T.C. Memo. 1998-395
UNITED STATES TAX COURT
IVOR F. AND DEBRA A. BENCI-WOODWARD, ET AL.,1 Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 3769-96, 4185-96, Filed November 9, 1998.
8265-96.
In these consolidated cases, R determined
deficiencies in Ps' Federal income taxes for their 1992
taxable year due to their failure to include in gross
income certain punitive damages and interest arising
out of a State court lawsuit. (Ps now concede that all
amounts received as punitive damages, plus interest,
are includable in gross income as determined by R. See
O'Gilvie v. United States, 519 U.S. 79 (1996).) R
allowed Ps miscellaneous itemized deductions for legal
fees and costs attributable to their punitive damages
awards pursuant to sec. 67, I.R.C. However, in
computing Ps' alternative minimum tax (AMT)
adjustments, R disallowed their miscellaneous itemized
deductions pursuant to sec. 56(b)(1)(A)(i), I.R.C.
1 Cases of the following petitioners are consolidated
herewith: Laurentz J. and Barbara Mangum, docket No. 4185-96,
and Jose and Dianne M. Ragatz, docket No. 8265-96.
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1. Held: Ps' deductions for legal expenses
attributable to punitive damages are miscellaneous
itemized deductions, deductible to the extent they
exceed 2 percent of adjusted gross income. Sec. 67,
I.R.C; sec. 1.67-1T(a)(1)(ii), Temporary Income Tax
Regs., 53 Fed. Reg. 9875 (Mar. 28, 1988).
2. Held, further, miscellaneous itemized
deductions for legal expenses related to punitive
damage awards are not allowed for purposes of
calculating AMT. Sec. 56(b)(1)(A)(i), I.R.C.;
Alexander v. Commissioner, 72 F.3d 938 (1st Cir. 1995),
affg. T.C. Memo. 1995-51, applied.
3. Held, further, Ps' gross income includes their
punitive damage awards unreduced by attorney's fees
(and costs). Cotnam v. Commissioner, 263 F.2d 119 (5th
Cir. 1959), affg. in part and revg. in part 28 T.C. 947
(1957), distinguished.
Philip Garrett Panitz, for petitioners.
Mark A. Weiner, for respondent.
MEMORANDUM OPINION
NIMS, Judge: In these consolidated cases, respondent
determined the following deficiencies with respect to the Federal
income taxes of petitioners Ivor F. and Debra A. Benci-Woodward
(the Benci-Woodwards), Laurentz J. and Barbara Mangum (the
Mangums), and Jose and Dianne M. Ragatz (the Ragatzes):
Docket No. 3769-96
(the Benci-Woodwards)
Year Deficiency
1992 $321,002
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Docket No. 4185-96
(the Mangums)
Year Deficiency
1992 $314,873
Docket No. 8265-96
(the Ragatzes)
Year Deficiency
1992 $316,965
Unless otherwise indicated, all section references are to
sections of the Internal Revenue Code in effect for the year in
issue. All Rule references are to the Tax Court Rules of
Practice and Procedure. All dollar amounts are rounded to the
nearest dollar.
After concessions by petitioners, the issues remaining for
decision are: (1) Whether legal expenses attributable to
petitioners' receipt of punitive damages constitute miscellaneous
itemized deductions within the meaning of section 67(b); if so,
(2) whether such deductions are subject to disallowance for
purposes of computing petitioners' alternative minimum tax (AMT)
liability; and (3) whether attorney's fees and costs may be
excluded from gross income under the facts of this case.
These cases were submitted fully stipulated. The
petitioners resided in California at the time they filed their
petitions.
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Background
Ivor F. Benci-Woodward (Benci-Woodward), Laurentz J. Mangum
(Mangum), and Jose Ragatz (Ragatz) (collectively referred to
herein as the plaintiffs) filed a lawsuit (lawsuit) against
Dayton-Hudson, Inc. (Dayton-Hudson), and Dana Pereau (Pereau)
(collectively referred to herein as the defendants). Plaintiffs
brought the following causes of action, among others, against the
defendants: False imprisonment, fraud, defamation, intentional
infliction of emotional distress, wrongful discharge, and breach
of contract.
In connection with the lawsuit, Benci-Woodward, Mangum, and
Ragatz each entered into a Retainer Agreement (Agreement) with
John H. Howard, an attorney, which empowered him to "handle any
and all legal proceedings arising out of said incidents", and
further provided, among other things, that
Client agrees to pay Attorney for services a sum equal
to forty percent (40%) of any amounts received or recovered
in this matter on behalf of Client. Attorney may retain his
share out of the amount finally collected by settlement or
judgment, herein termed "recovery", in full for the services
and any advanced costs.
Attorney is given a first lien and assignment on any
recovery however procured to the extent of this contract and
such amounts may be retained therefrom. Attorney is given a
further lien and assignment on any sums recovered herein for
fees incurred for all legal work performed for client
whatsoever and such amounts shall be in addition to the
contingent fee and costs provided for in this agreement.
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A jury trial was held before Judge Melinda A. Johnson of the
Superior Court of California, County of Ventura, on April 23,
1990. Verdict was entered on July 11, 1990. In addition to
awards for compensatory damages, each plaintiff was awarded
punitive damages in the amount of $1,190,000, plus interest, from
Dayton-Hudson. Furthermore, Ragatz and Mangum were each awarded
punitive damages in the amount of $16,000 from Pereau, plus
interest, and Benci-Woodward was awarded $12,000 in punitive
damages, plus interest, from Pereau. Dayton-Hudson paid its
portion of both the compensatory and punitive damage awards in
full to Howard's trust account.
According to a Breakdown dated October 8, 1992, supplied by
Howard to Benci-Woodward, the latter was entitled to receive a
net combined amount from Dayton-Hudson and Pereau of $915,097,
consisting of judgment amounts, interest, and costs paid by
Dayton-Hudson, less attorney's fees and certain costs advanced by
Howard and another. The $915,097 was disbursed by Howard to
Benci-Woodward out of the trust account.
According to a Breakdown dated October 8, 1992, supplied by
Howard to Ragatz, the latter was entitled to receive a net
combined amount from Dayton-Hudson and Pereau of $881,226,
consisting of judgment amounts, interest, and costs paid by
Dayton-Hudson, less attorney's fees, costs advanced by Howard,
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and certain other miscellaneous items. The $881,226.03 was
disbursed by Howard to Ragatz out of the trust account.
The details of the disbursement to Mangum are not in the
record.
Petitioners did not report their punitive damages awards as
taxable income on their respective 1992 tax returns, although the
Benci-Woodwards and the Mangums disclosed the awards on their
returns. In addition, petitioners did not report in full their
interest on punitive damages on their respective 1992 returns.
Respondent timely issued notices of deficiency to
petitioners. Among other adjustments, respondent determined that
punitive damages and related interest were fully includable in
petitioners' gross income pursuant to section 61. Petitioners
have since conceded that their punitive damages, and related
interest, are includable in gross income in the amounts
determined by respondent. See O'Gilvie v. United States, 519
U.S. 79 (1996).
Respondent also determined that the Benci-Woodwards, the
Mangums, and the Ragatzes were entitled to miscellaneous itemized
deductions, subject to the 2-percent floor provided by section
67(a), for attorney's fees and costs attributable to the punitive
damages awards in the amounts of $670,135, $626,448, and
$609,767, respectively. However, for AMT purposes, respondent
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disallowed petitioners' miscellaneous itemized deductions for
legal fees completely, and determined AMT liability for the
Benci-Woodwards, the Mangums, and the Ragatzes in the respective
amounts of $85,009, $73,787, and $75,694.
Howard reported on Schedule C, Profit or Loss From Business
(Sole Proprietorship), attached to his 1992 individual tax return
as gross receipts from his legal practice all of the attorney's
fees he received from plaintiffs.
Discussion
The dispute here concerns the appropriate treatment for the
legal fees and costs attributable to punitive damages that the
plaintiffs incurred in pursuing their lawsuit against the
defendants. Section 67(a) imposes a 2-percent floor on the
miscellaneous itemized deductions of individuals for all taxable
years beginning after December 31, 1986. In other words,
miscellaneous itemized deductions may be taken only to the extent
that they exceed 2 percent of an individual taxpayer's adjusted
gross income. Miscellaneous itemized deductions are defined in
section 67(b) as those itemized deductions that are not
specifically enumerated therein. Legal expenses related to the
production or collection of income and thereby deductible under
section 212(1), as here, are not specifically enumerated in
section 67(b).
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Petitioners argue that Congress never intended legal
expenses attributable to punitive damages to fall within the
category of miscellaneous itemized deductions. In that
connection, petitioners maintain that
Since punitive damage awards were not definitively
determined to be taxable until recently, there was no
prior need for a determination that attorney fees
should be allowed as an itemized deduction excluded
from the miscellaneous itemized deduction "catch-all"
of section 67(b).
Petitioners cite no authority in support of their
proposition, and their argument is, in fact, untenable. The
treatment of legal expenses attributable to punitive damages as
miscellaneous itemized deductions results from the purely
mechanical application of section 67. Moreover, such treatment
accords with the treatment of legal fees attributable to damages
awarded in, or settlements connected with, contractual disputes,
for example, which have always been subject to tax. Alexander v.
Commissioner, 72 F.3d 938 (1st Cir. 1995), affg. T.C. Memo. 1995-
51; see also Brewer v. Commissioner, T.C. Memo. 1997-542 (holding
that a deduction for legal fees attributable to settlement of
Title VII gender discrimination suit is a miscellaneous itemized
deduction subject to the 2-percent floor); Glassman v.
Commissioner, T.C. Memo. 1997-497 (holding that section 212
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deduction for legal fees is a miscellaneous itemized deduction
subject to section 67(a)).
Had Congress intended to except legal fees attributable to
taxable punitive damages from the 2-percent limitation of section
67(a), it easily could have done so. It did not, and we must
interpret the statute as it is written. See United States v. Ron
Pair Enters., Inc., 489 U.S. 235, 241 (1989); see also Estate of
Young v. Commissioner, 81 T.C. 879, 890 (1983) (Chabot, J.,
concurring), where it is observed that "our task is to interpret
the statute that the Congress enacted and not to guess at what
the Congress would have done had it faced the matter we deal with
in the instant case".
We hold that legal expenses incurred in connection with the
receipt of punitive damages constitute miscellaneous itemized
deductions within the meaning of section 67(b). Having so held,
we must also decide whether miscellaneous itemized deductions for
legal expenses related to receipt of punitive damages are subject
to disallowance pursuant to section 56(b)(1)(A)(i) for purposes
of computing petitioners' AMT.
Since 1969, the Internal Revenue Code has included minimum
tax provisions for both corporate and individual taxpayers. Tax
Reform Act of 1969, Pub. L. 91-172, 83 Stat. 487. Congress
enacted the minimum tax to prevent corporate and individual
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taxpayers from aggregating deductions to the point where they pay
either no tax or a "shockingly low" tax. First Chicago Corp. v.
Commissioner, 842 F.2d 180, 181 (7th Cir. 1988), affg. 88 T.C.
663 (1987).
The post-1986 AMT rules, codified as sections 55 through 59,
were enacted to achieve one overriding objective: To establish a
floor for tax liability, so that a taxpayer pays some tax
regardless of the tax benefits available to him under the regular
income tax (RIT). See S. Rept. 99-313 (1986), 1986-3 C.B. (Vol.
3) 515, 518. The AMT is paid only if, and to the extent that, it
exceeds the taxpayer's RIT. Sec. 55(a). Computing AMT liability
begins with determining alternative minimum taxable income
(AMTI). AMTI is computed in the same manner as regular taxable
income except that the adjustments provided in sections 56 and 58
are taken into account for AMTI, and so-called tax preference
items set forth in section 57 are not permitted to reduce AMTI.
Sec. 55(b)(2).
Section 56(b) provides as follows:
(b) Adjustments Applicable to Individuals.--In
determining the amount of the alternative minimum
taxable income of any taxpayer (other than a
corporation), the following treatment shall apply (in
lieu of the treatment applicable for purposes of
computing the regular tax):
(1) Limitations on deductions.--
(A) In general.--No deduction shall be
allowed--
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(i) for any miscellaneous itemized
deduction (as defined in section 67(b))
* * * [Emphasis added.]
Thus, since we have already concluded that the legal
expenses at issue are miscellaneous itemized deductions within
the meaning of section 67(b), it follows that they are not
allowed for purposes of computing petitioners' AMT liability.
Alexander v. Commissioner, supra; sec. 56(b)(1)(A)(i); sec. 1.67-
1T(a)(1)(ii), Temporary Income Tax Regs., 53 Fed. Reg. 9875 (Mar.
28, 1988).
Petitioners acknowledge that section 56(b)(1)(A)(i)
expressly disallows miscellaneous itemized deductions for
purposes of computing AMT. However, petitioners alternatively
assert that the application of the AMT in the instant cases
unfairly creates "a circumstance of double taxation", inasmuch as
petitioners and attorney Howard must pay tax on the same amount
recovered from the defendants. Petitioners' argument on this
score is unavailing. See, e.g., Alexander v. Commissioner, supra
at 947 ("It is well established that equitable arguments cannot
overcome the plain meaning of the statute.").
We hold that petitioners' legal expenses are miscellaneous
itemized deductions subject to disallowance pursuant to section
56(b)(1)(A)(i) for purposes of computing petitioners' AMT
liability for their 1992 taxable years.
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Petitioners argue in the alternative that they are in the
"identical position as the taxpayers in Cotnam and Davis." See
Cotnam v. Commissioner, 263 F.2d 119 (5th Cir. 1959), affg. in
part and revg. in part 28 T.C. 947 (1957); Davis v. Commissioner,
T.C. Memo. 1998-248. While as to the salient facts this may be
true, petitioners' legal position is not the same.
In Cotnam v. Commissioner, supra at 125, the Court of
Appeals for the Fifth Circuit concluded that under 46 Ala. Code
sec. 64 (1940), attorneys have the same right over "suits,
judgments, and decrees for money" as their clients, so the
taxpayer in that case did not realize income as to her attorneys'
interests of 40 percent in her cause of action and judgment.
Davis v. Commissioner, supra, involving the case of a taxpayer
who was a resident of Alabama, followed Cotnam. See Golsen v.
Commissioner, 54 T.C. 742 (1970), affd. 445 F.2d 985 (10th Cir.
1971).
The law of Alabama, as analyzed in Cotnam, is not the law of
California, the State of petitioners' residence during all times
relevant here. The parties have not brought to our attention any
statute of California regulating attorney's liens, and we are
aware of none. Nevertheless, the case law of California is clear
that liens for attorney's fees, whether created expressly or
implied from a retainer agreement, do not transfer to the
attorney an ownership or proprietary interest in the client's
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cause of action. In an en banc opinion, Isrin v. Superior Court
of Los Angeles County, 403 P.2d 728, 732 (Cal. 1965), the Supreme
Court of California concluded that contingent fee agreements "do
not operate to transfer a part of the cause of action to the
attorney but only give him a lien upon his client's recovery."
Petitioners also argue that cases which have addressed the
taxability of punitive damages have consistently analyzed those
damages net of attorney's fees and costs. Petitioners cite
Hawkins v. United States, 30 F.3d 1077 (9th Cir. 1994); O'Gilvie
v. United States, 66 F.3d 1550 (10th Cir. 1995), affd. in part,
revd. on the issue of taxability of punitive damages 519 U.S. 79
(1996); and Commissioner v. Miller, 914 F.2d 586 (4th Cir. 1990),
revg. and remanding 93 T.C. 330 (1989), supplemented by T.C.
Memo. 1993-49.
In both Hawkins v. United States, supra, and O'Gilvie v.
United States, supra, the respective Courts appear to have
accepted, without further consideration or discussion, the
premise that the question to be resolved was the taxability of
punitive damages, net of attorney's fees and costs. In
Commissioner v. Miller, supra, the Court of Appeals for the
Fourth Circuit reversed a prior Tax Court decision holding that
punitive damages are exempt from tax. The taxpayer had obtained
a jury verdict awarding $500,000 in compensatory damages and
$450,000 in punitive damages, which was settled for an overall
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amount of $900,000, the taxpayer receiving a net of $525,000
after attorney's fees and costs. On remand, the Court of Appeals
provided the Tax Court with instructions on possible methods of
valuing the punitive damage portion of the settlement, stating
that "It is appropriate for the case to be remanded to the Tax
Court to permit a determination as to what portion of the
$900,000 gross amount in settlement (reduced to $525,000 net) was
attributable to punitive damages." Id. at 592. (Emphasis
added). The Court of Appeals does not explain its reason for
reducing the $900,000 gross amount to the $525,000 net amount,
before the directed allocation between punitive and compensatory
damages.
With the exception of Cotnam v. Commissioner, supra, and
Davis v. Commissioner, supra (which, as noted, followed Cotnam
under the Golsen rule), courts, when directly confronted with the
question, have uniformly rejected the contention that taxpayers
may exclude the amount of their legal fees and costs from gross
income in cases such as the one before us. Since the courts in
the 3 cases cited by petitioners were not so confronted, and
therefore did not have the occasion to focus directly on the
issue, we decline to accept those cases as precedent for the
proposition that petitioners' gross income is to be determined
net of their attorney's fees (and costs). For examples of recent
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cases which have distinguished Cotnam, see Sinyard v.
Commissioner, T.C. Memo. 1998-364; Srivastava v. Commissioner,
T.C. Memo. 1998-362; and Coady v. Commissioner, T.C. Memo. 1998-
291, and additional cases cited therein. We hold that
petitioners' gross income includes their punitive damage awards
unreduced by their attorney's fees (and costs).
To reflect the foregoing and petitioners' concessions,
Decisions will be entered
for respondent.