# Amicus Curiae Brief — Commissioner v. Banks

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URL: https://www.frixlaw.com/law-library/documents/brief%3Amicro_IA40385014_0727%3A11

## Record

- **Collection:** Supreme Court brief
- **Document type:** Amicus Curiae Brief
- **Published:** January 1, 2005
- **Citation:** 543 U.S. 426

## Text

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

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/brief%3Amicro_IA40385014_0727%3A11. Public record. Not legal advice.