Estate of Arthur L. Clarks, by v. United States of America

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RECOMMENDED FOR FULL-TEXT PUBLICATION
Pursuant to Sixth Circuit Rule 206
ELECTRONIC CITATION: 2000 FED App. 0020P (6th Cir.)
File Name: 00a0020p.06
UNITED STATES COURT OF APPEALS
FOR THE SIXTH CIRCUIT
_________________
ESTATE OF ARTHUR L.
C LARKS, by and through its
duly appointed Independent
Personal Representative,
M ARY J. BRISCO -W HITTER,
also known as MARY J.
C LARKS,
Plaintiff-Appellant,
v.
UNITED S TATES OF AMERICA ,
Defendant-Appellee.
;>

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No. 98-2437
Appeal from the United States District Court
for the Eastern District of Michigan at Ann Arbor.
No. 96-60446—George C. Steeh, District Judge.
Argued: December 16, 1999
Decided and Filed: January 13, 2000

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2 Clarks v. United States No. 98-2437
*The Honorable Sandra S. Beckwith, United States District Judge for
the Southern District of Ohio, sitting by designation.
Before: MERRITT and SILER, Circuit Judges;
BECKWITH, District Judge.*
_________________
COUNSEL
ARGUED: Harley D. Manela, LAKRITZ, HERMAN &
WISSBRUN, Bingham Farms, Michigan, for Appellant.
Kenneth W. Rosenberg, U.S. DEPARTMENT OF JUSTICE,
APPELLATE SECTION, TAX DIVISION, Washington,
D.C., for Appellee. ON BRIEF: Harley D. Manela,
LAKRITZ, HERMAN & WISSBRUN, Bingham Farms,
Michigan, for Appellant. Kenneth W. Rosenberg, Kenneth L.
Greene, U.S. DEPARTMENT OF JUSTICE, APPELLATE
SECTION, TAX DIVISION, Washington, D.C., for Appellee.
_________________
OPINION
_________________
MERRITT, Circuit Judge. The question on appeal
concerns the federal income taxation of clients on contingent
fees paid to lawyers. In June 1988, a jury awarded Arthur
Clarks $5,600,000 in personal injury damages against K-Mart
for head injuries sustained while unloading his truck. In
1991, K-Mart paid $11,307,875.55 in total satisfaction of the
judgment, $5,600,000 for the award and $5,707,837.55 in
interest. From that amount, the judgment debtor paid Clarks’
lawyer under a one-third, contingent fee contract
$1,865,156.54 based on the original award and $1,901,314.67
based on the interest for a total fee of $3,766,471.21. After
Clarks died in March 1992, his estate filed his 1040 for the
1991 tax year. Recovery for personal injury is ordinarily not
taxable under § 104(a)(2) of the Internal Revenue Code, but
the interest on the award is. The only question before us on
No. 98-2437 Clarks v. United States 7
interest, only a hope to receive money from the lawyer's
efforts and the client's right, a right yet to be determined by
judge and jury. Clarks, as an assignor, had no predetermined
interest in any res before entering a contingency fee
arrangement with his attorney, unlike the taxpayer plaintiffs
in Lucas and Horst. There was no purpose to shift tax
liability among members of a family.
In Lucas and Horst, the assignees were the object of gifts
and not subject to income taxation themselves if the income
was taxed to their assignor or donor. The IRS chose to tax the
assignors, not both the donors and donees. By having the
income taxed to the donor, the donee escapes income
taxation. Not so here. Here the lawyer is taxed on the full
amount of the payment. Under the government’s theory both
the lawyer and the client are taxable.
The present transaction under scrutiny is more like a
division of property than an assignment of income. Here the
client as assignor has transferred some of the trees in his
orchard, not merely the fruit from the trees. The lawyer has
become a tenant in common of the orchard owner and must
cultivate and care for and harvest the fruit of the entire tract.
Here the lawyer’s income is the result of his own personal
skill and judgment, not the skill or largess of a family member
who wants to split his income to avoid taxation. The income
should be charged to the one who earned it and received it,
not as under the government’s theory of the case, to one who
neither received it nor earned it. The situation is no different
from the transfer of a one-third interest in real estate that is
thereafter leased to a tenant. See Wodehouse v. Comm’r, 177
F.2d 881, 884 (2d Cir. 1949); Surrey, “Assignments of
Income and Related Devices, Choice of the Taxable Person,”
33 C OL. L. R EV . 791 (1933).
For the forgoing reasons, we reverse the judgment of the
district court and grant plaintiff estate's motion for summary
judgment.

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6 Clarks v. United States No. 98-2437
never received the income apportioned to his wife and Horst
never actually received any interest from the coupons, both
claimed that they should not have to include the assignment
as income. In rejecting the taxpayer’s argument, the Supreme
Court concluded that the "dominant purpose of the revenues
laws is the taxation of income to those who earn or otherwise
create the right to receive it and enjoy the benefit of it when
paid." Horst, 311 U.S. at 119. In Lucas and Horst, each
taxpayer earned and created the right to receive and enjoy the
benefit of the income before any assignment.
We follow Cotnam concluding that the majority in Cotnam
correctly distinguished Lucas v. Earl, 281 U.S. 111 (1930),
and Helvering v. Horst, 311 U.S. 112 (1940). In the instant
case, as in Cotnam, the value of taxpayer's lawsuit was
entirely speculative and dependent on the services of counsel.
The claim simply amounted to an intangible, contingent
expectancy. The only economic benefit Clarks could derive
from his claim against the defendant in state court was to use
the contingent part of it to help him collect the remainder.
Like an interest in a partnership agreement or joint venture,
Clarks contracted for services and assigned his lawyer a one-
third interest in the venture in order that he might have a
chance to recover the remaining two-thirds. Just as in
Cotnam, the assignment Clarks' lawyer received operated as
a lien on a portion of the judgment sought to be recovered
transferring ownership of that portion of the judgment to the
attorney.
In Lucas and Horst, the income assigned to the assignee
was already earned, vested and relatively certain to be paid to
the assignor. It was a gift of accrued income to a family
member. The assignor’s purpose was to split income with a
family member and avoid the donor’s higher rate under the
progressive income tax. The income had a tangible known
value to the assignor. The assignee performed no services in
order to receive the income. There was no business purpose
other than tax avoidance. There was no joint venture to
reduce a speculative claim to money. Not so in this case.
Here there was no res, no fund, no proceeds, no vested
No. 98-2437 Clarks v. United States 3
appeal is whether the $1,901,314.67 in interest paid to the
lawyer must be included as gross income of the decedent
under § 61(a) of the tax code (“gross income means all
income from whatever source derived”), as well as included
in the lawyer’s income. The estate did not include the interest
portion of the attorney fee award as interest income because
the estate did not receive any of the money. It was paid
directly to the lawyer.
In November 1992, the IRS conducted an audit of Clarks'
1991 tax return. It notified the decedent’s estate that it had a
tax deficiency of $254,298 because the estate improperly
failed to include as income the interest paid to the lawyer on
the contingent fee contract and because the interest should be
deducted as a miscellaneous itemized deduction subject to a
two percent of adjusted gross income limitation. See 26
U.S.C. §§ 61(a), 67(a). As a result of the two percent floor on
itemized deductions under Code § 67(a) ("miscellaneous
itemized deductions... allowed only to the extent that the
aggregate of such deductions exceeds 2 percent of adjusted
gross income") and the alternative minimum tax applicable to
interest income under Code § 55, the estate had to pay the
additional $254,298 in taxes owed, plus interest. The estate
filed an action in federal district court seeking a refund of all
tax and interest paid on the interest portion of the damage
award for the 1991 tax year. At no time has the non-interest
portion of the award ($5,600,000) been at issue since it is
clearly not taxable as income pursuant to 26 U.S.C.
§ 104(a)(2). Neither is there an issue before us concerning the
taxation of the income in the hands of the lawyer. Both
parties filed cross motions for summary judgment. The
district court granted summary judgment for the government
and against the taxpayer. We do not agree.
* * *
There is a conflict in the Circuits on the issue of whether
the interest portion of an attorney's contingency fee should be
included in the client’s income under Code § 61(a), even
though the lawyer received and paid taxes on all of the money

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4 Clarks v. United States No. 98-2437
and the client received none of the money. Compare Cotnam
v. Comm'r, 263 F.2d 119 (5th Cir. 1959), with Baylin v.
United States, 43 F.3d 1451 (Fed. Cir. 1995). Cotnam was
the first to address the issue. In a 2-1 decision, the old Fifth
Circuit held that the amount of the contingent fee paid out of
the judgment to plaintiff's attorneys was not income to
plaintiff. See Cotnam, 263 F.2d at 126. Under Alabama state
law, a contingency fee contract operates as a lien on the
recovery. The Alabama code provided at the time that
"attorneys at law shall have the same right and power over
said suits, judgments and decrees, to enforce their liens, as
their clients had or may have for the amount due thereon to
them." 46 ALA . C ODE § 64 (1940). The Cotnam court found
that this lien operated as a transfer of part of plaintiff's claim
and that any recovery as to that portion of the claim would not
be regarded as gross income to the plaintiff taxpayer.
Cotnam, 263 F.2d at 125. The court concluded that the
amount of the contingent fee was earned by the attorney, not
the taxpayer, whose only real economic benefit from the
claim amounted to a percent of the total judgment he received
due to the lawyer's efforts. See id. at 126.
The common law lien in this case under Michigan law
operates in more or less the same way as the Alabama lien in
Cotnam. R AY ANDREWS BROWN , THE LAW OF P ERSONAL
P ROPERTY § 116, at 559 (2d ed. 1955), describes a common
law attorney’s lien as follows:
According to Mr. Justice Earl, of the New York Court of
Appeals, “the lien, as thus established, is not strictly like
any other lien known to the law, because it may exist
although the attorney has not and cannot, in any proper
senses, have possession of the judgment recovered. It is
a peculiar lien, to be enforced by peculiar methods. It
was a device invented by the courts for the protection of
attorneys against the knavery of their clients, by disabling
clients from receiving the fruits of recoveries without
paying for the valuable services by which the recoveries
were obtained. The lien was never enforced like other
liens. If the fund recovered was in possession or under
No. 98-2437 Clarks v. United States 5
the control of the court, it would not allow the client to
obtain it until he had paid his attorney, and in
administering the fund it would see that the attorney was
protected. If the thing recovered was in a judgment, and
notice of the attorney’s claim had been given, the court
would not allow the judgment to be paid to the prejudice
of the attorney.” [Quoting Goodrich v. McDonald, 112
N.Y. 157, 19 N.E. 649 (1889)].
Although the underlying claim for personal injury was
originally owned by the client, the client lost his right to
receive payment for the lawyer’s portion of the judgment.
Michigan law is not inconsistent with this view of the
attorney’s lien, Dreiband v. Candler, 166 Mich. 49, 131 N.W.
129 (1911), — holding that “the [contingent fee] agreement
amounts to an assignment of a portion of the judgment sought
to be recovered.” Id. at 51, 131 N.W. at 129.
In a more recent decision, the Federal Circuit reached the
opposite result. Baylin held that the contingent fee portion of
settlement from a condemnation proceeding paid directly to
the lawyer was income to the plaintiff taxpayer. Baylin, 43
F.3d at 1455. Baylin mentioned the Supreme Court's liberal
interpretation of "gross income" and then found that although
the plaintiff never had actual possession of the funds paid to
the lawyer, plaintiff received the benefit of those funds in that
they discharged an obligation of the plaintiff owed to the
lawyer as a result of his work. See Baylin, 43 F.3d at 1454.
Baylin relied on two early Supreme Court tax cases
interpreting § 61(a), Lucas v. Earl, 281 U.S. 111 (1930) and
Helvering v. Horst, 311 U.S. 112 (1940). In Lucas, taxpayer
Earl assigned one half his right to salary and fees earned by
him to his wife in order to avoid paying taxes on the whole,
Lucas, 281 U.S. at 113-14. In Horst, taxpayer Horst, the
owner of negotiable bonds, detached from them negotiable
interest coupons shortly before their due date and delivered
them as a gift to his son who later that year collected interest
on them. Horst, 311 U.S. at 114. Even though the proceeds
were originally vested in the donors, since Lucas himself

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