A recent decision on the taxability of damage awards highlights the significant differences in taxes paid by workers who successfully sue their employers, based upon little more than where they live. In Banks v. CIR, the 6th Circuit Court of Appeals held that workers do not have to pay taxes on the amount of the worker’s settlement which goes to his or her attorney. In doing so, the 6th Circuit strongly rejected the notion that the specific language of a state’s attorneys’ lien law makes a significant difference when it comes to assessing taxation, contrary to the logic followed by several other circuits who look closely at lien law language when assessing taxes on some awards but not others.
John W. Banks II worked for the California Department of Education (“CDOE”) as an educational consultant from 1972 to 1986, when he was fired. After his termination, he filed an employment discrimination against the CDOE and some of its employees. This case proceeded to trial in 1989 before a judge, as this case was brought before the 1991 Civil Rights Act was passed, giving plaintiffs a right to a jury trial. Although plaintiff’s original complaint had included a claim for emotional distress under California state law, those claims were dismissed before trial. During the trial, the judge urged the parties to pursue settlement talks, and reached a settlement. Although plaintiff had requested $850,000 during settlement discussions, he ultimately agreed to the amount of $464,000, based at least in part on the parties’ agreement to characterize the settlement as a non-taxable settlement for emotional distress (although even then, the parties and attorneys were unsure whether this strategy would ultimately succeed.) The parties settled for $464,000, with $150,000 of that amount going to plaintiff’s attorney under a contingency fee arrangement, and plaintiff did not declare any of the settlement as taxable income.
Fast forward several years later, after plaintiff had presumably moved to a state within the 6th Circuit (Ohio, Michigan, Kentucky or Tennessee). (The opinion does not state how this happened, but it was certainly a fortuitous move as far as his tax situation is concerned.) In 1997, the IRS assessed a deficiency for the money plaintiff received in tax year 1990, claiming that Banks should have paid taxes on a portion of the settlement proceeds and that he now owed $101,168.00 in back taxes. Banks appealed this decision to the Tax Court and lost. His next stop in appealing his tax deficiency was the 6th Circuit Court of Appeals.
At the 6th Circuit, Banks found a far more receptive audience regarding at least some of his tax claims. Banks made three arguments (although one, about an alimony payment, is presumably of lesser interest to our audience and will not be discussed here. His first argument was that he did not owe taxes on the amount of the award that he kept, as it was a non-taxable award for personal injury, while his second was that he did not owe taxes on the $150,000 portion of the award which was used to pay his attorney. While the 6th Circuit did not accept his first argument, the court agreed with Banks and ruled that he did not owe back taxes on the attorneys’ fee portion of the award.
Between 1990, when Banks received his settlement award, and 1997, when he heard from the IRS that he owed additional taxes, the law on the subject of taxation of damage awards went through some significant changes. One of these changes involves two cases decided by the U.S. Supreme Court, U.S. v. Burke and Commissioner v. Schleier. In 1992, the Supreme Court ruled in Burke that awards under Title VII prior to 1991 were taxable, because they were for economic damages (back pay) only, and could therefore be distinguished from non-taxable personal injury awards which under Internal Revenue Code section 104(a)(2) are not taxable.
The question then arose as to what tax treatment awards under Title VII should receive after 1991, since the law was amended then to provide for non-economic compensatory (emotional distress) damage awards. The Supreme Court answered that question in 1995, in the Schleier case, when it ruled that even though the Age Discrimination in Employment Act (like Title VII amended in 1991) now contained a right to jury trial and additional damages provisions, an ADEA award was still nonetheless taxable. Schleier established the test the 6th Circuit applied to Banks’ claim: (1) there was an underlying tort claim; (2) the claim existed at the time of the settlement; (3) the claim encompassed personal injuries; and (4) the agreement was executed “in lieu” of the prosecution of the tort claim and “on account of” the personal injury. According to the 6th Circuit, Banks’ Title VII claim did not satisfy that text. While he had other claims that might properly have served as the basis of a tort (personal injury) claim, those claims were abandoned prior to trial, and could not be resurrected in the settlement agreement, no matter what the language of that agreement said and the parties intended. So as a result, Banks must pay back taxes on the portion of the award that he kept, as none of it could be allocated to personal injury.
Banks fared better, however, on the portion of the award given to his attorney under their contingency fee arrangement, as the 6th Circuit determined that he did not owe back taxes on that portion of the award. As noted by the court, there is a split in the circuits about whether this amount can be taxed twice (once to the plaintiff and again to the attorney). Footnote 7 in the decision provides helpful cites for all of the federal circuit decisions on this point, in case you’re interested in reading all of these decisions:
The Fifth, Sixth, and Eleventh Circuits have held that contingency fees are excludable. See Foster v. United States, 249 F.3d 1275 (11th Cir. 2001); Srivastava v. Comm’r, 220 F.3d 353 (5th Cir. 2000); Estate of Clarks v. United States, 202 F.3d 854 (6th Cir. 2000). The Third, Fourth, Seventh, Ninth, Tenth, and Federal Circuits have taken the opposite view. See Campbell v. Comm’r, 274 F.3d 1312 (10th Cir. 2001); Kenseth v. Comm’r, 259 F.3d 881 (7th Cir. 2001); Young v. Comm’r, 240 F.3d 369 (4th Cir. 2001); Benci-Woodward v. Comm’r, 219 F.3d 941 (9th Cir. 2000); Coady v. Comm’r, 213 F.3d 1187 (9th Cir. 2000); Baylin v. United States, 43 F.3d 1451 (Fed. Cir. 1995); O’Brien v. Comm’r, 38 T.C. 707 (1962), aff’d, 319 F.2d 532 (3d Cir. 1963) (per curiam).
As noted, the 6th Circuit had previously ruled that this amount was not taxable; however, since Banks’ case was brought in California, it was necessary for the 6th Circuit to determine whether it would agree with the 9th Circuit courts analyzing California law, which have found the attorneys’ fee portion taxable (see Benci-Woodward and Coady) or whether it would remain true to its own existing precedent.
Thankfully for Banks and all of us representing the workers’ perspective who care about this subject, the 6th Circuit stuck with its own precedent, and determined that Banks’ award was not taxable. Unlike the 9th Circuit, which has made the decision based upon decades-old attorneys fee statutes (leading to confusing results within the circuit itself where awards are taxed on California but not Oregon–see Banaitis v. CIR for the Oregon decision), the 6th Circuit has recognized that the problem needs to be analyzed consistently, regardless of the state of residence and the language in the attorneys’ fees statute. The 6th Circuit first adopted the rationale in Estate of Clarks that the income obtained with an attorney’s assistance was akin to a partnership between the plaintiff and attorney, where the attorney’s skills contribute to the success of the award (and without the attorney, plaintiffs are unlikely to obtain the award on their own.) As the court explains it:
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 . . . to one who neither received it nor earned it.
While the IRS acknowledged the prior 6th Circuit decision, they argued that it did not apply due to the language of the California lien statute applicable to Banks’ award when Banks received it (and certainly if Banks had remained in California, the 9th Circuit would have agreed and taxed Banks on his award.) However, the 6th Circuit rejected the rationale of the 9th Circuit and other circuit courts which have hinged their decisions on the state attorney lien statute. As the 6th Circuit noted, when choosing to follow the 5th Circuit’s approach
We likewise are not inclined to draw distinctions between contingency fees based on the attorney’s lien law of the state in which the fee originated. Given the various distinctions among attorney’s lien laws among the fifty states, such a “state-by-state” approach would not provide reliable precedent regarding our adherence to the Cotnam doctrine or provide sufficient notice to taxpayers as to our tax treatment of contingency-based attorneys fees paid from their respective jury awards
The 6th Circuit also reiterated the importance of 4 additional factors, regardless of the attorneys’ fee language in any particular state:
(1) the fact that the claim, at the time the contingency fee agreement was signed, was “an intangible, contingent expectancy,” (2) taxpayer’s claim was like a partnership or joint venture in which the taxpayer assigned away one-third in hope of recovering two-thirds; (3) no tax-avoidance purpose was at work with the contingency fee arrangement… and (4) double taxation would otherwise result by including the contingency fee in taxpayer’s income.
The 6th Circuit decision, which is among the most persuasive out there on this subject, is nonetheless in the majority when compared to other circuits around the country. If the IRS appeals this ruling to the U.S. Supreme Court, there exists a possibility the Court will hear the case in order to resolve the conflict between the circuits. (The Supreme Court has previously refused to hear cases going the other way, including many if not most of the decisions listed above.) The decision does provide certainty to those who live and/or pay taxes in the states affected by the 6th Circuit, and plenty of wisdom that will hopefully serve to persuade those courts which have not yet ruled on this issue, such as the 1st, 2nd, 8th, and DC Circuits, to follow the Banks precedent rather than poring over attorneys’ lien statutes to tax discrimination awards twice. The need for Congress to resolve this problem has never been more apparent, when you consider the disparity (often amounting to tens or hundreds of thousands of dollars) between workers in the 5th, 6th, and 11th Circuits and the rest of the country, so please write your member of Congress today: