Structuring Fees

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If a taxpayer has entered into a binding contract or agreement to defer income before it is due, the taxpayer is not required to report such income until it is actually received. Similarly, if the income under such a contract or agreement is not yet due, a taxpayer may elect to defer that income further by entering into a superseding binding contract or agreement.

(Citations omitted.)⁴

In Oliver v. United States ⁵ , the U.S. District Court summarized the foregoing principles of the constructive-receipt doctrine as follows:

Where income, although not actually received, is unqualifiedly and without substantial limitation available to the taxpayer in a given year, and his failure actually to receive it is due to nothing other than his own volition, then such income is considered as having been constructively received during that year, and it must be so reported and the tax paid thereon. . . . But, if during the tax year in question the taxpayer has no right to receive income, or if his right to receive it is subject to substantial qualifications or restrictions, then he will not be deemed to have received such income constructively during that year. . . .

When the item of income in question consists of the proceeds of a sale by the taxpayer of merchandise or other property . . . and where the sale is completed in a given year and the taxpayer at the time acquires an unconditioned vested right to receive the proceeds of the sale, and the buyer is ready, willing, and able to make payment, the taxpayer cannot avoid treating the proceeds as income for that year by voluntarily declining to accept payment during that year, or by requesting the purchaser not to pay him until a later year, or even by voluntarily putting himself under some legal disability or restriction with respect to payment. In such circumstances, he will be deemed in constructive receipt of the income notwithstanding his refusal to accept payment or his self-imposed restraints on payment. . . .

On the other hand, it must be recognized that a taxpayer has a perfect legal right to stipulate that he is not to be paid until some subsequent year, or that the payments are to be spread out over a number of years. Where such a stipulation is entered into between buyer and seller prior to the time when the seller has acquired an absolute and unconditional right to receive payment, and where the stipulation amounts to a binding contract between the parties so that the buyer has a legal right to refuse payment except in accordance with the terms of the agreement, then the doctrine of constructive receipt does not apply, and the taxpayer is not required to report the income until the same actually is received by him. (Citations omitted.)⁶

The I.R.S. has stated that an individual may elect to defer his or her compensation provided that such election is made before the individual’s “period of service” begins.7 In the context of deferred compensation, an election to defer compensation must generally be made prior to the beginning of the year in which the services are rendered,8 and the employee’s right to payment in the future must be unsecured.9

Example 1:¹⁰ An attorney settles a case in December and receives a check for the full settlement proceeds, which he deposits into his attorney trust account. The attorney delays making payment to his client (and receiving his fee) until the following January. The attorney is treated as constructively receiving his legal fees in the year in which the fees could have been withdrawn from the trust account by the attorney.11

Example 2: After an attorney and her client have accepted a settlement under which the client’s recovery is to be structured and the attorney’s compensation is to be paid as a lump sum, the attorney asks the defendant’s insurance company to delay payment of the attorney fees until the following year. The attorney is treated as constructively receiving her legal fees in the year in which the payment could have been received by the attorney even though the payment is actually received in the following year.

Example 3: An attorney and his client agree at the commencement of the case that if the client’s recovery is structured, the attorney fees also will be structured. Provided that the structured recovery does not trigger recognition under the economic benefit doctrine, as discussed later in this paper, the attorney’s compensation will be taxed to him as installment payments are received by him under the structure.

Example 4: During settlement negotiations immediately prior to trial, the defendant’s insurance company insists upon the structuring of both the client’s recovery and the attorney’s fees. The settlement agreement conforms to the insurance company’s requirements; however, the client’s recovery is paid over a longer term than the attorney’s fees. This example illustrates the essential facts in Childs v. Commissioner,12 wherein the Tax Court held that the constructive receipt doctrine does not apply to fees structured in such manner. It is unclear from the court opinion whether the defendant’s insurance company’s insistence upon the structuring of legal fees was essential to the result. As discussed in more detail below, it is arguable that the result should be the same if the request for the structuring of legal fees is made by the defendant, the defendant’s insurance company or the attorney.13

Example 5: During settlement negotiations after a verdict has been rendered, but prior to the expiration of the appeal period, the defendant’s insurance company offers and the attorney and his client accept a settlement that includes structured payments for both the client and the attorney. While I.R.S. guidance and case law permit income to be deferred for tax purposes prior to the time that it is “earned,” certain cases go further and permit income to be deferred until payment of the income is “due.” If the I.R.S. approach is applied, at issue is when an attorney’s legal fees are earned. If the case law approach is applied, it is arguable that the deferral is effective for tax purposes if made prior to the time that the case is settled because the attorney’s fees are not due until that point. This issue is explored below.

Applying I.R.S. guidance (and, again, assuming that the economic benefit doctrine, as discussed below, does not apply), an attorney may defer the recognition of his or her fees in a contingent fee case if a structuring arrangement is entered into prior to the date that the attorney’s legal fees are earned. This legal conclusion, of course, raises the question, when are legal fees earned in a contingent fee case? No I.R.S. ruling or case has directly answered this question.

A conservative approach may be to divide litigation into a number of stages and allocate a percentage of the contingency fee recovery to each stage. This approach might allocate 25% of the fees to discovery, 25% to negotiation prior to trial, 25% to the trial itself and 25% to post trial negotiation and the appeal process, and treat legal fees as earned in each stage at the end of that stage. Under this approach, the attorney could safely negotiate a percentage of his or her compensation to be paid in installments depending upon the stage of the litigation. For example, in a settlement agreement entered into immediately prior to trial, the attorney could structure up to 50% of his or her fee and still comply with the IRS requirement that the fee arrangement be entered into before the fee is earned.

Case law may support going further, perhaps even taking a position that the entire attorney fee can be structured prior to the final settlement of the case. In Childs, the court addressed the structuring of attorney fees in two separate cases. The first case was settled immediately prior to trial and the second case was settled during trial. The fee structure in both cases took the form of annuities acquired by the defendant’s insurance companies for the benefit of the attorneys. The court concluded that the attorneys did not constructively receive amounts paid under the annuity contracts in the year that the cases were settled because in each case, the attorneys had entered into a legally binding settlement agreement that provided for structured payments and had no right to accelerate payments under such agreement.

In addressing the timing of the settlement agreement as it applied to constructive receipt, the court in Childs held that:

Petitioners [the attorneys] were not entitled to their fees until recovery by their clients, so their right to receive payment arose only after settlement or disposition of the case. Thus, for the [first] litigation, petitioners did not become entitled to their attorney’s fees until the judgment was entered, by which time the structured settlements had been agreed upon.

Likewise, in the [second] litigation, petitioners had no right to receive payment until the settlement was effected on [the settlement date], by which time the parties had agreed upon payment of attorney’s fees in installments. The right of petitioners to receive payment of fees existed only after the [client] release agreement became effective, since any rights arising from the fee agreement were dependent on amounts recovered for petitioners’ clients. Petitioners had no right to receive any moneys prior to such time as their clients ‘recovered’ amounts from their claims. Petitioners never had the right to receive immediate payment, and no fund or property was set aside for petitioners which they could draw from at a time of their choosing. Because each of the deferred payment agreements was binding between the parties and was made prior to the time when petitioners acquired an absolute and unconditional right to receive payment, petitioners, who were on a cash basis, were not required to report the proceeds as income until actually received.

(Citations omitted.)¹⁴  

The I.R.S. summarized the holding of Childs in a 2001 Field Service Advice,¹⁵ as follows:

[W]here attorneys entered into a structured settlement which called for deferred payments of their fee, and the settlement was entered into prior to obtaining an unconditional right to compensation for their legal services, the court held that they had not constructively received income upon the purchase of the annuity contracts meant to provide payment for the legal services fee. (Citing Childs)

It is unclear from the holding in Childs whether the court found that the legal fees were not “earned” prior to the date of settlement, or instead refused to apply the concept of “earned income” in its analysis. It appears that the court focused instead on whether the legal fees were due and payable to the attorneys. The I.R.S. followed this concept as well in the Field Service Advisory referred to above, wherein it notes that “if income is not unqualifiedly subject to the taxpayer’s demand, it has not been constructively received.”¹⁶  The ruling cites Reed v. Commissioner, in which the First Circuit held that a taxpayer may defer recognition of income if an agreement is entered into prior to the time that the taxpayer acquires an “absolute and unconditional right to receive payment.”¹⁷  The reference to Reed is instructive because in that case, the taxpayer’s right to payment had accrued and only the timing of the payment was in question.

Other cases have also blurred the distinction between earned vs. unearned income, and have permitted the deferral of amounts that were not yet “due.” For example, in Oates v. Commissioner,¹⁸ the court held that an insurance agent could recognize income from renewal commissions as payments were made to him over a fifteen year term, even though the agent had an existing right to receive higher commissions over a shorter term and amended his agreement to provide for the new payment structure. The I.R.S. has sought to distinguish the holding in Oates on the basis that the renewal commissions were not earned until the policy renewals were made; however, it is evident from the case that all services required to earn the commissions had been rendered prior to the date that the amendment was signed.¹⁹

In Veit v. Commissioner,²⁰  the Tax Court held that the renegotiation of an agreement to provide installment payments over a term of years in lieu of payments over a single year was effective to defer the income for tax purposes because “[u]nder [the] existing contract there was never a time when the [amount] was unqualifiedly subject to petitioner’s demand or withdrawal.”²¹ The court reached this result because the payments were not yet due and with recognition that amounts payable under the existing agreement had been both earned and calculated with certainty by the parties. The I.R.S. has sought to distinguish the holding in Veit on the basis that modification of the existing agreement arose out of “bilateral negotiations.”²²  In Foster v. U.S.,²³  the court respected an agreement entered into between a plaintiff and her attorney that on appeal, the attorney could take all of the post-judgment interest rather than just the one-half that she was entitled to based upon the pre-trial contingency fee agreement. The court accepted this approach because before the appeal process there was no guarantee that the plaintiff would ultimately receive the amount awarded by the jury.

Oates, Veit and Foster each permit the deferral of income in the context of an existing agreement that has been amended to provide for payments different from those contained in the original agreement. These cases and others have held that an amendment must become effective prior to the time that the taxpayer has an unqualified right to demand immediate payment under the existing agreement and must be legally binding upon the parties.²⁴  Cases have permitted deferral in this context even if the payor was initially willing to contract for immediate payment and the taxpayer’s primary objective in entering into the deferred payment agreement was to minimize taxes.²⁵ On the other hand, courts have consistently held that a deferred arrangement that is not a bona fide agreement, but is a “self-imposed limitation” created by the taxpayer, will not be effective to defer the timing of taxation.²⁶  

Under the rationale of Childs and other cases cited, it is arguable that an attorney’s fee in a contingent fee case may be structured at any time prior to the entry of a final judgment. It may even be argued that a fee deferral structure is effective for tax purposes if entered into prior to the settlement of a case after trial, but prior to the expiration of the statutory appeal period.

Example 6: During settlement negotiations immediately prior to trial, the defendant’s insurance company makes a settlement offer which provides for a lump sum payment of damages. The attorney negotiates and executes on behalf of her client a settlement agreement that includes the structuring of both the client’s recovery and the attorney’s fees. At issue in this example is whether the “selection” of a structured payment arrangement in lieu of a lump sum payment triggers the constructive receipt doctrine. In Martin v. Commissioner,²⁷  the Tax Court held in the context of a shadow stock plan that a taxpayer’s election of installments in lieu of a lump sum payment was effective to defer taxation where the election was made before amounts under the plan became ascertainable and payable. That case and others cited arguably support deferral by an attorney who structures his or her fee in a contingency fee case prior to the entry of a final judgment settling the case. A more conservative approach may be to limit the structuring to a percentage of the fee applying the litigation stage approach described above. The tax result should be the same even if the attorney agrees to structure her fee, but not her client’s recovery.

The Economic Benefit Doctrine. While the constructive receipt doctrine seeks to treat a payment that is not received by the taxpayer as constructively received by him or her, the “economic benefit” doctrine considers whether the taxpayer has received such ownership and/or economic benefits in property that he or she should be taxed on the property in the year received. The economic benefit doctrine looks at the property or other interest actually received by the taxpayer under the structured arrangement. If the taxpayer receives property that is the equivalent of cash, such as a funded arrangement, then the taxpayer is treated as receiving compensation equal to the fair market value of the arrangement.²⁸  It is not necessary that the taxpayer’s interest be assignable in order to constitute an economic benefit, or that the taxpayer be entitled to immediate possession of the property. What is required is that there be identifiable property and that the taxpayer’s right to the property be vested. The economic benefit doctrine does not apply if amounts funding the arrangement are subject to the claims of the obligor’s creditors.

Example 7: Upon the commencement of a case, an attorney agrees to accept the payment of his fees in installments, provided that funds equal to the amount of the fees are placed into an escrow account. After the case is settled, the attorney’s fees are paid into an escrow account from which installment payments are made to him over a term of years. This arrangement avoids the application of the constructive receipt doctrine because the attorney has no right to receive his fee until installments are paid to him. The attorney nonetheless is taxed on the entire legal fee in the year that the case is settled because the arrangement is funded and secure and thus fails under the economic benefit doctrine. Legal fees payable under this arrangement would not be taxable in the year that the case is settled if the escrow is subject to the claims of the general creditors of the party obligated to make the payments.²⁹  

The economic benefit doctrine was first introduced in 1951 in Sproull v. Commissioner.³⁰  In that case, an employer established a secure and funded trust to provide for installment payments due to an employee. While the employee had no right to the installment payments prior to the date that they were made to him, the court held that the establishment of the trust itself conferred an “economic or financial benefit” on the employee and that payments due to the employee were taxable to him when the trust was established.³¹  

Code Section 83 contains statutory provisions relating to the taxation of “property” received by a taxpayer in connection with the performance of services. Regulations under that section provide that an “unfunded or unsecured promise” to pay money in the future is not property immediately subject to taxation to the recipient.³²  Under this regulation, if structured payments are “unfunded and unsecured,” taxation of the payments is deferred until they are received. On the other hand, if payments are secured or funded, they are taxable when the structure is established, even though they are not received until a later date. The tax court in Childs held that a provision for future payments is secured or funded “[o]nly at the time when the beneficiary obtains a nonforfeitable economical or financial benefit in the trust or insurance policy.”33 A mere guarantee of payments is insufficient to cause an unsecured promise to be secured for this purpose.34

Example 8: In a settlement agreement negotiated immediately prior to the trial date, an attorney agrees to accept the payment of his fees as a structured settlement, funded with an annuity. The attorney agrees that payments under the annuity may not be accelerated and are subject to the claims of general creditors of the obligor. After the case settles, the defendant’s insurance company assigns the liability to a “section 130 qualified assignee,” which acquires an annuity that is used to pay the attorney’s fees over a term of years. This arrangement follows the Childs case. Under the holding of that case, this arrangement is effective to avoid application of the constructive receipt and economic benefit doctrines because the attorney has no right to accelerate payments to him and the payments are subject to the claims of the obligor’s general creditors. The result is the same even if the defendant’s insurance company guarantees the payments to be made to the attorney under the annuity.³⁵

The Tax Court in Childs noted that each annuity policy acquired for the benefit of the attorneys permitted the obligor of the annuity to change the annuitant or beneficiary under the policy without the consent of the annuitant. It is unclear if this provision was essential to the holding in the case. Provided that payments under an annuity policy remain subject to the claims of the obligor’s general creditors, the ability of the assignee to change the beneficiary should not be necessary to achieve income deferral.

As with the constructive receipt doctrine, avoiding the economic benefit doctrine imposes certain risks to the attorney. The risk in structuring under the constructive receipt doctrine is that the attorney will defer payments due to him and then be unable to accelerate such payments in the event of a financial crisis. The risk in structuring under the economic benefit doctrine is that the attorney’s legal fees must be subject to the claims of the general creditors of the obligor (the plaintiff).

Continued...