Last month, for the first time in two decades, the IRS took a critical look at deferrals of plaintiff attorneys’ fees. 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 these aggressive developments are rare, the GLAM also anticipates how the IRS would evaluate more conservative fee deferrals. Many settlement planners, those who advise plaintiff attorneys, see this as an opportunity to emphasize how tax deferrals can be done right.
Deferral and Basis Benefits
Annuity companies and other investment providers facilitate the deferral of plaintiffs’ attorneys’ fees, and are typically placed and advised by settlement planners. In effect, deferrals secure the tax benefits of an uncapped 401(k) with a pre-scheduled payment. In 1994, the IRS lost its challenge to such an arrangement in the US Tax Court (Childs v. commissioner), then lost again on appeal in the Eleventh Circuit Court of Appeals. Since then, he has quoted children approvingly.
In general, the GLAM’s reasons for concluding that the Aggressive Deferral failed are based on facts not generally common to rate deferrals. Did the IRS review deferrals to support an ongoing audit of a particularly aggressive provider? Or, to remind those considering postponements not to extend children Far away? With the recent increase of $80 billion in funding to the IRS, auditors may be looking for more conservative arrangements. However, given the aggressive facts considered, that seems unlikely. And hopefully, by explaining what the IRS considers problematic and why, providers can align their structures with that thinking.
Says Matt Meltzer, attorney for Flaster Greenberg, “The IRS attorneys who control this area probably found a product they didn’t like, and GLAM was the result. While it appears at first to launch a broadside against the law that has been unraveled for nearly three decades, it is actually much more limited in scope. If anything, the GLAM is a reminder for everyone to pause and refresh themselves on how to do things the right way.”
The right direction
Most fee deferral arrangements copy children in most respects, with modest changes to make them easier to use. The typical adjournment scenario begins with an attorney and client approaching settlement of a lawsuit against a defendant. Your fee agreement establishes a contingent legal fee (for example, 33%) on any amount received. Prior to settlement, the attorney and client modify the fee agreement to defer the attorney’s entitlement to fees in accordance with any future payment schedule agreed upon in the agreement.
At the time of settlement, the documentation goes through two “steps”. First, the client releases the defendant in exchange for a payment, part of which is planned to be made in the future to the attorney on the client’s behalf. Second, the defendant pays a deferred provider to assume its obligation to make any future payments. The provider is often associated with a life insurance company and purchases an annuity that will finance future payments.
As anyone familiar with “structured settlements” will notice, a key point is to compare the steps a plaintiff typically takes to defer settlement proceeds. The IRS has issued multiple rulings approving the effectiveness of structured settlements. And, a US Supreme Court decision, Commissioner against banks, holds that payments received by a plaintiff’s lawyer are treated as received by the plaintiff and then paid by the plaintiff to the lawyer. A deferral agreement may rely on these authorities to effect a structured settlement that is scheduled to satisfy an attorney’s right to deferred fees.
the wrong way
Lawyers and their settlement planning teams can best protect themselves by recognizing the “negative facts” that can make a stay unsuccessful. Or at least, acknowledge facts that the IRS may believe cause a fault. Aggressive Deferral in the GLAM included many negative facts. When deferring fees, here’s what not to do.
1. Skip the Fee Agreement Amendment
In the Aggressive Deferral, the attorney never modified the attorney-client fee agreement. Therefore, immediately after the settlement, the lawyer received the contingent fee. In addition, the defendant was bound by the agreement to make the payment to whomever the attorney directed. Under the “implicit receipt doctrine,” a taxpayer is subject to tax on an amount to which the taxpayer has unrestricted access. The lawyer could have avoided the implied receipt by deferring the client’s obligation to pay the fees.
2. Omit Defendant’s Promise of Future Payment
In the Aggressive Stay, the defendant promised a lump sum payment. Therefore, the full settlement was received immediately, with no opportunity to avoid immediate taxes. This could have been avoided by deferring the defendant’s obligation to make a portion of the payment in the future (ie, the fee portion of the settlement).
3. Omit the defendant’s contract with the provider
In the Aggressive Deferral, the provider of the postponement first promised the attorney’s right to a deferred payment. Therefore, the liability was created separately from the agreement and was financed with amounts already received by the attorney for tax purposes. The fact that the defendant paid the provider directly, instead of paying the attorney, doesn’t help. Under the “anticipated assignment of income doctrine,” a taxpayer entitled to income cannot avoid it by ordering the payer to pay someone else. The attorney should have arranged for the defendant to promise future payment in the settlement agreement and then for the provider to assume the obligation to make that future payment.
4. Omitting the Customer Part in the Deferred Payment
In the Aggressive Deferral, the client’s obligation to pay the fees ended with the defendant’s payment to the deferral provider. The lawyer was the only obligee of the provider. Thus, the amount received by the provider was reserved for the exclusive benefit of the lawyer, generating immediate taxation for the lawyer under the “economic benefit doctrine”. The attorney could have drastically reduced that risk by deferring the client’s obligation to pay the fees and by arranging for the provider’s future payment to be made on the client’s behalf.
5. Bypass the lawyer’s right to borrow
In the Aggressive Deferment, the deferment provider lent funds to the attorney, reserving the right to reduce the attorney’s deferred payment by the amount of the loan default. The ability to borrow against the entitlement to future funds has sometimes been treated as support for immediate taxation under Section 83 of the Internal Revenue Code and under the economic benefit doctrine. Removing the attorney’s ability to borrow “against” the deferred payment would remove yet another basis for immediate taxation.
a future of postponement
In general, the strongest positions in the GLAM are based on rare “bad facts” in most plaintiff attorneys’ fee deferrals. While his explanations touch on facts and thoughts that could be used against typical procrastinations, in doing so they lose much of their punch.
Helpfully, the report allows deferral providers to better avoid structures that the IRS might find problematic. And it informs settlement planners who recommend and advise on postponements, including those from the Society of Settlement Planners, the American Association of Settlement Consultants, and the National Structured Settlement Trade Association.
In summary, it appears that rate deferrals are here to stay and provide significant benefits. And the lawyers who use them are better equipped to confirm that they are done right.