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Contingent Attorneys’ Fees Constitute Gross Income to Plaintiff
In an important case of first impression in the U.S. District Court for the District of Connecticut, the court, in Parmanand v. Capewell Components, LLC, held in September that contingent attorneys’ fees paid directly by the defendant to the plaintiff’s attorney constitutes gross income to the plaintiff (as well as to the attorney). The Second Circuit has not yet decided this issue, although a Vermont district court recently held that contingent attorneys’ fees are not includable in a plaintiff’s gross income. Additionally, there is a split among the Courts of Appeals that have considered this issue, with the Third, Fourth, Seventh, Ninth, Tenth and Federal Circuits including contingent attorneys’ fees paid directly to a plaintiff’s attorney in the plaintiff’s gross income and the Fifth, Sixth and Eleventh Circuits holding that such contingent attorneys’ fees do not constitute gross income to the plaintiff. The Supreme Court has denied certiorari on this issue four times.
The Case.
In the settlement agreement reached by the parties in Parmanand, the defendant was required to make a separate payment directly to the plaintiff’s attorney for contingent attorneys’ fees that the plaintiff incurred in pursing his legal claims. The plaintiff took the position that the attorneys’ fees paid did not constitute gross income to the plaintiff, but only to the attorney, as Connecticut’s lien law gives an attorney a property interest in contingent attorneys’ fees superior to that of a plaintiff. The defendant contended that the contingent attorney’s fees did constitute gross income to the plaintiff and, as such, the defendant was required to report the contingent attorneys’ fees to the plaintiff (and to the attorney) on Form 1099-Misc.
In rebuking the plaintiff’s lien argument, the court found that because a property interest in a legal case belongs primarily to the client and not to an attorney, the client is the primary owner of any amounts received, including any contingent attorneys’ fees. In coming to this conclusion, the court found an attorney’s right to the contingent fee portion of a settlement award as akin to a charging lien or an encumbrance, which is not superior to the ownership interest of the client under Connecticut law. Thus, the court held that the entire amount of the settlement proceeds, including the contingency attorneys’ fees portion, constituted gross income to the plaintiff.
Impact of the Parmanand Case.
The Parmanand case is a troubling decision for Connecticut plaintiffs who receive contingent attorneys’ fees as part of a settlement agreement or who are awarded contingent attorneys’ fees pursuant to a judgment against the defendant. While these fees should be and are taxable to the attorney, the plaintiff may also pay federal income tax on all or some portion of the fees, notwithstanding that the fees may be paid directly to the attorney and never seen by the plaintiff, and will definitely pay Connecticut income tax on such fees. This is the case because the attorneys’ fees, which according to the Parmanand case can only be claimed as a miscellaneous itemized deduction for federal income tax purposes, are deductible by a plaintiff only to the extent that that such fees, combined with the plaintiff’s other miscellaneous itemized deductions (if any), exceed two percent of the plaintiff’s adjusted gross income including the attorneys’ fees. The attorneys’ fees are also not deductible in determining the alternative minimum tax liability of the plaintiff (if any). In addition, a plaintiff may find herself or himself ineligible for certain deductions or tax credits based on adjusted gross income, such as the child tax credit, the adoption tax credit and the student loan interest deduction. For Connecticut income tax purposes, the plaintiff will have to pay tax on the full amount of the attorneys’ fees as Connecticut tax law does not allow miscellaneous itemized deductions. Parties need, therefore, to take the court’s holding in Parmanand into account when negotiating settlement agreements with a contingent attorneys’ fees component.