March 2003
EXTRA

Structuring Fees

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Structuring attorney fees in personal injury cases raises issues under Code Section 130. That section permits parties to structure damages via a qualified assignment from the defendant (or the defendant’s insurance company) to an entity that assumes liability to make the structured payments. In the typical assignment, the assignee agrees to pay the structured damages via an annuity; however, the structure also may incorporate a trust arrangement if certain conditions are satisfied.36 If the section 130 requirements are satisfied, the assignee does not recognize income when it receives cash to fund the periodic payments, provided that such cash is used to acquire assets to make the periodic payments. ³⁷  If the section 130 requirements are not satisfied, then the assignee may recognize income when it receives the funding principal.

Code Section 130(c) defines the term “qualified assignment” to mean “any assignment of a liability to make periodic payments as damages (whether by suit or agreement), or as compensation under any workmen’s compensation act, on account of personal injury or sickness (in a case involving physical injury or physical sickness) . . ..” This definition by its terms does not include an assignment of the plaintiff’s obligation to pay legal fees to his or her attorneys. Because the legal fees are payable for services rendered (and not for personal injuries of the attorney), they do not qualify for assignment under section 130. This presents a trap for the unwary that would cause the subject section 130 assignment and possibly the assignee to fail.

If the assignee under section 130 accepts a direct assignment of the structured attorney fees, the assignee will not obtain the benefits of section 130. In such event, the assignee will owe income taxes on all of the funding principal attributable to the structured attorney fee. Were the I.R.S. to challenge attorney fee structuring in cases that failed to address this issue, the results could be devastating. Because the majority of assignees are single purpose entities with no assets other than those used to fund periodic payments, a tax assessment (with interest and penalties) by the I.R.S. would cause these entities to default on a portion or all of their obligations to plaintiffs and their attorneys.

In Childs, the court makes reference to the structuring of payments under “‘a qualified assignment [which] . . . meets the requirements of Section 130,’” ³⁸ but does not address the assignment of the attorney fees under that section. Presumably the court determined not to mention this issue because it relates solely to the taxation of the assignee, not the attorney. What is important from Childs is that the I.R.S. need not audit the assignee to find this issue. The I.R.S. could trip over this issue upon the audit of one attorney and then expose the structures undertaken by the assignee in all of the other cases.

A viable solution to this problem is to structure the entire recovery for the plaintiff and then enable the plaintiff to direct a portion of the plaintiff’s recovery to be paid on behalf of the plaintiff to his or her attorneys to satisfy the contingent fee agreement. Under the representation agreement between the plaintiff and the attorney, the plaintiff can agree to direct that a portion of the structured recovery be paid to the attorney for services rendered. This direction by the plaintiff should be revocable to avoid immediate income recognition to attorney under the economic benefit doctrine. Structuring in this manner is more readily accomplished under a trust structure (in which the trustee can comply with the payment direction) than under an annuity-based structure.

The second issue, which was only briefly addressed by Childs, but is relevant in the current structuring environment relates to the attorney’s lien on recovery.³⁹  Under the applicable state lien laws, the payment of a contingent fee is not subject to the claims of the general creditors of the plaintiff unless the lien is irrevocably waived by the attorney prior to the funding of the settlement. If the plaintiff has a secured interest in funding assets and the attorney retains his or her lien under an applicable law, the attorney would be held to have a funded arrangement that causes income recognition under the economic benefit doctrine.

While Childs may be instructive in resolving this issue, attorneys must recognize that the facts in that case relate to a structure employed during the mid-1980s and the holding may not apply in the current environment. Before the amendment of Code Section 130 in 1988,⁴⁰ structured settlements for plaintiffs and attorneys required that neither plaintiffs nor attorneys had rights greater than those of a general creditor. After the 1988 amendment, structures implemented for plaintiffs can provide a secured interest for the plaintiff. This structuring change makes attorney liens more relevant today than they were before the 1988 amendment. The author is aware that in structures currently being implemented, counsel is not being instructed that they must waive their right to the state lien. This approach is followed under an assumption that the economic benefit doctrine does not apply to the attorney because the attorney has rights “no greater than those of a general creditor” of the assignee. This assumption is clearly erroneous because with respect to the lien, the creditor status of the attorney in relation to the assignee is irrelevant. The attorney’s lien applies to the plaintiff’s recovery and would cause economic benefit to the attorney even if the attorney’s status is unsecured with respect to the assignee.

A viable solution to the state lien problem is for the attorney to affirmatively waive the benefit of the lien for fees that are structured. This waiver is implemented in the representation agreement. In taking this approach, the attorney must recognize that the structured fees will then be subject to the claims of the plaintiff’s creditors until they are paid to the attorney. The attorney will retain a contractual cause of action against the plaintiff for the legal fees until they are paid in full. For so long as payments are being made to the plaintiff, the attorney should be able to recover any fee that is structured; however, if the structure fails to satisfy the requirements of Code Section 130, the attorney may achieve a better result under a trust structure (which generally provides for a distribution of assets to the plaintiff) vs. an annuity-based structure (which generally provides for a renegotiation of the settlement terms).

Conclusion:

As with any tax saving or tax deferral procedure, structuring attorney fees have their own pros and cons.

Pros

1. The attorney recognizes income as the legal fees are paid to him or her, and then only with respect to the fees that are received each year in accordance with the structure.

2. The tax on the interest accrued on the funding amount of the structured fee is likewise deferred as above

Cons

1. The attorney has no right to the structured fee until it is payable to him or her in the future, and may not modify the payment schedule even if his or her circumstances change

2. The attorney may be in a higher tax bracket when the payments are made than at the time of deferral, thereby increasing the tax imposed on the legal fees and failing to accomplish the objectives of the deferral.

3. The payment of the structured fee must be subject to the claims of plaintiff’s creditors and to a modification by the plaintiff of his or her payment direction to the assignee.

4. With the exception of only one structured settlement available today, the fee structure will lock in today’s low interest rates for the life of the structure.

1 Internal Revenue Code of 1986, as amended (the “Code”). 2 The deferral arrangement may provide that payments will commence upon the death or incapacity of the attorney, but, to be effective for tax purposes, may not be unilaterally accelerated by the attorney. See the discussion of the “constructive receipt” doctrine that follows. 3 T.C. Memo 2000-228 (July 28, 2000). 4 Id. 5 193 F. Supp. 930 (E.D., Ark. 1961). 6 Id. at 933. 7 See Revenue Ruling 60-31 and Revenue Ruling 71-419. 8 See Revenue Procedure 92-65. 9 See the discussion below regarding the economic benefit doctrine. 10 All of the examples in this paper assume that a contingent fee agreement is in place. Except as otherwise provided, all contingent fee agreements initially provide for lump sum payment of attorney fees at the conclusion of the case. 11 The I.R.S. audit manual advises agents to scrutinize attorney trust accounts for deferred income. See I.R.S. Market Specialization Paper for Attorneys (Rev. 6-94). 12 103 T.C. 634 (1994), aff’d per curium 89 F. 3d 856 (11th Cir. 1996). 13 Attorneys may need to address applicable attorney ethics rules in attempting to structure their fees during settlement negotiations. Note, for example, that in Childs the plaintiff’s attorneys consulted with the State Bar of Georgia regarding the terms of such negotiations. A discussion of the ethical issues arising from the structuring of attorney fees is beyond the scope of this paper. 14 103 T.C. at 654-655 15 Field Service Advice 200151003 (July 5, 2001) [Note that pursuant to Code Section 6110(k)(3), a Field Service Advice may not be used or cited as precedent.] 16 Id., citing Reed v. Comm’r, 723 F.2d 138 (1st Cir. 1983) and Childs. 17 Reed, 723 F.2d at p. 142. 18 Oates v. Comm’r, 18 T.C. 570 (1952), aff’d 207 F.2d 711 (7th Circuit, 1953). 19 See TAM 8632003 (April 18, 1986). [Note that pursuant to Code Section 6110(k)(3), a Technical Advice Memorandum may not be used or cited as precedent.] 20 Veit v. Comm’r, 8 T.C.M. 919 (1949) (sometimes referred to as Veit II) 21 Id. at 922. 22 TAM 8632003 (April 18, 1986). [Note that pursuant to Code Section 6110(k)(3), a Technical Advice Memorandum may not be used or cited as precedent.] 23 Foster v. United States, 249 F.3d 1275 (11th Cir. 2001). 24 See e.g., Reed; Oates, 18 T.C. at 585, 207 F.2d, at 712-19; Comm’r v. Olmstead Incorporated Life Agency, 304 F.2d 16, 22-23 (8th Cir. 1962); Goldsmith v. United States, 586 F.2d 810, at 817 (Cl. Ct. 1978). 25 See e.g., Cowden v. Comm’r, 289 F.2d 20 (5th Cir. 1961); Amend v. Comm’r, 13 T.C. 178 (1949). 26 See e.g., Williams v. United States, 219 F.2d 523, 527 (5th Cir. 1953). 27 96 T.C. 814 (1991). 28 Closely tied to the “economic benefit” doctrine is the so-called “cash equivalency” doctrine. The cash equivalency doctrine applies when a promise is so good that the receipt of cash is “certain.” In such event, the fair market value of the agreement or other right received is taxable upon receipt even though cash under the agreement is not received until later. For the cash equivalency doctrine to apply, the promise received by the taxpayer must be from a solvent obligor, must be unconditional, must be freely transferable and must not be subject to set-offs. Because the concepts underlying the cash equivalency doctrine are similar to those applicable to the economic benefit doctrine, this paper addresses the cash equivalency doctrine as a subset of the economic benefit doctrine. 29 Cf. Childs; See also IRS General Counsel Memorandum 39230 (May 7, 1984) (Under facts that included separate trust accounts established by an employer for each employee under a deferred compensation arrangement, the IRS concluded that deposits into the trust accounts were not taxable when made because the trust accounts remained subject to the claims of the employer’s creditors.) 30 16 T.C. 244 (1951), aff’d. 194 F.2d 541 (6th Cir. 1952). 31 Id. at 248-249; See also Minor v. United States, 772 F.2d 1472 (9th Cir. 1985). 32 Treasury Regulations Section 1.83-3(e). 33 103 T.C. at 651. 34 Id. at 654. 35 Id. 36 See e.g., Private Letter Ruling 9703038 (July 24, 1996) (third party assignee was a trust that assumed liability for payments). [Note that pursuant to Code Section 6110(k)(3), a private letter ruling may not be used or cited as precedent.] 37 Code Section 130(a) provides that “[a]ny amount received for agreeing to a qualified assignment shall not be included in gross income to the extent that such amount does not exceed the aggregate cost of any qualified funding assets.” 38 103 T.C. at 643. 39 In Childs, the court addressed the attorney lien issue in an endnote, finding with minimal discussion that the attorney waived the state lien by accepting the structured settlement. (See Childs, endnote 9 referenced at page 654). 40 Code Section 130 was amended to provide that no amount is currently includible in the recipient’s income solely because the recipient is granted creditor rights that are greater than the rights of a general creditor. See Code Section 130(c) flush language. 14