Estate of Arthur Clarks v. U.S., 98-2437

• Decision Date: 16 December 1999
• Docket Number: No. 98-2437,98-2437
• Citation: 202 F.3d 854
• Parties: (6th Cir. 2000) Estate of Arthur L. Clarks, by and through its duly appointed Independent Personal Representative, Mary J. Brisco-Whitter, also known as Mary J. Clarks, Plaintiff-Appellant, v. United States of America, Defendant-Appellee. Argued:
• Court: U.S. Court of Appeals — Sixth Circuit

Page 854

202 F.3d 854 (6th Cir. 2000) Estate of Arthur L. Clarks, by and through its duly appointed Independent Personal Representative, Mary J. Brisco-Whitter, also known as Mary J. Clarks Plaintiff-Appellant, v. United States of America, Defendant-Appellee.

No. 98-2437

UNITED STATES COURT OF APPEALS FOR THE SIXTH CIRCUIT

Argued: December 16, 1999

Decided and Filed: January 13, 2000

Appeal from the United States District Court for the Eastern District of Michigan at Ann Arbor, No. 96-60446--George C. Steeh, District Judge.

Harley D. Manela, LAKRITZ, HERMAN & WISSBRUN, Bingham Farms, Michigan, for Appellant.

Kenneth W. Rosenberg, U.S. DEPARTMENT OF JUSTICE, APPELLATE SECTION, TAX DIVISION, Washington, D.C., for Appellee.

Before: MERRITT and SILER, Circuit Judges; BECKWITH, District Judge.^*

OPINION

MERRITT, Circuit Judge.

The question on appeal concerns the federal income taxation of clients on contingent fees paid to lawyers. In June 1988, a jury awarded Arthur Clarks $5,600,000 in personal injury damages against K-Mart for head injuries sustained while unloading his truck. In 1991, K-Mart paid $11,307,875.55 in total satisfaction of the judgment, $5,600,000 for the award and $5,707,837.55 in interest. From that amount, the judgment debtor paid Clarks' lawyer under a one-third, contingent fee contract $1,865,156.54 based on the original award and $1,901,314.67 based on the interest for a total fee of $3,766,471.21. After Clarks died in March 1992, his estate filed his 1040 for the 1991 tax year. Recovery for personal injury is ordinarily not taxable under § 104(a)(2) of the Internal Revenue Code, but the interest on the award is. The only question before us on appeal is whether the $1,901,314.67 in interest paid to the lawyer must be included as gross income of the decedent under § 61(a) of the tax code ("gross income means all income from whatever source derived"), as well as included in the lawyer's income. The estate did not include the interest portion of the attorney fee award as interest income because the estate did not receive any of the money. It was paid directly to the lawyer.

In November 1992, the IRS conducted an audit of Clarks' 1991 tax return. It notified the decedent's estate that it had a tax deficiency of $254,298 because the estate improperly failed to include as income the interest paid to the lawyer on the contingent fee contract and because the interest should be deducted as a miscellaneous itemized deduction subject to a two percent of adjusted gross income limitation. See 26 U.S.C. §§ 61(a), 67(a). As a result of the two percent floor on itemized deductions under Code § 67(a) ("miscellaneous itemized deductions... allowed only to the extent that the aggregate of such deductions exceeds 2 percent of adjusted gross income") and the alternative minimum tax applicable to interest income under Code § 55, the estate had to pay the additional $254,298 in taxes owed, plus interest. The estate filed an action in federal district court seeking a refund of all tax and interest paid on the interest portion of the damage award for the 1991 tax year. At no time has the non-interest portion of the award ($5,600,000) been at issue since it is clearly not taxable as income pursuant to 26 U.S.C. § 104(a)(2). Neither is there an issue before us concerning the taxation of the income in the hands of the lawyer. Both parties filed cross motions for summary judgment. The district court granted summary judgment for the government and against the taxpayer. We do not agree.

There is a conflict in the Circuits on the issue of whether the interest portion of an attorney's contingency fee should be included in the client's income under Code § 61(a), even though the lawyer received and paid taxes on all of the money and the client received none of the money. Compare Cotnam v. Comm'r, 263 F.2d 119 (5th Cir. 1959), with Baylin v. United States, 43 F.3d 1451 (Fed. Cir. 1995). Cotnam was the first to address the issue. In a 2-1 decision, the old Fifth Circuit held that the amount of the contingent fee paid out of the judgment to plaintiff's attorneys was not income to plaintiff. See Cotnam, 263 F.2d at 126. Under Alabama state law, a contingency fee contract operates as a lien on the recovery. The Alabama code provided at the time that "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." 46 Ala. Code § 64 (1940). The Cotnam court found that this lien operated as a transfer of part of plaintiff's claim and that any recovery as to that portion of the claim would not be regarded as gross income to the plaintiff taxpayer. Cotnam, 263 F.2d at 125. The court concluded that the amount of the contingent fee was earned by the attorney, not the taxpayer, whose only real economic benefit from the claim amounted to a percent of the total judgment he received due to the lawyer's efforts. See id. at 126.

The common law lien in this case under Michigan law operates in more or less the same way as the Alabama lien in Cotnam. Ray Andrews Brown, The Law of Personal Property § 116, at 559 (2d ed. 1955), describes a common law attorney's lien as follows:

According to Mr. Justice Earl, of the New York Court of Appeals, "the lien, as thus established, is not strictly like any other lien known to the law, because it may exist although the attorney has not and cannot, in any proper senses, have possession of the judgment recovered. It is a peculiar lien, to be enforced by peculiar methods. It was a device invented by the courts for the protection of attorneys against the knavery of their clients, by disabling clients from receiving the fruits of recoveries without paying for the valuable services by which the recoveries were obtained. The lien was never enforced like other liens. If the fund recovered was in possession or under the control of the court, it would not allow the client to obtain it until he had paid his attorney, and in administering the fund it would see that the attorney was protected. If the thing recovered was in a judgment, and notice of the attorney's claim had been given, the court would not allow the judgment to be paid to the prejudice of the attorney." [Quoting Goodrich v. McDonald, 112 N.Y. 157, 19 N.E. 649 (1889)].

Although 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. Michigan law is not inconsistent with this view of the attorney's lien, Dreiband v. Candler, 166 Mich. 49, 131 N.W. 129 (1911), -- holding that "the [contingent fee] agreement amounts to an assignment of a portion of the judgment sought to be recovered." Id. at 51, 131 N.W. at 129.

In a more recent decision, the Federal Circuit reached the opposite result. Baylin held that the contingent fee portion of settlement from a condemnation proceeding paid directly to the lawyer was income to the plaintiff taxpayer. Baylin, 43 F.3d at 1455. Baylin mentioned the Supreme Court's liberal interpretation of "gross income" and then found...