Commissioner of Internal Revenue v. Banks
543 U.S. 426 (2005)
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Rule of Law:
When a litigant's recovery constitutes income, the portion of that recovery paid to their attorney under a contingent-fee agreement is included in the litigant's gross income for federal income tax purposes.
Facts:
- In one case, John W. Banks, II, was fired from his job and retained an attorney on a contingent-fee basis to sue his former employer for employment discrimination.
- Banks' lawsuit settled for $464,000, of which he paid $150,000 to his attorney pursuant to their agreement.
- In a separate case, Sigitas J. Banaitis sued his former employer after leaving his job, also retaining an attorney on a contingent-fee basis.
- After a jury verdict, Banaitis's case settled, with the defendants paying over $8.7 million in total; $3,864,012 was paid directly to Banaitis's attorney.
- Both Banks and Banaitis excluded the amounts paid to their attorneys from their gross income on their federal income tax returns.
Procedural Posture:
- Taxpayers John W. Banks and Sigitas J. Banaitis both excluded the contingent-fee portions of their litigation recoveries from their gross income.
- The Commissioner of Internal Revenue issued notices of deficiency to both taxpayers, asserting that the full recoveries were taxable income.
- Both taxpayers challenged the deficiencies in the U.S. Tax Court, which sided with the Commissioner in both cases.
- On appeal, the U.S. Court of Appeals for the Sixth Circuit reversed in Banks' case, holding the fee was not his income.
- Similarly, the U.S. Court of Appeals for the Ninth Circuit reversed in Banaitis' case, finding that state law gave his attorney a property interest in the fee.
- The Commissioner of Internal Revenue petitioned the U.S. Supreme Court for a writ of certiorari to resolve the conflict among the circuits, which the Court granted and consolidated the cases.
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Issue:
Does a taxpayer's gross income include the portion of a litigation recovery paid directly to their attorney under a contingent-fee agreement?
Opinions:
Majority - Justice Kennedy
Yes. A litigant's gross income includes the portion of a litigation recovery paid to their attorney as a contingent fee. The Court applied the anticipatory assignment of income doctrine, which holds that income is taxable to the person who earns it. The income-generating asset in a lawsuit is the plaintiff's underlying cause of action. The plaintiff retains dominion and control over this asset throughout the litigation, including the power to settle the claim. A contingent-fee agreement is merely an arrangement to divert a portion of the expected income to the attorney, which does not change the fact that the client earned the entire amount. The attorney-client relationship is a principal-agent relationship, not a partnership or joint venture, meaning the income earned by the agent (attorney) is attributable to the principal (client).
Analysis:
This decision resolved a long-standing circuit split, establishing a uniform national rule for the tax treatment of contingent fees. It firmly applies the classic anticipatory assignment of income doctrine from Lucas v. Earl to the modern attorney-client relationship, reinforcing that control over the income-generating asset (the legal claim) determines tax liability. The ruling also highlighted the potentially harsh consequences of the Alternative Minimum Tax (AMT), which often prevented taxpayers from deducting these legal fees, effectively taxing them on income they never received. This outcome was a significant factor in prompting Congress to enact the American Jobs Creation Act of 2004, which created an above-the-line deduction for attorney's fees in certain types of cases, mitigating the effect of this ruling for future litigants.
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