Commissioner v. Banks
Encyclopedia
Commissioner v. Banks, 543 U.S. 426 (2005), together with Commissioner v. Banaitis, was a case decided before the Supreme Court of the United States
, dealing with the issue of whether the portion of a money judgment or settlement paid to a taxpayer's attorney under a contingent-fee agreement is income to the taxpayer for federal income tax purposes
. The Supreme Court held when a taxpayer's recovery constitutes income, the taxpayer's income includes the portion of the recovery paid to the attorney as a contingent fee. Employment cases are an exception to this Supreme Court ruling because of the Civil Rights Tax Relief in the American Jobs Creation Act of 2004
. The Civil Rights Tax Relief amended Internal Revenue Service § 62(a) to permit taxpayers to subtract attorney’s fees from gross income in arriving at adjusted gross income.
(IRS) contended that the entire amount was income to Banks, a position upheld by the United States Tax Court
. The United States Court of Appeals for the Sixth Circuit
ruled in favor of Banks, holding the lawyer's share could be excluded from the taxpayer's gross income
. The Court of Appeals reasoned the contingent-fee arrangement “is more like a partial assignment of income-producing property than an assignment of income.” Under this theory, Banks and his attorney were in effect partners in a joint venture who shared a recovery, and who should each be taxed only on his separate part.
In the second case, Sigitas J. Banaitis, a vice president of the Bank of California
, retained an attorney on a contingent-fee basis and sued the bank and its successor in ownership, the Mitsubishi Bank, for interference with his employment agreement and wrongful discharge. The parties settled the case. The defendants paid $4.9 million to Banaitis and $3.9 million to his attorney, following the formula set forth in the contingent-fee contract. The IRS viewed the entire amount as gross income to Banaitis. This view was rejected by the United States Court of Appeals for the Ninth Circuit
, which reasoned that because the state law granted attorneys a superior lien in the contingent-fee portion of any recovery, that part of Banaitis’ settlement was not includable as gross income.
Both cases were then heard by the United States Supreme Court.
(AMT) with larger awards. Double taxation of the attorney fees may result because the amount for attorney fees is income to the plaintiff and the attorney who is eventually paid. Some plaintiffs may be put in a worse financial situation after winning a case if the attorney fees far exceeded plaintiff’s actual damages.
The impact of this decision may have little impact on future tax disputes involving substantially the same facts. After these cases arose, the Internal Revenue Code
Section 62(a)(20), enacted as part of the American Jobs Creation Act of 2004
, expressly permits a taxpayer to subtract from his or her gross income, in arriving at adjusted gross income, the “attorneys fees and court costs paid by, or on behalf of, the taxpayer in connection with any action involving a claim of unlawful discrimination” as defined by the Act. The Act was not retroactive and only applied to attorney fees paid after the date of enactment with respect to any settlement or judgment occurring after its enactment. This provision eliminates the double taxation of attorney fees on plaintiff discrimination awards by changing he deduction for attorney fees from itemized deduction to an above the line deduction
.
Commissioner v. Banks is still precedent for those contingent fee arrangements not eligible for an above the line deduction, which include claims for defamation, invasion of privacy
, and tortious interference
with contract.
Supreme Court of the United States
The Supreme Court of the United States is the highest court in the United States. It has ultimate appellate jurisdiction over all state and federal courts, and original jurisdiction over a small range of cases...
, dealing with the issue of whether the portion of a money judgment or settlement paid to a taxpayer's attorney under a contingent-fee agreement is income to the taxpayer for federal income tax purposes
Income tax in the United States
In the United States, a tax is imposed on income by the Federal, most states, and many local governments. The income tax is determined by applying a tax rate, which may increase as income increases, to taxable income as defined. Individuals and corporations are directly taxable, and estates and...
. The Supreme Court held when a taxpayer's recovery constitutes income, the taxpayer's income includes the portion of the recovery paid to the attorney as a contingent fee. Employment cases are an exception to this Supreme Court ruling because of the Civil Rights Tax Relief in the American Jobs Creation Act of 2004
American Jobs Creation Act of 2004
The American Jobs Creation Act of 2004 was a federal tax act composed of numerous tax credits for agricultural and business institutions. Included was the repeal of some excise taxes on fuel and alcohol, and the creation of tax credits for biofuels...
. The Civil Rights Tax Relief amended Internal Revenue Service § 62(a) to permit taxpayers to subtract attorney’s fees from gross income in arriving at adjusted gross income.
Background
In the first case, John W. Banks, II was fired from his job with the California Department of Education. He retained an attorney on a contingent-fee basis and filed a civil suit against his employer alleging employment discrimination against his employer. Banks settled the case for $464,000 and paid $150,000 to his lawyer. The Internal Revenue ServiceInternal Revenue Service
The Internal Revenue Service is the revenue service of the United States federal government. The agency is a bureau of the Department of the Treasury, and is under the immediate direction of the Commissioner of Internal Revenue...
(IRS) contended that the entire amount was income to Banks, a position upheld by the United States Tax Court
United States Tax Court
The United States Tax Court is a federal trial court of record established by Congress under Article I of the U.S. Constitution, section 8 of which provides that the Congress has the power to "constitute Tribunals inferior to the supreme Court"...
. The United States Court of Appeals for the Sixth Circuit
United States Court of Appeals for the Sixth Circuit
The United States Court of Appeals for the Sixth Circuit is a federal court with appellate jurisdiction over the district courts in the following districts:* Eastern District of Kentucky* Western District of Kentucky...
ruled in favor of Banks, holding the lawyer's share could be excluded from the taxpayer's gross income
Gross income
Gross income in United States tax law is receipts and gains from all sources less cost of goods sold. Gross income is the starting point for determining Federal and state income tax of individuals, corporations, estates and trusts, whether resident or nonresident."Except as otherwise provided" by...
. The Court of Appeals reasoned the contingent-fee arrangement “is more like a partial assignment of income-producing property than an assignment of income.” Under this theory, Banks and his attorney were in effect partners in a joint venture who shared a recovery, and who should each be taxed only on his separate part.
In the second case, Sigitas J. Banaitis, a vice president of the Bank of California
Bank of California
The Bank of California was opened in San Francisco, California, on July 4, 1864, by William Chapman Ralston. It was the first commercial bank in the Western United States, the second-richest bank in the nation, and considered instrumental in developing the American Old West.-History:The ancestor of...
, retained an attorney on a contingent-fee basis and sued the bank and its successor in ownership, the Mitsubishi Bank, for interference with his employment agreement and wrongful discharge. The parties settled the case. The defendants paid $4.9 million to Banaitis and $3.9 million to his attorney, following the formula set forth in the contingent-fee contract. The IRS viewed the entire amount as gross income to Banaitis. This view was rejected by the United States Court of Appeals for the Ninth Circuit
United States Court of Appeals for the Ninth Circuit
The United States Court of Appeals for the Ninth Circuit is a U.S. federal court with appellate jurisdiction over the district courts in the following districts:* District of Alaska* District of Arizona...
, which reasoned that because the state law granted attorneys a superior lien in the contingent-fee portion of any recovery, that part of Banaitis’ settlement was not includable as gross income.
Both cases were then heard by the United States Supreme Court.
Issue
The issue presented to the United States Supreme Court was whether the portion of a money judgment or settlement paid to a taxpayer's attorney under a contingent-fee agreement is income to the taxpayer for federal income tax purposes.Holding
The United States Supreme Court held that a taxpayer's income includes the portion of the recovery paid to the taxpayer's attorney as a contingent fee.Significance
Successful plaintiffs may face an unintended and unfair tax result because of this ruling. Gross proceeds from settlement or litigation are considered income and the related legal fees are deductible only as an itemized deduction. Some or all of the deduction benefit may be lost because of the 2% limitation on miscellaneous itemized deductions or the loss of the deduction for legal fees for purposes of calculating the Alternative Minimum TaxAlternative Minimum Tax
The Alternative Minimum Tax is an income tax imposed by the United States federal government on individuals, corporations, estates, and trusts. AMT is imposed at a nearly flat rate on an adjusted amount of taxable income above a certain threshold . This exemption is substantially higher than the...
(AMT) with larger awards. Double taxation of the attorney fees may result because the amount for attorney fees is income to the plaintiff and the attorney who is eventually paid. Some plaintiffs may be put in a worse financial situation after winning a case if the attorney fees far exceeded plaintiff’s actual damages.
The impact of this decision may have little impact on future tax disputes involving substantially the same facts. After these cases arose, the Internal Revenue Code
Internal Revenue Code
The Internal Revenue Code is the domestic portion of Federal statutory tax law in the United States, published in various volumes of the United States Statutes at Large, and separately as Title 26 of the United States Code...
Section 62(a)(20), enacted as part of the American Jobs Creation Act of 2004
American Jobs Creation Act of 2004
The American Jobs Creation Act of 2004 was a federal tax act composed of numerous tax credits for agricultural and business institutions. Included was the repeal of some excise taxes on fuel and alcohol, and the creation of tax credits for biofuels...
, expressly permits a taxpayer to subtract from his or her gross income, in arriving at adjusted gross income, the “attorneys fees and court costs paid by, or on behalf of, the taxpayer in connection with any action involving a claim of unlawful discrimination” as defined by the Act. The Act was not retroactive and only applied to attorney fees paid after the date of enactment with respect to any settlement or judgment occurring after its enactment. This provision eliminates the double taxation of attorney fees on plaintiff discrimination awards by changing he deduction for attorney fees from itemized deduction to an above the line deduction
Above the line deduction
In the United States, an above the line deduction is a term used to describe those deductions which the Internal Revenue Service allows a taxpayer to subtract from his or her gross income. These deductions are set forth in Internal Revenue Code Section 62. A taxpayer's gross income minus his or...
.
Commissioner v. Banks is still precedent for those contingent fee arrangements not eligible for an above the line deduction, which include claims for defamation, invasion of privacy
Invasion of privacy
United States privacy law embodies several different legal concepts. One is the invasion of privacy, a tort based in common law allowing an aggrieved party to bring a lawsuit against an individual who unlawfully intrudes into his or her private affairs, discloses his or her private information,...
, and tortious interference
Tortious interference
Tortious interference, also known as intentional interference with contractual relations, in the common law of tort, occurs when a person intentionally damages the plaintiff's contractual or other business relationships...
with contract.