Franklin P. Coady Nona Coady v. Commissioner of Internal Revenue

Citations: 213 F.3d 1187; 2000 Daily Journal DAR 6303; 2000 Cal. Daily Op. Serv. 4709; 16 I.E.R. Cas. (BNA) 681; 85 A.F.T.R.2d (RIA) 2049; 2000 U.S. App. LEXIS 13692; 2000 WL 763843Docket: 98-71358

Court: Court of Appeals for the Ninth Circuit; June 14, 2000; Federal Appellate Court

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Franklin and Nona Coady appealed a decision from the U.S. Tax Court regarding the exclusion of $168,217 from their 1994 gross income, which represented costs and contingent legal fees incurred from a wrongful termination judgment awarded to Nona Coady against Alaska Housing Finance Corporation (AHFC). After Nona's discharge in 1990, the Coadys hired a law firm on a contingency basis, resulting in a total award of $373,307, of which $259,610.89 was received after tax withholdings. They reported $89,225 as income from wages for back pay, while excluding the remaining award as self-employment income and claiming deductions for legal fees and costs related to the excluded portion.

The IRS challenged this approach, asserting that the entire award should be included in gross income and that the legal fees and costs were deductible only as miscellaneous itemized deductions. The Coadys conceded that the self-employment classification was incorrect and agreed on the deduction for part of the legal fees. However, they disputed the characterization of the remaining fees and costs. The Tax Court sided with the IRS, leading to the Coadys' appeal. The Ninth Circuit affirmed the Tax Court's ruling, concluding that the Coadys were not entitled to exclude the $168,217 from their gross income.

The Coadys argue for exclusion of $168,217 from their gross income, claiming it was 'assigned' to their counsel from a settlement. They cite Cotnam v. C.I.R., where Ms. Cotnam received $120,000 from a contract action, with $50,365.83 paid to her attorneys. The Fifth Circuit determined that Cotnam's award was taxable income, not exempt as a bequest, but split on whether the attorney's fee should be included in her gross income. Judges Rives and Brown concluded that the fee was income to the attorneys, not to Cotnam, due to Alabama law granting attorneys a superior lien on recoveries related to their services.

The court noted that Cotnam could not have received the attorney's fee directly, as the Alabama statute created an equitable assignment in the attorney's favor, allowing attorneys to enforce liens before the client's claims. Consequently, the court ruled that Cotnam realized no income from the attorneys' interest in her lawsuit. Judge Wisdom dissented, arguing that all services had been rendered at the assignment time.

The rule from Cotnam has seen differing interpretations, with the Sixth Circuit following it in Estate of Clarks v. United States. The Clarks court found that the attorney's contingency fee interest should not be included in the client's gross income, paralleling Alabama's lien system under Michigan law. The court reasoned that the client's claim was contingent and speculative, and the assignment of a portion of the judgment to the attorney effectively transferred ownership of that portion.

The Federal and First Circuits have opted not to follow the Cotnam precedent. In Baylin v. United States, 43 F.3d 1451 (Fed. Cir. 1995), the Federal Circuit dismissed a taxpayer's argument that funds paid directly to attorneys were not part of the taxpayer's gross income, stating that accepting this argument would prioritize form over substance and allow tax avoidance through strategic fee arrangements. The court emphasized that the partnership benefited from the funds used to pay the attorney, as these payments discharged the partnership's obligation resulting from the attorney's work to secure a higher settlement. The fee arrangement reflected the value placed on the attorney's services, and the partnership's agreement to assign part of its recovery to the attorney did not imply that this amount never belonged to the partnership.

The court noted that under Alaska law, attorneys do not possess a superior lien or ownership interest in the cause of action, but rather a lien for compensation that attaches to the client’s property without granting ownership rights. The Coadys received full judgment payment from AHFC, and under Title 26 U.S.C. § 61(a), gross income is defined broadly to include all income from any source unless specifically excluded. The nature of the underlying action was crucial in determining that the awarded damages constituted gross income, as back wages from wrongful termination are clearly gross income. The entire award was reportable as income, with the Coadys merely using a portion to settle their liability to their attorneys.

The Supreme Court has made it clear that tax obligations cannot be avoided by directing payments to creditors or by setting up anticipatory arrangements to prevent income from vesting in the earner, affirming that the Revenue Act can tax earned salaries regardless of any arrangements made.

Income is not considered taxable until realized; however, taxpayers cannot evade taxation simply because they have not personally received payment, even if they have benefited from the income. Taxpayers remain liable for taxes on income they earn, regardless of whether they divert that income to creditors or others through contractual arrangements. The Coadys argue that their situation is different due to doubts surrounding their contingency fee assignment, but prior rulings indicate that such doubts do not exempt them from taxation on earnings. Therefore, Coady's recovery for back pay and benefits is taxable income, which cannot be avoided by directing payment to creditors, including attorneys. Additionally, the Coadys' claim that their arrangement with HPC constitutes a joint venture for tax purposes under § 7701(a)(2) is disregarded because it was not presented in the Tax Court. The ruling is affirmed. Notably, litigation expenses totaled $99,951.74, and the Coadys made a $3,300 advance payment for legal costs in 1993. Miscellaneous itemized deductions may be claimed only to the extent that they exceed 2% of adjusted gross income, as per 26 U.S.C. § 67.