Plaintiff lawyers have successfully deferred tax on contingent fees—securing the tax benefits of an uncapped 401(k) with a pre-scheduled payout—since the IRS lost its challenge to a fee deferral arrangement in Childs v. Commissioner in 1994. Since then, the IRS has cited Childs with approval, but some arrangements over the years have evolved away from the “classic facts” of the case.
In December, the IRS Office of Chief Counsel considered and rejected a hypothetical and particularly aggressive deferral. In its non-binding Generic Legal Advice Memorandum, the IRS explained four independent reasons to tax the lawyer on fees placed in the aggressive deferral. One could say that the lawyer did “everything wrong.” And while this deferral described bore little resemblance to the way they are typically done, the GLAM’s discussion provides insight into how the IRS might analyze more conservative deferrals.
This article summarizes the aggressive deferral versus the typical deferral, then considers how the GLAM’s arguments against the first might apply to the second. On the whole, the arguments don’t fit when applied to the typical deferral. And where they might pose risk, deferral providers have the opportunity to adapt their structures to more closely suit potential IRS positions.
Two Deferrals, Two Levels of Risk
In an aggressive deferral, a lawyer and client agree to a 30% contingent fee. The lawyer negotiates a settlement with the defense insurer acceptable to the client. The settlement agreement provides a full release to the insurer upon the insurer following the lawyer’s payment instructions.
Then, the day before the client signs the settlement agreement, the lawyer enters into a deferral agreement with a deferral provider, in which all fees that the lawyer earns from the settlement will be paid to the provider. The provider promises to pay the lawyer in 10 years based on the performance of a “hypothetical investment portfolio” that the lawyer selects.
After the insurer pays the provider, the funds are placed in a grantor trust. Two months later, the lawyer borrows funds from the provider. The loan documentation allows the provider to reduce its promised payment to the lawyer to recoup any amount of non-repayment on the loan.
Given the number of providers and deferral arrangements, there are plenty of differences in the way fee deferrals are effected. There are some elements that are (or are intended to be) fairly common to all.
In a typical deferral, prior to settlement, the lawyer and client amend their fee agreement in anticipation of the fee deferral. The amendment defers the lawyer’s right to fees according to any schedule of payments intended for the lawyer and promised in the settlement agreement. Pursuant to an assignment agreement, a provider assumes the insurer’s obligation to make the scheduled payments in exchange for a lump sum amount.
The settlement agreement and assignment agreement state that payments directed to the lawyer will be made “for the benefit of” the client.
Anticipatory Assignment of Income Doctrine
The anticipatory assignment of income doctrine causes a taxpayer to be taxable on income that is nearly certain to be received if the taxpayer “retains control over the disposition of the income” and “diverts the payment” of that income to someone else.
In the aggressive deferral, the lawyer controls and diverts the fee portion of the settlement to the provider. Thus, the lawyer can be taxed on that amount. The aggressive deferral is different in several ways from typical deferrals, creating more opportunity for the IRS to apply the anticipatory assignment of income doctrine. Most importantly, the settlement agreement calls for the insurer to pay the settlement amount “according to payment instructions to be provided by [the lawyer].” Thus, immediately upon payment, the lawyer is entitled to receive a 30% contingent fee and to direct that portion of the settlement to the provider.
In a typical deferral, several items would prevent the lawyer from controlling or directing funds. First, the insurer would sign a settlement agreement and an assignment agreement. As a result, the insurer becomes obligated to pay the fee portion of the settlement to the provider rather than to the lawyer. Unlike in the aggressive deferral, the lawyer typically has no ability to direct the amount elsewhere.
Second, the lawyer would have amended the client fee agreement to defer the lawyer’s right to fees according to the expected deferral payment schedule. As a result, those fees wouldn’t be “earned” immediately after executing the settlement agreement. The lawyer would have no present right to the fee portion of the settlement.
As noted in Childs, contingent fees are earned only after a settlement agreement becomes effective. Other authorities have noted that the assignment of income doctrine wouldn’t apply to proceeds from a claim with unexhausted appeals because such proceeds are inherently “contingent and doubtful in nature.” It stands to reason that the same logic would apply to a contingent fee on such proceeds. Unlike what is typically done, the lawyer’s fee in the aggressive deferral becomes “payable at the time of the recovery.”
Third, a typical assignment agreement states that payments by a provider are made “for the convenience of,” “for the benefit of,” or “on behalf of” the client. This is consistent with the amendment to the client fee agreement referenced above. A payment from the provider would be treated for tax purposes as a payment to the client, followed by a payment by the client to the lawyer. This follows directly from Commissioner v. Banks and a series of IRS rulings regarding structured settlements, including Rev. Rul. 2003‑115, which addressed payments to Sept. 11 victims whose rights to settlement proceeds were similarly restricted.
Banks holds that payments received by a lawyer are treated as received by the client, and then paid by the client to the lawyer. And Rev. Rul. 2003-115 confirms that a plaintiff who effects a structured settlement is only treated as receiving payments as they are actually received. Since the client wouldn’t be treated as receiving the future payment until the provider makes them, it would seem inconsistent for the lawyer to be treated as receiving them even earlier.
Economic Benefit Doctrine
The economic benefit doctrine causes a taxpayer to be taxable on amounts irrevocably set aside for the taxpayer’s exclusive benefit. In the aggressive deferral, the insurer’s transfer to the provider irrevocably satisfied the client’s obligation to pay the lawyer. Because the client isn’t a beneficiary of the future payment, the payment is beyond the reach of the client’s creditors. The lawyer gained the exclusive “economic benefit” of those proceeds at the time that the insurer made payment.
The aggressive deferral is different in several ways from typical deferrals, creating more opportunity for the IRS to apply the economic benefit doctrine. Most importantly, the scheduled payment owed by the provider lacked two attributes typical of fee deferral arrangements.
First, documentation defining future payments owed by a provider typically states that payments to the lawyer are made “for the convenience of,” “for the benefit of,” or “on behalf of” the client. As such, the amount paid to the provider isn’t paid for the “exclusive benefit” of the lawyer, as was the case in the GLAM. And, as noted above, Banks and Rev. Rul. 2003-115 support the treatment of each deferral payment as a payment to the client followed by a payment by the client to the lawyer. The aggressive deferral is completely different in that the client’s obligation to the lawyer terminated upon the Insurer’s transfer to the provider.
Second, typical deferrals are effected through the insurer’s “assignment” to the provider of an obligation. Unlike in the aggressive deferral, the typical settlement agreement creates an obligation for the insurer to make scheduled payments to the lawyer, which the provider then assumes.
This parallels the typical steps to create a structured settlement. Those steps were approved of in Rev. Rul. 2003‑115, in which the IRS concluded that a plaintiff didn’t obtain the economic benefit amounts paid to a provider to assume an obligation to make scheduled payments to the plaintiff. Typical deferrals follow this structure; the aggressive deferral doesn’t.
Section 83 causes a taxpayer to be taxable on the receipt of a “funded promise to pay” or a “beneficial interest” in assets that are set aside from the claims of creditors of the transferor, such that the assets aren’t forfeitable. The IRS has recognized that Section 83 codified the economic benefit doctrine (discussed above). In the aggressive deferral, the insurer’s payment to the provider funded the provider’s promise to make the future payment to the lawyer. And since the lawyer had already earned the right to the payment, it was nonforfeitable. The lawyer obtained a beneficial interest in an amount that was out of reach of the client’s and the insurer’s creditors, making the lawyer taxable on the amount paid to the provider.
Regarding whether the provider’s promise to pay is “funded,” the GLAM overlooks the relevance of Banks and Rev. Rul. 2003-115. It acknowledges that Childs concluded that the promise to make scheduled payments to the lawyer wasn’t funded, but in Childs, the insurers remained liable for the scheduled payments. In the aggressive deferral, as in typical deferrals, the insurer paid a provider to wholly assume that obligation. This may be the most concerning objection in the GLAM because it isn’t based in “bad facts.”
However, the GLAM doesn’t consider Rev. Rul. 2003-115, in which the obligor paid a provider to wholly assume an obligation to make periodic payments to a plaintiff. There, the IRS considered the application of the economic benefit doctrine, noting that it applies “if a promise to pay an amount is funded and secured by the payor,” and concluding that the doctrine didn’ apply. The GLAM discussion regarding Section 83 also makes no mention of Banks, which would seem to prevent the treatment of a payment to the provider as a funded promise to pay the lawyer.
Because the plaintiff isn’t treated for tax purposes as having yet received those funds , how could it be treated as funding a promise to the lawyer? The GLAM may have overlooked this point because in the aggressive deferral, the lawyer had already earned the contingent fee. The analysis is substantially incomplete with respect to typical deferrals insofar as it misses this key distinction.
Regarding whether the lawyer has a beneficial interest in assets set aside from creditors, the aggressive deferral includes that the client isn’t a beneficiary in the deferred fee arrangement. However, in typical deferrals, assignment agreements state that scheduled payments are made “for the convenience of,” “for the benefit of,” or “on behalf of” the client. Although a client’s creditors are unlikely to be able to succeed due to bankruptcy law protections, the second Section 83 trigger isn’t met.
Section 409A causes a taxpayer to be taxable on the value of non-qualified deferred compensation arrangement unless an exception applies. The “independent contractor” exception exempts agreements between a “service provider” and “service recipient.” Since the scheduled payments to the lawyer are paid by the provider, and the provider didn’t receive services from the lawyer, the independent contractor exception doesn’t apply. Therefore, the lawyer is taxable on the value of the obligation assumed by the provider.
The aggressive deferral is different in several ways from typical deferrals, creating more opportunity for the IRS to apply Section 409A. Most importantly, in the aggressive deferral, the client’s obligation to pay the lawyer is satisfied upon the insurer’s payment to the provider.
In a typical deferral, though, the client’s obligation to pay the lawyer isn’t satisfied at the time the Insurer makes payment to the provider. Typical deferrals include an amendment of the client fee agreement deferring that obligation. And language in the settlement agreement and the assignment agreement requiring future payments to the lawyer state that such payments will be made “for the convenience of,” “for the benefit of,” or “on behalf of” the client. For tax purposes, the client is treated as making payments to the lawyer, consistent with Banks. And since the client is clearly a “service recipient” of the lawyer, the “independent contractor” exception to Section 409A should apply.
Sticking to the Right Deferrals
Plaintiff lawyers have been deferring fees for nearly three decades. While the GLAM could be a first step for the IRS in a deeper look, it seems more likely that it was prepared for the audit of a particularly aggressive deferral. It would be difficult to imagine worse facts from a tax perspective. And in what may be a silver lining for most trial lawyers and deferral providers, the IRS just provided the playbook of what to avoid and why.
This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Jeremy Babener is the founder of Structured Consulting and previously served in the US Treasury’s Office of Tax Policy. He consults for businesses on strategy, partnerships, and marketing.
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