All lawyers know something about taxes: we all pay them, and we all know that legal fees are income. In fact, legal fees are ordinary income, and are even subject to self-employment taxes. Lawyers occasionally try to argue that legal fees are capital gains, but that is an awfully tough sell with the IRS. So, you must figure that you will be paying full freight in taxes on your legal fees, no matter what.
But what about timing? Much in the tax law is about timing. In general, 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, so there are many decades of tax lore to draw from.
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. The classic example is a bonus check available in December, where the employee asks to have the employer hold it until January 1. You might think that 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 often lament the unpredictability of their own income. They may also lament the need to resort to borrowing to finance their cases. In some cases, plaintiff lawyers complain that they cannot take the cases they really want to take, given the financial realities of contingent fee practice.
However, plaintiff lawyers can actually use a benefit most other people—including other lawyers—can’t: structured legal fees. Reduced to simplicity, the concept of structured legal fees is a kind of tax-advantaged installment plan that doesn’t rely on the credit worthiness of either the defendant or the client. Like much else that is tax-advantaged, this exception 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 before settlement that instead of taking a contingent fee upon settlement of the case, he wants 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” his contingent fee over the course of the case. Yet the tax authorities say that the lawyer hasn’t technically earned his fee for tax purposes until the settlement documents are actually signed.
Amazingly, the attorney can have complete discretion whether to structure all of his fee or a percentage of it. The tax case uniformly cited as establishing the bona fides of attorney fee structures is Childs v. Commissioner, 103 T.C. 634 (1994), affirmed without opinion 89 F.3d 56 (11th Cir. 1996). For a few years, there was concern that the IRS might disagree with contingent fee structures despite the Childs case. But over the last several decades the IRS has often favorably cited Childs.
But care is still needed when using structured legal fees. The settlement agreement must call for it, and no lawyer wants to rely on the defendant to pay the fees over time. So frequently the settlement agreement requires the defendant to pay the full amount to a third party, which then distributes the payments over time to the plaintiff lawyer. 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.