ABSTRACT:
A failure by an attorney to structure his or her fee in
accordance with applicable tax law represents a significant threat to the
attorney. Noncompliance may be viewed by the Internal Revenue Service (I.R.S.)
as a failure to report income, causing the attorney to incur tax on
income, compound interest retroactively to the date of settlement, and
penalties on the tax due.
An attorney seeking to defer the recognition of
contingent fee income must evaluate a number of business and tax issues.
From a business perspective, the attorney must recognize that fee
structuring may cause the attorney to lose the protection of state lien
laws and must subject his or her fees to the claims of creditors of the
person obligated to make the payments (the plaintiff). The attorney also
must consider his or her future cash needs. Once structured, the attorney
fees may not be accelerated or deferred.
From a tax perspective, the attorney must consider the
applicable tax laws. If the structured arrangement is found not to comply
with the tax laws, the I.R.S. will treat the attorney fees as taxable on
the date upon which the case is settled, and will impose taxes, interest
and penalties from that date.
Although the Tax Court upheld the deferral of legal fees
in one decision, attorneys should be careful not to rely too heavily on
that case. The facts in that case are quite specific and the result
reached in that case should not be relied upon in cases that would be in
any way materially dissimilar. With a greater understanding by the I.R.S.
of Internal Revenue Code1 Section 130 transactions, it is possible that
the result will be different in the future. Moreover, there can no be
assurance that the I.R.S. will not attack the same issue in jurisdictions
in which the case does not have precedence. The foregoing analysis is not
intended to suggest that attorney fee structuring is no longer viable, but
to note that the tax rules are complicated and must be applied with
consideration to the actual facts of each case.
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. The constructive
receipt doctrine requires an individual who is on the cash method of
accounting to recognize income when the individual has an unqualified,
vested right to receive immediate payment of income. Constructive receipt
is primarily a question of timing. To be in “constructive receipt” of the
income, the 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.
While the constructive receipt doctrine seeks to treat a
payment that is not received by the individual as constructively received
by him or her, the “economic benefit” doctrine considers whether the
individual 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 individual under the structured
arrangement. If the individual receives property that is the equivalent of
cash, such as a funded or secured arrangement, or any arrangement in which
the individual has a non-forfeitable right to the identifiable property,
then the individual is treated as receiving current compensation equal to
the fair market value of the arrangement. It is not necessary that the
individual’s interest be assignable in order to constitute an economic
benefit, or that the individual be entitled to immediate possession of the
property. What is required is that there be identifiable property and that
the individual’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.
Structuring attorney fees in cases in which the
underlying damages are received on account of physical injuries raises
additional tax and business risks for the attorney. Code Section 130, in
general terms, provides beneficial tax treatment to an entity that agrees
to assume a defendant’s obligation to make periodic payments of personal
injury damages to a plaintiff. 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. If the Section 130 requirements are
not satisfied, then the assignee may recognize income when the funding
principal is received.
Because the attorney fees are an obligation of the
plaintiff and are paid to the attorney for services rendered (and not for
physical injuries of the attorney), attorney fees do not qualify for
assignment under Section 130. If the assignee under Section 130 accepts a
direct assignment of the plaintiff’s obligation to pay the structured
attorney fees, the assignee will not obtain the benefits of Section 130.
In such event, the assignee will recognize income upon receipt of the
funding principal.
The risk for the attorney in this context results from
the nature of the assignees used in Section 130 structures. The majority
of assignees are single purpose entities with no assets other than those
used to fund periodic payments. If the I.R.S. were to successfully
challenge the assignment of attorney fees from the date that they were
first implemented, the single purpose entities would have no funds to pay
the taxes, interest and penalties that would be due. Should this result
occur, the periodic payments due to plaintiffs and their attorneys would
be diminished or entirely eliminated, thus causing not only a loss of
income, but also potential tax and legal issues, for the attorney.
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