Last month, for the first time in two decades, the IRS took a critical look at plaintiff lawyer fee deferrals. In its December, 2022, Generic Legal Advice Memorandum (the “GLAM”), the IRS considered and rejected a hypothetical deferral with a particularly bad set of facts (the “Aggressive Deferral”).
While such aggressive facts are uncommon, the GLAM also previews how the IRS would evaluate more conservative fee deferrals. Many settlement planners, those who advise plaintiff lawyers, see this as an opportunity to emphasize how tax deferral can be done right.
Deferral Benefits & Basis
Plaintiff lawyer fee deferrals are facilitated by annuity companies and other investment providers, and typically placed and advised on by settlement planners. In effect, deferrals secure the tax benefits of an uncapped 401(k) with a pre-scheduled payout. In 1994 the IRS lost its challenge to such an arrangement in the U.S. Tax Court (Childs v. Commissioner), then lost again on appeal in the Eleventh Circuit Court of Appeals. Since then, it has cited Childs with approval.
On the whole, the GLAM’s reasons for concluding that the Aggressive Deferral failed are based on facts not generally common to fee deferrals. Did the IRS revisit deferrals to support an ongoing audit of a particularly aggressive provider? Or, to remind those considering deferrals not to extend Childs too far? With the recent $80 billion funding increase to the IRS, it’s possible that auditors will go after more conservative arrangements. However, given the aggressive facts considered, that seems unlikely. And fortunately, by explaining what the IRS sees as problematic, and why, providers can align their structures with that thinking.
Says Matt Meltzer, Counsel at Flaster Greenberg, “The IRS lawyers who keep tabs on this area likely came upon a product they didn’t like, and the GLAM was the result. While it at first appears to launch a broadside against law that’s been settled for almost three decades, it’s actually much narrower in scope. If anything, the GLAM is a reminder for everyone to pause and refresh on how to do things the right way.”
The Right Way
Most fee deferral arrangements copy Childs in most respects, with modest changes to make them easier to use. The typical deferral scenario begins with a lawyer and client approaching the settlement of a lawsuit against a defendant. Their fee agreement provides for a contingent legal fee (e.g., 33%) on any amount received. Prior to settlement, the lawyer and client amend the fee agreement to defer the lawyer’s right to fees according to any future payment schedule arranged at settlement.
At settlement, the documentation effects two “steps.” First, the client releases the defendant in exchange for payment, some of which is scheduled to be made in the future to the lawyer on behalf of the client. Second, the defendant pays a deferral provider to assume its obligation to make any future payment. The provider is often related to a life insurance company and purchases an annuity that will fund future payments.
As anyone familiar with “structured settlements” will note, a key takeaway is to parallel the steps normally taken by a plaintiff to defer settlement proceeds. The IRS has issued multiple rulings approving the effectiveness of structured settlements. And, a U.S. Supreme Court decision, Commissioner v. Banks, holds that payments received by a plaintiff’s lawyer are treated as received by the plaintiff, then paid by the plaintiff to the lawyer. A deferral arrangement can rely on these authorities by effecting a structured settlement that is scheduled to satisfy a lawyer’s right to deferred fees.
The Wrong Way
Lawyers and their settlement planning teams can best protect themselves by recognizing “bad facts” that may cause a deferral to fail. Or at least, recognize facts that the IRS may believe cause a failure. The Aggressive Deferral in the GLAM included many bad facts. When deferring fees, here’s what you shouldn’t do.
1. Skip the Fee Agreement Amendment
In the Aggressive Deferral, the lawyer never amended the lawyer-client fee agreement. Thus, immediately upon settlement, the lawyer earned the contingent fee. Moreover, the defendant was obligated by the settlement to make payment to whomever the lawyer directed. Under the “constructive receipt doctrine,” a taxpayer is taxable on an amount to which the taxpayer has unrestricted access. The lawyer could have avoided constructive receipt by deferring the client’s obligation to pay fees.
2. Skip the Defendant’s Promise of Future Payment
In the Aggressive Deferral, the defendant promised a lump sum payment. Thus, the full settlement was received right away, with no opportunity to avoid immediate taxation. This could have been avoided by deferring the defendant’s obligation to make some portion of payment in the future (i.e., the fee portion of the settlement).
3. Skip the Defendant’s Contract with the Provider
In the Aggressive Deferral, the lawyer’s right to a deferred payment was first promised by the deferral provider. Thus, the liability was created separate from the settlement, and funded by amounts already received by the lawyer for tax purposes. The fact that the defendant paid the provider directly, rather than paying the lawyer, is unhelpful. Under the “anticipatory assignment of income doctrine,” a taxpayer entitled to income cannot avoid it by directing the payor to pay someone else. The lawyer should have arranged for the defendant to promise the future payment in the settlement agreement, and then, for the provider to assume the obligation to make that future payment.
4. Skip the Client’s Part in the Deferred Payment
In the Aggressive Deferral, the client’s obligation to pay fees was terminated upon the defendant’s payment to the deferral provider. The lawyer was the provider’s sole obligee. Thus, the amount received by the provider was set aside for the exclusive benefit of the lawyer, triggering immediate taxation for the lawyer under the “economic benefit doctrine.” The lawyer could have dramatically reduced such risk by deferring the client’s obligation to pay fees and arranging for the provider’s future payment to be made on behalf of the client.
5. Skip the Lawyer’s Right to Borrow
In the Aggressive Deferral, the deferral provider loaned funds to the lawyer, reserving the right to reduce the deferred payment to the lawyer by the amount of loan nonpayment. The ability to borrow against the right to future funds has sometimes been treated as support for immediate taxation, under Internal Revenue Code Section 83 and under the economic benefit doctrine. Removing the lawyer’s ability to borrow “against” the deferred payment would remove yet another basis for immediate taxation.
A Future of Deferral
On the whole, the strongest positions in the GLAM are based on “bad facts” uncommon to most plaintiff lawyer fee deferrals. While its explanations touch on facts and thinking that could be used against typical deferrals, in doing so, they lose much of their strength.
Helpfully, the write-up empowers deferral providers to better avoid structures that the IRS might find problematic. And it informs settlement planners who recommend and advise on deferrals, including those at the Society of Settlement Planners, the American Association of Settlement Consultants, and the National Structured Settlements Trade Association.
In short, fee deferrals look like they’re here to stay, and provide significant benefits. And the lawyers who use them are more equipped to confirm that they’re done right.