Petition for Writ of Certiorari — Freeman v. Commissioner

f Supreme Court, U.@.

FIiL&oD

yO 8 660 OCT 23 2003

OFFICE OF THE CLERK

In The

Supreme Court Of The Anited States

JACK FREEMAN and

JANET FREEMAN,

Petitioners,

COMMISSIONER OF

INTERNAL REVENUE,

Respondent.

ON PETITION FOR A WRIT OF CERTIORARI TO

THE UNITED STATES COURT OF APPEALS

FOR THE NINTH CIRCUIT

PETITION FOR WRIT OF CERTIORARI

William E. Dannemeyer*

*Counsel of Record

Bruce W. Dannemeyer

1105 E. Commonwealth, Box 13

Fullerton, CA 92831

(714) 871-4318

Counsel for Petitioners.

(i)

QUESTION PRESENTED

Does entry into a contingency arrangement with an

attorney constitute an assignment of income such that 100%

of the eventual jury award is income to the client?

(ii)

PARTIES TO THE PROCEEDINGS

Petitioners Jack and Janet Freeman petition for a writ

of certiorari to review the judgment of the Court of Appeals

for the Ninth Circuit in this case. They are represented by

William E. Dannemeyer and Bruce W. Dannemeyer.

Respondent Commissioner of Internal Revenue presumably

will be represented by the Office of the Solicitor General of

the United States. .

i eA L ABATED: EK. 0000

(iii)

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a TABLE OF CONTENTS

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(iv)

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TABLE OF AUTHORITIES

United States Supreme Court Decisions:

Helvering v. Horst, 311 U.S. 112 (1940).........cceeeeee 25 4, 5

Leces ¥. Gard, ZE1 U.S. VEL CEG SD) eosccvccssesssecsevvesereees Os GO

Federal Couris of Appeal Decisions:

Banaitis v. Comm’'r, 340 F.3d 1074 (9" Cir. 2003) ......0.00+ 3 i

Campbell v. Comm'r, 274 F.3d 1312 ( 10" Cir.

BE ceciecucbovavencecaeiseplsastsausiateiadalsccdactnibinunbaile 3 : |

Estate of Clarks v. United States 202 F.3d 854

"ge a ERR UN not re EE: A

Foster v. United States, 249 F.3d 1275 (11™ Cir.

BED sisricckcsciniiiekiec ibd anaeaieciia deed auawie a aiabcailanimaiads 2

Kenseth vy. Comm'r, 259 F.3d 881 (7" Cir. 2001).......+4+. 3,5

O'Brien v. Comm ’r, 319 F.2d 532 (3d Cir. 1963),

cert. Gentbed,, 75 U.S. F3i CUFG) vciccesscssevessessesascsvsevsens 2

Sinvard v. Comm’r, 268 F.3d 756 (9"" Cir. 2001) ...c.seeesee 3

Srivastava v. Comm'r, 220 F.3d 353 5" Cir. |

PE ccs tiadanisaccicieetin teas ematical baaenedataaaeuien 2

Young v. Comm’r, 240 F.3d 369 (4™ Cir. 2001) ....ssssseeeeee 3

Federal Statutes:

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OPINIONS BELOW

The opinion of the Court of Appeals for the Ninth

Circuit is not published. The memorandum is included in the

accompanying appendix. The memorandum opinion of the

United States Tax Court is not published, but is included in

the appendix.

JURISDICTION

The judgment of the Ninth Circuit was filed on

March 5, 2003, and petitioners’ timely petition for rehearing

and suggestion for hearing en banc was rejected on July 25,

2003, as reflected in the order included in the appendix.

Jurisdiction is proper in the United States Supreme Court

pursuant to 28 U.S.C. sections 1254(1) and 2101(c) and Rule

13 of the Rules of the Supreme Court of the United States.

STATUTORY PROVISIONS INVOLVED

26 U.S.C. § 61(a), which reads in relevant part:

“Except as otherwise provided in this subtitle, gross income

means all income from whatever source derived....”

STATEMENT OF THE CASE

Petitioner Jack Freeman’s employer wrongfully

terminated his 34-year career. The $300,000 jury award was

divided $199,642 to Freeman and $114,470 to his attorney

(in addition to the $82,764 Freeman previously paid on an

hourly basis before entering into the contingency

agreement).' The Internal Revenue Service seeks $115,415

in taxes and interest, claiming the entire jury award was

income to Freeman. The State of California will seek

‘ When the judgment was paid, interest had accrued so that the payment

exceeded the award.

2

$40,792. Asa result, Freeman will be worse off than if he

had never filed the lawsuit; his lawyers and the government

will take $39,329 more than the jury awarded.

REASONS FOR GRANTING THE PETITION

The inequity stems from a misapplication of this |

Court's rule concerning assignment of income. See |

Helvering v. Horst, 311 U.S. 112 (1940); Lucas v. Earl, 281

U.S. 111 (1930). Under that rule, a taxpayer cannot escape

tax liability by assigning the right to income. Having earned

a salary or purchased a negotiable bond, the taxpayer cannot j

escape taxation by making an anticipatory transfer of the |

right to collect the fruits of his efforts. However, the

situation is different when the taxpayer unites with an

attorney, for all practical purposes in a joint venture, and the

two of them engage in an enterprise that results in a jury

award. Were it not for the combination of the two, there

would be no award. Had they remained separate, neither

would have realized a cent. But together they generate a

single fund which they divide according to the terms of their

agreement.

The misapplication of the assignment rule has led to a )

split in the Circuits. The Fifth, Sixth, and Eleventh Circuits |

have found that entry into a contingency agreement with an

attorney is not an assignment of income; the client, therefore,

realizes income only on his portion of a jury award.

Srivastava v. Comm’r, 220 F.3d 353, 363-365 (5" Cir.

2000): Estate of Clarks v. United States, 202 F.3d 854, 857-

858 (6" Cir. 2000); Foster v. United States, 249 F.3d 1275,

1279-1281 (11" Cir. 2001). The Third, Fourth, Seventh, and

Tenth Circuits have attributed the entire award to the client,

finding there has been an assignment and under state law, the

attorney is merely a lienholder. O’Brien v. Comm’r, 319

3

F.2d 532 (3d Cir. 1963), cert. denied, 375 U.S. 931 (1963):

Young v. Comm’r, 240 F.3d 369, 376-379 (4" Cir. 2001 );

Kenseth v. Comm’r, 259 F.3d 881, 883-885 (7" Cir. 2001);

Campbell v. Comm’r, 274 F.3d 1312, 1314 (10" Cir. 2001).

The Ninth Circuit agrees an assignment has occurred, but has

reached different conclusions, based on state law, on whether

the award is income to the client. Sinvard v. Comm’r, 268

F.3d 756 (9" Cir. 2001) (entire award taxed to client based

on Arizona law); Banaitis v. Comm'r, 340 F.3d 1074, 1082

(9"" Cir. 2003) (client taxed only on his portion based on

Oregon law).

This Court recently has denied certiorari on similar

cases, but those cases did not focus on the actual source of

the error — misapplication of the assignment of income rule.

If entry into a contingency fee arrangement is viewed as an

assignment, then examination of state law is obligatory and

the result inexorable. But entry into a contingent fee

arrangement is not an assignment. Once the assignment of

income analysis was imposed, a logical result followed. But

that analysis never should have been imposed. Instead a

uniform, nationwide rule should apply which says that

contingent fee arrangements do not involve assignment of

income. The money resulting from the contingent

attorney/client joint venture should be taxed to each

according to their allocation of the proceeds of that venture.

Estate of Clarks v. United States, supra, analyzed the

issue properly and consequently reached the just result. The

court recognized that by entering into a contingency

arrangement with his lawyer, by which the proceeds of a

lawsuit would be split, Mr. Clarks had not assigned income.

“Like an interest in a partnership agreement or joint venture,

Clarks contracted for services and assigned his lawyer a one-

4

third interest in the-venture-u order that he might have a

chance to recover the remaining two-thirds.” /d. at p. 857.

The court distinguished Lucas v. Earl, supra, and Helvering

v. Horst, supra. \n Lucas, this Court rejected the taxpayer's

claim that a contract with his wife, which recited that all

income generated by either would be considered earned

jointly, meant that each would be taxed on half the husband’s

salary. This Court reasoned that since the taxpayer did all

the work to earn the salary, he should be taxed on the entire

amount. He would have earned the salary even if he had

never entered into the contract with his wife. Similarly in

Helvering, the taxpayer could not escape taxation on the

interest paid on negotiable bonds simply by giving his son

the interest coupons. Because the interest was earned

regardless of the gift to the son, it was still income to the

father.

A contingent fee arrangement between an attorney

and a client is far different. Without that arrangement there

would be no income to tax. The client had nothing until the

lawyer was hired and the case tried. The lawyer had nothing

until approached by the client. Each gave the other an _

opportunity otherwise unavailable. When labor is performed

or bonds purchased, sa!ary has been earned and interest is

due. All that remains is cashing the check. But far more is

required when a contingent fee arrangement is created. The

client has assigned nothing. He has contributed the capital to

a joint venture, and his lawyer contributes his labor to that

same venture. If the venture is successful, they will share in

the rewards. If unsuccessful, they also will share in the loss.

There is no assignment.

The tax treatment of assignment of income best

demonstrates why a contingency arrangement is not an

5

assignment. In a genuine assignment of income situation, as

in Helvering and Lucas, only the assignor pays tax on the

income. The assignment is ignored for tax purposes. In a

contingency situation, the client is taxed on 100% of the jury

award, and the attorney is taxed on the contingency amount.

The award is taxed twice. The “assignment” to the attorney

is both ignored and recognized: ignored in the sense that the

entire award is attributed as income to the client, and

recognized in the sense that the attorney's portion is

attributed as income to him. This Court created the

assignment of income rule in response to a tax scheme

designed to shift income to persons in lower tax brackets.

The rule has been twisted in some Circuits so that income is

taxed twice.

An argument has been made in the past that Congress

should solve the inequity by amending the statute concerning

deductibility of attorneys’ fees. elimination of the 2%

limitation on miscellaneous deductions (which currently

includes attorneys’ fees), and/or modifying the alternative

minimum tax. But simply because the problem can be

solved by legislation does not mean this Court should wait

for Congress. Every tax issue can be solved by legislation,

yet this Court has intervened when appropriate. That is what

happened when it created the assignment of income rule. It

is that rule, or rather its misapplication, that has created this

problem. “[T]he assignment of income doctrine is judges

made law, not a rule of statutory interpretation of the more

recently enacted itemized deduction and AMT provisions.

Contrary to the claims of the majority and a recent

commentator, we need not wait for Congress to change those

provisions.” Kenseth vy. Comm'r, 114 T.C. 399, 427 (Beghe.,

J. dissenting), aff'd 259 F.3d 881, 883-885 (7" Cir. 2001).

This Court, therefore, should intervene now.

CONCLUSION

Without a uniform rule, taxpayers in identical

situations will be taxed differently. The Circuits are split

with respect to application of the assignment of income rule.

In those Circuits where the rule is misapplied, such as the

Ninth Circuit, the inequity impacts every plaintiff who is

awarded compensation for non-physical injuries, of which

there are thousands, if not millions, each year. Clarifying the

assignment of income rule will not require abrogation of that

rule. Just the opposite, it will emphasize its underlying

policy by reinforcing the concept that income will be taxed

to the person who earned it. When the effort is joint,

taxation will be joint. When the effort is individual, so is

taxation. Ruses to hide income still will be exposed, and

combinations to create income that would not exist if the

participants remained separate will be recognized. The

assignment of income rule will be applied as intended and

great inequity will be avoided.

The petition for certiorari should therefore be

granted.

Respectfully submitted,

‘

Dated: October*?> 2003 William E. Dannemeyer a

Attorney for

petitioners Jack

and Janet

Freeman

eS I EES 2S roe

(i)

APPENDIX

Page

TABLE OF CONTENTS

Order filed July 25, 2003 [denying petition for

rehearing and suggestion for rehearing en banc].... App. 1

Memorandum filed March 5, 2003 [affirming

decision of the United States Tax Court].............. App. 2

Memorandum Opinion of the United States Tax

Court filed September 28, 2001.................sseeeeeeees App. 4

App. |

[NOT FOR PUBLICATION]

UNITED STATES COURT OF APPEALS

FOR THE NINTH CIRCUIT

No. 02-70006 ~~

IRS No. 13195-99

JACK FREEMAN; JANET FREEMAN,

Petitioners — Appellants,

V.

COMMISSIONER OF INTERNAL REVENUE,

Respondent — Appellee.

Filed July 25, 2003

ORDER

Before: BEEZER, THOMAS and CLIFTON, Circuit Judges.

The panel has voted to deny the petition for rehearing

and to reject the suggestion for rehearing en banc.

The full court has been advised of the suggestion for

rehearing en banc, and no judge of the court has requested a

vote on the suggestion for rehearing en banc. Fed. R. App. P.

35(b).

The petition for rehearing is denied and the

suggestion for rehearing en banc is rejected.

App. 2

[NOT FOR PUBLICATION]

UNITED STATES COURT OF APPEALS

FOR THE NINTH CIRCUIT

No. 02-70006

Tax Ct. No. 13195-99

JACK FREEMAN; JANET FREEMAN,

Petitioners — Appellants,

V.

COMMISSIONER OF INTERNAL REVENUE,

Respondent — Appellee.

MEMORANDUM*

Appeal from a Decision of the United States Tax Court

Argued and Submitted February 14, 2003

San Francisco, California

Filed March 25, 2003

App. 3

Before: BEEZER, THOMAS and CLIFTON, Circuit Judges.

The judgment of the United States Tax Court is

affirmed for the reasons stated by Judge Whalen in his

memorandum opinion dated September 28, 2001.

AFFIRMED.

* This disposition is not appropriate for publication and may

not be cited to or by the courts of this circuit except as may

be provided by Ninth Circuit Rule 36-3.

App. 4

UNITED STATES TAX COURT

T.C. Memo. 2001-254

JACK AND JANET FREEMAN, Petitioners

V.

COMMISSIONER OF INTERNAL REVENUE,

Respondent.

Docket No. 13195-99.

Filed September 28, 2001.

William E. Dannemeyer, for petitioners.

James J. Posedel, for respondent.

MEMORANDUM OPINION

WHALEN, Judge: Respondent determined a

deficiency in petitioners' Federal income tax for 1994 of

$77,415. Petitioners filed the instant petition seeking

redetermination of that deficiency. They resided in Los

Alamitos, California, at the time. We must decide the

following three substantive issues: (1) Whether petitioners

are entitled, pursuant to section 104(a)(2), to exclude from

the gross income reported on their 1994 return the proceeds

of a judgment in a State court action in the amount of

$314,173.91; (2) if not, whether petitioners may exclude

from their gross income for 1994 a portion of the proceeds of

the judgment equal to the amount of the attorney's fees paid

under a retainer agreement to one of the attorneys who

represented them in the State court action; and (3) whether

the alternative minimum tax imposed by section 55 violates

App. 5

the Constitution of the United States. All section references

are to the Internal Revenue Code as in effect during 1994,

and all Rule references are to the Tax Court Rules of Practice

and Procedure.

The facts have been fully stipulated by the parties and

are so found. The stipulated facts and the accompanying

exhibits are incorporated into this opinion by this reference.

Petitioners were husband and wife at the end of 1994,

the taxable year at issue, and they filed a joint return for that

year. In this opinion, references to petitioner are to Mr. Jack

Freeman.

In 1991, after 34 years of service, petitioner was

summarily fired by his employer, Thrifty Corp. (Thrifty), a

corporation that operates a large chain of retail stores. At

that time, he was vice president/regional manager in charge

of coordinating and directing the activities of 11 district

managers, and he was responsible for 130 retail stores in the

Los Angeles area and Nevada with retail sales of $349

million.

In June 1991, petitioner filed suit against Thrifty in

the Superior Court of the State of California for the County

of Los Angeles (herein referred to as superior court).

Petitioner's complaint included counts for: Breach of

contract, breach of the covenant of good faith and fair

dealing, intentional infliction of emotional distress, fraud and

deceit, and specific performance. Thereafter, petitioner

amended his complaint by deleting his claim for intentional

infliction of emotional distress and adding a claim for age

discrimination under the California Fair Employment and

Housing Act, Cal. Govt. Code secs. 12900-12996 (Deering

1982 & Supp. 1988) (FEHA).

Initially, petitioner was represented in his suit against

Thrifty by Gregory S. Koffman, Esquire. On or about

December 15, 1992, petitioner substituted a new attorney to

App. 6

represent him in the suit. Petitioner paid Mr. Koffman a total

of $83,411.44 for his services.

Petitioner entered into a retainer agreement with the

law offices of his new attorney, the Law Offices of Paul A.

Greenberg. The agreement states in pertinent part as follows:

2. Client shall pay to Attorney, upon

execution of this Retainer Agreement, the sum of

$7,500.00, which shall constitute a nonrefundable

retainer fee, in exchange for substituting into this

case.

3. Client shall pay to Attorney, after receipt of

the first Trial or Arbitration date set, the sum of

$7,500.00, payable equally over a three month

period, $2,500.00 per month.

4. Client shall pay to Attorney upon receiving

or filing a Notice of Appeal, the sum of $5,000.00,

payable equally over a two month period, $2,500.00

per month.

5. Attorney shall receive as an additional fee a

contingency fee equal to thirty five percent (35%) of

the total amount of any sums recovered in this matter,

after deducting fifty percent (50%) of the fees paid

pursuant to Paragraphs 2, 3 and 4 above. For

example, if $100,000.00 is received as a settlement or

award and client has paid $7,500.00 in fees, then

Attorney will receive 35% of $96,250.00. Attorney is

hereby given a lien for its fees and advances upon

any settlement, judgment or award made or secured

herein. IF NO RECOVERY IS OBTAINED,

ATTORNEY WILL RECEIVE NO ADDITIONAL

FEE, other than those specified in Paragraphs 2, 3

and 4 above. The fee schedule as set forth above is

not set by law but is negotiable between Attorney and

client.

App. 7

* KKK KK KKK KK KK KK KK KK K

8. As security for the fees and costs that will

become due to Attorney, Client does hereby give to

Attorney a lien on all papers, documents and records

of Client, and judgments and settlements concerning

the matter. Client authorizes Attorney to retain from

any recovery an amount sufficient to liquidate client's

accrued fees and expenses, on this or any other

matter.

Ultimately, petitioner's suit against Thrifty was tried

in superior court before a jury on the following four causes

of action: Breach of contract, breach of the covenant of good

faith and fair dealing, fraud and deceit, and age

discrimination under FEHA. The jury returned a special

verdict in petitioner's favor. The special verdict states as

follows:

We, the jury in the above entitled action, find

the following Special Verdict on the questions

submitted to us:

Issue No. | Was there an implied agreement

between the parties that the plaintiff, Jack Freeman,

would not be terminated except for good cause?

Answer "yes" or "no".

Answer: Yes

If you answered Issue No. | "yes", then

answer the next issue. If you answered Issue No. |

"no", then answer Issue No. 5.

Issue No. 2 Did the defendant, Thrifty Corp.,

either actually terminate the plaintiff, Jack Freeman,

without good cause or constructively terminate the

plaintiff, Jack Freeman, without good cause?

“Bien cig neni:

App. 8

Answer "yes" or "no".

_ Answer: No

If you answered Issue No. 2 "yes", then

answer the next issue. If you answered Issue No. 2

"no", then answer Issue No. 5.

Issue No. 5 Did defendant, Thrifty Corp..

breach the implied covenant of good faith and fair ©

dealing?

Answer "yes" or "no".

Answer: Yes

If you answered Issue No. 5 "yes" then

answer the next issue. If you answered issue No. 5

"no", then sign and return this veridct [sic].

Issue No. 6 Did such conduct by defendant,

Thrifty Corp., cause damage to the plaintiff, Jack

Freeman?

Answer "yes" or "no".

Answer: Yes

If you answered Issue No. 6 "yes", then

answer the next issue. If you answered issue No. 6

"no", the [sic] sign and return this verdict.

Issue No. 7 What is the total amount of

damages suffered by plaintiff, Jack Freeman, as a

result of defendant, Thrifty Corp.'s breach of the

implied covenant of good faith and fair dealing?

App. 9

Answer: $300,000.00

According to the above special verdict, the jury found that

Thrifty had breached an implied covenant of good faith and

fair dealing and that Thrifty's conduct had damaged

petitioner. The jury further found that the damages suffered

by petitioner by reason of Thrifty's breach amounted to

$300,000. Petitioner's claim for damages due to Thrifty's

breach of the covenant of goed faith and fair dealing was the

only cause of action as to whicl the jury found for petitioner

and awarded damages. Petitioner's final award, including

interest, totaled $314,173.91.

Thrifty issued a check dated August 11, 1994, in the

amount of $314,173.91 in full satisfaction of the judgment

against it. The check was made payable jointly to petitioner

and his attorneys.

Petitioner's attorney, Mr. Greenberg, received

Thrifty's check. He deducted his fees of $114,532.39 from

the award, as authorized by the retainer agreement, and

disbursed the remaining proceeds of Thrifty's payment,

$199,641.52, to petitioner by check dated August 26, 1994.

Mr. Greenberg also issued a check to petitioner in the

amount of $62.69 to reimburse him for unused cost

advances.

Petitioners timely filed their 1994 Federal income tax

return, but they did not include any portion of the jury award

in their gross income. Respondent issued a notice of

deficiency to petitioners. Among other adjustments,

respondent determined that petitioners should have included

the entire jury award of "$314,174.00" in their gross income

for 1994. The notice of deficiency states in part as follows:

It is determined that you received an award in the

amount of $314,174.00 from Thrifty which was not

LO LL A PE NO PEE OS

BATS eens ns

App. 10

reported on your return for the taxable year ended

December 31, 1994. This amount is determined to be

taxable to you because you have failed to establish

that this amount is excludable from gross income

under the provisions of the Internal Revenue Code.

Accordingly, income is increased in the amount of

$314,174.00.

Respondent also adjusted the miscellaneous itemized

deductions claimed on Schedule A of petitioners’ return,

$610, by adding $194,595 to arrive at total miscellaneous

itemized deductions of $195,205, before taking into account

the 2-percent floor as required by section 67(a). It appears

that the additional miscellaneous itemized deductions

allowed in the notice of deficiency relate to the attorney's

fees that petitioner paid with respect to his suit against

Thrifty, but the record does not readily disclose how

respondent computed the amount of the adjustment. The

parties agree that that amount is not correct and the correct

amount of the additional miscellaneous itemized deductions

is $129,698.70, computed as follows:

Attorney's fees paid $114,532.39

to Paul Greenberg, Esq.

Less: reimbursement for ‘. 62.69

unused cost advance

Plus: attorney's fees paid $ 15,229.00

in 1994 before trial

Total additional miscellaneous $129,698.70

itemized deductions

App. 11

Respondent also determined that for 1994 petitioners

are liable for alternative minimum tax of $52,303. The notice

of deficiency states as follows:

It is determined that you are subject to the alternative

minimum tax imposed by the Internal Revenue Code

on items of tax preference for the taxable year ended

December 31, 1994. We have attached an an [sic]

alternative minimum tax worksheet to explain how

we computed the alternative minimum tax.

Whether the Court Properly Granted Respondent's Motion

To Quash Subpoenas To Compel the Testimony of a

Revenue Agent and an Appeals Officer

Petitioners ask the Court to reconsider the granting of

respondent's motion to quash the subpoenas issued to a

revenue agent and to a manager in respondent's Appeals

Office. According to petitioners' posttrial brief, the agent

would have testified that he advised petitioners’ accountant

that petitioners’ "return should be accepted as filed", and the

Appeals officer would have testified that he informed

petitioners’ accountant that "the return was correct when filed

and [he] removed the penalties but * * * that Petitioner still

owed the tax."

The proffered testimony would be immaterial to the

issues in this case. As we have often observed. a trial before

this Court is a proceeding de novo in which our

determination as to a texpayer's tax liability must be based

on the merits of the case and not any record developed at the

administrative level. See, e.g.. Greenberg's Express, Inc. v.

Commissioner, 62 T.C. 324, 328 (1974). Accordingly, we

properly quashed the subject subpoenas.

Whether Petitioners-May Exclude From Gross Income the

Entire Amount of the Jury Award Under Section 104(a)(2)

The first substantive issue in this case is whether

petitioners are entitled to exclude from their gross income for

abe aprons Matas

ih AR, Em RA AG tail bd 5 Abe eS Roan 8

App. 12

1994 the amount of the judgment awarded in petitioner's suit

against Thrifty, $314,173.91. Petitioners argue that their

gross income does not include any part of that amount by

reason of section 104(a)(2). During 1994, that provision

stated: "gross income does not include * * * the amount of

any damages received (whether by suit or agreement and

whether as lump sums or as periodic payments) on account

of personal injuries or sickness". The regulations

promulgated under section 104(a)(2) make clear that the

scope of excludable damages is limited to those received

through prosecution of an action based upon tort or tortlike

rights:

The term "damages received (whether by suit or

agreement)" means an amount received (cther than

workmen's compensation) through prosecution of a

legal suit or action based upon tort or tort type rights,

or through a settlement agreement entered into in lieu

of such prosecution. [Sec. 1.104- 1(c), Income Tax

Regs. |

After reviewing section 104(a)(2) and the above regulation,

the U.S. Supreme Court stated that a taxpayer must meet the

following two independent requirements before a recovery

may be excluded under section 104(a)(2):

First, the taxpayer must demonsirate that the

underlying cause of action giving rise to the recovery

is "based upon tort or tort type rights"; and second,

the taxpayer must show that the damages were

received "on account of personal injuries or

sickness." * * * [Commissioner v. Schleier, 515 U.S.

323, 337 (1995). ]

Petitioners acknowledge that the damages of

$300,000 awarded by the jury were based entirely on

petitioner's claim for breach of a covenant of good faith and

App. 13

fair dealing and that the amount paid by Thrifty included

interest of $14,173.91. Petitioners' brief states:

On May 23, 1994, the jury returned a verdict for

Petitioner on the Second Cause of Action, Breach of

the Covenant of Good Faith and Fair Dealing in the

amount of $300,000, and with interest, totaling

$314,173.91.

Petitioners also acknowledge that their claim against Thrifty

for breach of the covenant of good faith and fair dealing is a

contract claim and not a claim based upon tort or tortlike

rights. Petitioners’ brief states:

Petitioner went to trial on four causes of action:

1 - Breach of Contract, contract

2 - Breach of Covenant of Good Faith and Fair

Dealing, contract

3 - Fraud and Deceit, tort

4 - Violation of Fair Employment and Housing Act,

tort-like

Petitioners’ brief also states:

The jury in Petitioner's case may have given him an

award on the second cause of action for breach of the

covenant of good faith and fair dealing, but the

allegations of the complaint clearly involved a tort

and tort like claim.

Nevertheless, petitioners contend that the entire award is

excludable from gross income under section 104(a)(2) as

damages from personal injuries. To restate petitioners’

position more succinctly, petitioners contend that even

though the amount awarded in the superior court action

consists of damages for the breach of a contractual obligation

Bidet

App. 14

owed to petitioner and of interest, and does not involve

damages received through prosecution of tort or tort-type

rights, the entire award is excluded from gross income under

section 104(a)(2).

Petitioners ask us to reach the same conclusion, i.e.,

that the entire jury award is excluded from gross income

under section 104(a)(2), on the basis of a reading of

Threlkeld v. Commissioner, 87 T.C. 1294 (1986), affd. 848

F.2d 81 (6th Cir. 1988). Petitioners’ posttrial brief makes the

following argument:

[In Threlkeld v. Commissioner, supra,] The

court noted at page 1307 that even though the

settlement agreement allocated the sum of $75,000

for damages to petitioners [sic] professional

reputation, (the taxability of $21.500 [of] which was

the issue in the case), the settlement agreement does

not necessarily control in deciding whether the claim

being settled arises from a personal injury. The court

said:

"We therefore, look to the petitioners [sic]

allegations in his complaint in the State court."

The relevance of this last statement to

Petitioner is most important to note. Namely, the jury

may have given an award on the second cause of

action for breach of the covenant of good faith and

fair dealing, but the meaning of the language from

Threlkeld is that to answer the question of whether

the award represents compensation for personal

injuries, the court said the allegations in the

complaint must be examined.

App. 15

Petitioners do not adequately explain how an examination of

the complaint in the superior court action supports the

conclusion that the entire award is excludable from income

under section 104(a)(2).

We disagree with petitioners’ reading of Threlkeld v.

Commissioner, supra, and with their conclusion that the

entire award in the superior court action is excludable from

income under section 104(a)(2). In our view, none of the

award is excludabdle.

In Threlkeld v. Commissioner, supra at 1298, the

Court held that in deciding in a particular case whether the

damages were received on account of "personal injuries", the

nature of the claim as defined under State law, and the

concept of personal injury thereby embodied, are the

appropriate criteria in a case in which "damages are clearly

allocated to an identifiable claim". Id. at 1305- 1306. The

Court pointed out that State law may be of limited assistance

in certain cases, such as in a settlement where it is unclear

what claim is settled or where there are several claims not all

of which involve personal injuries. Id. In such cases, the

Court pointed out: "We must look to various factors,

including the allegations in the State court pleadings, the

evidence adduced at trial, a written settlement agreement,

and the intent of the payer." Id. at 1306.

In this case, unlike Threlkeld v. Commissioner,

supra, the award to petitioner in the superior court action is

set forth in the jury's special verdict. The award was based

entirely on petitioner's claim that Thrifty breached an

implied covenant of good faith and fair dealing. Thus, in this

case, in determining the basis for the damages awarded to

petitioner in the superior court action, the jury's special

verdict takes precedence over any of the other factors

mentioned by the Court in Threlkeld v. Commissioner,

supra.

App. 16

The jury award in the instant case was based upon a

single identifiable cause of action, breach of an impiied

covenant of good faith and fair dealing. Under California

law, that cause of action is not a tort. Mundy v. Household

Fin. Corp., 885 F.2d 542, 544 (9th Cir. 1989) ("the

California Supreme Court has spoken decisively, holding in

Foley [v. Interactive Data Corp., infra} that an allegation of

breach of the implied covenant is a purely contractual

claim"); Foley v. Interactive Data Corp., 765 P.2d 373 (Cal.

1988): see Cade v. Commissioner, T.C. Memo. 1999-394.

Accordingly, in the instant case, no part of the recovery in

the superior court action can be excluded from gross income

under section 104(a)(2) because the underlying cause of

action giving rise to the recovery was based entirely upon a

contract cause of action and not upon tort or tortlike rights as

required by section 1.104-1(c), Income Tax Regs. See

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

Whether Petitioners May Exclude From Gross Income a

Portion of the Recovery Equal to the Amount Paid to Their

Attorneys Under the Contingent Fee Agreement

Petitioners argue that if we hold that section

104(a)(2) does not apply, with the result that the judgment

proceeds are includable in their 1994 gross income, then the

portion of the judgment paid directly to their attorneys under

the retainer agreement is excludable from gross income.

Petitioners ask us to follow Cotnam v. Commissioner, 263

F.2d 119 (Sth Cir. 1959), revg. in part and affg. on another

issue 28 T.C. 947 (1957), and Estate of Clarks v. United

States, 202 F.3d 854 (6th Cir. 2000). In Cotnam v.

Commissioner, supra, the Court of Appeals for the Fifth

Circuit held that the amount of a contingent fee paid to the

taxpayer's attorneys out of a judgment was not income to the

taxpayer because under Alabama law a contingent fee

contract operates as a lien on the recovery that, in effect,

App. 17

transfers part of a plaintiff's claim to the attorneys. See also

Srivastava v. Commissioner, 220 - 17 -F.3d 353, 365 (Sth

Cir. 2000), revg. and remanding in part, and affg. on another

issue T.C. Memo. 1998-362; Davis v. Commissioner, 210

F.3d 1346 (11th Cir. 2000) ("this panel [of the Court of

Appeals for the 11th Circuit] is bound by Cotnam, which can

be overruled only by the en banc Court"), affg. T.C. Memo.

1998-248. In Estate of Clarks v. United States, supra, the

Court of Appeals for the Sixth Circuit followed Cotnam v.

Commissioner, supra, and held that the interest portion of a

judgment in an action for personal injuries could be offset by

the contingent legal fees paid to the taxpayer's attorney

because an attorney's lien under Michigan law was similar to

an attorney's lien under Alabama law.

Petitioners acknowledge that we recently

reconsidered the same issue and reached the opposite

conclusion in Kenseth v. Commissioner, 114 T.C. 399

(2000), affd. 259 F.3d 881 (7th Cir. 2001). In that case, the

taxpayer was one of a class of persons who had entered into

an agreement with their former employer in settlement of a

class action for age discrimination. The taxpayer's share of

the gross settlement amount was $229,501.37, of which the

taxpayer received $126,470.42, after the former employer

had withheld employment taxes of $11,230.41 and the

taxpayer's attorneys had withheld attorneys’ fees of

$91,800.54. The issue in that case was whether the taxpayer

could offset his recovery in the age discrimination suit by the

attorney's fees withheld by his attorney, $91,800.54.

We held that the taxpayer's gross income included all the _

proceeds of the settlement, including the portion used to pay

his attorneys under the contingent fee agreement. We

explained our position regarding this issue as follows:

This Court has, for an extended period of

time, held the view that taxable recoveries in lawsuits

App. 18

are gross income in their entirety to the party-client

and that associated legal fees—-contingent or

otherwise—are to be treated as deductions.” See

Bagley v. Commissioner, 105 T.C. 396, 418-419

(1995), affd. 121 F.3d 393, 395-396 (8th Cir. 1997);

O'Brien v. Commissioner, 38 T.C. 707, 712 (1962),

affd. per curiam 319 F.2d 532 (3d Cir. 1963); Benci-

Woodward v. Commissioner, T.C. Memo. 1998-395,

oe on appeal (9th Cir. Feb. 2, 1999). In O'Brien, we held

that "even if the taxpayer had made an irrevocable

assignment of a portion of his future recovery to his

attorney to such an extent that he never thereafter

became entitled thereto even for a split second, it

would still be gross income to him under" assignment

of income principles. O'Brien v. Commissioner, supra

at 712. "Although there may be considerable equity

to the taxpayer's position, that is not the way the

statute is written." Id. at 710. * * *

This view is based on the well-established assignment of income

doctrine that was originated by the Supreme Court in Lucas v. Earl, 281

U.S. 111 (1930). Lucas v. Earl. supra, has been relied on by this Court

for assignments of income involving both related and unrelated

taxpayers. [Id. at 411.]

In Kenseth v. Commissioner, supra, we reviewed and

declined to follow the cases relied upon by petitioners,

Cotnam v: Commissioner, supra, and Estate of Clarks v.

United States, supra. We stated as follows:

After further reflection on Cotnam and now

Estate of Clarks v. United States, supra, we continue

to adhere to our holding in O'Brien that contingent

fee agreements, such as the one we consider here,

come within the ambit of the assignment of income

App. 19

doctrine and do not serve, for purposes of Federal

taxation, to exclude the fee from the assignor's gross

income. We also decline to decide this case based on

the possible effect of various States' attorney's lien

statutes. [Kenseth v. Commissioner, supra at 412; fn.

ret. omitted. |

In Kenseth v. Commissioner, supra, we noted that

there is a disagreement about this issue among the Courts of

Appeals. We reviewed and agreed with Baylin v. United

States, 43 F.3d 1451 (Fed. Cir. 1995), and Alexander v.

Commissioner, 72 F.3d 938 (Ist Cir. 1995), affg. T.C.

Memo. 1995-51, cases in which the courts had rejected

arguments similar to the argument made by petitioners in the

instant case; see also Young v. Commissioner, 240 F.3d 369

(4"" Cir. 2001), affg. 113 T.C. 152 (1999).

Petitioners acknowledge that the court to which an

appeal of this case lies, the Court of Appeals for the Ninth

Circuit, has rejected their position in Benci- Woodward v.

Commissioner, 219 F.3d 941 (9th Cir. 2000), affg. T.C.

Memo. 1998-395. In that case, the court held that an award

of punitive damages was fully includable in the taxpayers'

gross income, notwithstanding the fact that a portion of the

award was retained by the taxpayers' attorney, pursuant to a

contingent fee agreement. Id. The Court of Appeals noted

that under California law, the law applicable in that case and

in the instant case, "an attorney lien does not confer any

ownership interest upon attorneys or grant attorneys any

right and power over the suits, judgments, or decrees of their

clients." Id. at 943; see also Brewer v. Commissioner, T.C.

Memo. 1997-542 (attorney's fees paid with respect to action

for statewide discrimination in California), affd. without

published opinion 172 F.3d 875 (9th Cir. 1999).

Accordingly, the Court of Appeals found no reason to

App. 20

distinguish the payment to the taxpayers' attorney under the

contingent fee agreement in that case from the attorneys’ fees

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

2000), affg. T.C. Memo. 1998-291.

ln Coady v. Commissioner, supra, the Court of

Appeals for the Ninth Circuit rejected a taxpayer's argument

that a judgment for lost wages and benefits arising out of her

wrongful termination should be reduced by contingent legal

fees and litigation costs on the ground that the taxpayer had

"assigned" those amounts to her attorneys. Id. The court

reasoned that the judgment in the wrongful termination

action was fully includable in the taxpayer's gross income

under the broad sweep of section 61, which defines gross

income as "all income from whatever source derived" and

the taxpayers had "simply used a portion of the award

subsequently to discharge their personal liability to their

attorneys." Id. at 1190-1191. The Court of Appeals noted

that, under longstanding authority of the U.S. Supreme

Court. income must be taxed to the person who earns it, and

a taxpayer cannot escape such taxation by procuring

payment directly to creditors or by making an anticipatory

assignment of the income. See United States v. Basye. 410

U.S. 441, 449 (1973); Helvering v. Eubank, 311 U.S. 122,

124-125 (1940); Helvering v. Horst, 311 U.S. 112 (1940):

Lucas v. Earl, 281 U.S. 111, 114-115 (1930).

Most recently, the Court of Appeals for the Ninth

Circuit again declined to follow Cotnam in Sinyard v.

Commissioner, F.3d (9th Cir. 2001), affg T.C.

Memo. 1998-364. That case involved attorney's fees paid in

connection with the settlement of two class actions brought

under the Age Discrimination in Employment Act, Pub. L.

90- 202. 81 Stat. 602, currently codified at 29 U.S.C. secs.

621-634 (1994).

App. 21

Arguments similar to petitioners’ in the instant case

were fully considered and rejected by this Court in Kenseth

vy. Commissioner, 114 T.C. 399 (2000), and by the Court of

Appeals for the Ninth Circuit in Sinyard v. Commissioner,

supra, Benci- Woodward v. Commissioner, supra, and Coady

v. Commissioner, supra. We have no reason to reconsider the

issue in this case. Accordingly, we sustain respondent's

determination that the judgment is fully includable in

petitioners’ gross income and cannot be reduced by the

amount retained by petitioner's attorney under the retainer

agreement.

Whether the Alternative Minimum Tax Is Unconstitutional

In the notice of deficiency. respondent treated the

attorneys’ fees that petitioner paid in connection with his

superior court action as a "miscellaneous itemized

deduction", as defined by section 67(b). In the case of an

individual, a miscellaneous itemized deduction is not

deductible in computing alternative minimum taxable

income. See sec. 56(b)(1)(A)(i). In petitioners' case, this has

the effect of causing the tentative minimum tax computed

under section 55(b) to exceed petitioners’ regular tax and,

thus, causes petitioners to be liable for the alternative

minimum tax in the amount of the excess. See sec. 55(a). See

generally Benci- Woodward v. Commissioner, supra at 994

(holding that legal expenses are classified as miscellaneous

itemized deductions and, as such, are not allowed as

deductions for purposes of computing alternative minimum

tax liability).

In the notice of deficiency, respondent determined

that petitioners are liable for alternative minimum tax of

$52,303. This was based upon the treatment of attorneys'

tees of $194,595 as an additional miscellaneous itemized

deduction. As mentioned above. the parties agree that the

attorneys’ fees, to be treated as an additional miscellaneous

App. 22 -

itemized deduction, are $129,698.70, rather than $194,595.

Petitioners do not take issue with respondent's computation

of the amount of alternative minimum tax in this case. They

argue:

THE FAILURE OF THE ALTERNATIVE -

MINIMUM TAX TO ALLOW A DEDUCTION

FOR ATTORNEYS FEES AND COSTS, WHICH

RESULTS IN A DOUBLE TAXATION OF THE

SAME INCOME TO PETITIONER AND HIS

ATTORNEYS, [IS] A VIOLATION OF THE

CONSTITUTIONAL RIGHTS OF PETITIONER IN

THAT IT IS A TAKING WITHOUT DUE

PROCESS OF LAW AND A DENIAL OF THE

EQUAL PROTECTION OF THE LAW IN

VIOLATION OF THE 5TH AND 14TH

AMENDMENT [sic] TO THE FEDERAL

CONSTITUTION.

Petitioners acknowledge that the constitutionality of the

alternative minimum tax was upheld in Okin v.

Commissioner, T.C. Memo. 1985-199, affd. 808 F.2d 1338

(9th Cir. 1987), but they argue that their case "is totally

different" from Okin. We disagree.

In Okin v. Commissioner, supra, the taxpayer's

principal argument was that under a prior version of the

alternative minimum tax, viz the Revenue Act of 1978, Pub.

L. 95-600, sec. 421. 92 Stat. 2763, 2871, alternative

minimum taxable income should be computed using

"average annual adjusted gross income", a concept taken

from the income averaging provisions of sections 1301-

1305. We rejected the taxpayer's argument and pointed out

that, in defining alternative minimum taxable income, the

statute used the words "gross income" and did not refer to

App. 23

the income averaging provisions or to any adjusted figure.

Okin v. Commissioner, supra. After trial, the taxpayer made

a general argument, "not supported by any specific

references to the Constitution or citations to precedent", that

section 55 is unconstitutional. Id. We rejected that argument

on the basis of cases upholding the constitutionality of the

so-called add-on minimum tax under former section 56. See

Wyly v. United States, 662 F.2d 397, 403-406 (Sth Cir.

1981); Graff v. Commissioner, 74 T.C. 743, 765-767 (1980),

affd. per curiam 673 F.2d 784 (Sth Cir. 1982).

On appeal, the Court of Appeals for the Ninth Circuit

also rejected the taxpayer's challenge to the constitutionality

of the alternative minimum tax imposed by section 55. Okin

v. Commissioner, 808 F.2d at 1341-1342. The Court of

Appeals rejected the taxpayer's argument that, as applied in

his case, the alternative minimum tax constitutes a "taking of

property without due process of law and without adequate

compensation." Id. The court agreed that the effect of the

alternative minimum tax was to virtually nullify the

taxpayer's tax savings under the income averaging provisions

but pointed out that that effect was consistent with

congressional intent. Id. at 1341. The court noted that “the

due process clause ordinarily places no limits upon the

congressional taxing power." Id. at 1341-1342; see A.

Magnano Co. v. Hamilton, 292 U.S. 40, 44 (1934). The court

further rejected the taxpayer's contention that taking away

the benefits of averaging through the application of the

alternative minimum tax is discriminatory. According to the

court, in enacting the alternative minimum tax, Congress

intended "to remedy general taxpayer distrust of the system

growing from large numbers of taxpayers with large incomes

who were yet paying no taxes." Okin v. Commissioner, 808

F.2d at 1342. The court stated that that intent is a legitimate

App. 24

governmental end as to which reducing the benefits of

averaging bore a reasonable relation. Id.

The instant case involves the benefits of a

miscellaneous itemized deduction, rather than the benefits of

income averaging. Nevertheless, the reasoning of the Court

of Appeals in Okin v. Commissioner, supra, applies.

Congress provided that, in computing alternative minimum

taxable income, no deduction shall be allowed for

miscellaneous itemized deductions as defined by section

67(b). Sec. 56(b)(1)(A)(i). Congress thereby restricted the

benefits from miscellaneous itemized deductions through the

application of the alternative minimum tax. Cf. Weiser v.

United States. 959 F.2d 146 (9th Cir. 1992). The alternative

minimum tax no more violates the due process or equal

protection requirements of the U.S. Constitution in this case,

involving miscellaneous deductions, than in Okin, which

involved the benefits of income averaging. See Lickiss v.

Commissioner, T.C. Memo. 1994-103. See generally

Wallach v. United States, 800 F.2d 1121 (Fed. Cir. 1986);

Gajewski v. Commissioner, 84 T.C. 980, 984-985 (1985):

Klaassen v. Commissioner, T.C. Memo. 1998-241, affd.

without published opinion, 182 F.3d 932 (10th Cir. 1999):

Keese v. Commissioner, T.C. Memo. 1995-417; Christine v.

Commissioner, T.C. Memo. 1993-473: Ross v.

Commissioner, T.C. Memo. 1987-500.

Finally, even if we agreed with petitioners that the

application of the alternative minimum tax produces an

inequitable result in this case, it is not for us to change that

result. It is well established that such an equitable argument

cannot overcome the plain meaning of the statute. See,

Sinyard v. Commissioner, F.3d ___; Benci- Woodward

v. Commissioner, 219 F.3d at 944; Alexander v.

Commissioner, 72 F.3d at 946-947; Weiser v. United States,

supra at 148-149; Okin v. Commissioner. 808 F.2d at 1342.

parties,

App. 25

Based upon the foregoing, and concessions of the

Decision will be entered under Rule 155.

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