else,” government lawyers told the court. Paying an attorney, even through a contingency fee arrangement, is the same as paying a debt. But that conclusion defies the common-sense rule that taxpayers should not be forced to pay taxes on money they never received, said lawyers for civil rights and business groups. This tax is not only unfair, but in extreme cases, it will result in successful plaintiffs being hit with a tax bill that exceeds their award, they added.
For example, a similar case cited in briefs for Banks is that of Illinois police officer Cynthia Spina who, after a long and hard-fought sex discrimination and harassment case, was awarded $300,000 in damages. Spina v. Forest Preserve District of Cook County, 207 F. Supp. 2d 764 (N.D. Ill. 2002). But her attorney fees and costs came to nearly $1 million. When the IRS insisted that, too, was taxable income, she ended up losing every penny of the award, plus she got an extra tax bill of $99,000, according to reports. Two developments during the mid-1990s made this prospect more likely. Until then, compensatory awards were usually not taxed.
However, the high court in several decisions said damages awards were taxable, except when they compensated a victim for a true personal injury, such as an auto accident. Commissioner v. Schleier, 515 U.S. 323 (1995).
At the same time, the tax code made it harder for many to take large deductions. While an attorney fee could be subtracted as an itemized deduction, those deductions begin to phase out after a taxpayer’s income reaches $142,700. Moreover, the alternative minimum tax, which affects more taxpayers now, removes all deductions. So, it becomes crucial whether the money paid an attorney must be included in gross income.
Discrimination Victims Hit
“It would seriously undermine civil rights statutes,” says Chicago attorney Russell R. Young, if discrimination victims had to pay taxes on their compensatory awards and on the amount that goes to their lawyer. “It would make any type of lawsuit more costly to pursue,” he adds. Several employer groups filed amicus briefs arguing that the double taxation rule would make it harder and costlier to settle lawsuits.
Young represents John W. Banks II, a former California Department of Education employee, who filed a discrimination suit after he was dismissed. During trial, the case settled for $464,000, of which $150,000 went to Banks’ lawyer. The IRS maintained that Banks owed taxes on the total, and the U.S. Tax Court agreed.
But the 6th U.S. Circuit Court of Appeals ruled his lawyer’s portion was not taxable income for Banks. It reasoned that “a contingency fee, as part of a litigation claim, is not already earned” money for the plaintiff. Rather, it depends “upon the attorney’s skill” to convert the plaintiff’s claim into a money judgment, the appeals court said. “The income should be charged to the one who earned it and received it, not (as in the instance of Mr. Banks) to one who neither received it nor earned it,” the court said.
David G. Savage covers the U.S. Supreme Court for the Los Angeles Times and writes regularly for the ABA Journal.
