In the world of attorney contingent fees, having the flexibility to choose when and how much income you can defer can be a crucial factor in long-term financial success. Attorneys who receive large settlements in lump sums often face significant tax burdens, but structured legal fees offer a powerful tool for deferring and managing taxable income more effectively. In a recent discussion, Andrew Samalin of Samalin Wealth sat down with Robert Wood of Wood LLP to explore the ins and outs of structured legal fees and their impact on tax planning for attorneys.
Why Structure Legal Fees?
The fundamental reason attorneys structure legal fees is simple: they can. Unlike most forms of income, which are immediately taxable when earned, structured legal fees provide an exception. This strategy, popularized in the 1990s, allows attorneys to defer income before they receive it, spreading payments over time and potentially reducing their tax liability in a given year.
Federal and state taxes, particularly in high-tax states like New York and California, can take a substantial bite out of large one-time payments. By deferring income, attorneys can maintain control over their tax exposure and align earnings with their long-term financial planning goals. This approach is comparable to structured settlements for plaintiffs, ensuring financial stability through scheduled disbursements rather than a single large payout. The attorney defines when, and how much, they choose to take by agreement prior to receiving the funds.
The Legal Precedent: Childs v. Commissioner
Structured legal fees gained credibility through the 1996 Childs v. Commissioner case, which validated the tax deferral benefits of structured fees. The case involved contingent fee attorneys who arranged to have their payments made to a third party—a life insurance company—before receiving them personally. The IRS challenged this approach, arguing that the attorneys had already earned the income. However, both the Tax Court and the Eleventh Circuit upheld the strategy, setting a precedent that remains in place today.
The key takeaway from the Childs case is that structured legal fees must be arranged before the attorney takes control of the funds. Once the attorney receives the fee, the ability to defer taxation is lost.
Annuities vs. Market-Based Structured Fees
Historically, structured legal fees were primarily backed by annuities issued by life insurance companies. These annuities provide guaranteed, predictable payments over time, making them attractive for attorneys seeking long-term financial security.
However, over the past 15 years, many attorneys have opted for market-based structured fees, which offer greater flexibility and potential for growth. Instead of relying solely on fixed annuity payouts, market-based structures allow attorneys to invest their deferred fees in portfolios tailored to their risk tolerance and financial goals. This shift has made structured legal fees even more attractive as an income management strategy, not to mention a meaningful retirement planning tool.
Qualified Settlement Funds (QSFs) and Structured Fees
Qualified Settlement Funds (QSFs) provide attorneys with even greater control over when and how they structure their fees. Established under Section 468B of the tax code, QSFs serve as an intermediary entity between the defendant and the attorney, allowing for delayed decision-making on structuring fees.
QSFs were originally designed to benefit defendants by providing them with an immediate tax deduction upon funding the settlement. However, plaintiff attorneys quickly recognized their potential as a planning tool. A QSF preserves the ability to structure fees even after a case settles, as long as the money remains within the fund.
IRS Scrutiny: The 2022 GLAM Memo
Despite the longstanding acceptance of structured legal fees, the IRS issued a Generic Legal Advice Memorandum (GLAM) in December 2022, signaling renewed scrutiny of the practice. While the memo does not overturn the Childs decision or change existing law, it suggests that the IRS is more likely to challenge certain structures, particularly those that involve immediate access to funds through loans.
This development underscores the importance of proper documentation and legal compliance when structuring fees. Attorneys should work closely with experienced tax advisors to ensure that their structured arrangements align with best practices and withstand potential IRS scrutiny.
The Role of Loans in Structured Fees
Some attorneys may consider borrowing against structured legal fees to access liquidity while maintaining tax deferral benefits. While loans can be a legitimate financial tool, they must be carefully structured to avoid triggering IRS concerns.
If an attorney structures a fee and immediately takes a loan against it, the IRS may argue that the structure was a sham transaction designed solely to defer taxes without a genuine income deferral. However, loans taken years later for unexpected financial needs are generally seen as more defensible. The key distinction is whether the structure and the loan are truly separate transactions or part of an integrated plan to bypass tax obligations. Loans increase the risk of the structure and one should contemplate if the risk is worth the reward.
What Should Attorneys Do Now?
Despite the increased IRS scrutiny, structured legal fees remain a valuable strategy for contingent fee attorneys seeking to manage income and taxes effectively. Attorneys should consider the following steps:
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Plan Early – Structured fees must be arranged before settlement funds are received. Last-minute planning may limit options.
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Consider QSFs – If there's uncertainty about how to structure fees, using a QSF can provide additional time to make informed decisions.
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Work with Experts – Given the complexities of tax law, attorneys should seek guidance from professionals with experience in structured fees and QSFs.
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Be Mindful of Loans – Borrowing against structured fees should be approached with caution. If necessary, loans should be clearly documented as separate transactions with commercially reasonable terms.
Final Thoughts
Structured legal fees offer a strategic advantage for attorneys looking to manage income, taxes, and financial planning over the long term. While the IRS may be paying closer attention to these arrangements, the Childs precedent remains intact, and properly structured fees continue to be a powerful tool for wealth management. By working with knowledgeable financial and tax professionals, attorneys can maximize the benefits of structured fees while ensuring compliance with evolving IRS guidelines.
To learn more, schedule a chat with us today.
Samalin Wealth does not offer tax advice, Please note that financial planning deliverables related to tax planning and topics should not be construed as tax advice. They are tax information that is to be vetted and approved by your tax preparer.
