Amicus Curiae Brief — Commissioner v. Banks

Nos. 03-892 and 03-907

IN THE

Supreme Court of the United States

COMMISSIONER OF INTERNAL REVENUE, Petitioner,

Uv.

JOHN W. BANKS, Respondent.

COMMISSIONER OF INTERNAL REVENUE, Petitioner,

vU.

SIGITAS J. BANAITIS, Respondent.

On Writs Of Certiorari to the

United States Courts of Appeals

for the Sixth and Ninth Circuits

AMICUS CURIAE BRIEF OF THE

ASSOCIATION OF TRIAL LAWYERS

OF AMERICA

IN SUPPORT OF RESPONDENTS

Topp A. SMITH JEFFREY ROBERT WHITE *

1050 31st St., N.W. Center for Constitutional

Washington, DC 20007 Litigation, P.C.

(202) 965-3500 1050 31st St., NW

President, Washington, DC 20007

The Association of (202) 965-3500 -

Trial Lawyers *Counsel of Record

of America Attorney for Amicus Curiae

TABLE OF CONTENTS

TABLE OF AUTHORITIES....... iii

IDENTITY AND INTEREST OF

AMICUS CURIAE. ee |

SUMMARY OF THE ARGUMENT........ 2

ARGUMENT ......... ; 5

I. TAXATION OF ATTORNEY FEES AS

INCOME TO CLIENTS IS UNFAIR AND

UNDERMINES THE PURPOSES OF

STATE AND FEDERAL LAWS. Mitintnameall

A. Treatment of Attorney Fees Income

To Both Client and Attorney

Results in Unfair Double Taxation

of Damages Received on Account of

Nonphysical Injury ; 5

B. Inclusion of Attorney Fees As

Income to Plaintiffs In Nonphysical

Personal Injury Cases Undermines

the Purpose of Federal and State

Laws. 10

1. Unfair Taxation Hinders States’

Ability to Enforce Their Own

Subtantive Tort Laws. .............ccccccssccesseeseees 10

2. Excessive Taxation Undermines the

Objectives of Federal Law6...................:..+++: 12

3. The Include-Deduct Tax Treatment

of Attorney Fees Unnecessarily

Increases the Costs of Settlements. .............. 15

ii iii

II. THE IRS POSITION IS BASED ON AN TABLE OF AUTHORITIE

ERRONEOUS APPLICATION OF THIS Oo S

COURTS JUDICIAL DOCTRINES CASES

REGARDING INCOME. ....ccccceseeees 17 Ab Lightolier 1

rams v. ’

A. The Assignment of Income Doctrine 1995)........ weit aa, SUES SE06 OS Cle. 15

2 Does Not Apply To Attorney ETS tc Cpe gga epmeeemenemeammeenaee

Agreements. ae 17 Albemarle Paper Co. v. Moody, 422 U.S. 405 (1975)13

B. Characterizing Attorney Fees as Alexander v. IRS, 72 F.3d 938 (1st Cir.1995).......8, 17

Satisfaction of a Debt Does Not Alyeska Pipeline Services. Co. v. Wilderness Soc'

Support Include-Deduct Tax 421 U.S. 240 (1975) ooecccccsssccssssscesessssnssssseeseeee ”” 21

atment.... — . ee

Appalachian Elec. Power Co. v. United States, 158 F.

C. Include-Deduct Tax Treatment Is Supp. 138 (Ct. Ct. 1968) ..........ssssssssssssssssssensecesseees 27

Not Required To Avoid Favoring Banaitis v. Mi ans

Contingency Fees Over Hourly naitis v. Mitsubishi Bank, Ltd., 129 Or. App. 371,

ay ; “ccoseee 22 879 P.2d 1288 (1994)................. neteiiisinmttnesiesnsneed 5

II]. DAMAGES RECEIVED ON ACCOUNT — v. Commissioner, 340 F.3d 1074 (9% Cir.

OF PERSONAL IN. JURY ARE ). TIT I IIIT IIIT IIIT TTT TTT TTTTTTTTTTre errr rere eee Tere 5

PROCEEDS OF A DISPOSITION OF | Banks v. Commissioner, 345 F.3d 373 (6% Cir. 2003).

PROPERTY, FROM WHICH ___ _——Ci—C:—sC=—:=—=—_RRREEEEEEEEEEEEEEARRHHRRRHRRHHHHHetERennnnneneeeeeenenennnnecessnaaatenteenens 5

ATTORNEY FEES ARE SUBTRACTED Banks v. Commissioner, T.C. Memo. 2001-048 (Tax

As A CAPITAL EXPENSE. ....++s0e000 23 a ncsnesmnons 26, 29

A. A Judgment or Settlement of a Benedum v. Granger, 180 F.2d 564 (3™ Cir. 1950) ..27

Personal Injury Cause of Action Is ,

A Disposition of Property. 94 = : Third Ave. Ry. Co., 155 N.E. 58, 61 (N.Y. -

B Capitalization of Attorney Fees Blaney v. International Ass'n of Machinists &

Does Not Violate The “Source of the

Claim” Doctrine. Aerospace Workers, 55 P.3d 1208 (Wash. Ct. App.

28 Th 16

CONCLUSION... soveee 30

CLUSIO Christiansburg Garment Co. v. EEOC, 434 U.S. 412

ELS AT 13

Coady v. Commissioner, 213 F.3d 1187 (9th Cir.

2000), cert. denied, 532 U.S. 972 (2001)

iv

Commissioner v. Glenshaw Glass, 348 U.S. 426

(( een 17

Commissioner v. Golonsky, 200 F.2d 72 (3™ Cir.

BIE... xcccoccssescnscutensesnssenttsnnentiimmentenimenmanemenenenatl 27

Commissioner v. Schleier, 515 U.S. 323 (1995).......... 6

Copeland v. Marshall, 205 U.S. App. D.C. 390, 641

A E cccscstecetentemennemenmemmennemnnens 14

Estate of Clarks v. United States, 202 F.3d 854 (6th

ee 19

Farmer v. Carpenters, 430 U.S. 290 (1977)...........++- 11

Flannery v. Prentice, 28 P.3d 860 (Cal. 2001).......... 15

Goodman v. Lukens Steel Co., 482 U.S. 656 (1987) .12

Hantzis v. Commissioner, 638 F.2d 248 (1st Cir.

TTI, scccsccscesesesinsiciisseititnittetlaiaamteactiliaiaelitaianmailidiieaill 17

Helvering v. Horst, 311 U.S. 112 (1940)............. 18, 19

Herbert’s Estate v. Commissioner, 139 F.2d 756 (3rd

ie, THI cncnccnsssnineoiniiiniimiienananeiatnieniaiaadaiiemamainal 27

INDOPCO, Inc. v. Commissioner, 503 U.S. 79

ITT cccnnsnnnsnniiiininsiitiinatnestaieeatiemeummeeeanmiaiaaaelil 25, 28

International Paper Co. v. Ouellette, 479 U.S. 481,

arene eee 11

Jalali v. Root, 109 Cal.App.4th 1768, 1 Cal. Rptr. 3d

0 EAE eee 17, 18

Jeffrey v. United States, 261 B.R. 396 (2001)........... 25

Kenseth v. Commissioner, 114 T.C. 399

TTI ccncsnsiitiensttabainiiatiieiiieeamaminiaddiammaniiiaduadl 8, 18, 22

Logan v. Zimmerman Brush Co., 455 U.S. 422

EIT csnpcsandenisneensnanenaeumneetaimaaiemenmeenieimniaieemmeniiaail 25

Lucas v. Earl, 281 U.S. 111 (1930)..................... 18, 19

v

Marek v. Chesny, 473 U.S. 1 (1985).........cccccceccceeeeee 15

Martinez v. California, 444 U.S. 277 (1980)............. 25

McCulloch v. Maryland, 17 U.S. (4 Wheat.) 316

eee iseahesnitinseainesiitiilipisiaraneciintaiataataeaasiaaiaaaiaesiitiataaiial 12

McGinnis v. Kentucky Fried Chicken, 51 F.3d 805

SE eee nrnntibcennnerscitniaeennnsarnatinineninipieinedecmae 15

Newman v. Piggie Park Enterprises Inc., 390 U.S.

Gy ie ininencdininninerienseniantinciniamaiansemasiilintassiaeial 13

O’Gilvie v. United States, 66 F.3d 1550 (10th Cir.

TE cncecsunsensnntsnenemstnmnatneabaniasibaiiiedtiiinasilstsiael 6

Old Colony Trust Co. v. Commissioner, 279 U.S. 716,

ay eae hcerieinecitncicnttciininmssiiiapiamainantasaiaeesineamtinsieadl 20, 21

Pennsylvania v. Delaware Valley Citizens’ Council for

Clean Air, 478 U.S. 546 (1986)..............ccccccceeseeeeee 15

Porter v. United States Agency for International

Development, 293 F. Supp.2d 152 (D.D.C. 2003)..16

Ray v. Commissioner, 18 T.C. No. 52 (1952)............ 27

Riverside v. Rivera, 477 U.S. 561 (1986) ..9, 13, 22, 23

Sinyard v. Commissoner, 268 F.3d 756 (9th Cir.

Sui al varnennntnenniennsnescsniniennniensninnmimiaait 15, 17, 18, 21

Siple v. Commissioner, 54 T.C. 1 (1970).............00000. 26

Spina v. Forest Preserve Dist. of Cook County, 207 F.

Supp. 2d 764 (N.D. Ill. 2002)................ccccccescsseeeeeees 9

Spina v. Forest Preserve Dist. of Cook County, No. 98

C 1393 (D. Il., July 30, 2002) .................cccceseseseseees 9

Srivastava v. Commissioner, 220 F.3d 353 (5th

Sou NGae el cansennsasscnninenensinnnicensdtintiinainnainentetaiog’ 10, 20

United States v. Bayse, 410 U.S. 441 (1973) ............ 18

United States v. Burke, 504 U.S. 229 (1992), .6, 12, 13

vi

United States v. Gilmore, 372 U.S. 39 (1963)..........- 28

Ward. v. Commissioner, 20 T.C. 332 (1953)........-.++. 23

Woodward v. Commissioner, 397 U.S. 572

(ROTO .accrcccecccceccccccscssceceseccossosssocssossssssonsosonosees 25, 29

STATUTES

Internal Revenue Code, 26 U.S.C.:

§1, Note .........:c.sccsesssssseersesseensssensnesenssenssnnssnnannnannnens 7

§ BG(DM LMA). ....-..cceceeeeesersseneeeensnenennanecnsnnanennsnannens 7

§ Ga) ......ccceceeceeccsecsvssssenrennssnsensnscsnessvsnsssnennsnnsonees 17

§ G7(a).......eceeccersscssscossssssscerensenssnsscssssenssssnrsnnensensenees 7

§ 104(a)N2).......-cceeccecceseeeserseeesenssssneseesnnssnnsneseneneasnenens 6

© 1GB .....c.eccseccesccsecsserscosssensecsseesenssessoosssonsosooess 28, 29

B BID ...cccccecccecrecrecccscoscosscosscssessecsssssosssossossooooess 28, 29

BLOOD ........cccccccersseccescccssecssevcseresssessssssoossossossess 24, 25

§ 101 ........cccecccocserssessesscccsrecsesresssssssssonsoosscosoosessoss 24

§ 101G ............ccccrcosscsccssescseersensenssnssssssnssenssnsssosensess 24

© ABBA ....eccccoceccccceecreceseccsevssesesessssesssossoossoossosososoosees 26

42 U.S.C. § 1988(b) (Civil Rights Attorney's Fees

Awards Act of 1976)............:cccccsseeeereeeeeeeeeneeneeseene 13

42 U.S.C. § 2000e-5(k) (Civil Rights Acts of 1964) ..13

42 U.S.C. § 3612(p) (Fair Housing Act)................+++. 13

42 U.S.C. § 12205 (Americans With Disabilities Act

, 13

42 U.S.C. § 19731 (e) (Voting Rights Act

Amendments of 1975). ...........c-:eesseseeeeeeneeseenerenes 13

Small Job Protection Act of 1996, Pub. L. No. 104-

188, § 1605(a), 110 Stat. 1755, 1838 (1996) ........... 6

OTHER AUTHORITIES

“Outrageous Injustice,” Newsday, Aug. 17, 2002. .....9

American Bar Association, TOWARDS A

JURISPRUDENCE OF INJURY (1984) .00......0cccccccceeeee 11

Cooter, Robert D., Economic Analysis of Punitive

Damages, 56 So. Cal. L. Rev. 79 (1982) ........cc0000.. 11

Internal Revenue Manual (2000).......0......ccccccceceseees 25

Internal Revenue Service, “Selling your Home,” Pub.

Seen tsheninsiitnsniintiadinananinatnendiatitintiniatid stain! 24

Internal Revenue Service, Market Segment

Specialization Program Audit Guide for Lawsuit

Awards and Settlements (Doc. 2001-2574). ............ 7

Internal Revenue Service, Priv. Ltr. Rul. 98-09-053

Ss Ba i rresirtciccarinceititcnieniiasiniiciniaaitieaariats biatateaeiatiand 7

Keeton, W. Page et al., PROSSER AND KEETON ON THE

LAW OF TORTS (5th ed. 1984) .0.0......ccccccscceceeceseseee 11

Liptak, Adam, “Tax Bill Exceeds Award To Officer in

Sex Bias Suit,” N.Y. Times, Aug. 11, 2002............. i)

McKechnie, William S., MAGNA CARTA (2d ed. 1914)

Forbes, Apr. 1, 2002

putonenniabonsnenntuitenssitiataanpeasimesiaiaiininil 8

MERTENS LAW OF FEDERAL INCOME

Se cnttgertdtinnenidhiniiineiiiiiiiiatebeteiaiiadl 6, 28, 29

Morris, Clarence, Punitive Damages in Tort Cases,

46 Harv. L. Rev. 1173 (1931).........cccccccccceccessecseeees 11

Morse, Edward A., Taxing Plaintiffs: A Look At Tax

Accounting For Attorney's Fees and Litigation

Costs, 107 Dick. L. Rev. 405 (2008)................. 14, 26

National Taxpayer Advocate, Annual Report to

Congress, Pub. 2104 (Rev. 12-2002), ............00++ 8,17

Sager, Laura and Stephen Cohen, How the Income

Tax Undermines Civil Rights Law, 73 So. Cal. L.

RD OO —————————————S 7,8

Silver, Charles, Due Process and the Lodestar

Method: You Can’t Get There From Here, 74

Tulane L. Rev. 1809 (2000) ...............ccccceeeeeeeeeeenees 23

Silver, Charles, Unloading The Lodestar: Toward A

New Fee Award Procedure, 70 Tex. L. Rev. 865

Nos. 03-892 and 03-907

IN THE

Supreme Court of the United States

COMMISSIONER OF INTERNAL REVENUE, Petitioner,

v.

JOHN W. BANKS, Respondent.

COMMISSIONER OF INTERNAL REVENUE, Petitioner,

Uv

SIGITAS J. BANAITIS, Respondent.

AMICUS CURIAE BRIEF OF THE

ASSOCIATION OF TRIAL LAWYERS

OF AMERICA

IN SUPPORT OF RESPONDENTS

IDENTITY AND INTEREST OF AMICUS CURIAE

The Association of Trial Lawyers of America

(“ATLA”] respectfully submits this brief as amicus

curiae. The parties have filed letters of consent to the

filing of this amicus brief with this Court.1

ATLA is a voluntary national bar association

whose approximately 50,000 trial lawyer members

primarily represent individual plaintiffs in civil

actions.

1 Pursuant to Rule 37.6, Amicus discloses that no counsel for a

party authored any part of this brief, nor did any person or

entity other than Amicus Curiae, its members, or its counsel

make a monetary contribution to the preparation or submission

of this brief.

2

ATLA is concerned that the tax treatment of

aitorney fees proposed by the Commissioner will

result in unfair and excessive taxation of plaintiffs in

nonphysical personal injury cases and_ will

undermine the enforcement through private civil

lawsuits of important personal rights guaranteed

under both state and federal law.

SUMMARY OF THE ARGUMEN':

1. The Commissioner asks this Court to approve the

IRS treatment of attorney fees that are incurred by

plaintiffs who receive damages in nonphysical

personal injury cases. The Commissioner asserts

that legal fees must be included in gross income and

deducted as miscellaneous itemized deductions.

Although a number of lower courts have agreed with

the Commissioner, this include-deduct method

results in unfair taxation and undermines

substantive state and federal law.

Miscellaneous itemized deductions are not

fully deductible, and, where the alternative

minimum tax is triggered, are not deductible at all.

As a result, plaintiffs are taxed on amounts they did

not receive and over which they had no dominion or

control. Although the cases before the Court involve

contingency fees, the IRS has applied this treatment

to court-awarded fees under fee-shifting statutes,

which permit fees in excess of monetary awards. In

some cases, a victim of discrimination who “won” in

court has owed more in taxes than the net recovery.

This draconian result is not only unfair to the

affected taxpayers; it also undermines the purposes

of state and federal laws protecting personal rights.

The prospect of excessive tax liability, even to the

point of exceeding any recovery, is a powerful

disincentive to seeking vindication of rights in court.

3

It undermines the legitimate interests of the States

in enforcing their own tort laws, a result Congress

did not intend. And it undermines the intent of

Congress to rely on private lawsuits to eradicate

discrimination and to assure legal representation to

the victims of discrimination by authorizing court-

awarded attorney fees.

The include-deduct method also undermines

congressional purpose by making good faith

settlement of such claims more complicated and

expensive for plaintiffs and defendants alike.

2. The Commissioner does not base the include-

deduct treatment of attorney fees on specific Code

provisions, but on an interpretation of judge-made

doctrines. It is clear that the assignment of income

doctrine does not apply to contingency fee

agreements. The doctrine preserves the graduated

structure of the income tax by barring an assignment

of income by the person who earned it to a lower

bracket donee. It does not result in allocating the

income to both.

Most importantly, the doctrine applies to

taxpayers who retain an income-producing asset

while redirecting the stream of income produced. In

this case, the taxpayers’ causes of action are not

income-producing. They relinquished their claims

entirely in exchange for money. The appropriate tax

rules are those governing the disposition of property.

Nor is the payment of fees a repayment of a

debt owed by the client to the attorney. Under a

contingency fee agreement, no pre-existing debt

exists. Moreover, court-awarded fees satisfy a debt

owed by the defendant, not the client.

4

The include-deduct method is not required to

avoid a tax incentive favoring contingency fee

arrangements over hourly-rate payment. For

compelling non-tax reasons, few individuals pay

attorneys by the hour to pursue nonphysical personal

injury claims. Plaintiffs cannot afford such hourly

fees, as Congress itself recognized. Contingency fees

also shift the risk of loss to the attorney, and align

the attorney’s interest with that of the client.

3. Damages received on account of personal injury

constitute the proceeds of disposition of property. An

unliquidated cause of action is a species of property.

Under the Code, it is “intangible personal property”

which can be bought, sold or assigned. In fact,

taxpayer Banks in this case purchased his cause of

action. A cause of action also qualifies as a capital

asset under the Code. The taxpayer’s release or

relinquishment of a cause of action in exchange for a

monetary award or settlement comes within the

broad definition of a “disposition” of property. The

proper treatment of legal fees is as a capital expense,

subtracted from the proceeds of the settlement or

award, not as a deduction.

This capitalization of legal fees does not offend

the “origin of the claim” test, which governs

deductions from income for legal fees related to

income-producing assets. The test does not address

the antecedent question of whether taxpayer has

income in the first place. The test does not apply to

the disposition of property, where the general rule is

that legal fees are a capital expense. Subtracting

attorney fees to arrive at gross income does not lead

to lead to conversion of that income from ordinary to

capital gain.

5

ARGUMENT

I. TAXATION OF ATTORNEY FEES AS INCOME

To CLIENTS IS UNFAIR AND UNDERMINES

THE PURPOSES OF STATE AND FEDERAL

LAWS.

A. Treatment of Attorney Fees Income To

Both Client and Attorney Results in

Unfair Double Taxation of Damages

Received on Account of Nonphysical

Injury.

Taxpayer Sigitas Banaitis, a bank vice

president, brought suit against the bank and its new

owner, alleging wrongful discharge, interfering with

his employment agreement, and punishing him for

refusing to disclose confidential information of the

bank’s customers. An Oregon state court jury agreed

and awarded Banaitis compensatory and punitive

damages. The court of appeals upheld the jury’s

verdict. Banaitis v. Mitsubishi Bank, Ltd., 129 Or.

App. 371, 879 P.2d 1288 (1994). The parties reached

a settlement totaling $8,728,599. Of that amount,

$3,864,012 was paid directly to Banaitis’s attorneys,

pursuant to their contingency fee agreement with

Banaitis. Banaitis v. Commissioner, 340 F.3d 1074,

1077-78 (9% Cir. 2003).

Taxpayer John W. Banks, brought suit against

his former employer, the California Department of

Education, alleging he was fired in violation of Title

VII, 42 U.S.C. § 1981, and 42 U.S.C. § 1983. During

the trial, the parties settled. DOE paid $464,000 to

Banks, who paid $150,000 to his attorney pursuant

to their contingency fee agreement. Banks v.

Commissioner, 345 F.3d 373, 375-76 (6% Cir. 2003).

6

In both instances the Commissioner issued a

notice of deficiency, asserting that the taxpayers

were required to include the amount paid to their

attorneys in gross income. Banaitis at 1078; Banks

at 382. As a result, taxpayers’ liability was

substantially increased. Their situation is hardly

unique.

Prior to the mid-1990’s, I.R.C. § 104(a)(2),

which excluded from income “damages received .. .

on account of personal injuries,” was widely viewed

as encompassing such nonphysical harms as

employment discrimination. See Commissioner v.

Schleier, 515 U.S. 323, 338-39 (1995) (O’Connor, J.,

dissenting). Even as this Court set forth a more

restrictive reading of that section in Schleier and in

United States v. Burke, 504 U.S. 229 (1992), the

Court indicated that taxable damages in such cases

excluded attorney fees. In O'Gilvie v. United States,

519 U.S. 79 (1996), the Court held that the “net

proceeds” of plaintiffs punitive damages claims were

not excluded under I.R.C. § 104(a)(2).2 See 6

MERTENS LAW OF FEDERAL INCOME TAXATION §

24A:42.12 (Supp. 2001). See also id. at § 24A:42.12

n.24 (citiig lower federal court opinions treating

punitive damages, net of attorney fees, as taxable

income).

Shortly thereafter, Congress amended the

Code to exclude only damages received on account of

_ “physical injuries.” Small Job Protection Act of 1996,

Pub. L. No. 104-188, § 1605(a), 110 Stat. 1755, 1838

(1996); I.R.C. § 104(aX(2) (1997). As a result, many

2 The lower court opinion makes clear that the “net proceeds”

were net of attorney fees and expenses. See O’Gilvie v. United

States, 66 F.3d 1550, 1552 (10th Cir. 1995).

7

types of tort or tort-like damages involving

nonphysical harm under state and federal law were

no longer excluded from income.

The IRS quickly took the position that

plaintiffs income in such cases should also include

fees paid to plaintiffs attorney under a contingent

fee agreement. See Priv. Ltr. Rul. 98-09-053 (Dec. 2,

1997). Such fees, the IRS maintained, should be

treated as miscellaneous itemized deductions under

I.R.C. § 67(a). The Service has targeted such

taxpayers for enforcement attention. See generally,

Internal Revenue Service, Market Segment

Specialization Program Audit Guide for Lawsuit

Awards and Settlements (Doc. 2001-2574).

Taxpayers would not be significantly harmed

if the included attorney fees were fully deductible.

But they are not. ILR.C. § 67(a) sets a floor,

permitting deductions “only to the extent that the

aggregate of such deductions exceeds 2 percent of

adjusted gross income.” They are also subject to a

phase out when adjusted gross income exceeds the

applicable amount — $142,700 ($71,350 for a married

individual filing separately) in 2004. I.R.C. §1, Note.

The combined effect of these limitations is to

increase the taxpayer’s effective marginal tax rate

significantly. Laura Sager and Stephen Cohen, How

the Income Tux Undermines Civil Rights Law, 73 So.

Cal. L. Rev. 1075, 1085 (2000).

Worse yet, the taxpayer may be denied any

deduction at all for legal fees where the Alternative

Minimum Tax is triggered. The AMT imposes rates

of 26 or 28%, and “[n]o deduction shall be allowed for

any miscellaneous itemized deduction.” I.R.C. §

56(b\(1(AXi) (2000). As one Tax Court judge stated,

applying the AMT in this situation “can raise

8

effective tax rates to hardship levels.” Kenseth v.

Commissioner, 114 T.C. 399, 419 (2000) (Chabot, J.,

dissenting). In fact, notes Judge Beghe, dissenting in

the same case, where total legal fees exceed about

72% of gross recovery, the tax can exceed plaintiffs

net recovery. Id. at 425-26 n. 17 (Beghe, J.,

dissenting). See also Sager & Cohen, supra, at 1076-

78.

For example, the taxpayer in Alexander v.

IRS, 72 F.3d 938, 946-947 (1st Cir.1995), obtained a

favorable settlement oof her employment

discrimination suit. However, legal fees and the high

costs of her court battle left her with a net recovery

of only $5,000, but a tax bill of $53,900. Sager &

Cohen, supra, at 1078 & n.15. Similarly, in Coady v.

Commissioner, 213 F.3d 1187 (9th Cir. 2000), after

prevailing in her bench trial on her claim that she

was wrongfully discharged, Mrs. Coady was left with

a tax liability greater than her net recovery, telling a

reporter, “I won the battle, but I lost the war.” Brigid

McMenamin, “The Lawyers Did Just Fine,” Forbes,

Apr. 1, 2002, at 80.

Such outcomes prompted the office of the

National Taxpayer Advocate, within the IRS, to state

that the include-deduct method “deviates from the

concept of taxing net income” and does not bring

about a fair result for taxpayers in nonphysical

personal injury cases. National Taxpayer Advocate,

Annual Report to Congress, Publication 2104 (Rev.

12-2002), p. 166. The Taxpayer Advocate added, “The

result would be the same whether the attorney’s fee

arose from a contingent fee agreement or a court-

ordered award.” Jd. at 162.

In fact, the unfairness of the Commissioner's

inelude-deduct theory is even more egregious in such

9

cases because court-awarded fees may, for good

reason, well exceed the monetary award to the

plaintiff. Riverside v. Rivera, 477 U.S. 561, 574

(1986). Nevertheless, the IRS has applied its theory

to court awarded fees under federal fee-shifting

statutes

One such case that came to national attention

is that of police officer Cynthia Spina. For eight

years, she endured a campaign of sexual harassment

by her coworkers and superiors. Sexual rumors were

spread through her workplace, pornography

repeatedly was placed on her desk, her tires were

slashed, she was passed over for assignments and

promotions, and fellow officers refused to back her up

in dangerous situations. See Spina v. Forest Preserve

Dist. of Cook County, 207 F. Supp. 2d 764 (N.D. Ill.

2002). She prevailed in a hard-fought sex

discrimination and harassment lawsuit under Title

VII. The damage award was $300,000, and attorney

fees and costs totaled almost $1,000,000. Spina v.

Forest Preserve Dist. of Cook County, No. 98 C 1393

(D. Iil., July 30, 2002) (granting plaintiffs fee

petition). Because the IRS required Spina to report

the court-awarded fee as income, according to her

lawyer,’ “She loses every penny of the award plus

she will end up owing the Internal Revenue Service

$99,000.” Adam Liptek, “Tax Bill Exceeds Award To

a in po Bias Suit,” N.Y. Times, August 11,

» at Al2. See also “Ou justice,”

Newsday, Aug. 17, 2002. —

The prospect that a “victorious” plaintiff may

be required to pay for the privilege may lead some

3 Ms. Spina was represented by ATLA member Monica

McFadden, of Chicago. ” =

10

Americans to believe that their government has

taken back the promise that was wrested from King

John in 1215: “To no one will we sell, to no one will

we refuse or delay, right or justice.” William S.

McKechnie, MAGNA CARTA 395 (2d ed. 1914). Many

will simply decide that they cannot afford justice.

B. Inclusion of Attorney Fes As Income to

Plaintiffs Im Nonphysical Personal

Injury Cases Undermines the Purpose of

Federal and State Laws.

1. Unfair Taxation Hinders States’ Ability to

Enforce Their Own Subtantive Tort Laws.

The harm caused by Commissioner's include-

deduct treatment of attorney fees in personal injury

cases is not limited to the unfairness to individual

taxpayers like those before this Court. Obviously, the

threat that the IRS will take an excessively large

bite out of the net recovery is a powerful disincentive

to those who may seek to vindicate their rights.

Without private enforcement, personal rights

protected by state and federal law may become

hollow promises.

Few of the reported cases addressing this

issue involve plaintiffs like Banaitis, asserting rights

under state law.‘ See e.g., Coady v. Commissioner,

213 F.3d 1187 (9th Cir. 2000), cert. denied, 532 U.S.

972 (2001) (wrongful discharge); Srivastava uv.

Commissioner, 220 F.3d 353 (5th Cir. 2000)

4 Banaidis’s underlying lawsuit was based on state tort rules

protecting not only employment relationships, but also the

confidentiality of trade information, as the jury's special verdict

reflects. See 340 F.3d at 1077.

11

(defamation). Nevertheless, most tort law is state

law. Approval of the Commissioner’s tax treatment of

fees in nonphysical personal injury cases will affect

plaintiffs in a wide variety of state tort actions, such

as invasion of privacy, false. imprisonment,

intentional infliction of emotional distress, and

causes of action created by state statute.

The purpose of substantive tort law is not only

to make whole the victim, but also to deter

misconduct and prevent such harms in the first

place. See American Bar Association, TOWARDS A

JURISPRUDENCE OF INJURY 4-3 (1984) (deterrence of

misconduct is “a strong thread running through tort

law”); W. Page Keeton et al., PROSSER AND KEETON

ON THE LAW OF TorTs § 4 (5th ed. 1984); Clarence

Morris, Punitive Damages in Tort Cases, 46 Harv. L.

Rev. 1173, 1177 (1931) (both compensatory and

punitive damages serve tort law’s “admonitory”

function of deterring misconduct); Rebert D. Cooter,

Economic Analysis of Punitive Damages, 56 So. Cal.

L. Rev. 79, 137 (1982) (“There is now a rich body of

academic literature supporting the view that a

primary purpose of tort liability rules is to

discourage inappropriate behavior.”).

“It is beyond dispute,” this Court has

emphasized, that the States have “a significant

interest in redressing injuries that actually occur

within the State.” International Paper Co. v.

Ouellette, 479 U.S. 481, 502-503 (1987). Though the

supremacy of federal law sweeps broadly, this Court

has cautioned that the “State’s interest in applying

its own tort laws cannot be superseded by a federal

act unless that was the clear and manifest purpose of

Congress.” Id. Similarly, in Farmer v. Carpenters,

430 U.S. 290 (1977), where the Court held that the

12

NLRA did not preempt a union member's suit

against his union for intentional infliction of

emotional distress, the Court pointed out that federal

law must take into account the legitimate and

substantial interest of the State in protecting its

citizens through tort liability. Jd. at 304.

Keeping in mind that “[t]he power to tax

involves the power to destroy.” McCulloch v.

Maryland, 17 U.S. (4 Wheat.) 316, 431 (1819), this

Court should reject the Commissioner’s invitation to

adopt a tax treatment of state tort damages that

undermines a State’s ability to enforce its own

substantive tort law.

2. Excessive Taxation Undermines the

Objectives of Federal Laws

Most reported cases addressing this issue have

involved taxpayers who, like Banks, succeeded in

vindicating their rights under federal civil rights

statutes. Those plaintiffs obtained legal

representation under contingency fee agreements

under which the attorney would be paid a percentage

of any settlement. Frequently, where such cases

proceed to trial, a prevailing plaintiff may move for

attorney fees under a fee-shifting statute. Taxpayer

Banks, for example, could have moved for an award

of attorney fees if the parties had not settled and

Banks had prevailed in his Title VII claims.

Without question, unlawful discrimination “is

a fundamental injury to the individual rights of a

person,” Goodman v. Lukens Steel Co., 482 U.S. 656,

661 (1987), that causes grave harm to its victims.

United States v. Burke, 504 U.S. 229, 238 (1992).

Congress enacted the federal civil rights

statutes not only to make those victims whole, but

13

also with “the central statutory purposes of

eradicating discrimination throughout the economy.”

Albemarle Paper Co. v. Moody, 422 U.S. 405, 420-421

(1975); United States v. Burke, 504 U.S. 229, 250

(1992) (O’Connor, J., dissenting). Individual lawsuits

serve as “the chosen instrument of Congress to

vindicate ‘a policy that Congress considered of the

highest priority.” Christiansburg Garment Co. v.

EEOC, 434 U.S. 412, 418 (1978), quoting Newman v.

Piggie Park Enterprises Inc., 390 U.S. 400, 402

(1968).

Congress also recognized that if plaintiffs

acting as a “private attorney general” were forced to

bear their own litigation costs, “few aggrieved parties

would be in a position to advance the public

interest.” Piggie Park, supra, at 401-02. “Congress

therefore enacted the provision for counsel fees . . . to

encourage individuals injured by racial

discrimination to seek judiciai relief.” Id.5 Courts

may properly award attorney fees in such cases in

excess of the monetary damages awarded to the

plaintiff. Riverside v. Rivera, 477 U.S. 561, 574

(1986) (upholding award of $245,456 in attorney fees

where a jury awarded damages totaling $33,350);

5 See, e.g., Civil Rights Attorney's Fees Awards Act of 1976, 42

U.S.C. § 1988(b) (“In any action or proceeding to enforce a

provision of sections 1981, 1982, 1983, 1985, and 1986 of this

title, title [IX of Public Law 92-318 . . . , or title VI of the Civil

Rights Act of 1964 . , the court, in its discretion, may allow

the prevailing party, other than the United States, a reasonable

attorney's fee as part of the costs.”’. Congress enacted similar

fee-shifting provisions in the Civil Rights Act of 1964, 42 U.S.C.

§ 2000a-3(b); Civil Rights Acts of 1964, 42 U.S.C. § 2000e-5(k);

Americans With Disabilities Act of 1990, 42 U.S.C. § 12205;

Fair Housing Act, 42 U.S.C. § 3612(p) (1994); the Voting Rights

Act Amendments of 1975, OUSL. § 1973] (e).

14

Copeland v. Marshall, 205 U.S. App. D.C. 390, 400-

410, 641 F.2d 880, 890-900 (1980) (upholding

attorney fees of $160,000 for representing a plaintiff

who recovered $30,000).

In the event of settlement, of course, fees are

generally allocated by a contingency fee agreement,

rather than court award. However, it is the prospect

of a substantial fee award that motivates defendants

to make settlement offers that will compensate both

attorney and client and, ultimately, allow victims of

discrimination to obtain competent legal

representation. Separate tax treatment of

contingency fees and statutory fee awards would

therefore be unworkable.®

This Court’s approval of the Commissioner's

include-deduct tax treatment of such fees would have

the cruelly ironic result of discouraging those with

meritorious cases from seeking judicial redress. Few

aggrieved persons are likely to pursue their claims if

this Court announces that they thereby obligate

themselves to report as income an unknown sum of

money they will never see and which could leave

6 The Commissioner states that the rule would apply only in

cases involving taxable damage awards. Brief of Petitioner at

n.5. However, the Commissioner's arguments are not so limited.

If a plaintiff prevails in a case, obtaining important injunctive

relief but nominal or no monetary damages, the fee award

would appear to have the same status under the

Commissioner's application of the assignment of income ~

doctrine or the view that the fee satisfies a debt owed by the

client to the attorney. See Edward A. Morse, Taxing Plaintiffs:

A Look At Tax Accounting For Attorney's Fees and Litigation

Costs, 107 Dick. L. Rev. 405, 481 (2003) (“consistency would

require extending similar treatment to awards under fee-

shifting statutes -- regardless of whether any monetary awards

are ultimately collected”).

15

them owing the IRS more than they recover. “This

Draconian result,” it has rightly been stated, “can

only undermine our civil rights laws.” Sinyard v.

Commissoner, 268 F.3d 756, 763 (9th Cir. 2001)

(McKeown, J., dissenting).

Moreover, this Court’s approval of the

Commissioner’s position would likely extend such

draconian results far beyond employment

discrimination cases. Congress has enacted an

estimated 150 fee-shifting statutes whose purpose is

“to enable private parties to obtain legal help in

seeking redress for injuries resultirg from the actual

or threatened violation of specific federal laws.”

Pennsylvania v. Delaware Valley Citizens’ Council for

Clean Air, 478 U.S. 546, 565 (1986). Charles Silver,

Unloading The Lodestar: Toward A New Fee Award

Procedure, 70 Tex. L. Rev. 865, 873 (1992)

(estimating 150 fee-shifting statutes); Marek v.

Chesny, 473 U.S. 1, 43-51 (1985) (Appendix to

dissenting opinion of Brennan, J., listing fee-shifting

statutes).

Many States have also adopted legislation

providing court-awarded fees. See, e.g., Abrams v.

Lightolier, Inc., 50 F.3d 1204 (3d Cir. 1995) (applying

New Jersey fee-shifting statute in connection with

employment discrimination claim); McGinnis uv.

Kentucky Fried Chicken, 51 F.3d 805 (9th Cir. 1994)

(applying Washington fee-shifting statute in

employment discrimination case); Flannery v.

Prentice, 28 P.3d 860 (Cal. 2001) (attorney fees

awarded under California's Fair Employment and

Housing Act).

3. The Include-Deduct Tax Treatment of

Attorney Fees Unnecessarily Increases the

Costs of Settlements.

16

Congress, of course, did not intend to promote

litigation for its own sake. Congress aimed to

eliminate discrimination and to make whole its

victims. Good faith settlements of meritorious claims

further this objective. However, as many trial

lawyers can attest, the include-deduct tax treatment

of attorney fees introduces additional complexity,

uncertainty, and expense into settlement

negotiations. Counsel must undertake a thorough

review of the tax impact that fees may have on the

client and adjust settlement demands upward to

avoid an unanticipated and unjust outcome.

Defendants, as a result, may expect to face more

difficult and expensive’ settlements. Tax

considerations figured into Respondent Banks’s

settlement negotiations, for example. 345 F.3d at

376.

It may also be expected that courts,

recognizing that Congress did not intend to penalize

successful civil rights claimants, will endeavor to

avoid unfair tax consequences of fee awards. For

example, in Blaney v. International Ass'n of

Machinists & Aerospace Workers, 55 P.3d 1208, 1210

(Wash. Ct. App. 2002), the court awarded plaintiff a

supplemental judgment to offset the tax

consequences of attorney fees awarded under a state

fee-shifting statute. In Porter v. United States Agency

for International Development, 293 F. Supp.2d 152,

157 (D.D.C. 2003), the district court tentatively

declined to “gross up” plaintiffs fee award to offset

potential taxes, but fashioned its award “to ensure

that the attorneys’ fee award never becomes a tax

problem for Porter.” Jd. at 157.

17

Il. THE IRS POSITION IS BASED ON AN

ERRONEOUS APPLICATION OF THIS COURT’S

JUDICIAL DOCTRINES REGARDING INCOME.

A. The Assignment of Income Doctrine

Does Not Apply To Attorney Fee

Agreements.

How does the Commissioner support a result

that even courts that accept it say “smacks of

injustice,” Alexander, supra, 72 F.3d at 946,

“unfairness,” Sinyard, supra, 268 F.3d at 760, and

creates “a terror for civil rights plaintiffs.” Jalali v.

Root, 109 Cal. App.4th 1768, 1775, 1 Cal Rptr. 3d

689, 693 (2003)?

. Oddly, apart from stressing that I.R.C. § 61(a)

includes in gross income “all income from whatever

source derived,”’? the Commissioner does not base the

7 The Court’s interpretation of this section in Commissioner v.

Glenshaw Glass, 348 U.S. 426 (1955), relied upon in Brief of

Petitioner at 15, is indeed broad, but not unbounded. The Court

used a three-prong test for determining gross income, looking to

taxpayers’ “undeniable accessions to wealth, clearly realized,

and over which taxpayers have complete dominion.” 348 U.S. at

431. It is difficult to agree that taxpayers in this case either

“clearly realized” or had “complete dominion” over the fees

retained by their attorneys which taxpayers never saw and

never had the right to spend on anything other than attorney

fees. Nor did they experience “undeniable accessions to wealth”

where neither taxpayers’ net worth nor personal consumption

were increased by the amount of the fees.

Rather, the fees fall within the basic principle that “that

a person's taxable income should not include the cost of

producing that income.” Hantzis v. Commissioner, 638 F.2d 248,

249 (1st Cir. 1981). See also National Taxpayer’s Advocate,

supra, at 166, stating that inclusion of attorney fees “deviates

from the concept of taxing net income.”

18

inclusion-deduction treatment of attorney fees in

nonphysical injury cases on provisions enacted by

Congress in the Code. Indeed, this “anomalous result

[was] no doubt unintended” by Congress. Sinyard,

supra, 268 F.3d at 759. Or, as more memorably

phrased by the California Court of Appeal, “Chalk

another one up to the law of unintended

consequences.” Jalali v. Root, supra, 109 Cal. App.

4th at 1781, 1 Cal. Rptr. 3d at 698 (2003).

The Commissioner instead relies on an

interpretation of judge-made doctrine, which has

been referred to as “the Federal common law of

taxation as adopted by the Supreme Court.” Kenseth,

supra, 114 T.C. at 432 (Beghe, J., dissenting).

Primarily, the Commissioner relies on the

“assignment of income” doctrine set forth by this

Court in Lucas v. Earl, 281 U.S. 111 (1930), and

Helvering v. Horst, 311 U.S. 112 (1940). Brief for the

Petitioner at 18-22.

Lucas arranged to have half his salary paid

directly to his wife. Horst had the interest earned by

his bonds paid directly to his son by detaching and

giving the negotiable bond coupons to his son. The

Court in both cases held that the salary or bond

interest was income to the donor.

The basic principle at work, the Commissioner

recognizes, is to ensure that income is taxed to the

person who earns it. Brief of Petitioner at 19 & 20.

The doctrine serves as a “cornerstone of our

graduated income tax system,” United States v.

Bayse, 410 U.S. 441, 450 (1973), by ignoring for tax

purposes gratuitous transfers of income from the

person who earned it to a lower-bracket donee.

19

The doctrine simply does not apply to

attorney-client fee agreements. It cannot be argued

that the attorney who secures a favorable verdict or

settlement has not earned his or her fee. Nor does

the Commissioner assert that these agreements shift

income to a lower bracket taxpayer. Moreover, the

issue resolved in Lucas and Horst was whether the

income more properly belongs to the taxpayer or the

donee. As has been noted, the assignment of income

doctrine does not result in attributing the income to

both. See Estate of Clarks v. United States, 202 F.3d

854, 857 (6th Cir. 2000).

The most crucial distinction, however, is that

Lucas and Horst were taxpayers who retained

ownership or control over an income-producing asset,

while attempting to redirect the stream of income

that was produced. Lucas did not give up his job;

Horst did not part with his bonds. As the Court in

Horst stated, “where the donor retains control of the

trust property the income is taxable to him although

paid to the donee.” 311 U.S. at 119.

Much confusion, it appears, comes from the

attempts to characterize the contingency agreement

as the transfer of the fruits of the client’s orchard or

some of its trees. See Brief of Petitioner at 29. Judge

Cardozo has warned that “[m]etaphors in law are to

be narrowly watched, for starting as devices to

liberate thought, they end often by enslaving it.”

Berkey v. Third Ave. Ry. Co., 155 N.E. 58, 61 (N.Y.

1926) (Cardozo, J.).

ATLA suggests that the significant event is

not the signing of the contingent fee agreement,

which is a nontaxable event. Rather it is the

payment of the settlement or judgment. The

Commissioner correctly states that “the settlement

20

proceeds represcut the value given in exchange for

the dismissal of respondents’ claims.” Brief of

Petitioner at.12.

Unlike Lucas and Horst, the taxpayer’s cause

of action does not produce income while he retains

ownership and control of the asset. Rather, Banks

and Banaitis relinquished their claim entirely,

agreeing to pay their counsel a percentage of the

proceeds. This, ATLA submits, is in the nature of a

sale or disposition of property.6 ATLA argues in Part

III, below, that the tax rules applicable to legal fees

in connection to such sales or dispositions should

apply.

B. Characterizing Attorney Fees _ as

Satisfaction of a Debt Does Not Support

Include-Deduct Tax Treatment.

-The Commissioner asserts that the

“relationship between the client and his attorney is

simply that of debtor and creditor.” Brief of

Petitioner at 13. The payment of attorney fees, the

Commissioner reasons, is in satisfaction of that debt,

resulting in income to the debtor-taxpayer under Old

Colony Trust Co. v. Commissioner, 279 U.S. 716, 720

(1929). Brief of Petitioner at 19.

ATLA suggests that this approach is not

useful -here, where there is no pre-existing debt.

Under a contingency fee agreement, until the

defendant makes payment in exchange for release of

the plaintiffs claim, the client owes nothing to the

lawyer.

8 Cf. Srivastava v. Commissioner, 220 F.3d 353, 359 (5th

Cir.2000) (“the doctrine does not apply to a taxpayer who

transfers, sells, or otherwise relinquishes an asset)

21

—

Constructing a debt in these circumstances

leads to anomalous results. For example, a client’s

contingency fee may amount to $10,000. It is not

uncommon for a trial lawyer in a case where high

expenses and low recovery would leave the client

with little compensation, to reduce his or her fee,

perhaps in this instance by $1,000. However,

forgiveness of indebtedness is also income to the

debtor. Under the Commissioner’s view, the clieni

would have to report as income $11,000 on an

attorney fee of $10,000.

Moreover, the creditor-debtor theory does not

address the most egregiously unfair application of

the include-deduct tax treatment: Court awarded

fees under fee-shifting statutes. Congress enacts

such statutes as an exception to the general rule that

a party is responsible for his or her own legal fees.

Alyeska Pipeline Services. Co. v. Wilderness Soc'y,

421 U.S. 240, 247 (1975). Payment of fees awarded

by the court are in satisfaction of a debt which is

debt by the defendant, not the client, to the attorney.

As Judge McKeown noted in his dissent in Sinyard,

supra, “the district court taxed attorney’s fees

against IDS. When IDS paid those fees to the

Sinyards’ attorneys, IDS satisfied its own statutory

obligation. Old Colony is inapposite.” 268 F.3d at 762

(McKeown, dissenting).

Again, the situation more closely resembles a

disposition of property. If a taxpayer sells stock and

pays the broker an agreed percentage of the

proceeds, the IRS does not view the payment as the

satisfaction of a debt owed to the broker. Rather,

broker’s commission is subtracted from the price paid

to arrive at gross income. Treas. Reg. § 1.263(a)-2(e)

(1987). As ATLA argues in Part III, below, similar

22

treatment is appropriate for fees allocable to

personal injury damages.

C. Include-Deduct Tax Treatment Is Not

Required To Avoid Favoring

Contingency Fees Over Hourly Fees.

The Commissioner’s third contention is in the

nature of a policy argument: To permit taxpayers to

exclude attorney contingency fees from gross income

would create “an artificial, a purely tax- motivated,

incentive to substitute contingent for hourly legal

fees.” Brief of Petitioner at 33, quoting Kenseth,

supra, 259 F.3d at 884.

The Commissioner’s concern is on a par with

locking the barn door to keep fish from escaping to

the river. The truth is that almost no individuals

retain an attorney in a nonphysical personal injury

case on an hourly fee basis. The reasons for this are

legitimate and entirely non-tax related. First, and

most important, many individuals simply could not

afford to pay for legal representation on an hourly

basis. Indeed, it is precisely because many aggrieved

persons “cannot afford to purchase legal services at

the rates set by the private market” that Congress

has enacted fee-shifting statutes. Rivera, supra, 477

U.S. at 576.

Second, even if a client can afford to pay by

the hour, a contingency fee agreement shifts the risk

of loss of the case to the attorney, who is generally

better equipped to bear that risk. Third, the

contingency fee assures that the lawyer’s interests

are firmly aligned with the clients: The lawyer earns

more not by billing more hours, but by obtaining

more compensation for the client. See Charles Silver,

Due Process and the Lodestar Method: You Can’t Get

23

There From Here, 74 Tulane L. Rev. 1809 (2000)

(noting a “broad consensus that percentage-based

formulas harmonize the interests of agents and

principals better than time-based formulas”).

In short, taxation of contingent fees to clients

will not motivate people to retain lawyers on an

hourly basis. Rather, they are likely to abandon

efforts to enforce their legal rights altogether.

Rivera. supra, 477 U.S. at 578.

Nor does Commissioner's policy argument

address the tax treatment of court-awarded fees,

which are hourly-based and not a matter of the

client’s choice.

Moreover, the Commissioner has not

established that attorney fees paid on a fixed or

hourly basis would necessarily be deductible if

contingent fees were excluded from income.? There

appears no reason why such fees could not receive

the same treatment. For example, in Ward. v.

Commissioner, 20 T.C. 332 (1953), the Tax Court

held that a fixed fee retainer paid to an attorney in

connection with the sale of a partnership is not

deductible, but “is to be used as an offset against the

selling price just like any other expenditure made in

connection with the sale of a capital asset.” Jd. 342

III.DAMAGES RECEIVED ON ACCOUNT OF

PERSONAL INJURY ARE PROCEEDS OF A

9 The Commissioner asserts that the taxpayers here have

conceded if they had paid their attorneys on an hourly basis the

fee “would have been an deduction from, not a reduction of”

gross income. Brief of Petitioner at 25. Commissioner provides

no citation to the record evidencing such a concession. ;

24

DISPOSITION OF PROPERTY, FROM WHICH

ATTORNEY FEES ARE SUBTRACTED AS A

CAPITAL EXPENSE.

A. A Judgment or Settlement of a Personal

Injury Cause of Action Is A Disposition

of Property.

The Commissioner supports the inclusion of

attorney fees as income to both the taxpayer the

attorney with this analogy: “[W)hen an individual

uses a portion of his salary to pay for the services of

a plumber, the same income is taxed to both the

individual and the plumber.” Brief of Petitioner at

34.

ATLA offers a different analogy that is closer

to the mark. A taxpayer who wants to sell his or her

house may retain the services of a real estate agent

on a contingent basis. If the house sells, the agent

receives a commission, perhaps 6% of the sales price.

As the IRS correctly instructs taxpayers, the gain on

the sale is the sales price minus selling expenses,

including the agent’s commission (and any legal

fees). Internal Revenue Service, “Selling your Home,”

Pub. 503, at 3-4 (2003).!°

LR.C. § 1001(a) states that the “gain from the

sale or other disposition of property shall be the

excess of the amount realized therefrom over the

adjusted basis.” I.R.C. § 1012 provides that the

“basis of property shall be the cost of such property,”

and I.R.C. § 1016 requires that “[p]roper adjustment

10 If the Commissioner's plumber installs a new water heater,

that expense is capitalized by adding it to the basis of the

property, regardless that the taxpayer used taxable salary to

pay the plumber.

25

in respect of the property shall in all cases be made

(1) for expenditures, receipts, losses, or other items,

properly chargeable to capital account.”

The proper adjustment for recovery of capital

expenditures, this Court has explained, occurs

through an offset to the selling price, rather than

deduction. Woodward v. Commissioner, 397 U.S. 572,

574-75 ( 1970) For example, attorney fees paid in

connection with the sale of stock “are an offset

against the selling price.” Treas. }

— pri Reg. § 1.263(a)-2(e)

/ A vested cause of action is, of course, “a

species of property.” Logan v. Zimmerman Brush Co.

455 U.S. 422, 428 (1982); Martinez v. California, 444

U.S. 277, 281 (1980). The Code classifies a cause of

action, or “chose in action,” as “intangible personal

property.” As the Internal Revenue Manual explains:

Intangible personal! property includes “choses in

action.” . . . A chose in action is a personal right

not reduced to possession and recoverable by a

suit at law. A plaintiff's cause of action in tort

aguas © Cotadent io an example of a chase in

on.

IR.M 5.17.2.4.3.4 -— Intangible Pro

(2000). See, e.g., Jeffrey v. United States, 1 Be

396, 401 (2001) (taxpayer’s unliquidated medical

malpractice cause of action held to be intangible

personal property).

I.R.C. § 1001 and its associated provisi

not limited to the sale or disposition of reo wana

INDOPCO, Inc. v. Commissioner, 503 U.S. 79. 87

(1992) (“creation of a separate and distinct asset . .

not a necessary, condition to classification as a

capital expenditure.”); See Edwin A. Morse, Taxing

Plaintiffs: A Look At Tax Accounting for Attorney’s

26

Fees and Litigation Costs, 107 Dick. L. Rev. 405, 474

(2003) (“It is important to recognize that “offset”

treatment is not limited to situations where capital-

gain producing assets are involved.”).

In any event, a taxpayer’s cause of action is a

clearly a capital asset under the Code. Under I.R.C. §

1221, intangible personal property falls within the

definition of a capital asset unless it is excluded as

being property used in the taxpayer's trade or

business that is subject to the allowance for

depreciation.

The status of an unliquidated cause of action

as property, subject to the tax rules governing the

sale or other disposition of property, is evident in

this case. Taxpayer Banks purchased his cause of

action against DOE from his estate in bankruptcy for

$10,000. Banks v. Commissioner, T.C. Memo. 2001-

048 (Tax Ct. 2001). The Tax Court excluded the

$10,000 purchase price from Banks’ gross income

from the settlement. Jd.

There remains only the question of whether

payment of a settlement or judgment that releases

the defendant from liability constitutes a sale,

exchange or “other disposition” of property under §

1001. The Commissioner himself suggests the

answer is yes, stating that in this case, “the

settlement proceeds represent the value given in

exchange for the dismissal of respondents’ claims.”

Brief of Petitioner at 12.

For example, in Siple v. Commissioner, 54 T.C.

1, 7 (1970), where Siple received $30,000 from

Mizner in return for a contingent claim against

Mizner and his company, the Tax Court stated that

“the transaction involved the sale or exchange of

capital assets”

27

This reflects longstanding practice, even under

the more restrictive predecessor sections of the

Internal Revenue Code of 1939. In Herbert’s Estate v.

Commissioner, 139 F.2d 756, 758 (3rd Cir. 1943), for

example, Herbert’s claim againet a corporation was

paid by the corporation to the estate. In the court’s

view, Herbert’s “estate had a chose in action,

property, which it got rid of or relinquished upon

payment. .. . We have no doubt that the payment

here of the claim held by the estate was a

‘disposition’ of the claim within the meaning of Sec.

111.”

Courts have long viewed the release by one

party of the legal obligations of another as a sale or

disposition of a property interest. In Commissioner v.

Golonsky, 200 F.2d 72, 74 (3™ Cir. 1953), the court

found it “no longer open to doubt” that choses in

action are intangible property and that the release of

such a right falls within the broad definition of a sale

or exchange of property. Similarly, in Appalachian

Elec. Power Co. v. United States, 158 F. Supp. 138,

140 (Ct. Ct. 1958), the court agreed with plaintiff

that an agreement releasing defendants’ obligations

under a prior contract was the sale or exchange of a

capital asset and “should receive capital assets

treatment for tax purposes.” See also Ray uv.

Commissioner, 18 T.C. No. 52 (1952) (lessee’s release

to lessor of a restrictive covenant held to be a sale of

a capital asset); Benedum v. Granger, 180 F.2d 564,

566 (3 Cir. 1950) (“Mr. Benedum having held

‘property,’ a chose in action, exchanged it for other

less valuable property. The transaction clearly

constitutes an exchange of capital assets.”)

In sum, ATLA submits that legal fees in

connection with damages on account of nonphysical

28

personal injury should be treated as capital

expenditures and offset against the total recovery to

arrive at gross income. Commissioner has pointed to

no specific Code provision that would require such

fees to be treated as deductions. As this Court has

made clear, “deductions are exceptions to the norm of

capitalization.” INDOPCO, Inc. v. Commissioner, 503

U.S. 79, 84 (1992) “(Capital expenditures, by

contrast, are not exhaustively enumerated in the

Code... For these reasons, deductions are strictly

construed and allowed only as there is a clear

provision therefor.” Jd.

B. Capitalization of Attorney Fees Does Not

Violate The “Source of the Claim”

Doctrine.

In Brief for Amici Curiae Professor Gregg D.

Polsky and Professor. Brant J. Hellwig, the

professors, without discussing capitalization of legal

fees in detail, suggest that including only the net

proceeds of an award or settlement would do violence

to yet another judge-made doctrine, the origin of the

claim rule. Id. at 15-16 n.15. Under that doctrine,

they state, “the cause of action is disregarded as a

separate asset” and the nature of the underlying

claim determines the tax treatment of the associated

legal expenses. Id.

In ATLA’s view, this extends the doctrine far

beyond its purpose. The “origin of the claim” rule,

which this Court first enunciated in United States v.

Gilmore, 372 U.S. 39 (1963), addresses whether a

taxpayer may take a deduction for legal fees as a

business expense under I.R.C. § 162, or as an

expense for the production or collection of income

under I.R.C. § 212. 6 MERTENS LAW OF FEDERAL

INCOME TAXATION § 25A:04 (2004). In Gilmore, for

29

example, the Court heid that the husband’s legal fees

in a divorce proceeding were “personal,” rather than

business expenses.

However, the doctrine has no application to

the antecedent question of whether the taxpayer has

income in the first place. The rule is designed to

properly classify the legal expenses incurred to

secure or maintain the production of income from

income producing property. See MERTENS, supra. But

it does not apply to the legal expense incurred in the

sale or disposition of that asset. As this Court made

clear in Woodward v. Commissioner, 397 U.S. 572,

575 (1970), “lilf an expense is capital, it cannot be

deducted,” under either § 162 or 212. “The law could

hardly be otherwise, for such ancillary expenses

incurred in acquiring or disposing of an asset are as

much part of the cost of that asset as is the price

paid for it.” Jd. at 575 & 576.

The professors’ fears that, unless this Court

adopts the include-deduct treatment of legal fees, the

distinction between income and property under the

Code would “be effectively eliminated,” Brief of Amici

at n.15, are overblown. When legal fees for personal

injury damages are subtracted to arrive at taxpayer's

gross income, the rule remains that the nature of the

underlying claim determines whether the taxpayer's

income is ordinary or capital gain.

For example, taxpayer Banks in this case paid

$10,000 to acquire his cause of action from the estate

in bankruptcy. The Tax Court subtracted that

$10,000 from the settlement to arrive at Banks’ gross

income. Banks v. Commissioner, T.C. Memo. 2001-

048 (Tax Ct. 2001). The is no dispute that if Banks

had incurred legal expenses in that acquisition, they

would also be excluded from income, as Woodward

30

makes clear. Capitalization of these costs and

expenses do not depend upon the origin of the claim.

However, the damages paid on account of the claim,

by virtue of the proper application of the origin of the

claim doctrine, are ordinary income.

There is no persuasive reason, under the Code

or in common sense, to treat the legal fees incurred

to obtain damages in nonphysical personal injury

cases as anything other than a capital expense,

offset, under Woodward, against the settlement to

arrive at taxpayer’s gross income.

CONCLUSION

For the above reasons, the decisions of the

courts of appeals should be affirmed.

Respectfully submitted,

Jeffrey Robert White

Center for Constitutional

Litigation, P.C.

1050 31st St., N.W.

Washington, DC 20007

(202) 965-3500

ATLA Senior Amicus Counsel

Attorney for Amicus Curiae

August 18, 2004