IRS Takes Aim at Law Firms’ Deferred Payment Arrangements for Contingency Cases

I. Introduction

When a U.S.-based cash-basis law firm receives a contingency fee, the fee generally is subject to U.S. federal income taxation in the year the settlement occurs and the fee is paid out by the defendant or its insurer (Settlement Year). Some law firms have arranged for a third party (Third Party) to have the legal right to receive the fees in the Settlement Year, subject to an obligation to pay certain amounts to the law firm or its principals in one or more later years. The goal of these “Deferral Agreements” is to defer taxation of the income (plus interest) until those later years.  

On Dec 16, 2022, the IRS released a Generic Legal Advice Memorandum (GLAM) which describes the tax treatment of such Deferral Agreements. In short, the IRS takes the position that the income is taxable to the law firm in the Settlement Year and not in the later year(s) when the Third Party pays the law firm. While a GLAM is not binding on the IRS or taxpayers, it offers valuable insights into how the IRS may address recurring issues.

In this alert, we summarize the IRS position. If confronted with an IRS audit, we recommend seeking counsel right away. Caplin & Drysdale regularly defends taxpayers facing IRS civil and criminal audits. 

II. IRS Position:

A law firm’s position that income subject to a Deferral Agreement is not taxable in the Settlement Year may be based on Childs v. Commissioner, 103 T.C. 634 (1994). In Childs, the U.S. Tax Court held that some such arrangements are not subject to immediate income inclusion because (1) the attorneys’ rights to receive payments under the settlement agreements were not “property” for purposes of section 83, and (2) the doctrine of constructive receipt was not applicable to the arrangement. The GLAM concludes that Childs is not dispositive for all Deferral Agreements and that the income may be taxable in the Settlement Year. The GLAM uses a scenario to explain why.

In the scenario, a law firm (Taxpayer) represents a client who agrees to pay Taxpayer a 30% contingency fee out of any money received from the defendant or defendant’s insurer. Taxpayer meanwhile enters into a Deferral Agreement, which features deferral of receipt and investment vehicles for the amounts deferred. Taxpayer agrees that any fees earned from the settlement are to be transferred directly from defendant/insurer to the Third Party, and that the Third Party will pay a lump sum to the Taxpayer at some future date. Taxpayer has no right to assign, accelerate, defer, change the terms or time of, or transfer or sell the deferred payment. The sums that are subject to the payment obligation are not subject to the claims of the general creditors of the Third Party.

The GLAM makes four distinct arguments for why the Taxpayer must include the amounts in taxable income in the Settlement Year:

a. Anticipatory Assignment of Income Doctrine:

Under the Anticipatory Assignment of Income doctrine, when the funds were transferred to the Third Party from the insurer, the funds represented (in substance) compensation owed to the Taxpayer from the client under the fee agreement. Taxpayer (in form) diverted these amounts to the Third Party in anticipation of receiving the income, but the diversion did not change the underlying substance: “The . . . assignor retains sufficient power and control over the … receipt of the income to make it reasonable to treat him as the recipient [in the Settlement Year] of the income for tax purposes.”

b. Economic Benefit Doctrine:

Under the Economic Benefit Doctrine, “the benefit derived from an employer’s irrevocable set-aside of money or property as compensation for services rendered is includible in the service provider’s gross income at the time of the set aside . . . .”  Our Country Home Enterprises, Inc. v. Commissioner, 145 T.C. 1, 53 (2015). The IRS concludes that Taxpayer had the “economic benefit” of the settlement in the Settlement Year because the client had a contractual obligation to pay the fee to the Taxpayer and payment of the fee put the funds beyond the reach of the client’s creditors. The Taxpayer’s entry into the Deferral Agreement did not alter the fact that Taxpayer had obtained that economic benefit. 

The IRS also cites United States v. Drescher, 179 F.2d 863, 865 (2d Cir. 1950) to clarify that the economic benefit received by the Taxpayer in the Settlement Year may be the obligation of the Third Party “to pay money in the future” to the Taxpayer. In Drescher, the taxpayer had “received as compensation for prior services something of economic benefit” in the form of “the obligation of the insurance company to pay money in the future … on the terms stated in the policy."

The GLAM points out that the Tax Court in Childs did not address the Economic Benefit Doctrine as a basis for income inclusion. 

c. Code Section 83:

The third and final IRS argument is that, once settlement occurred, the fees were Taxpayer’s property and were no longer subject to a substantial risk of forfeiture and, therefore, that Code section 83 requires inclusion in the Settlement Year. While section 83 “property” does not include unfunded or unsecured promises to pay money or property in the future, or funds that are subject to the rights of general creditors of the obligor, the Deferral Agreement described in the IRS scenario represents a funded arrangement.  Specifically, no further action was required on the part of the defendant’s insurer for the fee to be distributed to the Taxpayer. The Taxpayer had obtained a nonforfeitable economic or financial benefit in the future payment. Also, the Third Party’s promise to pay the Taxpayer under the payment arrangement was not subject to the claims of general creditors of defendant’s insurer. The GLAM distinguishes the facts in the Tax Court’s Childs decision, where the settlement had not been funded. 

d. Code Section 409A:

The GLAM concludes that, even if an arrangement is unfunded for purposes of section 83, the Deferral Agreements will result in Code section 409A violations, requiring not only immediate income inclusion but also heavy associated penalties. The GLAM explains that the 409A timing requirements for initial deferral elections have not been met, and that a limited exception to 409A for independent contractors, has not been met. Thus, a successful assertion that the payment arrangement is unfunded for section 83 purposes could lead to even harsher tax consequences for the Taxpayer under Code section 409A.

III. Conclusion

The GLAM is based upon not one, but several legal arguments by the IRS, each of which itself derives from the specific facts of the hypothetical scenario. Therefore, the implications of the GLAM for taxpayers who have entered into or are contemplating Deferral Agreements require both close factual review and further legal analysis of the merits of each of the IRS arguments as applied to those facts. Attorneys at Caplin & Drysdale are available to assist with those efforts.