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Supreme Court Finally to Address Taxation of Damage Awards (and Disparate Impact Age Cases Too)

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Those of us who have been following the taxation of damage awards issue for several years now cannot help more than a twinge of excitement about the fact that the U.S. Supreme Court has finally decided to address the issue — regardless of the ultimate outcome of the case. You know you care too much about this issue when you find yourself upset over the relative dearth of news coverage for yesterday’s cert grant in two tax cases, when compared to another case the Supreme Court decided to hear yesterday: whether disparate impact claims may be brought under the Age Discrimination in Employment Act. While that case is certainly important too, the two tax cases have the potential to affect almost every civil rights litigant, as the Court could either wipe out the current double taxation of most discrimination awards, or by erasing the circuit splits, cause every taxpayer to be subjected to them, even those who currently have favorable protections.

Yesterday, March 29, 2004, the Supreme Court agreed to hear (or granted cert in) two cases, C.I.R. (Commissioner of Internal Revenue) v. Banks and C.I.R. v. Banaitis, both which involve individuals who brought wrongful termination claims against their former employers.

John W. Banks, II, worked as an educational consultant for the California Department of Education for fourteen years before he was fired. He then filed a lawsuit in federal court in California contending that his civil rights were violated under sect. 1983 and Title VII of the Civil Rights Act (and some additional claims, most of which were later dropped.) His case proceeded to trial in 1990, and during the trial, the parties began discussing settlement. Banks settled the case during trial for $464,000 — much less than his original demand of $850,000 — because he believed that none of the settlement would be taxable. The parties characterized his settlement as “personal injury” damages not subject to taxation, he paid $150,000 of his award to his attorney under a contingency fee arrangement, and paid no taxes on any of the settlement amount for the tax year 1990. In 1997, the IRS issued a “Notice of Deficiency,” claiming Banks owed $101,168.00, based on his failure to pay taxes on the settlement amount above. Banks filed a petition in the Tax Court, seeking a declaration that he did not owe the taxes at issue, but the Tax Court ruled against him.

Luckily for Banks in this instance, he had moved from California to Michigan, which meant that he could appeal his ruling to the 6th Circuit Court of Appeals, which had previously ruled favorably for plaintiffs in his situation, as compared to the 9th Circuit Court of Appeals, which has not treated California plaintiffs nearly as well. Banks was lucky enough to be one of the few plaintiffs nationwide to successfully appeal his ruling and win his case at the circuit level. (See Banks v. C.I.R. Sixth Circuit, 2003) The Sixth Circuit determined that four factors weighed in Banks favor when analyzing whether he should have to pay taxes on the portion that went to his attorney:

“(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 Sixth Circuit likened Banks’ lawsuit to a situation where an orchard owner gives some of his trees to someone else to care for, so that the fruit yielded by the tree is dependent on the care it receives from the new caretaker. Without Banks’ lawyer, his lawsuit would not have borne nearly as much fruit. As the court said, “By signing the contingency fee agreement, [Banks] transferred some of the trees from the orchard, rather than simply transferring some of the orchard’s fruit.”

Sigitas Banaitis, the other plaintiff affected by the Supreme Court’s ruling, worked for seven years as a vice president and loan officer with the Bank of California in Oregon, where he had access to a great deal of confidential financial information of companies who received financing from the bank. In 1984, the Mitsubishi Bank obtained a controlling interest in the Bank of California, which greatly troubled many of Banaitis’ clients, as the Mitsubishi Group, the bank’s parent company, controlled many of the direct competitors of Banaitis’ clients. Banaitis had many of his clients therefore demand that he keep their financial information confidential and not available for review by others employed by the Mitsubishi Bank or Bank of California, which eventually caused Banaitis trouble with his superiors and led to his leaving the Bank of California, after he had been given a letter telling him he had 30 minutes to clean out his desk — one day before his pension for the year had vested. Banaitis hired attorney Charles Merten of Portland under a contingency fee arrangement, and proceeded to take his case to trial. At trial, he was awarded over $6 million in back wages, emotional distress, and punitive damages. The banks appealed the ruling, but later settled in 1995 with Banaitis for $8.7 million, which included fees of $3,864,012 to attorney Merten, and the rest retained by Banaitis. For the tax year 1995, Banaitis excluded the entire settlement amount from his income, while attaching an explanatory sheet to his return stating that he believed the settlement amount to not be taxable. The IRS disagreed, filing a Notice of Deficiency against him, concluding he owed an additional $1,708,216 in taxes, resulting from the application of the alternative minimum tax to Banaitis’ deduction for his attorney’s fee. The Tax Court ruled against Banaitis, and he appealed his case to the 9th Circuit Court of Appeals, where like Banks, he prevailed. (See Banaitis v. C.I.R., Ninth Circuit, 2003)

Unlike some previous California and Alaska plaintiffs who had appealed their cases to the 9th Circuit, Banaitis lived in Oregon, and was therefore subject to Oregon law which determined the status of his relationship with his attorney, known as the attorney lien law. The Ninth Circuit held that Oregon’s lien law was different than the ones it had previously considered, holding that

Oregon law is unlike the laws of California and Alaska. In pertinent part, in fact, Oregon law mirrors Alabama law in that it affords attorneys generous property interests in judgments and settlements….In some respects, in fact, Oregon goes even further than does the Alabama law at issue in Cotnam.

[Plaintiffs subject to Alabama law have previously prevailed, based upon the state’s lien law in a key case from 1959 called Cotnam v. Commissioner.] Based on this ruling, Banaitis was not required to pay taxes on Merten’s portion of his award.

Many plaintiffs who have lost this issue and who have accordingly been forced to pay taxes on their attorney fee awards have petitioned the Supreme Court to hear their cases; however, despite numerous requests, the Court has previously declined to intervene, even though there were circuit splits that caused different results for different individuals, depending on where they lived. What is different about these cases? Quite simply, the IRS lost, and accordingly petitioned the Supreme Court for review. Court watchers know that when the government seeks review, it is more likely to get it. (See Court Revisits Tax on Contingency Cash) The IRS has resisted these adverse rulings tooth-and-nail for years, and instructs their staff on how to interpret the adverse rulings in the most restrictive fashion (see their Field Enforcement Manual if you don’t believe me, especially Chapter 3’s “Amount to be Included in Income.“)

What does this cert grant mean? An oft-repeated maxim is that “the Supreme Court doesn’t take cases to affirm them.” From that, one could conclude that the Court is poised to overturn the precedents in Banks and Banaitis, as well as the few other precedents around the country favoring workers who receive awards. However, this isn’t always true: the Supreme Court does sometimes affirm decisions from the circuits below — even the “liberal” 9th Circuit, so we shouldn’t assume that the cert grant spells instant doom for American workers. The government obviously wasn’t petitioning to have the cases heard that it won, so the existence of the circuit split coupled with the government’s petition may have carried more weight. The Court could also be taking the case to resolve the appropriate theory for analysis, even if it were to rule in favor of workers: Banaitis’ case hinges on state attorney lien law, while Banks’ case involves the “joint venture” theory. It would certainly be preferable to win on Banks’ terms, so that it is not necessary to change the lien law in multiple states, and so that a taxpayer’s outcome is not dependent on where he or she lives, instead of the nature of their case. The Banks theory would apply to the attorney-client contingency fee relationship, which is quite common throughout the country. After Banaitis, Oregon’s neighboring state Washington has changed its lien law to protect plaintiffs, but this sort of successful outcome cannot be guaranteed everywhere.

Many groups, including NELA and Workplace Fairness, are likely to weigh in as amicus on this matter, and so we have the opportunity to have the voice of the nation’s leading experts on this issue before the Court, when the matter is briefed and argued in the months to come. Since the Court is about to stop holding oral arguments for this year’s Term, the case will be argued in the fall, with a decision coming no later than late June 2005 (and quite possibly sooner.) So will that age discrimination case, Smith v. Jackson, Miss., which will be the subject of a future blog entry.

Plaintiffs don’t have to hold their breaths until then, however; legislation exists that if passed, could render this issue irrelevant (or at least confined to a few tax years). You’ve been asked many times to contact Congress in support of the Civil Rights Tax Relief Act, and if you haven’t yet done so, this is as good a time as any. Otherwise, it is likely that in April 2004 and April 2005, many more plaintiffs will have to pay taxes while awaiting the Supreme Court ruling, when an act of Congress could resolve their problem without waiting for the Court’s decision. There currently exists an opportunity to get tax relief passed, as part of the JOBS bill currently under consideration, and while that legislation is currently stalled, it could move again at any time. So write your letter today by clicking below:

Take Action Now: Stop Taxing Discrimination Awards Unfairly!

Additional News Articles on the Supreme Court Tax Cases:

New York Times: Supreme Court to Review Tax Dispute Over Judgments

The Oregonian: High Court Accepts Tax Case from State

Dallas Morning News: High Court Will Review Taxes on Lawsuit Awards

The Recorder (subscription required): Supreme Court to Decide Two Key Employment Cases

(features quotes from Bruce Fredrickson and Angie Dalfen of NELA)


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