The Demise of Cotnam and the Impact of the Jobs Act on the Income Tax Treatment of Contingent Legal Fees

Throughout the twentieth century, scholars and practitioners have debated the role of state law in the income tax treatment of contingent legal fees. Most courts held that taxpayers are taxable on legal awards that they, in turn, pay to their attorneys as contingent legal fees. In 1959, however, the then-Fifth Circuit Court of Appeals held to the contrary in Cotnam v. Commissioner, 263 F.2d 119, concluding that the attorneys, not the taxpayer, had an ownership interest in the award under state law. For many years, other circuits ignored the Cotnam decision, generally concluding that it was based on little more than sympathy for the taxpayer. The Cotnam decision was revived in two controversial holdings by the Sixth Circuit in 2000 and 2003, exacerbating the existing inter-circuit split of opinion. The Ninth Circuit joined the fray in 2003 when it reversed its previous position and allowed a taxpayer to exclude a legal award that was paid as contingent legal fees from income on the basis of state law, creating an intra-circuit split. The Supreme Court intervened to settle the dispute in early 2005, concluding that taxpayers are taxable on legal awards that are paid as contingent legal fees, notwithstanding provisions of state law. The Supreme Court's decision has been rendered moot for a number of taxpayers, however, by the American Jobs Creation Act of 2004, which allows taxpayers to effectively exclude from income any legal fees, whether contingent or hourly, and court costs in certain unlawful discrimination cases, claims against the government and claims brought under the Social Security Act.