Commissioner v. Banaitis

article issues
orphan =December 2007

Commissioner v. Banks / Commissioner v. Banaitis

"Commissioner v. Banks"

Facts: In 1986, John W. Banks II was fired from his job as an educational consultant with the California Department of Education. ["Commissioner v. Banks" / "Commissioner v. Banaitis", 543 U.S. 426, 430 (2005).] Banks sued his former employer for employment discrimination. ["Id."] In 1990, the parties settled his civil suit for $464,000. ["Id."] Banks paid $150,000 of the recovery to his attorney pursuant to a contingent-fee agreement. ["Id."]

Banks failed to report any of the settlement proceeds in his federal income tax return for 1990, and the Commissioner of Internal Revenue issued a notice of deficiency. ["Id."] The case was appealed to the Sixth Circuit Court of Appeals, which held that the settlement proceeds received by Banks were taxable income, but the amount paid to the attorney under the contingent-fee agreement was not income to Banks. ["Id." at 431.]

"Commissioner v. Banaitis"

Facts: In 1987, Sigitas J. Banaitis left his job as a vice president and loan officer at the Bank of California. ["Id."] Soon after, he sued his former employer and its successor in ownership, the Mitsubishi Bank, for willfully interfering with his employment contract and attempting to induce him to breach his fiduciary duties to customers and discharging him when he refused. ["Id."] A jury awarded damages, and, after all appeals and post-trial motions, the parties settled. ["Id."] The defendant paid Banaitis $4,864,547 and paid an addition $3,864,012 directly to Banaitis’s attorney pursuant to his contingent-fee contract with the attorney. ["Id."]

Banaitis included his share of the settlement proceeds as gross income, but did not include the amount paid to his attorney on his federal income tax return. ["Id." at 432.] The Commissioner issued a notice of deficiency. ["Id."] The case was appealed to the Ninth Circuit Court of Appeals, which held that the outcome depended on state law. ["Id."] The court held that where state law grants the attorney no special property rights in his fee, the whole amount is included in the plaintiff’s gross income. ["Id."] In this case, however, Oregon law grants attorneys a superior lien in their portion of the settlement, so the contingent-fee portion of the settlement was property excluded from Banaitis’s gross income. ["Id."]

"Banks" / "Banaitis"

Issue: Whether the portion of a money judgment or settlement paid to a plaintiff’s attorney under a contingent-fee agreement is income to the plaintiff under the Internal Revenue Code.

Analysis: “Gross income” for federal tax purposes is “all income from whatever source derived.” ["Id." at 433 (quoting 26 U.S.C. § 61(a)).] A taxpayer cannot avoid taxation by assigning, in advance, the gain to another party. ["Id."] If the taxpayer controls the source of the income, he also controls the disposition of that income. ["Id." at 434.] In litigation, “the income-generating asset is the cause of action that derives from the plaintiff’s legal injury.” ["Id." at 435.] The plaintiff has dominion over this asset throughout the litigation, diverts some of the income to another party, and received a benefit from this payment. ["Id."] Contingent fee contracts are just another form of anticipatory assignments of a taxpayer’s income to another party.

Holding: When a litigant’s recovery constitutes income, the litigant’s income includes the portion of the recovery paid to the attorney as a contingent fee.

Real-World Impact: After these cases arose, Congress enacted the American Jobs Creation Act of 2004. ["Id." at 433.] Section 703 of the Act added § 62(a)(20), which classifies attorney fees in certain litigation as an above-the-line deduction. [26 U.S.C. § 62.] “‘Adjusted gross income’ means, in the case of an individual, gross income minus the following deductions: . . . Any deduction allowable under this chapter for attorney fees and court costs paid by, or on behalf of, the taxpayer in connection with any action involving a claim of unlawful discrimination.” § 62(a)(20).

However, this statutory exception does not render the issue moot — some contingent-fee arrangements are not eligible for this deduction. [Samuel A. Donaldson, Federal Income Taxation of Individuals: Cases, Problems and Materials 168 (2d ed. 2007).] For example, in claims for defamation or invasion of privacy, § 62(a)(20) would not apply, and Banks/Banaitis would be precedent. ["Id."]

References