All lawyers pay taxes and know that legal fees are income. They are ordinary income and even subject to self-employment taxes. But what about timing? Much in the tax law is about timing. A classic tenet of tax-planning is to try to defer income and to accelerate deductions. For generations, tax lawyers have explored all manner of tax-deferral strategies.
According to the IRS, you have income for tax purposes when you have an unqualified, vested right to receive it. Asking for payment later doesn’t change that. The idea is to prevent taxpayers from deliberately manipulating their income. A classic example is a bonus check available in December, where the employee asks to have the employer hold it until Jan. 1. Normal cash accounting suggests that the bonus is not income until paid, but the employer tried to pay in December and made the check available. To the IRS, that makes the bonus income in December, even though it is not collected until January.
Lawyers are subject to these rules just like everyone else, but there is a surprising exception for contingent fee lawyers. Plaintiff lawyers can use a benefit most other people—including other lawyers—can’t: structured legal fees. Put simply, the concept of a legal fee structure is a kind of tax-advantaged installment plan that doesn’t rely on the credit worthiness of the defendant or the client. Like much else that is tax-advantaged, it has some rigidity. Yet it involves a tried-and-true tax structure that works, and it is grounded in economic reality.
In essence, the contingent-fee lawyer can decide that instead of taking a contingent fee upon settlement of the case, they want that fee paid over time. The lawyer must decide to do this before the case settles—but that can be right before it settles, even the night before. As a practical matter, the lawyer has “earned” their contingent fee over the course of the case. Yet the tax authorities say that the lawyer hasn’t technically earned the fee until the settlement documents are signed.
The attorney can also have complete discretion whether to structure all of the fee or any percentage of it. The tax case uniformly cited as establishing the bona fides of attorney fee structures is Childs v. Commissioner. There was initially concern that the IRS might disagree with fee structures despite the Childs case, but the IRS has often cited Childs favorably.
Still, care is needed. No lawyer wants to rely on the defendant to pay the fees over time. So, the defendant pays the full amount to a third party. In the early days of structured fees, the third party was invariably a life insurance company that funded annuities for the benefit of the lawyer. Then the annuity payments would be taxed over time.
Annuities still work fine today. But most lawyers seem to want a better return than life insurance annuities, so most structured fees today are done with a portfolio or stocks and securities. Whether the structure is done with annuities or securities, the format and documents are important. The lawyer can’t own the annuities or the securities, but is the named payee of the structure.
These days, most structured legal fees are not implemented by defendants directly, but rather by qualified settlement funds. The settlement agreement provides that instead of paying the settlement to the law firm trust account, it goes to a qualified settlement fund (QSF). Then, the QSF pays the plaintiff—or implements structured settlements for any plaintiffs who want one—and it implements the lawyer’s structured fees. Done properly, an attorney fee structure obviates the normal tax doctrines of constructive receipt and economic benefit. These fearsome tax doctrines can often result in amounts being taxed to someone even before they actually receive the income.
In the case of properly structured attorney fees, the attorneys will be taxed only when and as they receive each payment, according to the schedule the lawyers have set. This is such a good deal because paying tax later is nearly always preferable.
There is also investment return. Like a giant 401k, structured legal fees put the full amount of your fee to work. If you take your fee in cash and pay tax, you can lose half or more in taxes, and then can only invest the after-tax amount. With structured fees, you are investing the full amount, so your “principal” plus the investment return is taxed later when you receive the payments. Think of it as tax-free compounding, and the longer the attorney wants to stretch out the payments, the better the financial result.
In essence, the lawyer constructs a kind of unlimited individual retirement account. They are flexible too. The payments might start right away and go for five or 10 years. Alternatively, the payments might be deferred entirely for 10 or 15 years, building up tax-free. Thereafter, they might begin paying out annually for the rest of the attorney’s life.
Additionally, many structured legal fee companies allow lawyers who structure fees to borrow money too. Not paying current tax on your fees but being able to borrow money is a double benefit, since the amount borrowed doesn’t qualify as income.
Of all the topics with structured fees, perhaps the one where the most care is needed concerns borrowing. But if you’re careful, structured legal fees can allow tax-free compounding, defer taxes, and help build a solid financial plan.
Robert W. Wood. Robert W. Wood is a tax lawyer and managing partner at Wood LLP. He can be reached at Wood@WoodLLP.com.
