TAXABILITY OF EMPLOYMENT AWARDS

 

Author Bio : This is a Guest post written by Ty Hyderally, who is an employment law attorney in New Jersey. He is the proprietor of the Ty Hyderally Law Offices in New York, NY and Montclair, New Jersey. He is one of the New Jersey Leaders of Employment Law which is the main focus of his legal service.

Background of employment awards taxability

The taxability of awards in the arena of employment litigation has been a quagmire of uncertainty with practitioners in varying circuits having varying answers to questions surrounding whether awards are taxable and, if so, what part of the award is taxable. See generally, Commissioner v. Schleier, 515 U.S. 323, 115 S. Ct. 2159 (1995); United States v. Burke, 504 U.S. 229, 112 S. Ct. 1867 (1992); 26 U.S.C. ' 104(a); and IRS Rev. Ruling 96-56. What has occurred in many jurisdictions, is that the contingency fee plaintiff pays federal and state income taxes on the attorneys’ fees and costs part of the award that is paid by the defendant to the plaintiff’s attorney. Then the plaintiff’s attorney pays federal and state income taxes on that same payment of monies which results in double taxation.

Lawyers would face the difficult scenario found by the plaintiff in Illinois. There, Cynthia Spina prevailed in a hotly contested and litigated sexual harassment and discrimination lawsuit against the Illinois Police Department. Ms. Spina’s recovery for compensatory damages was subject to the $300,000 statutory damages cap found in Title VII of the Civil Rights Act of 1964, 42 U.S.C. § 2000e-2. Her attorneys were awarded fees and costs that approached $1,000,000. At the end of the day, Ms. Spina’s tax bill exceeded her damages award and left her with an additional tax liability of $99,000. Spina v. Forest Preserve District of Cook County, 207 F.Supp.2d 764 (N.D. Ill. 2002).

The US Supreme Court and employment award taxability

The issue of taxability of attorneys’ fees to a contingency fee plaintiff was presented to the United States Supreme Court in Commissioner of Internal Revenue v. John W. Banks, II and Commissioner of Internal Revenue v. Sigitas J. Banaitis, Nos. 03-892 and 03-907, 2005 U.S. LEXIS 1370; 73 U.S.L.W. 4117; 94 Fair Empl. Prac. Cas. (BNA) 1793 (January 24, 2005).

In Commissioner of Internal Revenue v. John W. Banks, II, 345 F.3d 373 (2003), Banks was an educational consultant who was fired from the California Department of Education. He filed a cause of action alleging violations of, inter alia, 42 U.S.C. §§1981, 1983 and Title VII. Defendant settled with Banks and paid him $464,000 of which Banks paid $150,000 to his attorney in accordance with the contingent fee agreement. Banks did not include any of the monies as income and was issued a notice of deficiency for the $464,000 by the Commissioner of the IRS. This was upheld by the Tax Court. The Sixth Circuit followed the Firth and Eleventh Circuit and reversed in part as to the taxability of the $150,000.

In Commissioner of Internal Revenue v. Sigitas J. Banaitis, 340 F.3d 1074 (2003), Banaitis was a vice president and loan officer at Bank of California that was acquired by Mitsubishi Bank. Banaitis filed a cause of action alleging, in essence, a breach of his employment contract. The matter proceeded to trial after which defendants filed post trial motions and appeals. After the resolution of these motions and appeals, the parties settled with Banaitis receiving $4,864,547, and defendants paying an additional $3,864,012 directly to his attorney. Banaitis did not include the additional $3,864,012 as income and was issued a notice of deficiency for the $3,864,012 by the Commissioner of the IRS. This was upheld by the Tax Court. The Ninth Circuit analyzed the law in Oregon. It found that only because Oregon law granted a special property right or superior lien on the attorneys’ fee, then that fee should not be income to Banaitis.

The United States Supreme Court consolidated both cases in Commissioner of Internal Revenue v. John W. Banks, II and Commissioner of Internal Revenue v. Sigitas J. Banaitis, Nos. 03-892 and 03-907, 2005 U.S. LEXIS 1370; 73 U.S.L.W. 4117; 94 Fair Empl. Prac. Cas. (BNA) 1793 (January 24, 2005) (“Banks”). On January 24, 2005, the US Supreme Court reversed both the Sixth and Ninth Circuits and found in favor of the Commissioner of the IRS, in ruling that the payment of attorneys’ fees was taxable to the plaintiff.

Analysis of employment award taxability

The analysis begins with the Internal Revenue Code that defines "gross income" for federal tax purposes as "all income from whatever source derived." 26 U.S.C. §61(a). This broad definition is all-encompassing and results in the IRS arguing that gross income includes all economic gains not otherwise exempted. Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 429-30, 99 L. Ed. 483, 75 S. Ct. 473 (1955); Commissioner v. Jacobson, 336 U.S. 28, 49, 93 L. Ed. 477, 69 S. Ct. 358 (1949).

Plaintiffs’ attorneys have historically argued that the value of the legal claim found in the contingency fee agreement was speculative at the moment of assignment and may end up being worth nothing. Thus, the attorneys’ fee and award should not be treated as an anticipatory assignment and thus should not be held as income to the plaintiff. They would argue that a contingent-fee arrangement is more like a partial assignment of income-producing property than an assignment of income. Estate of Clarks v. United States, 202 F.3d 854, 857-858 (2000).

The Banks Court definitively rejected this argument in stating that contingency fee agreements are still anticipatory assignments even though the value of the assignment may be unknown at the time of assignment Banks, supra at *17; Lucas v. Earl, 281 U.S. 111, 74 L. Ed. 731, 50 S. Ct. 241 (1930); United States v. Basye, 410 U.S. 441, 445, 450-452, 35 L. Ed. 2d 412, 93 S. Ct. 1080 (1973); Raymond v. United States, 355 F.3d 107, 115-116 (CA2 2004). Further, the Supreme Court has definitively held that such an anticipatory assignment of income is taxable to the plaintiff as he/she earned the income that gave rise to the attorneys’ fee. Banks, supra 2005 US Lexis 1370 at *14; Lucas, supra; Comm'r v. Sunnen, 333 U.S. 591, 604, 92 L. Ed. 898, 68 S. Ct. 715 (1948); Helvering v. Horst, 311 U.S. 112, 116-117, 85 L. Ed. 75, 61 S. Ct. 144 (1940).

Plaintiff’s attorneys have also historically argued that the plaintiff did not exercise dominion over the attorneys’ fees and costs part of the award. They argued that payment of attorneys’ fees and costs was compensation due to the attorneys’ effort and skill, independent of the litigation. Thus, the relationship should be seen as a joint venture or partnership where each partner can be taxed for the separate rewards that they actually received. The Banks Court also rejected this argument and found the relationship was more akin to that of principal-agent. The Court found that the plaintiff controls the critical decisions and makes the final decision as to whether to settle or proceed to judgment. Thus, the client retains ultimate dominion and control over the underlying income generating asset which is the plaintiff’s legal injury. Horst, supra, at 116-117, 85 L. Ed. 75, 61 S. Ct. 144. See also Lucas, supra, at 114-115, 85 L. Ed. 75, 61 S. Ct. 144; Helvering v. Eubank, 311 U.S. 122, 124-125, 85 L. Ed. 81, 61 S. Ct. 149 (1940); Sunnen, supra, at 604, 92 L. Ed. 898, 68 S. Ct. 715. The Court found that this is reflected by the attorney being ethically obligated to act for the exclusive benefit of the client-principal rather than for the benefit of the attorney. The Court favorably commented on Judge Posner’s analogy of treating the contingent fee relationship as similar to that of a commission salesman. Kenseth v. Comm'r, 259 F.3d 881, 883 (CA7 2001). In that case, Judge Posner opined that the commission salesman has as much ownership of his employer’s accounts receivable as the contingent fee lawyer has ownership over the plaintiff’s claim. Id. In both situations, the principal relies on the agent to realize an economic gain, and, in both cases, the economic gain is income to the principal. Id.