A Capital Gains Anomaly: Commissioner v. Banks and the Proceeds from Lawsuits

Abstract

When a litigant receives an award of damages or agrees to a settlement of a lawsuit for which the litigant and her attorney have agreed to a contingent fee, a portion of those damages or the settlement is paid to the attorney. For income tax purposes, there is a question of whether the litigant should include the portion paid to her attorney as her own income.

The question is not merely academic. In a tax system that does not always allow the litigant to deduct her attorney's fees, the litigant may end up paying tax on money that she never sees. In some cases, that tax can exceed the amount of money she gets from the lawsuit – making the litigant poorer by having pursued the suit at all.

The U.S. Supreme Court heard two cases regarding inclusion in income of contingent attorney’s fees, Commissioner v. Banks and Commissioner v. Banaitas. Although the cases seemed to resolve the question of including the fee paid to the attorney, the Court created an anomaly when they stated that the "income-generating asset is the cause of action that derives from the plaintiff's legal injury." Taking their words at face value, it appears the Supreme Court has made it possible to characterize all income from lawsuits or settlements as capital gain.

Keywords: attorneys fees, capital gains, taxation, income, damages

JEL Classification: H2, H24, H25, K34