It should not be a surprise to learn that attorneys often hire tax attorneys to help them minimize their taxes.
One popular tax savings strategy for attorneys is to structure their contingent fees.
A contingent fee is a payment arrangement in which a lawyer provides services on the condition that payment will only be made if the client wins or settles a case. In a contingent fee arrangement, the lawyer takes a percentage of the amount recovered as their fee, rather than charging an hourly rate or a fixed fee.
This type of arrangement is commonly used in personal injury, class action, and other types of lawsuits where the likelihood of recovery is uncertain and the client may not have the financial resources to pay a traditional fee upfront.
Contingent fee lawyers often enter into deferral agreements for tax purposes. With these agreements, the law firm assigns the right to receive their contingent fee to a third party who is then obligated to pay certain amounts to the lawyer in the future. The goal is to defer tax on the income until later years–preferably in a year in which the lawyer is in a lower tax bracket, potentially saving money on taxes.
There are other advantages as well. They can augment retirement income, provide guaranteed cash flow, and meet future overhead expenses. Additionally, they can accommodate diverse tax needs among partners and aid in buying out retiring partners. The fees can also be used to create college funds for children or grandchildren.
While this technique has been used by lawyers for quite some time, the IRS does not necessarily agree that the purported tax deferral can be realized. The IRS recently issued GLAM 2022-007 that addresses this very topic.
Facts & Procedural History
The taxpayer described in the guidance is a law firm. The law firm represents a client in a legal claim against a defendant.
The law firm and the client enter into a fee agreement, in which the client agrees to pay the law firm a 30% contingency fee out of any money paid by the defendant or the defendant’s insurance company as a result of a judgment or settlement. The law firm then negotiates a settlement agreement on behalf of the client, which results in a cash settlement of $1,500,000 (and this amount may be tax-free to the taxpayer).
Prior to the execution of the settlement agreement, the law firm enters into a deferral agreement with a third party, where the law firm agrees to transfer 100% of the legal fees it earns from the settlement to the third party in exchange for a lump sum amount to be paid in the future.
The settlement agreement is executed, and the insurance company transfers the settlement funds, with the law firm’s fee going to the third party. The third party placed the funds in a Rabbi Trust (which is a trust that holds funds for employees and is beyond the employer’s creditor’s reach) and the law firm obtained a loan from the third party, which is secured by the deferred payment.
With this arrangement, the law firm received the funds by way of a loan, but was not obligated to pay tax for some time in the future. The law firm took the position that the fee received in 2021 is not includible in its gross income based on the case of Childs v. Commissioner, 103 T.C. 634 (1994), aff’d without published opinion, 89 F.3d 856 (11th Cir. 1996).
Childs v. Commissioner – Assignment of Income
To better understand this issue, we also need to address the Childs v. Commissioner case.
The Childs case involved a settlement agreement between a plaintiff and defendant and, more specifically, the taxation of contingency fees received by attorneys who handled the case. The settlement agreements provided for payment of attorney’s fees through the assignment of obligations from the defendant’s insurance companies to a third insurance company, which purchased annuity policies for the attorneys. The case addressed whether the contingency fees were property for purposes of Section 83 and whether the doctrine of constructive receipt was applicable to the arrangement.
Section 83 applies when someone performs services and the payment for the services is delivered to a third party. Section 83 says that property transferred to a person for performing services has to be included in the income of the person who performed the services. The income is equal to the fair market value of the property (minus any amounts paid for it). This amount is income in the first tax year in which the property becomes transferable or is not subject to a substantial risk of forfeiture, whichever comes first.
Section 83 applies to “property,” such as real and personal property. It also applies to a promise to pay money in the future that is either funded or secured. The statute and regulations do not define when a promise to pay is considered “funded.” There have been court cases that touch on this topic in other tax contexts. They look to whether an economic or financial benefit was conferred on the taxpayer.
Given these other rulings, the U.S. Tax Court held that the fair market values of the taxpayers’ rights to receive payments under the settlement agreements were not includable in income under Section 83 in the year in which the settlement agreements were entered into. The court reasoned that the promises to pay under the structured settlements were neither funded nor secured and did not meet the definition of “property” for purposes of Section 83 (“the agreements by Georgia Casualty and Stonewall to pay petitioners in the future were unfunded and unsecured promises to pay money in the future, these agreements were not property within the meaning of section 83”).
Childs v. Commissioner – Constructive Receipt
The U.S. Tax Court also addressed the doctrine of constructive receipt. This issue starts with the concept of a method of accounting. For cash-basis taxpayers, their method of accounting is simple. They recognize income when they receive it.
But there is also the concept of constructive receipt. Income is constructively received by a taxpayer in the taxable year in which such income is credited to the taxpayer’s account, is set apart for the taxpayer, or is otherwise made available so that the taxpayer could have drawn upon it during the taxable year if notice of intention to withdraw had been given.
Income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions. The taxpayer recognizes income when the taxpayer has an unqualified, vested right to receive immediate payment. This means that there must be an amount that is immediately due and owing that the obligor is ready, willing, and able to pay. The amount owed must either be credited to the taxpayer or set aside for the taxpayer so that the taxpayer has an unrestricted right to receive it immediately, and the taxpayer being aware of these facts, declines to accept the payment.
Applying these rules to the attorney fee agreements in Childs, the court concluded that the taxpayers did not constructively receive their attorney’s fees for each case in the year that case was settled. The court noted that there was no money or property available at the law firms’ unfettered demand from the structured fee agreement. Thus, the court determined that the doctrine of constructive receipt was not applicable to the arrangement.
The IRS’s New Theory – The Economic Benefit Doctrine
With this background in Childs, we can get back to the simplified fact pattern in the IRS’s recent guidance.
In its recent guidance, the IRS concludes that the anticipatory assignment of income doctrine applies in this case because the taxpayer retained control over the disposition of the fee, diverted the payment to another entity, and realized a benefit when the cash representing the fee was received by that entity. The IRS argues that Childs only addresses Section 83 and constructive receipt. According to the IRS, Childs does not address the assignment of income doctrine.
The IRS guidance also argues that the economic benefit doctrine has to be considered and, it was not considered in Childs. The economic benefit doctrine holds that compensation received by a taxpayer must be recognized as gross income in the year that it is received, even if the compensation has been transferred to a third party and is beyond the reach of the taxpayer’s creditors.
This principle has been applied in various cases to funded compensation arrangements where the compensation was paid to a third party. For example, in United States v. Drescher, the Second Circuit Court of Appeals determined that the value of an annuity purchased by an employer for an employee was includible in the employee’s gross income in the year of purchase, rather than when payments were made, because the taxpayer had received an “economic benefit” in the form of the obligation of the insurance company to pay money in the future. Similarly, in Sproull v. Commissioner, an employer transferring money to a trust for the benefit of an employee was determined to be taxable income in the year the money was placed in the trust, because the payment to the trust represented an “economic or financial benefit conferred on the employee as compensation.” The principle of the economic benefit doctrine is that a taxpayer must include in gross income amounts paid to third parties exclusively for the taxpayer’s benefit that are not intended to be gifted.
According to the IRS’s guidance, it believes that this doctrine results in the law firm realizing its fee and owing tax on it in year one, not when the payments are received in the future.
The IRS’s New Theory – Section 409A
The IRS also argues that Section 409A applies as the arrangement was a non-qualified deferred compensation arrangement.
Section 409A applies to any plan that provides for the deferral of compensation other than qualified employer plans or certain bona fide leave, disability pay, or death benefit plans. According to the IRS, this “plan” fails to comply with the initial deferral election requirements of Section 409A(a)(4) and the law firm violated Section 409A(a)(3) by obtaining a loan from the third party could be repaid through an offset or reduction of the deferred payment. The IRS concludes that as a result of the violation of Section 409A, the entire value of the deferred payment is subject to income inclusion in the first year plus an additional 20% tax.
If the taxpayer could provide its response, it would no doubt dispute this contention. It would likely argue that, at best, the arrangement is an unfunded deferred compensation plan, and, as such, the fee is not taxable until the cash payment is received in the future years.
The practice of organizing attorney’s fees has grown into a lucrative business since the Childs ruling. With substantial amounts of money at play, sophisticated methods and products have been developed around these ideas. The recent release of guidance by the IRS, many years after the Childs decision, indicates that they may soon audit and challenge these arrangements, potentially leading to a reconsideration of the prior ruling in Childs and resulting in unfavorable outcomes. At present, this scenario has not yet come to fruition. In anticipation of this, those who structure attorney’s fees may want to consider the economic benefit doctrine and Section 409A when organizing their fees.
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