Deferring Attorney Fees: Is There Now A Critical Mass Of Enabling Legislation?

By Matthew Garretson

With Kemper Arnold contributing[1] 

Since the early 1990’s, many plaintiffs’ attorneys have - for tax planning purposes - deferred the receipt of the contingent fee earned in settling a client’s personal injury case. Most often, when attorneys defer receipt of contingent fees, they do so when their clients also elect to participate in a structured settlement.[2] These arrangements have historically been accomplished with varying degrees of success and risk.

Even in light of Childs v. Commissioner[3]- the lone pro “fee structure” authority published on the topic - some attorneys have stayed on the sidelines, questioning whether the IRS would truly retreat from its repeated attempts to require attorneys who structure fees to recognize income in the year their client’s case was settled. After all, in some respects, isn’t the structuring of fees too good to be true? What other occupation or profession allows for unlimited deferral of income? Most Americans are restricted by some cap on their 401K, IRA or profit sharing plan.[4]

Perhaps these concerns were alleviated by The Jobs Creation Act of 2004 (enacted on October 22, 2004), which contained significant changes in the law dealing with nonqualified deferred compensation plans. Ironically, perhaps even more comfort can be found in the silver lining of Commissioner v. Banks and Commissioner v. Banaitis[5] - the U.S. Supreme Court’s consolidated decision on January 24, 2005, regarding the taxability of attorney fees to clients in non-physical injury cases. If indeed we now have a critical mass of legislation enabling deferred fee arrangements, the marketplace should grow by unprecedented proportions as more life insurance companies, encouraged by this momentum, offer deferred-fee arrangements not only for contingent fees in personal injury matters but for non-physical injury cases as well.[6]

With this market broadening, some attorneys are already thinking beyond simply structuring that “one big fee” in order to spread the tax hit over several years. With burgeoning imaginations, some attorneys are strategizing with their tax and financial advisors to take a piece of every fee and build true “defined benefit” programs. Plans can be tailored to provide for a child’s college tuition, retirement income, contributions to other retirement programs, payments to cover the firm’s operating expenses as well as creative, incentive compensation programs to retain key associates. As an addedbenefit, the money in a structured settlement might be exempt fromthe attorney’s creditors.[7]

As a backdrop for examining the laws and regulations giving rise to this unique opportunity for attorneys, the following facts are assumed:[8]

Given these facts, why would you be allowed to recognize the fee as income in the years the deferred payments are received rather than being taxed in the year the case settles? The quick punch line is that the agreement to receive deferred payments is executed before you have an absolute, unconditional right to receive the funds. Specifically, even though you have a fee agreement with your client, the receipt of any compensation is uncertain until a favorable settlement is achieved. But lest you stop reading here, be forewarned that the issue is far more complex than this simple answer suggests.

This article will explore the lessons learned from the early attempts by attorneys to defer fees, the basic pillars (old and new) in the Internal Revenue Code relating to deferred compensation, the mechanics for deferred fee arrangements, and, finally, some “Practice Tips” for interested attorneys to consider.

Early Pioneers
In 1991, the IRS issued several private letter rulings (PLR’s) that held attorneys who agreed to receive fees over time from the liability insurance carrier must immediately include in gross income the value of the annuity purchased to pay their fees. How are the facts in these PLR’s to be distinguished from our sample facts above? In the PLR’s, the defendant’s obligation to make the deferred payments was considered funded and secured – taboo in the realm of deferred compensation arrangements.[12] Specifically, under the settlement agreements’ terms, the defendant liability carrier (company 1) assigned its obligation to make its deferred payments to an insurance company (company 2) and gave that assignee insurance company immediate proceeds for assuming that obligation. That assignee insurance company, in turn, used those proceeds to purchase an annuity from a related company (company 3), which, in turn, contractually guaranteed that these deferred payments would be made. But the hitch was that the liability carrier agreed to remain in the mix as a secondary guarantor. Under these facts, the IRS determined the attorney received an immediate economic benefit and the attorney had a funded promise to pay from all three companies - a fatal determination for the early pioneers.

Personal injury lawyers who are interested in deferring contingent fees (as well as steering clear of the potential pitfalls) need not rush to obtain an LL.M. designation in tax. Rather, they should understand the basic tenants (old and new) in the Internal Revenue Code related to deferred compensation.

IRC § 451 - “Constructive Receipt.”This doctrine basically stands for the proposition that you cannot opportunistically “control” the year in which you receive income. An often-cited example of this point is Palmer v. Commissioner.[13] In Palmer, the taxpayer was deemed to have constructive receipt of funds because he had an agreement whereby the company would not pay him his fees until he requested payment. In the eyes of the IRS, attempts like this to defer income are illusory since the taxpayer cannot unequivocally call the shots, as Treas. Reg. 1.451-1(a) and 2(a) explain:

Accordingly, if the attorney has an unrestricted right to receive funds immediately, he or she must recognize the fee or income. On the contrary, Martin v. Commissioner[14] explains that if attorneys enter a deferred fee arrangement before they ink a settlement agreement (i.e., before they have an unrestricted right to receive funds immediately), for tax purposes they have effectively done so before the fees are considered “earned.”[15]

As this article examines, in a properly perfected deferred fee arrangement, according to the mechanics outlined below, attorneys are substantially restricted in the spirit intended in IRC §451 as well as in Martin and Palmer - they have no rights to accelerate, defer, increase, or decrease the deferred payments. Furthermore, even though an annuity is purchased to fund the deferred fee obligation, the attorneys generally have no rights greater than that of a general creditor. Attorneys are paid from the general assets of the assignment company and those assets are fully exposed to claims of all creditors. As result, for tax purposes, no assets are, set aside for or otherwise ma de available to the attorneys.
Economic Benefit and IRC Sec. 83. The “economic benefit” doctrine stands for the proposition that constructive receipt, for tax purposes, occurs when assets are unconditionally and irrevocably paid into a fund or trust to be used for the (taxpayer’s) sole benefit.[16] In more colloquial language, that means if a promise to pay deferred compensation is completely funded and secured, then you are considered as having received the economic benefit and all that remains is for the payments to hit your mailbox at a later date. If so, you must pay Federal income tax on the present value of those future payments in the year you sign the settlement agreement.
So why doesn’t “economic benefit” occur immediately in a valid deferred fee arrangement? In Revenue Ruling 79-220 the IRS agreed that economic benefit does not occur when:

Under these facts, the IRS agrees that no constructive receipt or economic benefit existed.[17]

Internal Revenue Code §83 codifies the economic benefit doctrine as it pertains to compensation for services. According to §83, you must presently include in income the fair market value of any property transferred to you for the performance of services,[18] especially when you have such indicia of control as: a) the ability to convey the property or b) you do not substantially risk losing the property.[19] If not carefully constructed, a promise related to deferred compensation may fit the definition of “property” for purposes of this Code section.[20] At the risk of being redundant, the saving grace in a properly-executed deferred fee agreement is that “funding” has not occurred because:

Childs v. Commissioner[21] – The Dim Green Light. In Childs, the IRS challenged a deferred attorney fee arrangement, believing the attorneys could have requested all the fees as soon as the case settled and, for that reason, had constructive receipt and control before the fee was deferred. Childs is the only published authority on this subject, and its facts resemble the sample facts outlined above. In Childs, the Tax Court held that attorneys may defer their fees, holding that taxes are payable on structured attorney fees when the amounts are received. So why did the attorneys in Childs prevail while those in the early PLR’s effectively lost? The court reasoned that the fair market values of the attorney’s rights to receive payments under the settlement agreements were not includable in income under IRC §83 in the year settlement agreements were effected, since the promises to pay under the structured settlements were neither funded nor secured and thus didn’t meet the definition of property for purposes of §83. (According to Childs, a life insurance company guarantee is not considered “funding or securing.”)

The court also held that the doctrine of constructive receipt was inapplicable because the attorney had no right to receive the attorney’s fees before the agreement setting up a structured settlement was entered. Restated: a) the attorney had no rights to any fee until the settlement agreement was signed; b) before signing the settlement agreement he agreed to take his fee overtime; and c) no funds were accessible by the attorney or set aside for him before the agreement. (Additionally, the attorney did not own the annuity contract, and the owner had the right to change the attorney’s designation as payee.)
The American Jobs Creation Act of 2004. For nearly a decade after Childs, little additional guidance was offered, and the IRS never officially conceded. Then, along comes the American Jobs Creation Act of 2004,[22] which added §409A to the IRC. Section 409A contains far-reaching changes dealing with requirements for the deferral of the receipt - and taxability of - income for Federal income tax purposes.[23]According to §409(A), payments deferred under a nonqualified deferred compensation plan are currently includible in gross income if they are not subject to substantial risk of forfeiture and unless certain requirements are satisfied.

Since this language echoed the themes contained in challenges by the IRS in the early PLR’s and Childs, most (if not all) life insurance companies that underwrite attorneys’ fees structured settlements placed a moratorium on accepting this business as soon as the Jobs Act was signed by President Bush in October, 2004.These life companies explained that this moratorium was to be in place until Treasury issued guidance, as it was uncertain whether deferred fees fell within §409A’s scope.

On December 21, 2004, the Treasury and IRS issued “Guidance on Deferred Compensation”[24]under §409A. While the initial guidelines state that “[t]he application of §409A is not limited to arrangements between an employer and employee,” the guidance excludes many “service provider” arrangements from §409A’s scope. The “FAQ” section of the guidance notice expressly states in response to “To Which Services Providers Does Sec. 409A Apply?”:
Section 409A DOES NOT APPLY to arrangements between a service provider and a service recipient if (a) the service provider is actively engaged in the trade or business of providing substantial services, other than (I) as an employee or (II) as a director of a corporation; and (b) the service provider provides such services to two or more service recipients to which the service provider is not related and that are not related to one another.

Indeed, because most plaintiffs’ attorneys fit the above definition, The American Jobs Creation Act, which contains limits on the ability to defer income, will not adversely impact an attorney’s ability to defer his or her fees.”

The FAQ’s also explain that a valid deferral of compensation exists if: (a) the services provider has a legally binding right to compensation that has not been received and (b) such compensation is payable to the service provider in a later year pursuant to the terms of the plan. With regard to the first prong, the guidelines state that the service provider does not have an unrestricted right if compensation under the plan may be unilaterally altered or eliminated by the services’ recipient after the services creating the compensation right have been performed. With a contingent fee agreement, attorneys are not paid as they render services but rather upon the successful outcome of a case (which may or may not ever occur). Furthermore, even after substantial services have been performed, either a client or the court can later alter or eliminate the fee agreement’s terms (e.g., the client gives up, court determines claim has no merit, etc.). These circumstances further support the notion that at all times prior to the receipt of the deferred payments the attorney’s rights to it are subject to a “substantial risk of forfeiture” as contemplated by the IRC.[25]

All the life insurance markets that underwrite attorney fee structures found comfort in the Guidance’s language and enthusiastically began accepting this business again on January 1, 2005. Perhaps the only curb to the enthusiasm is that the initial guidance released last December 21 indicates the Treasury and the IRS anticipate issuing further guidance “that sets forth the requirements for compensation to qualify as performance-based compensation.”The initial guidance adds that the Treasury and IRS expect those requirements to be “more restrictive.” But if the IRS wanted to remedy its defeat in Childs and put an end to attorney fee “structures,” most likely they would have addressed it in §409A and the related initial guidance.
Banks and Banaitis. If inertia still existed for some even after The Jobs Act, perhaps for those the final thrust can be found in the U.S. Supreme Court’s decision on January 24, 2005, in the consolidated cases of Commissioner v. Banks[26]and Commissioner v. Banaitis.[27] Those cases dealt with taxability of attorney fees to clients in certain non-physical injury (i.e., “taxable damage”) cases.[28] While the Court’s opinion rectified the “double taxation” issue in a limited category of cases, unfortunately in other non-physical injury cases, attorneys’ fees appear to be taxable to both the attorney as well as the plaintiff. On claims falling outside the zone of relief, no deduction is allowed (for alternative minimum tax (AMT) purposes) for attorneys’ fees because miscellaneous itemized deductions are disregarded. As a result, the plaintiff may be subject to alternative tax on the full amount of the recovery, including the portion representing the attorneys’ fee. Put differently, the plaintiff's net cash after paying the attorney is burdened by the AMT not only on that net cash portion but also the AMT on the portion paid to the attorney.

While the Court’s opinion regrettably offered incomplete relief to clients, there was perhaps a silver lining for the attorney. The court rejected the argument that the attorney had a direct property interest in the recovery. Rather, the Court reasoned it is a classic principal-agent relationship.This rationale is critical to preserving an attorney’s ability to “structure” part of his attorneys’ fee. If the Court had accepted this “direct property interest” argument, a direct taxable benefit would be triggered for the attorney before a structured fee agreement could be established. As it is, this opinion arguably congeals the deferred fee concept to the Code when the mechanics outlined below are followed.

The Mechanics
In order to avoid the constructive receipt and economic benefit hazards outlined above, attorneys should adhere to the following mechanics when setting up deferred fee arrangements.
Settlement Agreement. The settlement agreement must certify that a contingency fee agreement between the attorney and the plaintiff is in place and that the deferred payments are directed to the attorney for the benefit and convenience of the claimant to satisfy the claimant’s attorney fee obligation. The payee should be named and the deferred “periodic payments” should be spelled out in detail (amount, timing, etc.).

Furthermore, the agreement must contain other essential terms, including the attorney’s acknowledgement that the structured payments, once agreed upon, “cannot be accelerated, deferred, increased or decreased by the attorney; nor shall the attorney have the power to sell, mortgage, encumber, or anticipate the Periodic Payments, or any part thereof, by assignment or otherwise.” In other words, the arrangement is irrevocable - period.
Assignment. An assignment of the obligation to make the deferred payments as specified in the settlement agreement should be made by the defendant to an assignment company. More particularly, IRC §130 describes the qualified assignment process where the settling defendant (or its liability insurance carrier) that agreed to provide the deferred payments set out in the settlement agreement transfers that obligation to a third-party assignment company (typically a wholly-owned subsidiary of the life insurance carrier issuing the structured settlement annuity). In this manner, the defendant’s (or its liability insurance carrier’s) tort liability as well as its obligation to make the periodic payments is terminated.

To further ensure that the attorney retains the appropriate modicum of “risk of forfeiture”[29] and does not have any indicia of ownership, the assignment documentation should articulate that the assignee maintains all ownership rights and control of the annuity, including the ability to change the beneficiary of the annuity contract.
Annuity Purchase. Under the terms of the assignment, the assignment company purchases an annuity contract from an affiliated life company to fund the obligation to make deferred payments to the attorney. Under these facts, defendant or defendant’s liability carrier would send money directly to the assignment company in exchange for having its obligation to make the deferred payments terminated.

An exception to this rule is when the proceeds to fund the deferred attorney fee arrangement come from a Qualified Settlement Fund (QSF) established pursuant to IRC §468B. According to Rev. Proc. 93-34, 1993-2 C.B.470, the QSF stands in the shoes of the defendant with regard to the assignment transaction. The QSF is often a useful temporary holding device for settlement proceeds. They are the only device that allows the defense to pay cash, execute a cash-only settlement agreement and still preserve the client’s ability to later structure part of his or her proceeds.The key advantage in many cases is that the fund allows for some “breathing space” after settling the case to compromise liens and/or subrogation claims; determining the appropriate role and underwriting of a structured settlement annuity; evaluating the need to preserve governmental entitlement benefits (e.g., the need for the establishment of a special needs trust); and many other decisions that can best be made without the pressure associated with the litigation itself.This breathing space is made available because, while temporarily parked in the 468B, the assets are not “constructively received” by any claimant, as that doctrine is set forth in Treasury Regulation §1.451.2.

Plaintiffs’ attorneys recognize a benefit from the QSF as well – the defendant is removed from the process of designing and executing the attorney’s deferred fee arrangement (a private affair with which the attorney may feel at ease with the necessity of the client being involved but perhaps not the defendant, the liability carrier or the defense attorney).
Beneficiary. The attorney can designate a beneficiary at the time of settlement. Some life companies will not allow the attorney the ability to change this beneficiary, the logic being that allowing a change to the beneficiary would imply some control or rights in the payment stream and might weaken the argument that the payment is made for the convenience of the plaintiff. More importantly, control could be interpreted as “economic benefit” in the future periodic payments, thus creating adverse tax consequences for the attorney.
Hold Harmless. The attorney must complete a Hold Harmless Agreement. This
agreement is intended to serve as notice that the attorney was advised of potential adverse tax consequences to structuring his / her fee and has been encouraged to obtain independent tax advice. The attorney holds the life insurance company (and affiliated assignment company) harmless should the IRS take an adverse opinion regarding the deferred fee arrangement. This requirement should not be surprising, as life insurance companies are not in the business of providing tax advice and without documentation a marketplace for deferred fee arrangements likely would not exist.
Reporting. Most life insurance companies require that the attorney complete an IRS Form W-9 and W-4P. The W-9 certifies that the life insurance company has the proper tax identification number. The W-4P allows the attorney to do one of two things: 1) opt out of federal income tax withholding on the payments; or 2) designate how much they want withheld from each payment for federal income taxes. If the form is not completed the life insurance company is required to do standard withholding (currently married with 3 allowances but subject to change). Furthermore, Form 1099-MISC requires the life insurance company to report the deferred payments.

Lost In Translation?
All life insurance companies currently underwrite deferred attorney fee “structures.” But given some subjective, albeit well-considered, interpretation of the cases and Code sections discussed above, some life companies have added some unique nuances to the equation. For example, most life insurance companies will underwrite the attorney fee structure by itself, but some require that the attorney’s client must structure an equal or larger portion with another life insurance company (supporting the argument that the attorney fee structure is being done for the convenience of the plaintiff). Some will not allow “lifetime” payments. Some allow “lifetime” payments but based upon the client’s life expectancy.[30] Finally, payments typically cannot be guaranteed for greater than 40 years or, in some instances, past the attorney’s 90^th birthday.

While these design criteria are no doubt critical, attorneys also should closely examine the financial strength and claims-paying ability of any life insurance company they are considering trusting with their money. As one example, whereas Company X may be offering $50.00 more per month in retirement income than a company Y is offering, attorneys should take note that Y has a rating of A++ (as opposed to A+) and the higher asset base ranking from the A.M. Best Company, as well as considerably more surplus on hand than Company X. The point is that considerations like size and strength might trump an otherwise undemanding “best price” buying habit.

Practice Tips for Those Who Like to Wear a Belt with Suspenders
If the door remains open for the long run, cautious plaintiffs’ attorneys might want to make very specific changes to their contingency fee agreements to comply with IRC §409A, including expressly providing for deferral of attorney fees in the form of periodic payments.For example, fee agreements might be amended to state “for the convenience of client, the fee may be paid in form of periodic payment and/or up front from settlement proceeds to fulfill client’s attorney fee obligation.”[31]

Finally, the ultra-conservative should consider having the structured payment go to the firm and then have the firm pay the attorney.Since the attorney performed the services for the firm, the compensation first belongs to the firm.While never tested, the cautious might fear that if the firm assigns the attorney any rights to the payment, it could be considered tantamount to a current payment of compensation.[32]This measure is arguably superfluous, though, given the fact that the attorney maintains the requisite “substantial risk of forfeiture” regardless of whether he or she is a direct payee. If the deferred payments go to the firm, the attorney could have a deferred compensation agreement (or employment agreement) providing that, upon termination of employment or in the event of death or disability, the firm is obligated to pay future compensation to the attorney that is identical to the payments deferred in the settlement agreement.[33]

These measures might be over-kill in light of IRC §409. But those who are extra cautious tremble at the consequences of non-compliance with §409, which include deferred fees being subject to immediate income tax liability, as well as a 20% penalty and interest.

If the mechanics and practice tips are strictly followed, the deferred fee arrangement should steer clear of the constructive receipt and economic benefit issues outlined above.

To Structure or Not To Structure - Practical Applications[34]
As a simple guideline, the design of an attorney’s structured fee arrangement is limited only by one’s imagination. As mentioned above, plans can be tailored to fund retirement income needs or alleviate the pressure of the law firm’s overhead expense by subsidizing monthly cash flow requirements. Some non-traditional uses of attorney fee structures may include strategies for the retention of key associates in one’s firm, or funding a schedule of payments to implement a senior partner buy-out. Other creative planning approaches may include funding any one of a variety of estate planning strategies or meeting one’s charitable planning objectives in an organized and disciplined fashion.

In the absence of legislative interference, the melding of one’s imagination with the leverage of this unique tax deferral opportunity presents unlimited planning opportunities. Below, some examples are more fully flushed out:

Whereas the example above relate to “personal” financial planning strategies for attorneys, the application of deferred income options to the law firm setting presents many distinctive planning strategies as well. Business succession planning, and the financial obligations attached thereto, is fertile ground for designing deferred income strategies to support annual buyout installments due a retiring partner, while providing the retiring partner the security desired in a stream of guaranteed future periodic payments. For younger partners or associates, a nonqualified, deferred compensation plan offers key person retention insurance and the golden handcuffs occasionally required as an inducement to protect a law firm’s investment.

Another significant opportunity capturing the interest of successful litigators and their estate planning attorneys is the ability to structure attorney fees to complement estate and/or charitable planning objectives. Some creative examples include the following:

These examples are intended to stimulate the reader’s imagination and expand one’s understanding of how deferring income - without the limitations surrounding qualified retirement plans and non-qualified deferred compensation plans – can be leveraged. Fundamental to the effective implementation of a deferred fee strategy is the thoughtful planning and design of one’s objectives well in advance of the resolution of a case. A piecemeal approach responding to an offer to structure fees at the time of settlement defeats the objective of a well-reasoned game plan.

Conclusion
Although the IRS hasn’t officially acquiesced and proclaimed, “Ok, go ahead and defer fees to your heart’s content”, it appears we now have a critical mass of positive, enabling legislation allowing attorneys to defer as much income as they wish. Furthermore, while the Childs case and Revenue Ruling 79-220 dealt with physical injury settlements (that are excludible from the client’s income under IRC 104(a)(2)), in light of §409A and the Banks and Banaitis decisions, presumably attorneys can defer fees in settlements involving damages that are taxable to the client as well.[36]That should mean there will be a greater opportunity for “structuring” fees to accomplish attorneys’ countless planning goals.

Clients may also benefit from this growing marketplace. As one insightful commentator, attorney Rob Wood notes, by spreading out the receipt of attorney fees in certain non physical injury cases (i.e., taxable damage cases), the “non-deductibility”/AMT problems of attorney fees for clients might be lessened.[37]

Like all things that may appear “too good to be true,” make sure you do your homework and strictly follow the roadmap above, which is the path of others who have succeeded before you. For now, the dim green light created by Childs v. Commissioner, previously visible apparently by only a few, should appear as a bright beacon to many.