IRS Awakens From Nearly 30-Year Slumber to Announce Objections to 1994 Tax Court Decision
On December 9, 2022, the Office of Chief Counsel of the Internal Revenue Service (“IRS”) issued a General Legal Advice Memorandum (“Memorandum”) challenging the 1994 Tax Court decision in Childs v. Commissioner, 103 T.C. 634 (1994), aff’d without published opinion, 89 F.3d 856 (11thCir. 1996) (“Childs”). Given the significant financial services industry that has developed under the cover of Childs over the last almost 30 years, and the fact that the Memorandum was drafted in the context of a hypothetical set of facts, the Memorandum is a significant shot across the bow for both the plaintiffs’ bar and the insurance, banking, and other financial organizations that have long sold structured contingent fees.
In a structured settlement, the settlement agreement between the plaintiff and the defendant generally provides that the defendant (or the defendant’s insurance company) will make future specified payments to the plaintiff in exchange for the release of the plaintiff’s claim. The mechanics of virtually all structured settlements follow a similar path. The defendant assigns all or a portion of its obligation to make the specified payments to a structured settlement company (“SSC”). In exchange for accepting the payment obligation, the SSC receives from the defendant a lump sum payment equal to the present value of the future payments owed to the plaintiff. The plaintiff, in turn, agrees to look only to the SSC for the future payments.
After receiving the lump sum payment, the SSC typically purchases an annuity from a life insurance company (or an investment-funded product from a bank or other financial services company). In almost every case, the SSC is a subsidiary of the life insurance company issuing the annuity (or is otherwise affiliated with the life insurance company). The annuity is referred to as the “funding asset.” The funding asset provides the SSC with the necessary liquidity to satisfy its payment obligations to the plaintiff.
The SSC’s acceptance of the defendant’s obligations in exchange for the lump sum payment, combined with the plaintiff’s express acceptance of the transaction, releases the defendant from any further obligation to the plaintiff and essentially allows the defendant to “close its books” with respect to the litigation.
The Tax Status of Structured Settlements
Prior to the enactment of the Periodic Payment Settlement Act of 1982 (“PPSA”), it was not clear whether a plaintiff who received a structured settlement for qualifying injuries or sickness could exclude the entirety of each periodic payment as it was received, or whether the exclusion only extended to the present value of the future payment stream. If the exclusion was limited to the present value, then the subsequent investment income earned on that value would be taxable.
In the PPSA, Congress amended section 104(a)(2) of the Internal Revenue Code of 1986, as amended (“IRC”), to exclude from gross income “the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness.” According to the Conference Committee that reconciled the House and Senate bills, the PPSA explicitly extended the exclusion from gross income for personal injury damages to amounts paid out of a fund “invested and owned by the tortfeasor or an insurer.” H.R. REP. NO. 97-984 at 12.
Prior to the PPSA, it was not clear whether the SSC was immediately taxable on the lump sum payment it received from the defendant or the defendant’s insurance company in exchange for assuming the defendant’s obligation. In addition to amending IRC section 104(a)(2), Congress added IRC section 130. This new IRC section was intended to address the tax consequences that arise when the SSC receives the lump sum payment and assumes the obligation to make periodic payments to the plaintiff. In general, IRC section 130 provides that any amount received for agreeing to a “qualified assignment” is not included in gross income to the extent that such amount does not exceed the aggregate cost of any qualified funding assets.
In cases where the assignment is not a “qualified assignment,” a Barbados-domiciled SSC is typically used. The U.S.-Barbados tax treaty does not impose a U.S. tax on the lump sum payment received by a Barbados SSC or on the investment income earned by a Barbados SSC. See United States-Barbados Income and Capital Tax Convention, U.S.-Barb., Dec. 31, 1984, 1991-2 C.B. 436.
For victim settlement agreements, trial lawyers often structure their contingency fees using an SSC regardless of whether or not the plaintiff elects to structure the settlement payment. In all such cases, the assignment is treated as a “nonqualified assignment,” thereby requiring the participation of a Barbados-domiciled SSC. The Tax Court’s decision in Childs is the foundation on which such transactions are structured (a “Fee Structure”).
For many years, distinguished commenters have argued that Childs was wrongly decided. For example, in 2010 Professor Gregg Polsky argued as follows:
The Tax Court decision in Childs, affirmed by the U.S. Court of Appeals for the Eleventh Circuit without a published opinion, is objectively flawed. There simply is no way of reconciling the result in Childs with the decisions in Brodie and Drescher and the analysis in Revenue Ruling 69-50. Like the executives in Brodie and Drescher and the physicians in Revenue Ruling 69-50, the attorneys in Childs received payment obligations from unrelated insurance companies as compensation for their respective services. Yet Brodie, Drescher, and the physicians were taxed immediately, while the attorneys in Childs were not. Because the Tax Court missed the third-party promise issue, it did not attempt to reconcile its conclusion with these contrary authorities. Despite these obvious flaws, the Childs decision now serves as the foundation of a burgeoning industry offering structured payments of attorney’s fees.
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In summary, Childs was wrongly decided, and its practical implications are significant. Under Childs, trial lawyers can easily avoid tax on capital income in a way that was certainly never contemplated by Congress. The IRS should immediately repudiate the Childs holding, and the Treasury should clarify that third-party promises (such as SSC obligations) constitute property in the I.R.C. § 83 regulations. Alternatively, Congress should enact legislation to close the loophole.
Polsky and Hellwig, Taxing Structured Settlements, 51 B.C. L. REV. 39, 72-73 (footnotes omitted) (2010).
The IRS Wakes Up
Although Professor Polsky argued that the IRS should “immediately repudiate the Childs holding,” the gears of the IRS obviously turn slowly. Nearly 30 years after Childs was issued, the IRS has now issued the repudiation Polsky and others commenters have long sought.
The Memorandum is a devastating takedown of the Tax Court’s decision in Childs. In fact, perhaps the most important part of the Memorandum is contained in a footnote. In footnote 1, the IRS writes as follows:
In terms of the authoritative weight of Childs, the Tax Court’s precedential opinion is binding on the Tax Court but not on any other court. The IRS has not issued an Action on Decision acquiescing to or disagreeing with the Tax Court’s opinion in Childs. The Eleventh Circuit’s decision affirming Childs is both unpublished (that is, not published in the Federal Reporter), and the text of any opinion that may have been issued is not available on any electronic databases, such as Westlaw, LexisNexis, or Bloomberg Law. In the Eleventh Circuit, “[u]npublished opinions are not considered binding precedent, but they may be cited as persuasive authority.” 11th Cir. R. 36-2. Because no written opinion is available for reference, it is not clear that the Eleventh Circuit affirmance of Childs would have much, if any, persuasive authority in the Eleventh Circuit or any of the other federal Circuit Courts of Appeals. In short, though the Tax Court opinion in Childs remains binding precedent in Tax Court, the Eleventh Circuit’s affirmance does not bind any court in and of itself.
The IRS is making it very clear that even if Childs remains binding precedent in the Tax Court, it remains fair game in all federal circuits, including the Eleventh Circuit. Moreover, the Memorandum leaves no argument in favor of upholding Childs on the table. Simply put, the Memorandum is a guide to how the IRS intends to challenge Fee Structures, including an attack based on IRC section 409A (addressing gross income inclusion of deferred compensation under nonqualified deferred compensation plans), which was enacted post-Childs and not addressed by the Childs court.
At this time, it is not known what prompted the IRS, and specifically the Tax Exempt and Government Entities branch, to request the Memorandum. The “burgeoning industry offering” Fee Structures that Polsky described in 2010 is now a formidable collection of the largest life insurance companies and financial organizations in the country. How this group of SSCs will respond to the Memorandum is not known at this time, although aggressive lobbying of Congress to codify Childs is likely to be a first step.
As for the plaintiffs’ bar, it now seems clear that relying on a Fee Structure carries more risk now than at any time in the recent past. Contingent fees locked in a Fee Structure for a fixed number of years would not be available to pay taxes assessed on an accelerated basis, not to mention the related interest and penalties. The additional cost for a loan funding the payment of such taxes, interest, and penalties, secured by the funding asset, would only add to the financial pain.
On a more practical level, tax professionals may now need to consider whether they can issue an opinion supporting a Fee Structure at even a “substantial authority” level given the scope and substance of the arguments made by the IRS in the Memorandum.
In fact, it is now not clear whether certain return preparers could sign a 2022 or later tax return reporting a Fee Structure. AICPA Statement on Standards for Tax Services No. 1, Tax Return Positions, includes the following standards for members when recommending tax return positions, or preparing or signing tax returns:
- A member should determine and comply with the standards, if any, that are imposed by the applicable taxing authority with respect to recommending a tax return position, or preparing or signing a tax return.
- If the applicable taxing authority has no written standards with respect to recommending a tax return position or preparing or signing a tax return, or if its standards are lower than the standards set forth in this paragraph, the following standards will apply:
a. A member should not recommend a tax return position or prepare or sign a tax return taking a position unless the member has a good-faith belief that the position has at least a realistic possibility of being sustained administratively or judicially on its merits if challenged.
b. Notwithstanding paragraph 5(a), a member may recommend a tax return position if the member (i) concludes that there is a reasonable basis for the position and (ii) advises the taxpayer to appropriately disclose that position. Notwithstanding paragraph 5(a), a member may prepare or sign a tax return that reflects a position if (i) the member concludes there is a reasonable basis for the position and (ii) the position is appropriately disclosed.
- When recommending a tax return position or when preparing or signing a tax return on which a position is taken, a member should, when relevant, advise the taxpayer regarding potential penalty consequences of such tax return position and the opportunity, if any, to avoid such penalties through disclosure.
At a minimum, it now appears that a tax return preparer may be required to disclose the Fee Structure on all 2022 and future income tax returns, even in those tax years for which a payment has not been received but a Fee Structure is in place, including pre-2022 Fee Structures.
Similar to the disclosure requirements regarding the deduction for donations of conservation easements, the IRS has now found a way to identify taxpayers who have entered into Fee Structure arrangements. As such, attorneys and their financial advisors currently contemplating a Fee Structure should carefully review and discuss the Memorandum with their tax advisors before committing to the Fee Structure.
For more information, please contact Michael Cumming (MCumming@dykema.com or 248-203-0740), Scott Kocienski (firstname.lastname@example.org or 248-203-0868), Richard Lieberman (email@example.com or 312-627-2250), Jillian “Jillie” Foerster (firstname.lastname@example.org or 210-554-5265), Asel Lindsey (email@example.com or 210-554-5298), Nardeen Dalli (firstname.lastname@example.org or 248-203-0793), or your local Dykema relationship attorney.