Contingent fees are only paid by the client to the lawyer only if the case was successfully handled. Clients and lawyers use this arrangement only when a case is based on claiming money, such as worker’s compensation or personal injuries. In such an arrangement, lawyers agree to accept a fixed percentage of the recovery (the amount finally paid to the client), usually one-third of it.
There are some cases in which lawyers try to negotiate with the insurance companies to easily settle the case. In such cases, the lawyers usually take lower percentages of the money, and it is much better, in general, to avoid going to court and filing lawsuits.
In criminal or family law cases, most jurisdictions prohibit working for a contingent fee as mentioned in Rule 1.5(d) of the Model Rules of Professional Conduct of the American Bar Association.
Some contingent fees arrangements can include a percentage of 100% or even more, these arrangements are usually characterized as being “revenge” cases, in which causing damage to the other parties involved is much more important than gaining money.
Contingent fee paid to attorneys is taxable income because on January 24, 2005; the United States Supreme Court ruled that all litigation recoveries of damages are taxable income, which includes contingent fees paid to attorneys. The Supreme Court reached a decision that attorney’s fees paid out of a judgment or with a contingent fee agreement are includable in a claimant’s gross income for federal tax purposes. The court prioritized the government’s position on the strength of a doctrine that says, “A taxpayer cannot exclude an economic gain from gross income by assigning the gain in advance to another party.”
To explain how that is valid, we have the case of Sigitas Banaitis who was a Vice President and Loan Officer with Mitsubishi Bank and the Bank of California. Banaitis developed stress-related medical problems during his employment and alleged that he was pressured to resign. He sued Mitsubishi Bank for intentional interference with economic and employment expectations and the Bank of California for their wrongful discharge in violation of public policy.
In 1991, a jury awarded Banaitis punitive and compensatory damages. The defendants paid $8.7 million in damages. And to follow the original contingency fee agreement, the defendants paid an approximately $4.8 million to Banaitis and $3.8 directly to Banaitis’ attorney. The plaintiff excluded the $8.7 Million settlement from gross income on his Federal Income Tax return and attached a statement of explanation to his return documents.
The Court’s decision confirms one of the oldest principles in income tax jurisprudence, namely, that income should be taxed only to the one who earned it, regardless of any attempts at anticipatory assignment of the income or damages to someone else. The Court stated that a contingent fee agreement constituted an anticipatory assignment to the attorney of a portion of the client’s income from the litigation recovery.