March 2003
EXTRA

Structuring Fees

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Professional ballplayers and movie stars have long favored arrangements for deferring the taxation of their compensation. With relatively short careers and substantial paychecks, they frequently find it advantageous to defer their compensation to periods in which they are no longer playing ball or making movies. Corporate executives have recently begun to more effectively use deferral techniques as well, with the advent of more complex compensation arrangements designed to provide benefits that extend beyond the period of employment. Underpinning deferral techniques are various goals, including a desire to move compensation from working to retirement years and a desire to achieve a higher rate of return on “excess” compensation by delaying its taxation. More recently, attorneys have begun to appreciate the benefits of tax deferral, and are now seeking ways to take advantage of deferral techniques. This paper analyzes the tax issues faced by attorneys in applying deferral techniques in contingent fee cases but should not be construed as the offering of a tax opinion. This paper is intended to provide information to assist attorneys and their advisors in identifying and addressing the issues relevant in structuring attorney fees, and does not constitute a legal opinion regarding the matters addressed herein. No attorney should consider structuring his or her legal fees without the advice of a competent tax professional. Because the facts of each particular case will differ, the attorney should rely upon the opinion of his or her tax professional in structuring the legal fees.

Deferred payments in physical injury cases are frequently referred to as structured settlements. A structured settlement in its simplest form results in the payment of damages over a term vs. a lump sum. Structured payments are an accepted norm in the settlement of personal injury cases because injured plaintiffs frequently require extensive ongoing medical treatment and face limitations in their ability to earn sustainable income. It is common for settlements to include both structured and lump sum payments. Legal fees may be structured to mirror the structuring of the underlying damages but more often are structured independently of the plaintiff’s damages. Legal fees may be structured as installment payments or deferred lump sum payments, and deferral may extend until the attorney’s retirement or other event.

The structuring of attorney fees is not a tax gimmick. Structuring must represent economic reality, which means that a consequence of structuring is that the attorney will have no right to the structured fees until they ultimately are paid. To be effective, the structure must provide that deferred fees cannot be accelerated by the attorney even if he or she later realizes an urgent need for the funds.2 In addition, amounts set aside for the payment of legal fees must be subject to claims of the general creditors of the obligor (the plaintiff), with a risk that the attorney will lose a portion of the fees in the event of a default of the obligor. If the I.R.S. successfully challenges the deferral arrangement, the attorney may incur income taxes, interest and even penalties in connection with the legal fees in the year that the case is settled even though the legal fees are not received by the attorney until a later period.

Delaying the payment of legal fees is a relatively simple matter. Deferring the taxation of legal fees is not so simple. Tax laws relating to the deferral of income recognition have become increasingly complex, as the Congress, the Internal Revenue Service and courts have struggled with recognition of income concepts. Code Section 83 provides rules for the taxation of compensation paid in forms other than cash, which includes certain deferred funding techniques, and Code Section 451 provides rules for the recognition of income generally. The I.R.S. has set forth rules for the taxation of compensation in numerous Treasury Department Regulations, revenue rulings and other announcements, while the courts have struggled with the deferral concepts under rules with labels such as the “constructive receipt doctrine” and the “economic benefit doctrine.”

To avoid the current taxation of attorney fees under a structured arrangement, the attorney must avoid application of both the “constructive receipt” and “economic benefit” doctrines. Any analysis of alternatives for the structuring of attorney fees must be made with reference to these doctrines.

The Constructive Receipt Doctrine. The “constructive receipt” doctrine is a creation of case law, but has been “codified” by the I.R.S. in Treasury Regulation Section 1.451-2(a), as follows:

Income although not actually reduced to a taxpayer’s possession is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given. However, income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions.

Constructive receipt is primarily a question of timing. To have “constructive receipt,” an individual must have both the right to the income and the power to compel payment. Under the constructive receipt doctrine, an individual who has an existing right to receive income payable immediately cannot defer taxation of that income by refusing or delaying receipt. Essential to constructive receipt analysis is whether the individual has an unrestricted right to the funds and turns his or her back on them.

The current parameters of the constructive receipt doctrine were recently summarized by the United States Tax Court in Palmer v. Commissioner,³ as follows:

The constructive receipt doctrine requires a taxpayer who is on the cash method of accounting to recognize income when the taxpayer has an unqualified, vested right to receive immediate payment of income. Under that doctrine, a taxpayer may not deliberately turn his back on income otherwise available. In order to trigger application of the constructive receipt doctrine, there generally must be an amount that is due and owing which the obligor is ready, willing, and able to pay. If a taxpayer has an absolute and unconditional right to receive income in the year earned, the constructive receipt doctrine requires the taxpayer to report such income for that year.

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