Legal aid fee award is not income to client with no fee obligation

Plain-English summary

A taxpayer obtained injunctive relief in a discrimination lawsuit while represented by two legal aid organizations. Both retainer agreements stated that the taxpayer would not have to pay the lawyers, and the defendants later paid the organizations' fees and costs under a settlement. The IRS ruled that those payments were not included in the taxpayer's gross income under IRC § 61. Unlike a contingency-fee recovery or payment of a taxpayer's debt, the award did not assign the taxpayer's income or discharge any legal obligation of the taxpayer.

Ruling snapshot

• Question: Are attorneys' fees paid directly to legal aid organizations taxable to a client who never owed those fees?
• Outcome: Approved
• Key authorities: IRC § 61; Commissioner v. Banks, 543 U.S. 426 (2005); Old Colony Trust Co. v. Commissioner, 279 U.S. 716 (1929)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201552001 [Third Party Communication:
Release Date: 12/24/2015 Date of Communication: Month DD, YYYY]
Index Number: 61.30-00
Person To Contact:
-------------------, ID No. ------------------

                                                           Telephone Number:

                                                           ----------------------

                                                           Refer Reply To:

                                                           CC:ITA:B04
                                                           PLR-107188-15
                                                           Date:
                                                           August 25, 2015


              TY: -------

Legend

Taxpayer = -----------------------------------------

Lawsuit = --------------------------------------------------

Defendants = -----------------------------------------------------------------------------
---------------------------------------------------------------------------------
---------------------------------------------------------------------------------
---------------------------------------------------------------------------------
-------------------------------

Court = -----------------------------------------------------------------------------
----------------

State = ----------------

Act 1 = -----------------------------------------------------------------------------

Act 2 = -----------------------------------------------------------------------------

Legal Aid Organization 1 = ----------------------------------------

Legal Aid Organization 2 = -----------------------------------------------------------------------------

Year 2 = --

$x =--

$y =--------------
PLR-107188-15 2

$z =----------

Dear -----------------:

This is in response to a request for a private letter ruling dated January 8, 2015,
submitted on your behalf by your authorized representative. You have requested a
ruling that an award of attorneys’ fees and costs paid by Defendants in settlement of
Lawsuit is not includible in your gross income under the circumstances described below.

FACTS

You engaged the services of two legal aid organizations to challenge under Act 1 and
Act 2 certain policies adopted by State. Act 1 forbids organizations receiving Federal
financial assistance from excluding or denying certain individuals an equal opportunity
to receive program benefits and services. Act 1 contains the following fee-shifting
provision:
In any action or proceeding to enforce or charge a violation of a provision of this
subchapter, the court, in its discretion, may allow the prevailing party, other than
the United States, a reasonable attorney’s fee as part of the costs.
Extending the prohibitions of Act 1, Act 2 prohibits discrimination by all public entities,
regardless whether they receive federal funding. Similar to the fee-shifting provision of
Act 1, Act 2 provides:

    In any action or administrative proceeding commenced pursuant to this chapter,
    the court or agency, in its discretion, may allow the prevailing party, other than
    the United States, a reasonable attorney’s fee, including litigation expenses, and
    costs, and the United States shall be liable for the foregoing the same as a
    private individual.

The retainer agreement with Legal Organization 1 provided that it would not charge you
for its legal work. Legal Aid Organization 1 and Legal Aid Organization 2 executed a
Request for Approval to Co-Counsel. The organizations reasoned that co-counseling
would expand the amount of legal resources available to you; the Legal Aid
Organization 2 attorney possessed special experience and expertise in the subject
matter to be litigated; and you were located in the area served by Legal Aid
Organization 2 and would otherwise be unrepresented. You were not a signatory to this
agreement. Subsequently, you executed a retainer agreement with Legal Aid
Organization 2, which provided that you would not have to pay for your lawyer or
paralegal.

The Lawsuit successfully sought injunctive relief against Defendants in Court under Act
1 and Act 2. Thereafter in Year 2, you and Defendants executed a settlement
PLR-107188-15 3

agreement requiring Defendants, inter alia, to pay attorneys’ fees and costs of $x ($z to
Legal Aid Organization 2 and $y to Legal Aid Organization 1.)

LAW AND ANALYSIS

Section 61(a) of the Internal Revenue Code defines “gross income” as “all income from
whatever source derived.” The Supreme Court broadly construed this definition “in
recognition of the intention of Congress to tax all gains except those specifically
exempted” from taxation by another section of the Code. Commissioner v. Glenshaw
Glass Co., 348 U.S. 426, 429-30 (1955).

Generally, a taxpayer must include in gross income under § 61 (a) of the Code fees and
costs recovered as a prevailing plaintiff. See, e.g., Sinyard v. Commissioner, 268 F.3d
756 (9th Cir. 2001), aff’g T.C. Memo. 1998-364. The rationale for this holding is
grounded in Old Colony Trust Co. v. Commissioner, 279 U.S. 716 (1929), where the
Court ruled that a taxpayer derives income when a third party discharges the taxpayer’s
legal obligation.

In Commissioner v. Banks, 543 U.S. 426 (2005), the Court held that the portion of a
plaintiff’s recovery from a money judgment or settlement paid to the plaintiff’s attorney
under a contingency-fee arrangement is included in the plaintiff’s gross income. The
Supreme Court viewed the contingency-fee agreement as an attempted anticipatory
assignment of income of a portion of the client’s income (litigation recovery) to the
attorney. The Court explained that a taxpayer cannot exclude an economic gain from
gross income by assigning the gain in advance to another party. Lucas v. Earl, 281
U.S. 111 (1930).

Attorneys’ fees awarded to a successful litigant are generally includible in a litigant’s
gross income under either the anticipatory assignment of income doctrine of Banks and
Earl or the payment of a liability doctrine enunciated in Old Colony Trust. However,
your situation is different because you had no obligation to pay attorneys’ fees.

CONCLUSION

Based on the information submitted and representations made, we conclude that the $y
paid to Legal Aid Organization 1 and the $z paid to Legal Aid Organization 2 is not
includible your gross income under § 61.

This ruling is directed only to Taxpayer, who requested it. Section 6110(k)(3) of the
Code provides that it may not be used or cited as precedent.
Except as expressly provided herein, we do not express or imply an opinion concerning
the tax consequences of any aspect of any transaction or item discussed or referenced
in this letter.
PLR-107188-15 4

A copy of this letter must be attached to any income tax return to which it is relevant.
Alternatively, taxpayers filing their returns electronically may satisfy this requirement by
attaching a statement to their return that provides the date and control number of the
letter ruling.
The ruling contained in this letter is based on information and representations submitted
by the taxpayer and accompanied by a penalty of perjury statement executed by an
appropriate party. While this office has not verified any of the material submitted in
support of the request for a ruling, it is subject to verification on examination.
In accordance with the Power of Attorney on file with this office, a copy of this letter is
being sent to your authorized representative.

                                   Sincerely,



                                   Michael J. Montemurro
                                   Chief, Branch 4
                                   Office of Associate Chief Counsel
                                   (Income Tax & Accounting)

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