The recently enacted American Jobs Creation Act of 2004 includes important results for two issues relating to plaintiff attorney compensation. The first issue addresses deferred compensation. The second issue concerns the deduction of attorney fees by plaintiff employees in discrimination cases.
Deferred Compensation
I. Background
Historically, when their clients have agreed to a structured settlement, some plaintiff attorneys have elected to receive a portion of their fee on a deferred basis. Although the factual circumstances vary depending upon the terms of the settlement documentation and the attorney’s fee agreement, the tax question is whether the attorney should be required to recognize income before receiving the future payments.
The IRS has challenged attempts by plaintiff attorneys to defer their fees in structured settlement cases beginning in 1991 when it issued three separate Technical Advice Memoranda. In each of these cases, the IRS utilized the doctrine of constructive receipt to determine income was received in the year the settlement occurred although the attorney received no actual cash. In 1994, however, in Childs v. Commissioner, the Tax Court ruled in favor of deferred attorney fees for five different plaintiff attorneys in two separate structured settlement cases. Although the IRS continues to challenge attempts by attorneys to defer fees in structured settlement cases, many plaintiff attorneys and several structured settlement annuity providers view the Childs case as authority permitting deferred compensation arrangements.
II. New IRC Section 409A
For plaintiff attorneys, a significant issue under the American Jobs Creation Act of 2004 is whether new IRC Section 409A applies generally to vendors providing services to multiple customers under a commission or other event-based compensation arrangement. Although Section 409A applies primarily to employer-employee situations, the Conference Report for this legislation indicated that the application of the new IRC Section 409A deferred compensation rules were not limited to arrangements between an employer and an employee.
In general, Section 409A provides that all amounts deferred under a nonqualified deferred compensation plan are currently included in gross income to the extent not subject to a substantial risk of forfeiture and not previously included in gross income unless certain requirements are met. One of these requirements, a special timing rule for elections with respect to “performance-based compensation” related to services performed over a period of at least 12 months, would create problems for plaintiff attorneys because their compensation does not follow the flow of services as in the traditional employer-employee situation.
III. IRS Guidance
On December 20, 2004, the IRS published initial guidance on Section 409A. This guidance includes the following language recommended by the National Structured Settlement Trade Association (NSSTA) to address the situation of plaintiff attorneys and other similarly situated service providers:
"Section 409A also does not apply to arrangements between a service provider and a service recipient if (a) the service provider is actively engaged in the trade or business of providing substantial services, other than (I) as an employee or (II) as a director of a corporation; and (b) the service provider provides such services to two or more service recipients to which the service provider is not related and that are not related to one another."
This exception to IRC Section 409A, however, does not mean that plaintiff attorney’s can now automatically defer their compensation in structured settlement cases. The December 20, 2004 IRS guidance also includes the following language:
“… Section 409A does not alter or effect the application of any other provision of the Code or common law tax doctrine. Accordingly, deferred compensation not required to be included in income under Section 409A may nevertheless be required to be included in income under Section 451, the constructive receipt doctrine, the cash equivalency doctrine, Section 83, the economic benefit doctrine, the assignment of income doctrine or any other application of the Code or common law tax doctrine.”
IV. Conclusion
Despite the IRC Section 409A exclusion, the tax issues for deferring plaintiff attorney compensation remain complex. Plaintiff attorneys should expect continuing challenges from the IRS and should retain tax counsel to review any potential deferred compensation arrangement.
Deduction of Attorney Fees in Discrimination Cases
In addition to new IRC Section 409A, the American Jobs Creation Act of 2004 also includes the Civil Rights Tax Relief Act. One important result of the Civil Rights Tax Relief Act is the elimination of attorney fees from a successful plaintiff employee’s gross income in discrimination cases. Tax relief under this legislation applies to settlements and judgments that occur after October 22, 2004.
Prior to enactment of the Civil Rights Tax Relief Act, it was uncertain whether a plaintiff’s gross income from the proceeds of discrimination litigation included the portion of his recovery paid to his attorneys pursuant to a contingent fee agreement. Although plaintiff employees could generally deduct these amounts as itemized deductions, the IRS claimed the alternative minimum tax required successful plaintiff employees to pay income taxes on their entire award including attorney fees and court costs. For example, if a victorious plaintiff in a discrimination case won a $100,000 verdict and paid $30,000 in attorney fees, the IRS required the plaintiff to pay income taxes on $100,000 while his attorney also paid taxes on $30,000. Although this result had been challenged in court prior to the enactment of the Civil Rights Tax Relief Act, several federal appellate courts had split on the issue. The US Supreme Court had granted certiorari in two cases where the results favored the plaintiffs prior to enactment of this legislation.
Additional information about plaintiff attorney fee compensation in structured settlement cases is available in “Structured Settlements and Periodic Payment Judgments”.
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