For decades, contingent fee claimant attorneys have been able to receive their fees as a lump sum or paid over time and taxed in installments. Formalities are required, but the tax treatment is well established. As a result, the publication of the IRS Generic Legal Advice Memorandum AM-2022-007 (known as GLAM) in December 2022 came as a surprise to insurance companies, structured settlement providers, and plaintiff attorneys. In 1994, the Tax Court and 11the Structured rates approved by the circuit in Childs v. commissioner 103 TC 634 (1994), aff’d no opinion89F3856 (11the cir. nineteen ninety six).
The IRS left structured legal fees alone for nearly 30 years, allowing attorneys to match their income, and in that regard, IRS GLAM is a big surprise. Even so, it does not address the precise facts in children or directly request its revocation. In either case, a GLAM is not binding on any taxpayer, but the IRS’s criticism of fee structures is wide-ranging. Most rate structures follow one of two models, an allocation structure modeled after children, or one based on deferred compensation authorities. Both erect formal barriers so that the attorney who is the beneficial owner does not own or have a security interest and cannot control it.
In essence, the price tag for the lawyer to be able to delay payment (and delay the corresponding taxes until each installment arrives) is a formal structure that guarantees that the lawyer is only a general creditor of the entity that has the deferred fees. The IRS can’t outvote the Tax Court or the 11th Circuit, but it can audit, and IRS arguments could arise there. The IRS makes four arguments why the legal fee structure (at least in its hypothetical) should not work:
1. It contravenes the doctrine of assignment of income. This tax doctrine applies when a person earns income but tries to allocate it elsewhere, so someone else pays the tax. However, the lawyer who collected the income is the same one who pays the tax, just later, so it’s hard to see how this applies.
2. Violates the doctrine of economic benefit. This doctrine applies when money is set aside or secured, even though they cannot currently obtain it. At a structured fee as approved in childrenthe assets are not segregated to the attorney and are not secured, so the attorney is simply a general creditor.
3. Is subject to tax under section 83 of the tax code. This branch of the economic benefit doctrine is the section of the code that taxes restricted stock and other property transferred in connection with services when the property is vested and the beneficiary is certain to obtain it. The GLAM makes a complex argument why section 83 should tax the fee structure in advance, but the children The court specifically rejected the applicability of Section 83 to the structured fees it approved.
4. It is a deferred compensation plan that violates section 409A of the tax code, which was enacted after children it was decided. Section 409A says that some of the deferred compensation should currently be taxed and face large penalties. Fortunately, the Treasury Regulations under Section 409A say that the full layout it does not apply to independent contractors who have two or more clients or clients (among other requirements that are generally easily satisfied by structured fees).
Since this Regulation was published in 2007, it has been widely understood that exempt structured legal fees. Most attorneys have two or more clients, so they are exempt from Section 409A. Even so, the GLAM argues that legal fee structures are subject to Section 409A because adding a third party means that it is no longer a deferred amount between client and attorney.
The IRS could attack any fee structure, but one like the hypothetical one may be the main target. It’s worth asking how the IRS will identify fee structures, since they are often not reported on a tax return until installment payments are reported and taxed. Even so, most attorneys who structure fees and the firms and brokers who assist them are likely to pay attention to GLAM. At the very least, it suggests that Yeah are audited, the IRS can make these arguments. That doesn’t mean the IRS will win, and the specific facts and documents in question will matter a great deal.
IRS audits can be resolved at the audit stage, where the best outcome is for the IRS to say no change. That used to be possible with structured fees, but GLAM can make it more difficult now, depending on the facts and documents. Many IRS audits are resolved one step further than the audit in IRS Appeals, where a large number of tax cases are resolved. IRS Appeals is still part of the IRS, but it is independent and tries, usually successfully, to resolve disputes between auditors and taxpayers, often through settlements.
Some industry pushback is also possible, particularly given the number of stakeholders affected by the IRS arguments, including life insurance companies that issue life insurance annuities exactly like those of children. Some commentators even suggest that Congress could get involved to confirm tax rules that plaintiff lawyers thought were clear in 1994. On the other hand, we may end up with other tax case to solve the problems that many thought were solved in children.
If that happens, it will take time, maybe years. And like any tax case, it will be based on the facts and documents in that case. particular case. It does not seem likely that plaintiff attorneys will stop structuring their fees, or that insurance companies, brokers, and others who facilitate structured fees will stop helping attorneys to do so. At the very least, though, IRS GLAM should make the entire industry dot its i’s and cross its t’s.
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