Coady v. Comm'r of Internal Revenue

Citation213 F.3d 1187
Decision Date14 June 2000
Docket NumberNo. 98-71358,98-71358
Parties(9th Cir. 2000) Franklin P. COADY; Nona Coady, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee
CourtUnited States Courts of Appeals. United States Court of Appeals (9th Circuit)

Lance Hulbert, Bothell, Washington, for the petitioners-appellants.

David English Carmack, Karen D. Utiger (signed the brief), and Kenneth W. Rosenberg (argued), United States Department of Justice, Washington, D.C., for the respondent-appellee. OPINION

Appeal from an Order of the United States Tax Court David Laro, Tax Court Judge, Presiding. Tax Ct. No. 4722-97

Before: Edward Leavy, Pamela Ann Rymer, and Thomas G. Nelson, Circuit Judges.

RYMER, Circuit Judge:

The issue before us is whether Franklin and Nona Coady were entitled to exclude from their 1994 gross income $168,217 for costs and contingent legal fees incurred in securing Nona Coady's judgment for lost wages and benefits arising out of her wrongful termination. We conclude that they were not, and affirm.

I

In May 1990, Nona Coady was discharged from her position as Senior Loan Officer at Alaska Housing Finance Corporation (AHFC). Along with her husband, Coady retained the law firm of Hellen, Partnow & Condon (HPC) to represent her in a wrongful termination suit against AHFC for a contingent fee of 33.33% (45% if the judgment were appealed) or $185 per hour plus costs. After a bench trial, the court held that AHFC was liable to Coady for $373,307 ($89,225 for back pay, $76,980 for future lost earnings, and $207,102 for lost fringe and pension benefits). AHFC issued a check to Coady for $259,610.89 in full payment of the judgment (withholding $113,696.11 for federal income taxes, FICA/OASDA, and FICA/MED). The Coadys paid $221,338.32 to HPC ($124,435.67 in attorneys' fees and $96,902.65 in litigation costs).1

On their joint 1994 Federal Income Tax Return, the Coadys excluded $284,082 for the portion of the $373,307 award not paid on account of past wages, instead reporting it as selfemployment income on Schedule C of their return. They reported as income from wages only that portion of the award that was paid for back wages ($89,225). The Coadys claimed a deduction of $168,217 for attorneys' fees and litigation costs (the amount of fees and costs proportionate to the portion of the award they reported as self-employment income). This resulted in a net income from self-employment of $115,865. The Coadys claimed a miscellaneous itemized deduction of $53,121 for attorneys' fees and litigation costs proportionate to the $89,225 of the award they reported as income from wages.

The Commissioner sent the Coadys a statutory notice of deficiency, stating that the entire $373,307 should have been included in their 1994 gross income and that the attorneys' fees and litigation costs of $221,338 were deductible as a miscellaneous itemized deduction. The Commissioner asserted a deficiency in tax of $49,531 (plus interest). The Coadys filed suit in tax court. The case was submitted on a fully stipulated record, and the Coadys conceded that the $284,082 reported on Schedule C should not have been reported as selfemployment income on Schedule C but should have been reported along with the $89,225 as income from wages. The parties agreed that the $53,121 was deductible as a Schedule A "Miscellaneous Deduction." The parties disagreed as to whether the remaining legal fees and costs of $168,217 ($221,338 less $53,121) constituted reportable income. The Commissioner contended that the fees and costs were deductible as a Schedule A "Miscellaneous Deduction. " The Coadys argued that the fees and costs were not reportable income at all.2. The tax court upheld the Commissioner's determination. The Coadys appeal.

II

The Coadys contend that they are entitled to exclude $168,217 from gross income because they "assigned " that portion of their settlement to counsel. They rely on Cotnam v. C.I.R., 263 F.2d 119 (5th Cir. 1959). There, the taxpayer (Ms. Cotnam) won a contract action against the estate of T. Shannon Hunter, who had promised Cotnam one-fifth of his estate in return for her serving him as an attendant. Hunter died without a will, but Cotnam sued and was awarded $120,000, of which $50,365.83 was paid to her attorneys as a contingency fee. After Cotnam paid her taxes, exempting the award as a bequest, the Commissioner determined a deficiency in tax of $36,985.02. The Fifth Circuit Court of Appeals first reasoned that the amount Cotnam received was not exempt as a bequest but was taxable income for services rendered. See id. at 121. However, the panel split as to whether the fee paid to Cotnam's attorney should be included in her gross income. Judge Rives and Judge Brown concluded that the $50,365.83 paid to Cotnam's attorneys "should not be included in her gross income. This sum was income to the attorneys but not to Mrs. Cotnam." Id. at 125. Under Alabama law, "[a]ttorneys have the same rights as their clients." Id. Pursuant to 46 Code of Alabama S 64 (1940):

Upon suits, judgments, and decrees for money, they shall have a lien superior to all liens but tax liens, and no person shall be at liberty to satisfy said suit, judgment or decree, until the lien or claim of the attorney for his fees is fully satisfied; and attorneys at law shall have the same right and power over said suits, judgments and decrees, to enforce their liens, as their clients had or may have for the amount due thereon to them.

Cotnam "could never have received the $50,365.83, even if she had settled the case directly with the Bank. " Id. at 125. The Alabama statute "creates a charge `in the nature of an equitable assignment * * * (or) equitable lien' in the cause of action. An attorney `holding such an interest has an equity in the cause of action and the recovery under it prior to that of the defendant in the judgment to exercise a right of set-off accruing to him after the attorney's interest had attached.' " Id. at 125 (quoting United States Fidelity & Guarranty Co. v. Levy, 77 F.2d 972, 975 (5th Cir. 1935)) (emphasis added). Accordingly, the court concluded that based on the Alabama statute, the taxpayer was "in a position where she did not realize income as to her attorneys' interests of 40% in her cause of action and judgment." Id. Judge Wisdom dissented, reasoning that "at the time of the assignment to the attorneys all of her services had been rendered and all of the income earned." Id. at 126 (Wisdom, J. dissenting).

The rule in Cotnam has been subject to disagreement among the circuit courts of appeals. The Sixth Circuit recently followed Cotnam in Estate of Clarks v. United States, 202 F.3d 854 (6th Cir. 2000), concluding that the interest portion of an attorney's contingency fee should not be included in the client's gross income. See id. at 855-56. The court reasoned that the "common law lien in this case under Michigan law operates in more or less the same way as the Alabama lien in Cotnam" because "[a]lthough the underlying claim for personal injury was originally owned by the client, the client lost his right to receive payment for the lawyer's portion of the judgment." Id. at 856. According to the Clarks court:

In the instant case, as in Cotnam, the value of the taxpayer's lawsuit was entirely speculative and dependent on the services of counsel. The claim sim ply amounted to an intangible, contingent expec tancy . . . . Like an interest in a partnership agreement or joint venture, Clarks contracted for ser vices and assigned his lawyer a one-third interest in the venture in order that he might have a chance to recover the remaining two-thirds. Just as in Cotnam, the assignment Clarks' lawyer received operated as a lien on a portion of the judgment sought to be recovered transferring ownership of that portion of the judgment to the attorney.

Id. at 857.

However, the Federal and First Circuits have declined to follow Cotnam. In Baylin v. United States, 43 F.3d 1451 (Fed. Cir. 1995), the Federal Circuit rejected a taxpayer's claim that because a portion of an award was paid directly to the taxpayer's attorneys, that portion was never part of its gross income: "Very little need be said about this argument, which, if accepted, would elevate form over substance and allow the partnership [the taxpayer] to escape taxation on a portion of its income through a `skillfully devised' fee arrangement." Id. at 1454 (citation omitted). Baylin reasoned that

[A]lthough the partnership did not take actual pos session of the funds it paid to its attorney, opting instead to pay him directly out of its eventual recov ery, it is evident that the partnership received the benefit of those funds in that the funds served to dis charge the obligation of the partnership owing to the attorney as a result of the attorney's efforts to increase the settlement amount. The fee arrangement signifies the value that the parties placed on the attorney's services. In other words, the partnership "made such use or disposition of [its] power to receive . . . the income as to procure in its place other satisfactions which are of economic worth." Helvering v. Horst, 311 U.S. 112, 116, 61 S. Ct. 144, 85 L.Ed. 75 (1940).

Id. at 1454-55 Additionally, the court stated:

That the partnership assigned a portion of its con demnation recovery to its attorney before it knew the exact amount of the recovery does not mean that this

amount never belonged to the partnership; it means simply that the attorney and client chose to estimate the value of the attorney's services by tying the fee to the ultimate recovery and by having the obligation of the client to the attorney discharged by having the state pay the attorney his fees directly from the recovery. The temporarily uncertain magnitude of the legal fees under such an arrangement and the vehicle of an assignment cannot dictate the income tax treatment of those fees.

Id. at 1454; see also Alexander...

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