Years of guarded optimism finally paid off this year, when a provision in the most recent tax legislation to otherwise plague our country contained a provision eliminating the double taxation of attorneys’ fees awards. Now there’s more room for guarded optimism, after the recent oral argument before the U.S. Supreme Court in the combined cases of Commissioner of Internal Revenue v. Banks and C.I.R. v. Banaitis. When Justice Sandra Day O’Connor refers to something as an “appalling situation,” there’s hope that the Supreme Court will take a good hard look at the situation that has been plaguing for most of the last decade those who have successfully challenged discrimination.

On October 22, some workers could breathe a small sigh of relief. On that day, the President, with little fanfare, signed the American Jobs Creation Act of 2004 while on Air Force One. (See WebCPA article.) (Perhaps that was because the Rose Garden would most likely not be large enough to host all those who had a hand in this bill’s passage…) (See Henderson Gleaner editorial, registration required.) Workers who settled cases based upon a designated set of employment discrimination and civil rights laws can now fully deduct the amount of fees they pay their lawyer, rather than in many cases having to pay taxes on that amount. (See Tax Relief Excerpt of the ARCA.) However, by its own terms, the measure applies only to fee payments made after October 22, when the law became effective due to the President’s signature.

This means that for all of the individuals who have already been forced to pay taxes on the attorneys’ fee portion of their awards, there would be no immediate relief coming from Congress. Congress and the IRS have traditionally been hostile towards the concept of making tax bills retroactive, claiming that retroactive changes are burdensome to administer. It is also very difficult to accurately project what a retroactive tax change will cost the government in lost revenue, since it is unknown how many people will learn about the change soon enough to file amended returns seeking refunds. (It is much easier to project who will newly escape paying a particular tax in the first place.)

However, there was some confusion created by Congress’ actions, and whether the new law would make the case moot. Banks’ and Banaitis’ attorneys filed a joint brief with the Supreme Court, asking for the cases before the Court to be dismissed. They told the Court that its decision would “have little or no impact on future tax disputes involving substantially the same facts.” [See Joint Supplemental Brief at p. 2] The brief also pointed out that some members of Congress believed that the impact of the law passing was simply to clarify existing law, rather than changing it. [See Joint Supplemental Brief at p. 3-4] However, the Court did not bite on this argument, at least not in advance of the scheduled oral arguments on November 1.

The oral arguments proceeded as scheduled, except as feared, the Chief Justice, William H. Rehnquist, was absent from the bench. Chief Justice Rehnquist had announced the previous week that he was undergoing treatment for thyroid cancer, and although he had also announced his intention to return to the bench on November 1, he was later forced to acknowledge that his plan to resume his active duties was “too optimistic.” [See Washington Post article.] Justice John Paul Stevens, the next most senior justice, assumed the Chief’s public duties that day (and subsequently) by swearing in the attorneys present to the Supreme Court bar and initiating oral argument.

In Banks and Banaitis’ case, the U.S. Government as the petitioner got to go first. David B. Salmons, a lawyer for the U.S. Solicitor General’s Office, was immediately peppered with questions about the Internal Revenue Service’s stance in the case. Justice O’Connor immediately questioned why the Service takes the position that attorneys’ fees income is not taxable to the plaintiffs in class action cases, but is in cases with individual plaintiffs. While Salmons responded that there is a difference in the plaintiff’s ability to control the outcome of the action (such as to make settlement decisions) between class action and individual plaintiff cases, Justice O’Connor appeared to remain skeptical.

The justices next turned to a theory posed by Professor Charles Davenport in an amicus (friend of the court) brief submitted in the case: that the attorneys fees should be considered non-taxable transaction costs, not expenses. (See Tax Analysts article (however, this article is incorrect in that the issue was raised by Justice O’Connor, not Justice Ginsburg. This mistake is unfortunately a common one, and even embarrassingly made by some oral advocates before the Court.)) Salmons, like his counterparts on the other side when their turn came later, struggled to explain why Davenport’s theory did not hold water. It appeared that at least some of the justices found Davenport’s theory persuasive, so perhaps we will see some signs of it in the Court’s opinion, since even Justice Scalia appeared through his questioning to be interested in the theory’s application.

Justice Kennedy appeared to favor considering the attorneys’ fee portion of the award an “ordinary and necessary expense” of litigation, which would make it fully deductible (an “above-the-line” deduction like that found in the new law) rather than subject to the alternative minimum tax and other limitations on deductions (a “below-the-line” deduction). While previous cases have held that since the plaintiff isn’t in the business of regularly suing his or her employer, this deduction doesn’t apply, Kennedy nonetheless appeared to believe this might be an appropriate way to address the problem.

Justice Souter appeared to be persuaded by the argument that the plaintiff’s success ultimately depends on the “skill and gumption” of the lawyer, and derives its value from the lawyer’s additional work. Later, Justice Scalia would attack this line of argument, when it was presented by Banaitis’ lawyer Philip N. Jones, calling it “like goldmining,” and claiming that a lawsuit was “not a search for buried treasure.” While this was essentially the theory adopted by the 6th Circuit in Banks (not Banaitis) below and strongly advanced by Banks and Banaitis in their briefs, it is unclear whether the Court will rule for the plaintiff on this basis. While it logically makes sense, in that it is the rare plaintiff who would be as successful without his or her lawyer’s effort than with it, Justice Scalia seemed disinclined to go that route (displaying more than a touch of animosity towards plaintiffs’ lawyers.)

The Court seemed to have the most trouble digesting the idea that a plaintiff could win at trial and still owe money to the IRS, questioning whether a taxation scheme that led to this result could even be constitutional. Justice Kennedy said this showed the IRS’ “theory was flawed,” while Justice Breyer asked whether the 16th Amendment to the Constitution permitted taxation in an amount that exceeded a plaintiff’s income. The government could only respond “go to Congress,” (as numerous plaintiffs did, ultimately with success.) Justice O’Connor wondered if the current situation violated the 5th Amendment “takings clause,” and said that this was an “appalling situation.”

The government’s lawyer was asked what became of Cindy Spina’s tax case (where a plaintiff who won $3 million at trial, but later had that award reduced, and as a result faced a tax bill of $99,000); he was forced to admit that he did not know. Unfortunately neither of the attorneys representing plaintiffs took this point up again to make clear that it was not a problem that exists just in rare, isolated cases. With the understandable reluctance of plaintiffs to come forward and voluntarily pay such an unjust tax, more than anecdotal evidence has been hard to come by, even though those who practice in this area are well aware of the types of cases that can trigger this kind of tax.

Justice Scalia asked Salmons whether the Service considered the change retroactive or not, and pointed out Congressional testimony that indicated at least some legislators believed the change merely would clarify the law. Salmons unsurprisingly responded that the Service’s position was the new law was a change rather than a clarification.

Banks’ and Banaitis’ lawyers split their argument time, with Banaitis’ lawyer Philip N. Jones of Portland, Oregon going first. Jones capably argued for the plaintiffs that when two people join together and combine their resources to generate income, that this income should not be taxed twice. The justices began submitting hypothetical examples, however, to test this theory. Justice Kennedy asked: what about the talent scout who receives a percentage of an athlete’s proceeds? Jones attempted to distinguish the other situations, by pointing out the situations where the principal party is engaged in a trade or business, but the justices were clearly searching for a narrowly-drawn principle that would not affect other types of taxation. Jones urged the Court to narrow the scope of the assignment of income doctrine to hold that this situation fell outside its boundaries, reminding the Court that they created the doctrine in the first place. It is unclear, however, whether the Court will rule in a way that invites reconsideration of large fields of taxation, especially when the new law limits the number of people ensnared in this difficulty in the future.

Banks’ attorney, James R. Carty of Los Angeles, also struggled to pin down a principle that the Court could satisfactorily adopt. Justice Breyer, in particular, wanted Carty to “fill in the blank” with an articulation of his position that would distinguish cases where the second party does no work to earn the income. Under the Court’s typical rapid-fire questioning, it can be difficult to articulate that type of position on the spot, especially after so many hypotheticals have been presented that it becomes hard to remember what the law really is any more. The Court did not appear satisfied with Carty’s responses, but given the tenor of the rest of the questioning, perhaps they will articulate a narrowly-drawn principle that is consistent with the rest of tax law.

Salmons got one last chance to rebut some of the other side’s arguments, saying that once there’s a fee agreement, the attorney’s right to be paid transforms the relationship between the parties into a creditor/debtor relationship, entitling the Service to tax the proceeds twice. On that point, the case was submitted.

It is unlikely that we will see a decision before the beginning of the year, and it may be well into the spring before the Court rules in that case. Hopefully a decision will be made by April 15, before those ensnared in 2004 by this unjust tax have to give the IRS its pound of flesh (and then some.) Until the ruling, those who care about this issue can remain cautiously optimistic that the Court will find a way to both resolve this impossible situation and preserve some level of philosophical continuity in the tax code (if that’s worth doing at this point!)

[All quotes above are from the notes I took at oral argument on November 1, before the release of the transcript, now available here. The transcript of that day’s argument had not yet been released when preparing this entry, so I take responsibility for any errors or misquotes. In a prior version of this post, I reversed the names of the respondents’ attorneys. This has now been corrected.]

For more information:

Pittsburgh Post-Gazette: Supreme Court hears case on taxability of some legal fees

law.com/National Law Journal: Supreme Court Reviews Taxes on Contingency Fees

ABANet: Supreme Court Briefs