This is the fourth in a series of articles on issues surrounding the Taxation of Settlements and Verdicts. This article explains why an award of attorneys fees is included in a taxpayer's gross income.
Gross Income and Anticipatory Assignment. The Internal Revenue Code defines “gross income” broadly to include all economic gains not otherwise exempted. Under the anticipatory assignment of income doctrine, a taxpayer cannot exclude an economic gain from gross income by assigning the gain in advance to another party, e.g., Lucas v. Earl, 281 U.S. 111(1930), because gains should be taxed “to those who earn them” id., at 114. The doctrine is meant to prevent taxpayers from avoiding taxation through arrangements and contracts devised to prevent income from vesting in the one who earned it. Id., at 115.
Contingent Fee Agreement – Anticipatory Assignment. The U.S. Supreme Court and U.S. Tax Court view a contingent-fee agreement as an anticipatory assignment to the attorney of a portion of the client's income from any litigation recovery. In an ordinary case, attribution of income is resolved by asking whether a taxpayer exercises complete dominion over the income in question. However, in the context of anticipatory assignments, where the assignor may not have dominion over the income at the moment of receipt, the question is whether the assignor retained dominion over the income-generating asset. In the case of a litigation recovery, the income-generating asset is the cause of action derived from the plaintiff's legal injury. See Commissioner v. Banks, 125 S.Ct. 826 (2005).
Principal-Agent Relationship. The attorney-client relationship is a principal-agent relationship. The client retains ultimate dominion and control over the underlying claim. The attorney can make tactical decisions without consulting the client, but the client still must determine whether to settle or proceed to judgment and make other critical decisions. The attorney is an agent who is duty bound to act in the principal's interests, and so it is appropriate to treat the full recovery amount as income to the principal. This rule applies regardless of whether the attorney-client contract or state law confers any special rights or protections on the attorney, so long as such protections do not alter the relationship's fundamental principal-agent character. See Commissioner v. Banks, 125 S.Ct. 826 (2005).