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Plaintiffs Must Pay Income Tax On Gross Recoveries,
Including Contingent Attorney’s Fees

PBy FRED SIMPSON

In January, the United States Supreme Court resolved a controversy among the various circuits in Commissioner v. Banks, ___ U.S. ___, 126 S. Ct. 826, 160 L. Ed. 2d 859 (Jan. 24, 2005). The Fifth, Sixth, and Eleventh Circuits were reversed in their holdings that taxpaying plaintiffs could exclude contingent fee payments to lawyers from gross income, approving the contrary position of six other circuits.
The reversed Fifth Circuit case, the prior law of Texas, was Srivastava v. Commissioner, 220 F.3d 353 (5th Cir. 2000). There, the Fifth Circuit circumvented the 1930 U.S. Supreme Court decision in Lucas v. Earl in favor of allowing taxpayers to net out attorney’s fees. The Circuit’s decision eliminated anticipatory assignments of income, in part on the rationale that an attorney’s work helps grow fruit on another’s tree. In addition, the Circuit Court was bound by a previous decision governed by Alabama law, which granted statutory ownership rights to attorneys who received fee assignments from their clients.
In Banks, the Supreme Court rejected the notion that a plaintiff’s case has no value at the moment the client enters a contingent fee contract with an attorney. The Court also rejected the idea that the client and attorney enter a joint venture or partnership when they sign a contingent fee contract. Instead, the Court found the attorney-client arrangement is purely a principal/agent situation where the attorney, as agent, has a fiduciary duty to act solely on behalf of the client-principal.
The impact of Banks is perhaps not as sweeping as one might initially conclude. First, fee-shifting statutes such as the American Jobs Creation Act of 2004 specifically allow attorney’s fees to be deducted from gross income in a variety of cases controlled by federal law. Second, personal injury or physical sickness recoveries (exclusive of interest and punitive damages) are tax exempt under 26 U.S.C. § 104(a)(2). Therefore, the actual effect of the general rule imposed by Banks may be limited to damages or settlements to the extent they involve: (a) interest, (b) punitive damages, (c) defamation damages, (d) fraud or deception damages, or (e) commercial situations where benefit of the bargain or out-of-pocket, or lost income or profits are the measures of damages.

Fred Simpson is a partner at Jackson Walker L.L.P. in Houston and a member of the editorial board of The Houston Lawyer.

Collateral Estoppel in Bankruptcy:
How Courts Handle Fiduciary Duties

By DON D. FORD III

In Gupta v. Eastern Idaho Tumor Institute, Inc., 394 F3d 347 (5th Cir. 2004), the Fifth Circuit Court of Appeals addressed the issue of when collateral estoppel applies to bar re-litigating a judgment that denies the discharge in bankruptcy of a debt for “fraud or defalcation while acting in a fiduciary capacity.”
In 1995, Dr. Gupta signed a joint venture agreement with Eastern Idaho’s predecessor company to operate a radiological clinic. The agreement had a twelve-month term and assigned specific responsibilities to each party. Gupta was responsible for medical and professional staffing, while Northwest contributed all necessary equipment, office space, and machinery. Revenues would be divided equally between the parties, and the parties would share equally in the management of the business. All non-medical decisions would be made by unanimous consent. The venture lapsed after the first twelve-month term, but Gupta remained on the property, conducted the same business, and retained all revenues collected for more than a year without paying any rent.
Eastern Idaho sued Gupta in Texas state court, and alleged that Gupta breached his fiduciary duty because he failed to divide the revenues and remit Eastern Idaho’s share. At trial, the jury found that a relationship of “trust and confidence” existed between the parties and that Gupta had breached both the joint venture agreement and the fiduciary duty to Eastern Idaho. Gupta appealed to the state appellate court and also filed for Chapter 7 bankruptcy.
Eastern Idaho objected to the discharge of its judgment debt in the bankruptcy, based on the state court jury findings of the breach of fiduciary duty. The bankruptcy court agreed with Eastern Idaho, saying that the state jury’s findings “are entitled to preclusive effect on the federal claim.” On appeal, the district court affirmed.
The Fifth Circuit, however, reversed. The Court first acknowledged that a bankruptcy court might apply collateral estoppel to preclude relitigation of state court issues relevant to dischargeability of a debt. However, the Court noted that the ultimate determination of dischargeability is a federal question. Basically, the scope of fiduciary concepts in bankruptcy is a federal question, but state law is important in determining when a trust obligation exists.
Nevertheless, the Court wrestled with the question of how to interpret the jury’s finding of a breach of fiduciary duty, in light of the difference between Texas partnership laws and the federal fiduciary standards. The Court recognized without question that debts arising from fraud or misappropriation by persons owing a traditional fiduciary duty (such as a corporate officer to the shareholders or a managing partner to the limited partners) are not dischargeable in bankruptcy. However, the Court noted a distinction with co-equal partners in a joint venture. The Court went on to examine the underlying duties imposed upon partners in a partnership or joint venture, recognizing that the partners’ duties are not to be expanded by “loose use of fiduciary concepts.”
In determining that collateral estoppel could not be used to preclude discharge, the Court noted that the jury’s finding of a breach of fiduciary duty was based on general phrases concerning the duty, rather than on specific events or actions. The Court further noted that there was no way to tie any of the damages back to specific instances of Gupta’s misconduct as a fiduciary under Texas partnership law. Instead, to uphold Eastern Idaho’s position, the Court would have required that the stricter guidelines of the federal fiduciary standards be found, and that the jury make specific findings as to the more limited issues that would impose strict fiduciary standards upon equal partners in a partnership or joint venture under Texas law.
The Court also observed that Texas partnership law was specifically amended in 1994 to delete former language regarding partners’ fiduciary duties to each, and to state specifically that, “Trustee Standard Inapplicable. A partner, in that capacity, is not a trustee and is not held to the same standards as a trustee.” Based on the lack of specific evidence and findings of a specific fiduciary relationship in the parties’ contract, the Court held that the state court judgment should not be permitted to govern the bankruptcy discharge determination.

Don D. Ford III is a partner with Ford & Mathiason LLP and practices in the area of Estate Planning, Probate & Guardianships. He is a member of the
editorial board of The Houston Lawyer.

Faulty Expert Opinions and Excited Utterances

By FRED A. SIMPSON

The Texas Supreme Court clarified the rules for expert witnesses testimony concerning causation for certain product liability claims in Volkswagen of America, Inc. v. Ramirez, 48 Tex. Sup. Ct. J. 307 (Dec. 31, 2004). At the same time, the Court grappled with the rules addressing running objections, and reviewed the anatomy of the “excited utterance” exception to the hearsay rule.
Based on its finding of legally insufficient evidence, the Court reversed the trial court and court of appeals, and rendered a take nothing judgment for Volkswagen. Of the three key issues on appeal, two of them involved plaintiffs’ experts. These experts testified that a manufacturing defect in a Volkswagen Passat proximately caused a 1996 highway auto accident in which two drivers were killed. Essentially, these experts opined that the Passat’s separated rear wheel assembly caused the fatal accident, and was not the result of the accident.

The Supreme Court disposed of the two experts in this manner:

1. No evidence of causation in the testimony of an accident reconstruction expert because that expert failed to close an “analytical gap” with scientific analysis. This expert merely interpreted the facts subjectively, concluding that a mechanical failure caused the accident rather than resulted from the accident.

2. No evidence of causation in testimony by plaintiffs’ metallurgical expert who presented only conclusory or speculative opinions about causation based principally on the expert’s personal qualifications, not on any physical evidence. (A one-page concurring opinion by Justices Hecht and Owen provides a more complete rejection of this testimony as legal evidence sufficient to support a claim of causation.)

The third key issue concerned an unidentified eyewitness whose statements were admitted at trial. A local news crew videotaped its interview with the eyewitness. However, the witness never identified himself to the news crew, and was never located or deposed by any of the parties. Furthermore, the witness made his statements in a remarkably calm manner, after he had an opportunity to think about the crash. As such, his statements were not spontaneous reactions or excited utterances. Although the court of appeals ruled it harmless error to allow this testimony, the Supreme Court held that the testimony was barred by rules of evidence.

Fred A. Simpson is a litigation partner at Jackson Walker L.L.P. He is a member of the editorial board of The Houston Lawyer.

Prejudgment Interest Related to Personal Injury
is Taxable Income

By FRED A. SIMPSON

In Chamberlain v. United States, No. 03-31136, 2005 WL 3878554, 2005 U.S. App. LEXIS 2890 (5th Cir. Feb. 18, 2005), the Fifth Circuit held that the prejudgment interest on personal injury damages cannot be excluded from taxable income under Section 104(a)(2) of the Internal Revenue Code. Although this was a case of first impression for the Fifth Circuit, three other circuits – the First, Third and Tenth – previously ruled the same way on this issue.
In Chamberlain, the taxpayer sustained a swimming injury due to negligence of the State of Louisiana. Damages against the State totaled approximately $9 million, including about $3.8 million in prejudgment interest. When the IRS assessed income taxes on the prejudgment interest portion of the award, the taxpayer paid the assessment under protest and sued to have the contested amount refunded.
The district court granted summary judgment for the IRS, applying the following two-part inquiry: (1) was the recovery based on tort-type rights, and (2) were damages received “on account of” personal injuries or sickness? The district court determined that prejudgment interest is paid to compensate injured parties for the time value of money that is lost as a result of delinquent payment. The court so held, even though prejudgment interest is part of a plaintiff’s reparation damages under Louisiana Civil Law.
In a de novo review, the Fifth Circuit recognized the “sweeping scope” of Section 61(a) of the Internal Revenue Code, with its broad definition of gross income as “all income from whatever source derived.” The Court then looked for guidance from three seminal U.S. Supreme Court cases: United States v. Burke, 504 U.S. 229 (1992) (which held that back pay under Title VII was taxable); Commissioner v. Schleier, 515 U.S. 323, 336-37 (1995) (which held that age discrimination damages under the ADEA were taxable); and United States v. O’Gilvie, 519 U.S. 79 (1996) (which held that punitive damages was not a “return of the victim’s personal or financial capital,” and were therefore taxable).
The Fifth Circuit rejected the taxpayer’s arguments that the Supreme Court’s interpretations of the language of Section 104(a)(2) supports a theory of compensation “because of” personal injury, and the Louisiana statute that causes prejudgment interest to become part of compensatory damages. The Court gave four reasons for its holding:

1. In order to be nontaxable, damages must have more than a “but for” connection with the personal injury. Therefore, they must be payable to an individual because they serve to replace otherwise nontaxable “human capital.”

2. Prejudgment interest serves to compensate an injured party for the purely economic harm of lost time value of money, not as a substitute for lost human or financial capital.

3. There is no significant difference between the prejudgment interest in this case and what the First, Third and Tenth Circuits found to be taxable in their cases, notwithstanding the Louisiana statute that labels prejudgment interest as reparation damages. In fact, the history of the statute confirmed that such interest was for delayed payment.

4. The rule that exclusions from taxable income under Section 104(a)(2) must be narrowly construed is well established, and therefore, the Court must follow this precedent.

Fred A. Simpson is a litigation partner at Jackson Walker L.L.P. He is a member of the editorial board of The Houston Lawyer.

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