Banaitis v. CIR, 340 F.3d 1074 (9th Cir. 2003)

In his tort claims against his former employer (Bank of California) and its successor (Mitsubishi Bank), Sigitas Banaitis alleged wrongful discharge and interference with his employment agreement. After losing at trial in Oregon state court (where Banaitis obtained a $6.27 million verdict in his favor) and failing in their appeals, Mitsubishi Bank and the Bank of California settled with Banaitis, paying $3.86 million to Banaitis’s attorney and $4.86 million directly to Banaitis. Banaitis excluded from his gross income the entire $8.73 million settlement amount. The IRS delivered a notice of deficiency to Banaitis and asserted that he owed an additional $1.71 million in 1995 federal income taxes. The Tax Court ruled in favor of the IRS, holding that Banaitis was not entitled to exclude from his income settlement amounts attributable to economic damages, punitive damages or the attorney’s fees that were paid directly to his lawyer. The Ninth Circuit affirmed the Tax Court judgment that settlement amounts attributable to economic and punitive damages should have been included in gross income because they were not “on account of personal injury or sickness.” However, the Court held that the settlement amount allocated to attorney’s fees was not taxable to Banaitis, because Oregon state law “affords attorneys generous property interests in judgment and settlements.” (The Court noted that other states’ law, including California’s, differs from Oregon’s.)