Breaking Down Structured Legal Fee Tax Break

• Publication year: 2023
• Author: Written by Robert W. Wood*

BREAKING DOWN STRUCTURED LEGAL FEE TAX BREAK

Written by Robert W. Wood*

All lawyers know something about taxes. We all pay them, and we all know that legal fees are income. In fact, they are ordinary income, and are even subject to self-employment taxes. Lawyers occasionally try to argue that legal fees are capital gain, but that is an awfully tough sell with the IRS. So, you have to 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 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 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...