The IRS has recently announced a compliance campaign intended to address “the attempted deferral of contingent or court-awarded attorney fees by cash-method attorneys/law firms (taxpayers) who direct that such fees be paid to a third-party instead of the taxpayer.”[1] The IRS is concerned that plaintiff’s attorneys are deferring payment of income tax on legal fees in contingent fee matters. This announcement comes on the heels of a recent Generic Legal Advice Memorandum (“GLAM”) by the IRS Office of Chief Counsel addressing these structures.[2]
Structured settlement agreements, where payments in settlement of a legal dispute are made over time rather than in a lump sum, are common. In contingent fee matters, attorneys face the question of how their fees are paid out of structured settlements. For example, if the attorney is to receive one-third of the settlement amount, how is that calculated when the plaintiff obtains a structured settlement? Is the attorney paid over time, i.e. as their client receives payments? Alternatively, is the attorney paid immediately based on a valuation of their client’s right to receive payments under the structured settlement? Typically, these questions should be answered in negotiating the settlement agreement.
As with most things in life, tax becomes part of the consideration for plaintiff’s attorneys in these questions. Similar to the timing of the attorney’s payment, when should the fee be taxed? Should the fee be taxed immediately when it is a fixed, determinable amount, i.e. when the settlement agreement becomes binding? Alternatively, should the attorney be taxed only as payments are received? As with many questions in tax law (or law in general), then answer is “it depends.” The structure of these fee arrangements largely should determine the tax result.
In Childs, the Tax Court, in the full en banc opinion that was subsequently affirmed by the Eleventh Circuit Court of Appeals, allowed deferral of income tax payable from the attorneys’ fees paid under a structured payment.[3] Since Childs, many plaintiff’s attorneys have used deferral arrangements both to smooth cash flows from settlements and to defer payment of income tax on their fees. Of course, qualifying for this treatment requires compliance with the tax law principles that allowed for the result in Childs. The IRS apparently believes, potentially correctly so, that many structures do not. They intend to make this a compliance priority.
GLAM Facts
In the GLAM, a cash method law firm represented a client in personal injury litigation. The law firm agreed to a 30% contingency fee from any funds paid by defendant or the defendant’s insurance company. Ultimately, before trial, a settlement agreement was entered into that provided for a cash settlement of $1,500,000. The law firm’s client desired to have the payment made “in full as soon as possible.”
Before the settlement agreement became final, the law firm entered into a deferral agreement under which the legal fees would be transferred to a third party (“Facilitator”). The Facilitator would hold the fees in a “Rabbi trust” arrangement[4] until payment of a lump sum to the law firm on August 1, 2031. The amount paid at that time would be based on investment performance in the portfolio selected by the law firm, less the Facilitator’s fees. The law firm had no right to assign, accelerate, defer, or change the terms of, or transfer or sell the deferred payment obligation.
Upon payment of the $1,500,000 settlement amount, the law firm directed the defendant’s insurance company to wire $1,050,000 to the law firm’s trust account to be held for their client. The law firm directed the remaining $450,000, representing legal fees, to be wired to the Facilitator.
Within one month of funds being wired to the Facilitator, the law firm obtained a $200,000 loan from the Facilitator. Under the terms of that loan, any default could be recovered by Facilitator against funds held in the law firm’s Rabbi trust. As of December 31, 2021, the deferred payment amount, after investment gains and the netting of Facilitator fees, was $470,000.
Fact Issues[5]
The GLAM and recent IRS announcement of a compliance campaign should likely be seen as significant in the structured settlement market. Of course, taxpayers should always exercise caution in structuring their arrangements to comply with tax law. That concern is heightened when there is affirmative IRS action on the issue (usually due to some overly aggressive taxpayers and promoters pushing the envelope beyond what existing authorities permit). However, it is worth noting that the GLAM, which presumably was the IRS’ first shot across the bow before announcing its compliance initiative, has some factual distinctions with typical structures, including the structure blessed by the Tax Court in Childs.
Some critical differences in the facts of the GLAM and what would be a more typical, or Childs, structure include:
- The settlement agreement in the GLAM provided for a cash payment in full at the time of settlement. This is in contrast with the settlement agreement, itself, providing for payments to be made over time, often including payments to the plaintiff (i.e. the law firm’s client, putting the law firm’s payment schedule on par with their client’s).
- Consistent with above, the law firm directed their fees, otherwise payable directly to the law firm in cash upon settlement, to be paid by the defendant (or the defendant’s insurance carrier) to the Facilitator. This is in lieu of the defendant having the obligation to pay fees in installments which the defendant then assigns to a Facilitator.
- The law firm’s client never consented or otherwise participated in the decision to pay the law firm under the terms of the deferral arrangement.
- The law firm’s funds were held in a segregated account, the Rabbi trust.
- The law firm had authority over investment of funds held in the Rabbi trust.
- Shortly after payment of settlement funds to the Facilitator, the law firm obtained a loan from the Facilitator subject to setoff against the funds held in the Rabbi trust.[6]
I note that, until the law is finally determined on these issues given the IRS’ positions, we cannot necessarily know which of these, or other, facts courts may find outcome determinative. Further, some of the distinguishing facts I reference above are part of common structured fee deferral arrangements. These distinctions are mentioned here in order to identify the facts which appear potentially important given the relevant authorities.
Legal Issues[7]
The GLAM, and presumably the IRS in future disputes with taxpayers, bases its conclusions on the following legal principles:
- Anticipatory Assignment of Income: A taxpayer “cannot exclude an economic gain from gross income by assigning the gain in advance to another party”[8] and a taxpayer cannot escape tax on their earnings “merely by transferring the right to income to a third person.”[9] However, assignment of income cases have been decided based on fact patterns where the one otherwise subject to income tax sought to transfer the income to a third party. Here, the law firm remained subject to income tax on their deferred fees. Only the timing was at issue. As such, use of assignment of income arguments appears to be a novel approach by the IRS.
- Economic Benefit Doctrine: In the GLAM, the IRS argues the “taxpayer must recognize gross income upon satisfaction of this obligation by means of the transfer of funds” to the Facilitator. Relevant here is that, although subjecting funds to the payor’s general creditors avoids current recognition, the IRS argued the funds must be subject to the client’s creditors, i.e. the one who was obligated to pay the fees or the service recipient. Subjecting those fees to the creditors of the Facilitator, according to the IRS, does not avoid the law firm receiving current economic benefit.
- IRC § 83: Under § 83, the receipt of property by a taxpayer in connection with the performance of services is taxable in certain circumstances. Important to the § 83 analysis is the question of when the property received for services is no longer subject to risk of forfeiture. Similar to the analysis on other legal arguments, the IRS takes the position that payment by the defendant (or the defendant’s insurance company) to the Facilitator eliminated any risk of forfeiture with respect to the service recipient. This is because the law firm’s client, who had the obligation to pay the law firm as the recipient of the law firm’s services,[10] has funded/satisfied the client’s payment obligations once funds were paid to the Facilitator. Since § 83 is considered codification of the economic benefit doctrine, it should be subject to the same, or substantially similar, considerations in whether the IRS’ arguments will be followed.
- IRC § 409A: Since enactment of § 409A in 2004, the tax treatment of many nonqualified deferred compensation plans has been controlled by certain requirements in order to benefit from tax deferral. The IRS argues that the deferral arrangement violated some of those requirements, importantly the initial deferral election and the subsequent loan subject to setoff against the deferred funds. Failure to comply required income to be recognized in the year the funds were paid to the Facilitator. It is quite novel for the IRS to seek application of § 409A principals to payments from a client to their attorney. This is especially true given the independent contractor exception that applies under § 409A when the contractor provides services to multiple service recipients (as is the case for the law firm representing multiple clients).[11] There are other reasons that the IRS’ § 409A arguments may be problematic.
The legal arguments made by the IRS, as outlined above, have counterarguments. Furthermore, many of aspects of these arguments are supported by the specific facts of the GLAM. The facts of most contingent fee deferral arrangements are different. Also, courts may not agree with the IRS’ legal arguments, especially those made by the IRS in Childs and not followed by the Eleventh Circuit.
Conclusion
A GLAM is not the law. Rather, it is a legal memorandum from the IRS Office of Chief Counsel offering an opinion of how the law should be interpreted. As such, while the GLAM and subsequent announcement of an IRS compliance campaign should be concerning, it is not binding legal authority. There are significant factual and legal issues to be considered, including those raised in this writing.
As with many tax planning structures, it is possible a few aggressive promoters and taxpayers are causing the IRS to consider an entire transaction as abusive (or at least paint it as such), thereby putting a chilling effect on the entire market. The IRS and/or courts may ultimately only negatively affect those aggressive structures. Alternatively, the law as understood under Childs could be changed or clarified causing some taxpayers who were not so aggressive to be in the crosshairs of unintended tax consequences.
In any event, as these issues unfold over the next number of years through IRS enforcement and tax litigation, the landscape will become clearer. Only time will tell where the boundaries will fall. In the meantime, especially given the IRS’ affirmative action against fee deferrals, contingency fee attorneys should carefully structure any such arrangements, in consultation with competent tax counsel, to maximize the opportunity for a successful outcome.
[1] https://www.irs.gov/businesses/corporations/irs-lbi-compliance-campaign-december-2-2024.
[2] GLAM 2022007, https://www.irs.gov/pub/lanoa/am-2022-007-508v.pdf.
[3] Childs v. Commissioner, 103 T.C. 634 (1994), aff’d without published opinion, 89 F.3d 856 (11th Cir. 1996).
[4] A Rabbi trust is a trust established by a service recipient for a service provider that segregates deferred payments due to the service provider from the service recipient’s access but defers income tax to the service recipient by making funds held in trust subject to the creditors of the service recipient, making the service provider a general unsecured creditor of the service recipient. See, e.g., PLR’s 8113107, 8329070, 8418105, 8509023, 8641039, 870306.
[5] This writing is intended to be a summary rather than a comprehensive analysis of the factual differences in the GLAM and other arrangements, especially given the variety of structures that may be available. However, for taxpayers and their advisors reviewing structured settlement fee deferral alternatives, understanding the distinctions between what was approved in Childs and the facts of the GLAM could be critical, depending on how courts ultimately decide the legal issues (which may turn on those factual distinctions). For a more complete discussion of some of the factual issues, as well as certain legal considerations, see Robert W. Wood and Alex Z. Brown, “IRS Targets Structured Legal Fees 28 Years after Childs,” Tax Notes Federal, Vol. 178, Feb. 13, 2023, https://www.woodllp.com/Publications/Articles/pdf/IRS_Targets_Structured_Legal_Fees_28_Years_After_Childs.pdf; and Robert W. Wood and Alex Z. Brown, “Lawyers are Structuring Fees Despite IRS Attack,” Tax Notes Federal, Vol. 182, Jan. 22, 2024, https://www.mondaq.com/pdf/1419032.pdf.
[6] It appears the IRS considers this an important fact given specific reference to this “[t]he taxpayer may gain access to some or all the fees by taking out a purported loan from such third party or a related party” in announcing the recent compliance campaign. Note the term “purported” raising question of whether the IRS takes issue with any loan from the deferred fee facilitator or, alternatively, only advances structured to appear as loans but more closely resemble an early advance of deferred funds.
[7] As with the factual issues, the purpose of this writing is not to comprehensively discuss the relevant legal issues which would be extensive. Rather, the purpose here is to identify the relevant issues raised by the IRS. For more comprehensive discussion, see articles cited at supra note 5 and letter to Lily Batchelder, Assistant Secretary for Tax Policy, U.S. Department of the Treasury, dated February 23, 2023, https://www.taxnotes.com/research/federal/other-documents/treasury-tax-correspondence/law-firms-denounce-generic-legal-advice-on-deferred-compensation/7g03z#7g03z-0000107.
[8] Lucas v. Earl, 281 U.S. 111 (1930).
[9] Wood Harmon Corp. v. U.S., 311 F.2d 918 (2d Cir. 1963).
[10] This analysis is consistent with the treatment under Commissioner v. Banks, 543 U.S. 426 (2005). That said, there are arguments that Banks does not support the IRS’ contentions. Specifically, the IRS argues settlement funds paid by the defendant were payable to the law firm which directed the funds to be paid to the Facilitator. However, under Banks, funds were payable only to the client who then had the obligation to pay the law firm.
[11] Treas. Reg. § 1.409A-1(f)(2).
