Late last year, when a measure to reduce the taxation of plaintiffs’ discrimination awards by eliminating taxation of attorneys’ fees was passed, those currently in legal battles against their employers, and the advocates who represent them, had a reason to celebrate. No longer would their victories run the same risk of being completely undone by taxation. Even then, however, the celebration was tempered by the measure’s lack of retroactivity, which meant that cases won or settled before the new law’s effective date still faced an excessive tax burden. Any hope of undoing that burden for those still subject to it faded considerably on Monday, when the U.S. Supreme Court issued its ruling in Commissioner v. Banks. In ruling unanimously against the plaintiffs in Banks, the Court essentially adopted a “tough luck” approach: if your case didn’t settle or go to trial after the new law went into effect, sorry, you’re out of luck.

As reported here, those who attended the oral argument before the Court in November were hopeful that the ruling would come down differently. Plaintiffs Banks and Banaitis, as well as other amicus (friends of the court) groups, had presented a variety of seemingly persuasive theories which appeared to have influenced the Court’s questioning, and the attorney representing the IRS was grilled about the impact of the law on plaintiffs such as Banks and Banaitis, as well as others such as Cynthia Spina, who faced losing the entire amount of her award and then some to the onerous tax laws governing her situation. (See Los Angeles Times article.) But it was not to be.

In an 8-0 decision (the Chief Justice, William Rehnquist, had previously announced that due to illness he would not participate in November cases where he was not needed to break a tie) written by Justice Kennedy for the Court, it held that: 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. This ruling reversed rulings of the 6th and 9th Circuits which had previously ruled to the contrary.

In so ruling, it seemed that the Court was unwilling to overturn long-standing principles of tax law, even when those principles squarely undermine the purposes of the civil rights laws. The principle at stake in the Banks case was the “anticipatory assignment of income” doctrine, which is the basic principle that if you, the taxpayer, are slated to receive an economic benefit, you can’t avoid taxation on that economic gain by assigning it to someone else. So plaintiffs who receive settlements comprised of taxable income receive an economic benefit from their attorneys’ efforts, and can’t assign that benefit in advance to their attorney (even if it ultimately ends up in the attorneys’ possession.) The Court strongly believed this was a principle not to be tampered with, referring to prior cases where it had been referred to as “a maxim we have called ‘the first principle of income taxation.'”

Plaintiffs attempted to avoid the application of that principle by dwelling on the nature of the attorney-client relationship, hoping the Court would recognize the nuanced contours of that relationship as operating outside the basic rule. The key question triggering application of the rule is whether the plaintiff “exercises dominion” over the income-generating asset. Legal and ethical principles have firmly established that a lawsuit remains under the plaintiff’s control at all times: the plaintiff ultimately determines when a lawsuit is filed, and must approve any final settlement. Without a plaintiff’s cooperation, any lawsuit is doomed, despite an attorney’s best efforts to keep cases moving forward. So while plaintiffs found it difficult to argue that the lawsuit wasn’t an asset belonging to the plaintiff, instead of the attorney, they attempted to propose exceptions.

One exception, which was the rationale behind the lower court’s ruling in Banks, is that the value of plaintiff’s asset, the ability to file a winning lawsuit, is so speculative when it is initiated. Moreover, it is only through the attorney’s labor that its value is derived. This certainly sounds persuasive in the real world, as the dismal success rate of pro se (unrepresented) plaintiffs in our system surely reflects. However, the Court found that the anticipatory assignment doctrine was not limited to cases where the value of the asset was certain rather than speculative, and often encompassed principal/agent relationships where the skill of the agent meant a better outcome than the principal could achieve alone. (One example discussed in the oral argument was that of a sports agent representing an athlete: although the athlete is the one with the marketable talent, the agent’s involvement often means the athlete’s prowess commands a higher value.)

The Court disposed of several other theories proposed by others in the case, saying that these theories had not been raised by the parties before the Court, and were thus not appropriate for consideration. Hindsight is 20-20, of course, but it is noteworthy that at oral argument, Justice Kennedy expressed his belief that the deduction for legal fees taken by plaintiffs should be considered a “above-the-line deduction” for business expenses that does not trigger the taxation morass created by taking the deduction as a “below-the-line” miscellaneous itemized expense.

A small handful of cases had previously ruled that plaintiffs were not entitled to take the deduction above the line (dollar-for-dollar against what they received in income) because they were not in the “business” of suing their employer. However, a defensible argument can be made that plaintiff’s relationship with the employer is close enough in nature to a business relationship to be characterized that way, and then there’s the patent unfairness of the defendant (often the wrongdoer, whether adjudicated that way or not) being able to fully deduct legal fees when the plaintiff cannot. Kennedy, who authored the opinion, in this ruling opined that this issue was not before the Court, as it had not been advanced by the parties before the lower courts. Reading between the lines, Justice Kennedy may have wished that it had been, however.

The opinion concludes by disposing of Banks’ argument that application of the anticipatory assignment doctrine runs counter to the purpose of provisions in civil rights statutes which award plaintiffs an additional amount to cover their attorneys’ fees (an argument advanced in the NELA amicus brief as well.) Since Banks ultimately paid his attorneys not with a fee awarded by a court, but through the operation of a contingency arrangement where his attorneys received a percentage share of his award, the Court held that he did not have standing to pursue this point, without precluding the ability of others who did receive court awarded fees to raise this point in the future.

However, the Court acknowledged that the number of people likely to do so in the future would be minimized by the passage of the American Jobs Creation Act, which meant that plaintiffs who win or settle cases after the law’s effective date of October 22, 2004, would not be burdened with the same high level of taxation faced by Banks, Banaitis, and thousands of others. In reading the opinion, one is left with the impression that the last few sentences were the rationale behind the entire opinion: since the law has been changed, we’re not going to work too hard to help the smaller number of people who missed out.

Ultimately, the Court opted for the administrative convenience of maintaining, rather than opening the door to undoing, long-existing tax principles, especially since the Court seems to consider the problem fixed now. That’s no small comfort to the thousands of plaintiffs who fought very hard to get the legislation passed, only to find that their efforts weren’t able to protect themselves after all. It’s hard to say what the Court would have done had the AJCA provision not been passed: perhaps they would have taken a closer look at Banks’ arguments. But the outcome might still have been the same, and all plaintiffs would still be paying a much higher tax burden.

The only ray of hope is either that a plaintiff who was awarded attorneys’ fees causing his or her award to be completely undone through taxation will still be able to bring their case, hopefully to be considered at some later point by the Court. That won’t help all those who settled their cases, but could conceivably help those most severely affected–those subject to negative post-litigation balances.

Or perhaps this will lend impetus to a legislative effort to create more retroactivity in the AJCA provision. There’s probably a slim-to-none chance of that happening, given Congress’ hostility to retroactive tax provisions, but any who justified the bill’s ultimate lack of retroactivity by rationalizing that the Court would take care of the others can no longer rely upon that rationalization.

Now, the messy part: what about all those plaintiffs in the 5th, 6th, and 11th Circuits (and Oregon only in the 9th) who didn’t pay taxes on their attorneys’ fees when they were received, relying on the decisions in those circuits which said that they didn’t have to do that. Those plaintiffs, and their advocates, should seek tax advice immediately on how to proceed. It’s too soon to tell how far back (and how aggressively) the IRS will go to recover unpaid taxes on damage awards, but given their efforts thus far, I think it’s fair to conclude they will be aggressive.

As a taxpayer, it will be important for you to know, from a knowledgeable expert familiar with your personal situation, how the IRS is likely to proceed. Giving that advice here is far beyond the scope of this blog (and I’m no tax attorney), but if you have tens or hundreds of thousands of dollars at stake (or any amount that you could not afford to pay back), then it’s worth it for you to spend some time and money on sound tax advice.

Unfortunately, the Court’s decision didn’t end the uncertainty faced by virtually everyone who has received a damage award in the last decade or so, unlike an opposite ruling might have done.

More Information:

New York Times: Justices Back Full Taxation of Awards

Law.com: Supreme Court: Contingent Fees Taxable to Client

SmartPros.com: U.S. Supreme Court Issues Anti-Taxpayer Ruling