Personal injury attorneys and other contingency fee-based professionals often wonder why deferring fees is exclusive to contingency-fee based attorneys.
Contingency fee-based attorneys can defer their legal fees because of a case law that provides the precedent for doing so. The ruling in the Childs v. Commissioner case in 1994 held that the attorneys could structure and defer their contingent fees — with the attorneys only being taxed when they receive the deferred payments in the future. In the Childs case, the personal injury attorneys settled the case and deferred their fees through the use of a structured settlement annuity.
Attorney Fee Deferrals and the IRS
The IRS challenged the fee deferral in court and argued that the fees should be recognized and taxed in the year the case is settled. The tax court ruled that 1) the annuity is not included in the attorney’s income on the year of the settlement because it is not considered property, and 2) there was not constructive receipt of the legal fees because the attorneys did not have the right to receive the settlement funds prior to the structured settlement agreement terms.
The IRS lost at the tax court level, and the IRS filed an appeal to the 11th Circuit Court. The appeals court ultimately affirmed the tax court decision in 1996, and held that taxes are incurred on deferred attorney fees only upon receipt. The IRS has not challenged contingency fee-based attorney fee deferrals since the Childs case, and has cited favorably to it in later publications.
Other Ways to Defer Legal Fees
Attorney fee deferrals have primarily been done through the use of structured settlement annuities, where the rates are guaranteed and the scheduled payments are fixed, but there are more innovative ways of deferring fees that are based on the same underlying concepts — but that don’t rely on a structured settlement annuity as the funding vehicle.
An alternative to structured settlement funds when deferring legal fees is through a deferred compensation plan. It offers more flexibility in terms of receiving the funds, with potentially better rates of return the funds can be invested in the market to achieve market-based returns. The funds also stay onshore, as opposed to annuities which are often sent offshore.
Having options to defer contingent legal fees can help attorneys create a strategy of deferring fees that fits their personal and business financial goals.
The Childs v. Commissioner case allowed contingency fee-based attorneys to defer their fees and income taxes to future years. The IRS has not challenged an attorney’s ability to defer fees since the IRS lost its appeal.
Aside from structured settlement annuities, which is the more traditional way of deferring fees, attorneys can also choose to defer fees into a deferred compensation plan, which offers a different set of advantages from annuities. Attorneys can take full advantage of fee deferrals to achieve their own financial goals. In addition, there are a variety of creative use cases, including placing golden handcuffs on key associates and normalizing firm cash flows.
Do you have any questions about attorney fee deferrals? Please give us a call. We love talking to attorneys about this tax planning strategy, and nearly every attorney we speak with wishes they had learned about these strategies much sooner.