The Tax Management Transfer Pricing Report ™ provides news and analysis on U.S. and international governments’ tax policies regarding intercompany transfer pricing.
By Gerald S. Deutsch, Esq.
He prepared his own return. He always did. He just followed the instructions, and there was never a problem. He knew what to do. It had been a good year. He had won the lawsuit and had been awarded $400,000 and, after paying his attorney her one-third contingent fee - $133,000 - he had been left with $267,000 and had paid his bills from that.Of course, he knew that he had to pay taxes on the award, and he knew that, while the attorney's fee could only be deducted to the extent that it exceeded 2% of his adjusted gross income - which was only $8,300 - almost $125,000 of that fee would be deductible, and he had reserved enough to pay the taxes he computed would be due - about $75,000.So he prepared his return, and when he came to line 45, he was asked for Alternative Minimum Tax and instructed to attach form 6251. He had never done this before. He had never paid the Alternative Minimum Tax before but, just for fun, he downloaded Form 6251 and began to fill it out. It was easy. Then he came to line 5, which asked him to insert miscellaneous deductions. He did, and as he completed the form, he saw that NO PART of the attorney's fee was deductible. He owed an additional $37,000! He should have used a tax professional.
He saw that, in fact, he had to pay tax on money he had never received - and never would receive!!
This was the argument made by the taxpayer in Hukkanen-Campbell v. Comr., 274 F.3d 1312 (12/19/2001), a 10th Circuit case which affirmed the decision of the Tax Court. The appellate court said:
Petitioner invites us to judicially overturn what she terms an “anomalous and unjust result” created by the application of the AMT to the present case. We must reject this invitation. The perceived inequities of the AMT are simply not at issue here. Congress, not this court, must correct any shortcomings in the AMT's application.The case, with others, was affirmed, and other cases which had held otherwise were reversed by the Supreme Court in 2005 (Comr. v. Banks, 125 S. Ct. 826 (2005)) where the taxpayers sought to include in gross income only the NET amount - that is, the gross award LESS the attorneys' fees. The Supreme Court held that the full amount with no reduction for the attorney fees had to be included in gross income because to do otherwise would “be viewed as an anticipatory assignment to the attorney of a portion of the client's income from any litigation recovery.” And “as a general rule, when a litigant's recovery constitutes income, the litigant's income includes the portion of the recovery paid to the attorney as a contingent fee.”
Our hero should certainly have used a tax professional, if for no other reason than to tell him to reserve the additional $37,000 he now needs in order to pay his tax.
It should be noted Congress followed the 10th Circuit's advice but only in a limited way. Section 62(a) and (e) now provide that “Adjusted Gross Income” means gross income minus any deduction allowable for attorney fees and court costs paid but ONLY in connection with a claim of unlawful discrimination (as defined) or certain other limited actions. For most legal claims, however, attorneys' fees still may not be netted but instead must be treated as miscellaneous itemized deductions, deductible for regular tax purposes only to the extent they (and other such expenses) exceed 2% of adjusted gross income and not deductible at all for Alternative Minimum Tax purposes.
For more information, in the Tax Management Portfolios, see Maule, 504 T.M., Deductions: Limitations: General, and in Tax Practice Series, see ¶2910, Floor Under Miscellaneous Itemized Deductions
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