Raymond v. U.S.

• Decision Date: 13 January 2004
• Docket Number: No. 03-6037.,03-6037.
• Citation: 355 F.3d 107
• Parties: David A. RAYMOND and Lori Raymond, Plaintiffs-Appellees, v. UNITED STATES of America, Defendant-Appellant.
• Court: U.S. Court of Appeals — Second Circuit

355 F.3d 107

David A. RAYMOND and Lori Raymond, Plaintiffs-Appellees, v. UNITED STATES of America, Defendant-Appellant.

No. 03-6037.

United States Court of Appeals, Second Circuit.

Argued: November 21, 2003.

Decided: January 13, 2004.

Appeal from the United States District Court for the District of Vermont, Sessions III, C.J James W. Runcie, Esq., Ouimette & Runcie, Vergennes, VT, for Plaintiffs-Appellees.

Kenneth W. Rosenberg, Esq., Tax Division, Department of Justice (Eileen J. O'Connor, Assistant Attorney General, Richard Farber, Department of Justice, on the brief, Peter W. Hall, United States Attorney for Vermont, of counsel), Washington, D.C., for Defendant-Appellant.

Before: OAKES, POOLER, and WESLEY, Circuit Judges.

WESLEY, Circuit Judge.

The Supreme Court has long asserted that "[i]n tax law, ... substance rather than form determines tax consequences." Cottage Sav. Ass'n v. Comm'r, 499 U.S. 554, 570, 111 S.Ct. 1503, 113 L.Ed.2d 589 (1991) (Blackmun, J., dissenting) (citing Comm'r v. Court Holding Co., 324 U.S. 331, 334, 65 S.Ct. 707, 89 L.Ed. 981 (1945)). In this appeal, we are presented with an issue in which the line between substance and form has blurred. The question presented is whether a taxpayer who receives a recovery for lost wages, and who agreed to pay his attorney on a contingent-fee basis, must include the contingent fee in his gross income. We answer that question in the affirmative.

I. Facts & Procedural Posture

Appellee-taxpayer Raymond entered into a contingent fee agreement with the law firm of Ouimette & Runcie, under which the firm agreed to represent Raymond in his wrongful termination suit against IBM in return for one-third of any recovery secured thereunder. In a jury trial in the United States District Court for the District of Vermont, Raymond prevailed; the court entered judgment on the jury's award of approximately $900,000. IBM satisfied the judgment by sending a check to Ouimette & Runcie, payable to Raymond. The firm deposited approximately $300,000 in its own account in satisfaction of the contingent fee agreement.

On his federal income tax return for 1998, Raymond initially included in his gross income the entire amount of the judgment. From his gross income he attempted to deduct the amount of the fees paid to Ouimette & Runcie. See 26 U.S.C. § 212(1). However, due to the amount of Raymond's gross income, his tax liability was controlled by the Alternative Minimum Tax ("AMT"). As legal fees are among the itemized deductions that may not offset the AMT, see 26 U.S.C. § 56(b)(1)(A)(i), Raymond's tax liability was based on the sum of the entire judgment proceeds and his household income of approximately $65,000. Accordingly, his tax liability for 1998 was approximately $275,000.¹

In December 1999, Raymond filed an amended 1998 return. On the amended return, he excluded from his gross income the amount paid to Ouimette & Runcie under the contingent fee agreement. This exclusion eliminated Raymond's AMT liability. Given the resulting adjustments on the amended return, Raymond calculated his tax liability for 1998 as approximately $220,000. He thus claimed the IRS owed him a refund of approximately $55,000. The IRS denied the claim.

Raymond filed suit in the United States District Court for the District of Vermont, pursuant to 28 U.S.C. § 1346(a)(1), challenging the IRS's denial of his refund claim. See Raymond v. United States, 247 F.Supp.2d 548 (D.Vt.2002). He moved for summary judgment contending that, as a matter of law, the amount paid as a contingent fee to his attorney was not includable in his gross income. The government cross-moved for summary judgment, arguing that the entire amount of the judgment was includable as gross income. The government maintained that the amount paid to Raymond's attorney was only deductible as a miscellaneous itemized deduction, as Raymond had claimed in his original return.

The district court granted Raymond's motion for summary judgment, holding the contingent fee excludable from gross income. Id. at 556. The court held that, under Vermont law, a contingent fee agreement between taxpayer and attorney gives rise to an equitable lien in favor of the attorney on the taxpayer's recovery. Id. at 554 (citing Estate of Button v. Anderson, 112 Vt. 531, 28 A.2d 404, 406 (1942)). This equitable lien, the court reasoned, effects a transfer to the attorney of a proprietary interest in the taxpayer's claim. Id. Thus, because the amount of the recovery used to pay the attorney's fee represents only the attorney's interest in the claim, it is gross income to the attorney, but not to the taxpayer. The court viewed Raymond as having an insufficient interest in that amount to permit a characterization of it as "income" to him. The government appealed.

II. Discussion

Whether contingent fees are includable in the gross income of a client recovering on a judgment is the subject of much debate among the circuit courts.² The majority position is that such fees are includable in the client's gross income. See Campbell v. Comm'r, 274 F.3d 1312 (10th Cir.2001); Kenseth v. Comm'r, 259 F.3d 881 (7th Cir.2001); Young v. Comm'r, 240 F.3d 369 (4th Cir.2001); Baylin v. United States, 43 F.3d 1451 (Fed.Cir.1995). The minority position is that contingency fees are income to the attorney, but not to the client. See Davis v. Comm'r, 210 F.3d 1346 (11th Cir.2000); Estate of Clarks v. United States, 202 F.3d 854 (6th Cir.2000); Cotnam v. Comm'r, 263 F.2d 119 (5th Cir. 1959).³

Courts to address the issue have generally recognized that, in applying a federal revenue act, state law determines the nature of legal interests in property, while federal law determines the tax consequences of the receipt or disposition of property. See United States v. Nat'l Bank of Commerce, 472 U.S. 713, 722, 105 S.Ct. 2919, 86 L.Ed.2d 565 (1985); Aquilino v. United States, 363 U.S. 509, 513-14, 80 S.Ct. 1277 (1960). Thus, the courts have typically first analyzed state law to determine the relative strength of the respective interests in the contingency fee. Where the attorney's interest in the fee is sufficiently strong, some courts — those in the minority — have held that the attorney has a "property" interest in it exclusive of the client's interest; from this, these courts conclude that the fee was never income to the client, but only to the attorney. Other courts — those in the majority — have determined that although state law might provide attorneys with an interest in the fee, that interest is merely a "security" interest; from this, they conclude that the fee is plainly income to the client, albeit income upon which the attorney has a lien.⁴

Notwithstanding the prevalence of state-law analysis in this area, several courts have expressly disavowed reliance on such analysis. In Young, the Fourth Circuit stated that "whether amounts paid directly to attorneys under a contingent fee agreement should be included within the client's gross income should be resolved by proper application of federal income tax law, not the amount of control state law grants to an attorney over the client's cause of action." Young, 240 F.3d at 378. And in Banks v. Commissioner, 345 F.3d 373 (6th Cir.2003), the court reversed the Tax Court's determination that the fee was includable in gross income, despite the fact that the contingent fee agreement was controlled by California law, thus diverging from Benci-Woodward on federal grounds. See id. at 385-86; see also Srivastava v. Comm'r, 220 F.3d 353, 363-64 (5th Cir.2000).

Before turning to the analysis of the present case, it should be noted that the minority position in this area is weaker than it may first appear, at least quantitatively. The Fifth Circuit was the first to speak on this issue, and it held that contingent fees are not includable in the gross income of the client. See Cotnam, 263 F.2d at 125. In Cotnam, the court held that, under Alabama law, a contingent fee arrangement effected an assignment of a portion of the client's claim to her attorney as of the date she entered into the contingent fee arrangement.⁵ This assignment reasoned the court, sufficiently deprived the client of control over that portion of the claim such that income derived therefrom was not the client's, but rather the attorney's.

Since Cotnam, only two circuit courts have defended the view originally articulated in that case. In Srivastava, the Fifth Circuit engaged in a lengthy analysis demonstrating why the majority position appears most sound — but then followed Cotnam as a matter of stare decisis. See Srivastava, 220 F.3d at 357-65. And in Davis, the Eleventh Circuit followed Cotnam insofar as it serves as "former Fifth Circuit" precedent — but offered no argument in its support. See Davis, 210 F.3d at 1347.⁶ This leaves just the Sixth and the Ninth Circuits as having independently supported the position that contingent fees may be excluded from a client's gross income — the former on federal grounds and the latter on state grounds. See Banks, 345 F.3d at 386; Banaitis, 340 F.3d at 1083. With that as our backdrop, we enter the fray.

Section 61(a) of the Internal Revenue Code defines "gross income" as "all income from whatever source derived." 26 U.S.C. § 61(a). The Supreme Court has broadly construed this definition "in recognition of the intention of Congress to tax all gains except those specifically exempted." Comm'r v. Glenshaw Glass Co., 348 U.S. 426, 430, 75 S.Ct. 473, 99 L.Ed. 483 (1955). Still, the Court has long held that income is not taxable unless and until it is "realized." See Helvering v. Horst, 311 U.S. 112, 115, 61 S.Ct. 144, 85 L.Ed. 75 (1940). That is, a gain is taxable not when the taxpayer acquires the right to receive it, but rather when the taxpayer receives the benefit of it. See id. And a taxpayer can receive the benefit of a gain not only by being paid, but also by otherwise "obtain[ing] the fruition of the economic gain...