Legal fee received as an annuity: the I.R.S. man cometh.

A trial lawyer I know opened to the jury: "Ladies and gentlemen, men, my client is charged with first-degree murder. He faces death by electrocution. But enough about him... "

Much has been written about how clients are taxed on structured settlements of their tort actions. But enough about them. This is the true story about a lawyer who represented a half-dozen plaintiffs in settling their personal injury actions.(1)

Hapless was entitled to his contingency fees as cash. But he chose to have the defendant's liability insurers buy a number of single-premium annuities. Hapless was named as the annuitant for some of the policies. Others named Hapless and Mrs. Hapless.

The defendant's liability insurer owns the annuities and can change the beneficiaries. But the defendant's insurer is also required to make the payments to Hapless (and in some cases also to his wife) if the annuity payments aren't made. Under applicable local (Texas) law, the annuities aren't subject to claims by Hapless's creditors; he can't assign his interest in the policies; and his rights to future payments aren't readily transferable or marketable.

Hapless hoped to have the annuities - and thus his fees - taxable each year as he received annuity payments. But the Internal Revenue Service threw the book, two Internal Revenue Code sections, some cases, and its own rulings at the star-crossed lawyer. Hapless, ruled I. R. S., has to report the current value of the annuities as income in the year he settled the cases - not piecemeal as he receives the payments.

Winning a case is great - even if you have to share your fee with Uncle Sam.

Example. Darrow earns a $100,000 fee and is paid this year. The tax in her 39.6 percent bracket is $39,600, leaving her with $60,400.

Not so great: being entitled to a no-strings-attached fee this year, electing to receive it over a period of years, but being taxed on the entire fee this year. Example. Instead of taking a $100,000 lump sum this year, Darrow elects to be paid $10,000 a year for 10 years. I. R. S. is entitled to its $39,600 tax this year. This presents Darrow with a possible cash-flow problem.

The Commandments

from Mount Taxmore

Here now are chapter and verse on why Hapless was taxed in the year of the settlement and not ratably as he received annuity payments.

I.R.C. [sections] 83 governs the taxation of property transferred to you as compensation for services.(2) You're not taxable under [sections] 83 unless the property (1) has been "transferred" and (2) has "substantially vested." If those two tests apply, the excess of the property's fair market value (when it becomes substantially vested) over any amount paid for it is includable in your income in the year that the property becomes substantially vested.(3)

A "transfer" generally takes place when you acquire a beneficial ownership interest in the transferred property.(4) Property that is either transferable or not subject to a substantial risk of forfeiture is "substantially vested."(5) Whether a risk of forfeiture is substantial depends on - you guessed it - the facts. A risk exists which rights in the transferred property are directly or indirectly conditioned upon the future performance (or refraining from performance) of services. The regularity of the performance of services and the time spent in performing them tend to indicate whether services required by a condition are substantial.(6)

Economic benefit doctrine. Section 83 codifies the economic benefit doctrine as it applies to property transferred as compensation for services. Under that doctrine, when the recipient of a service creates a fund in which a service provider (for example., a lawyer) has vested rights, the amount funded is includable in the service provider's gross income for that year. A "fund" is created when an amount is irrevocably deposited with a third party. A service provider's interest in the fund is "vested" if it isn't forfeitable.

Sproull v. Commissioner is the mother of all economic benefit cases. There, a corporation irrevocably deposited money in trust for its president. The trustee was directed to invest the principal and pay half of it to the president in each of the following two years. The Tax Court and the Sixth Circuit both held that creation of the trust resulted in an economic benefit to the president sufficient to tax the trust principal to him in the year that the money was initially deposited, because "it was then that the amount of the compensation was fixed . . .and irrevocably paid out for [his] sole benefit . . . ."(7)

Revenue Ruling 60-31 tells about a football team that agreed to pay a bonus to a star to induce him to sign on.(8) The team irrevocably deposited the bonus with a bank as escrow agent. The bank agreed to pay the bonus to the player in installments. Citing Sproull, the I.R-S. ruled that the entire bonus was includable in the player's income in the year that it was unconditionally paid to the escrow agent.

Revenue Ruling 69-50 tells about doctors who agreed with a health-care insurer to defer a portion of their fees for services already rendered to the subscribers.(9) The deferred amounts were to be paid to the doctors upon the earliest of their retirement, disability, or death. Citing Sproull, the I.R.S. ruled that the deferred fees were income to the doctors in the year of the deferral agreement.

Revenue Ruling 77-420 deals with the same facts but with the addition of a substantial forfeiture provision to the deferred compensation agreement.(10) It reaches the same conclusion as Revenue Ruling 69-50. Revenue Ruling 77-420 illustrates that not all substantial forfeiture provisions delay taxation - only those resulting in forfeiture to the service recipient or his or her creditors. Thus, all important inquiry in Hapless's situation was whether his annuities could be forfeited to his former clients or their creditors.

We've gotcha Hapless under $83. The current fair market value of the right to receive the annuity payments is includable in Hapless's income in the year the annuities were purchased, ruled I.R.S. To pay for Hapless's services, his clients transferred to him rights to receive payments that would otherwise have been payable to them. In effect, by irrevocably instructing the liability insurers to pay Hapless a portion of their judgment, the plaintiffs funded their promise to share the recovery with their lawyer.

The plaintiffs conferred an economic benefit on Hapless, ruled I.R.S. Since Hapless's retention of those rights doesn't depend on his future performance of substantial services, his beneficial interest in those rights isn't subject to a substantial risk of forfeiture. Hapless's rights to receive the payments were nonforfeitable property transferred for the performance of services. His compensation for services was property because it was funded and secured.

Another Richmond in the field - constructive receipt. I.R.C. [sections] 451 includes in your gross income for the taxable year income that you actually or constructively receive unless it's includable in a different year because of your accounting method.(11) Income is constructively received in the taxable year it is credited to your account or set apart for you. But it's not constructively received if your control of its receipt is subject to substantial limitations or restrictions.

Prizefighter KO's I.R.S. Sugar Ray Robinson, the world middleweight boxing champion, signed a deferred compensation agreement shortly before the big bout. He could have received the agreed-upon payment immediately after the fight, but he chose to be paid in annual installments.

The I.R.S. claimed that Robinson participated in a joint venture and thus was taxable in the year of the fight oil his share of the proceeds. In Robinson v. Commissioner, the Tax Court rejected I.R.S.'s argument, pointing out that when two parties agree to act together to achieve a stated economic objective, it doesn't automatically make them joint venturers.(12) Instead, the court ruled that the contract was for Robinson's personal services.

I.R.S. then gave Robinson the old one-two. The deferred payment agreement was a sham - the parties never intended to be bound by it - and Robinson was currently taxable under the constructive receipt doctrine.

The Tax Court rejected both arguments. The fight proceeds weren't placed in escrow or trust - or segregated in any way for the fighter's benefit. Instead, they were commingled with the payor's other assets. Robinson was merely an unsecured creditor. So Robinson clobbered the I.R.S., but he did lose the middleweight crown to Carmen Basilio.

We've also gotcha Hapless under [sections] 451. The amounts used to buy the annuities for Hapless were constructively received by him and are includable in his gross income in the year the annuities were, purchased, ruled I.R.S. In contrast to Sugar Ray Robinson, Hapless performed substantially all the services owed to his clients before he arranged deferred payment of his fees through annuities. There were no substantial restrictions on his receipt of the fees. Also, the liability insurers were ready, willing, and able to pay Hapless his fee in cash.

Summation 

I.R.S.'s position shouldn't have come as a surprise to Hapless. I.R.S. earlier had ruled the same way in Letter Rulings 91-34-004 through 91-34-006. Moral: A trial lawyer who is his or her own tax attorney has an unpleasantly surprised taxpayer for a client.

Query. Is an I.R.S. letter ruling or technical advice memorandum - whether pro- or anti-taxpayer - good "authority" when the I.R.S. and another taxpayer end up in court?

First an aside. Daniel M'Naghten, suffering from delusions of persecution, had a fancied grievance against Prime Minister Robert Peel. He went to London to assassinate him. M'Naghten fired into the Prime Minister's carriage, killing Sir Robert's secretary, Drummond. The Prime Minister was riding in Queen Victoria's carriage at the time.

M'Naghten was found not guilty by reason of insanity. As Lord Chief Justice Tindal put it: " [T]he party accused was laboring under such a defect of reason, from disease of the mind, as not to know the nature or quality of the act he was doing; or, if he did know it, that he was not aware he was doing what was wrong."(13)

Thus the birth of the M'Naghten Rule in England, which is followed in a number of our states.(14) (Some states have abandoned the M'Naghten rule for the "irresistible impulse" rule - an individual is not criminally responsible if he cannot control his conduct in committing a crime even though he knows it to be wrong. This rule was given national attention in the book and film Anatomy of a Murder)

A number of years ago the Times of London ran a series of articles on the M'Naghten Rule. U.S. Supreme Court Justice Felix Frankfurter complimented the London Times on the articles, having only one criticism. The paper misspelled M'Naghten's name, spelling it M'Naughten instead of M'Naghten.

The Times answered: "We have an old letter in our files signed by M'Naughten himself and he spelled his name exactly as we have in our newspaper." Justice Frankfurter responded: "I question whether a lunatic is authority for anything, even the spelling of his own name."

Now back to whether an I.R.S. letter ruling is "authority." A letter ruling only applies to the taxpayer involved. You can't rely on another's positive ruling - even if your situation is identical. And while a negative ruling is in itself not binding authority for I.R.S.'s position, it's a strong indication of I.R.S.'s position. If I were in Hapless's loafers, I'd take my entire fee in a lump sum. I.R.S.'s letter ruling is based on sound reasoning. And even if Hapless were to litigate with I.R.S. and win, it's a long way to certiorari.

Notes

(1) Tech. Adv. Mem. 93-36-001 (May 12, 1993). (2) I.R.C. [sections] 83(a) (1993). (3) Treas. Reg. [sections] 1.83-1(a) (1978). (4) Treas. Reg. [sections] 1.83-3(a) (1978). (5) Treas. Reg. [sections] 1.83-3(b) (1978). (6) Treas. Reg. [sections] 1.83-3(c) (1978). (7) 16 TC. 244, 247 (1951), aff'd, 194 F.2d 541 (6th Cir. 1952). (8) Rev. Rul. 60-31, 1960-1 C.B. 174. (9) Rev. Rul. 69-50, 1969-1 C.B. 140. (10) Rev. Rul. 77-420, 1977-2 C.B. 172. (11) Treas. Reg. [sections] 1.451-1(a) (as amended in 1978). (12) 44 T.C. 20 (1965), acq., 1976-2 C.B. 2. (13) M'Naghten's Case, 8 Eng. Rep. 718 (1843). (14) Variously spelled M'Naghten, M'Naughten, McNaghten.