United States: Lawyers Are Structuring Fees Despite IRS Attack

Introduction

If they observe the formalities, contingent-fee lawyers can defer their legal fees, have them invested pretax, and have them paid and taxed later. They must implement those arrangements before earning the fee. Yet even in cases that have been litigated for years, so long as the structure is implemented before the case settles — even the night before — the tax deferral is effective. The use of a qualified settlement fund (QSF) can expand the potential window of time to structure an arrangement because a QSF stands in the shoes of the defendant.

The execution of a formal settlement is the event that causes the receipt of income to the lawyer. From a tax and accounting viewpoint, the fee is contingent, so it is not income until the client signs the settlement agreement, triggering the fee. With the help of life insurance companies, lawyers have been implementing structured fee arrangements during settlement negotiations for 40 years. However, the real shot in the arm to plaintiff lawyers and the structured legal fee industry came in the 1990s, with Childs.¹

In that Tax Court case, the IRS lost its sole litigated attack on structured legal fees. It appealed the case to the Eleventh Circuit and lost there too, albeit without a published opinion. In Childs, the IRS argued that the annuity contracts used to defer the lawyer's receipt of fees were not viable, so the lawyer should have been taxed presently, not later when the periodic payments started to trickle in. Rejecting the IRS's arguments, the Tax Court and Eleventh Circuit upheld the arrangement.

For more than a decade, the IRS grumbled about Childs — at least informally. But then it began citing the case with approval in several private letter rulings. This suggested — to us at least — that the IRS had accepted Childs as the law. For example, in FSA 200151003, the IRS cited Childs to support the proposition that when attorneys enter into a structured settlement arrangement calling for deferred payment of their fees, there is no constructive receipt as long as the settlement is entered into before the attorneys obtain an unconditional right to compensation for their services.

Childs 30 Years Later

Childs involved structuring legal fees with annuities, which was the only game in town in the 1980s and 1990s. Indeed, many life insurance companies continue to offer these arrangements and they remain popular, especially in times of high interest rates. High interest rates generally make annuities attractive for plaintiffs who structure their recoveries, too.

As interest rates have risen over the last several years, there has been a resurgence in lawyers interested in structuring their fees with annuities. There is nothing wrong with annuities, and nothing wrong (and a lot right) with following Childs to the letter. Yet in the last three decades, during which structured legal fees have gained acceptance and popularity, many lawyers have moved away from annuities, despite the high interest rate environment. So has the insurance industry, offering market-based arrangements that essentially emulate Childs but with payments to the attorney calculated by reference to a portfolio of stocks and bonds.

There are various approaches, but there appears to be nothing magical about funding a structure with life insurance annuities.² Many lawyers and tax advisers are comfortable with alternative investments, so long as the teachings of Childs are followed. For example, the lawyer must remain a mere payee, a general creditor without ownership or control over the deferred fees. Although the amount of a payment may be calculated by reference to other assets (just as the payments in Childs were calculated by reference to amounts to be paid via an annuity), the attorney cannot own the referenced assets, either constructively or in fact.

Section 409A Enacted

A fly in the ointment of structured legal fees came in 2004 when Congress enacted section 409A following the Enron scandal. Section 409A was designed to regulate and tax many types of deferred compensation. Plaintiff lawyers are hardly corporate executives, but lawyers and insurance companies wondered if this complex provision would affect fee structuring by plaintiff lawyers. Not long thereafter, the IRS issued Notice 2005-1, 2005-1 C.B. 274.

This notice included a section labeled, "Arrangements With Independent Contractors," which described how new IRS regulations would protect independent contractors from the ambit of section 409A. It foreshadowed how the new regulations would provide that section 409A does not apply to arrangements between a service provider and a service recipient if (1) the service provider is actively engaged in the trade or business of providing substantial services (other than as an employee or corporate director), and (2) the service provider provides those services to at least two unrelated service recipients. This rule is designed to distinguish between employees (whose compensation arrangements are subject to section 409A) and bona fide independent contractors, whose compensation arrangements were not intended to be affected by section 409A.

The IRS position announced in the 2005 notice was followed by regulations in 2007 that said the same thing.³ And that seemed to be that, with structured legal fee arrangements proceeding apace with no worry over section 409A. From 2005 until December 2022, tax opinions on structured legal fee arrangements usually had one paragraph or a footnote that said that under the regulations, section 409A does not apply to structured legal fees for independent outside counsel. Then, in December 2022, the IRS revealed that it had a new idea about how section 409A could apply to structured legal fees after all.

Mother of all GLAMs

A GLAM is an IRS generic legal advice memorandum, and plenty of them have been issued over the years to inform taxpayers and IRS field personnel about the National Office's position on a particular item or issue. Some GLAMs are controversial, but it is hard to remember one as contentious or widely read as AM 2022-007 — the GLAM released in December 2022. It came as a surprise to insurance companies, structured settlement providers, plaintiff lawyers, and tax advisers.

A GLAM is not binding on taxpayers, and this GLAM's criticism of fee structures is broad and scattershot in approach. Still, its analysis merited close consideration. Most fee structures follow one of two models: (1) an assignment structure modeled strictly after Childs, or (2) one with changes that also rely on Childs and other deferred compensation authorities and principles to bridge any gap between Childs' facts and the structure's facts. Both models rely on Childs to a material degree, and both erect formal barriers so the lawyer who is the ultimate payee does not have even a security interest in the right to periodic payments of the underlying reference or funding assets, and cannot control the structure once it is put in place. Childs was itself determined by the application of deferred compensation legal authorities.

Originally Published by TAX NOTES FEDERAL

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Footnotes

1. Childs v. Commissioner, 103 T.C. 634 (1994), aff'd without opinion, 89 F.3d 856 (11th Cir. 1996).

2. Robert W. Wood, "Structuring Legal Fees Without Annuities: Offspring of Childs," Tax Notes, July 20, 2015, p. 341.

3. Reg. section 1.409A-1(f)(2)

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