am-2022-007-508v.pdf

Office of Chief Counsel

Internal Revenue Service

Memorandum

Number: AM 2022-007

Release Date: 12/16/2022

CC:EEE:EB:EC:RHNettles

Third Party Communication: None

POSTS-101486-22

Date of Communication: Not Applicable

UILC:

61.00-00, 83.00-00, 409A.00-00, 409A.01-00

date:

December 09, 2022

to:

Mark Hulse

Division Counsel

Tax Exempt & Government Entities (CC:TEGEDC)

from:

Rachel Levy

Associate Chief Counsel

Employee Benefits, Exempt Organizations, and Employment Taxes (CC:EEE)

subject:

Payment of legal fees to a third party

This Generic Legal Advice Memorandum (GLAM) responds to your request for

assistance. This GLAM may not be used or cited as precedent. All references herein

are to the Internal Revenue Code (the Code) and Income Tax Regulations, unless

otherwise noted.

ISSUE

A law firm is a cash method taxpayer that represents a client on a contingency fee

basis. Before formal settlement of the client’s claim, the law firm enters into an

arrangement with a third party that purports to defer receipt of the law firm’s fee,

payable out of the settlement amount negotiated by the law firm on behalf of its client.

The opposing party’s insurance company sends the portion of the settlement

representing the law firm’s fee to the third party, pursuant to the terms of the settlement

agreement. When does income inclusion for the law firm occur with respect to the fee

sent to the third party?

CONCLUSIONS

The law firm must include the fee in gross income in the year that the funds

representing the fee are transferred to the third party. The transaction creates a funded

compensation arrangement that results in gross income to the law firm under the

anticipatory assignment of income doctrine, the economic benefit doctrine, and section

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83. Alternatively, to the extent that the arrangement constitutes unfunded deferred

compensation, the arrangement is a nonqualified deferred compensation plan subject to

section 409A, and the law firm has gross income in the first year of the arrangement

because the plan fails to comply with section 409A.

FACTS

In order to respond to your request for advice on this recurring issue, we have

developed the following hypothetical facts to illustrate and clarify our position.

Taxpayer is a law firm organized as a partnership under applicable state law and

treated as a partnership for Federal tax purposes. Taxpayer is a cash method taxpayer.

Taxpayer represents a client (the Client) in connection with the Client’s legal claim

against a defendant (the Defendant) as a result of a personal physical injury suffered by

the Client. On March 1, 2017, Taxpayer and the Client enter into an engagement letter

(the Fee Agreement) pursuant to which Taxpayer will represent the Client in connection

with all the Client’s claims for damages against the Defendant. In exchange, the Client

agrees to pay Taxpayer a 30% contingency fee out of any money paid by the Defendant

or the Defendant’s insurance company (the Insurer) to the Client, either as a result of a

judgment or in settlement of the Client’s claims. The Fee Agreement provides that the

fee will be payable to Taxpayer upon any recovery through a judgement or a settlement.

During pendency of the case but before trial, Taxpayer negotiates a settlement

agreement (the Settlement Agreement) on behalf of the Client. The Settlement

Agreement is between the Client, the Defendant, and the Insurer. Pursuant to the

Settlement Agreement, the Client will release all legal claims against the Defendant in

exchange for a cash settlement of $1,500,000. For purposes of applicable state law, the

Settlement Agreement is binding and effective upon execution by the Client, the

Defendant, and the Insurer. The Client accepts the settlement and asks to have it paid

in full as soon as possible.

On June 30, 2021, prior to the execution of the Settlement Agreement, Taxpayer enters

into a deferral agreement (the Deferral Agreement) with a third party that was not

involved in the litigation (the Third Party). The Third Party markets a deferred

compensation product to law firms that features a purported income tax deferral and

investment vehicles for the amounts deferred. Pursuant to the Deferral Agreement,

Taxpayer agrees that 100% of any legal fees it earns arising out of the settlement of the

Client’s claim will be transferred directly from the Insurer to the Third Party. The Deferral

Agreement purports to be irrevocable. In exchange, the Third Party agrees to pay a

lump sum amount to Taxpayer on August 1, 2031, equal to the amount of the fee paid

to the Third Party, adjusted for gains and losses based on the performance of a

hypothetical investment portfolio selected by Taxpayer, less an annual administration

fee (the Deferred Payment).

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The Client, the Defendant, and the Insurer execute the Settlement Agreement on July 1,

2021. The Settlement Agreement provides that the entire amount of the settlement will

be distributed by the Insurer on August 1, 2021, according to payment instructions to be

provided by Taxpayer, acting on behalf of the Client.

On July 15, 2021, Taxpayer provides written instructions to the Insurer regarding where

to transfer the settlement funds. Taxpayer instructs the Insurer to split the lump sum into

two separate wire transfers. One transfer for $1,050,000 is to be sent to Taxpayer’s

trust account. This amount represents the Client’s net portion of the recovery

($1,500,000, less Taxpayer’s 30% contingency fee of $450,000). The second transfer

for $450,000 is to be sent to the Third Party. The second amount represents Taxpayer’s

fee.

On August 1, 2021, pursuant to the terms of the Settlement Agreement and wiring

instructions noted above, the Insurer makes the two separate transfers totaling

$1,500,000. Pursuant to the Settlement Agreement, the Defendant and Insurer are

discharged of any obligation to pay additional amounts to the Client. Shortly thereafter,

the case is dismissed by agreement of the parties. The entire value of the $1,500,000

settlement is excludible from the Client’s gross income pursuant to section 104(a)(2).

Upon receipt of the $450,000 from the Insurer on August 1, 2021, the Third Party places

the funds in a grantor trust that conforms to the model trust language contained in Rev.

Proc. 92-64, 1992-2 C.B. 422 (the Rabbi Trust). The Deferral Agreement provides that

Taxpayer is a general unsecured creditor of the Third Party with respect to the Deferred

Payment, Taxpayer has no right to assign, accelerate, defer, change the terms or time

of, or transfer or sell the Deferred Payment, and the Third Party is the sole owner of the

assets contained in the Rabbi Trust.

On September 1, 2021, Taxpayer obtains a $200,000 loan from the Third Party. For this

loan, Taxpayer and the Third Party enter into a written promissory note (the Note).

According to the Note, interest accrues on the loan at an annual rate of 6%, and the

loan principal, plus accrued interest, are payable on September 1, 2025. In the event of

Taxpayer’s default on the loan due to non-payment, the Third Party is permitted, under

the terms of the Note, to exercise a setoff right, such that the Third Party can reduce the

Deferred Payment by the amount of the loan and accrued interest, to the extent of the

default.

Due to investment gains, net of fees, the value of the Deferred Payment increases from

$450,000 to $470,000, as of December 31, 2021.

POSTS-101486-22 4

BACKGROUND

Taxpayer takes the position that the $450,000 fee is not includible in Taxpayer’s gross

income in 2021, based on Childs v. Commissioner, 103 T.C. 634 (1994), aff’d without

published opinion, 89 F.3d 856 (11th Cir. 1996).

In Childs, the taxpayers were attorneys who represented a client in a personal injury

matter in exchange for a contingency fee. 103 T.C. at 637. The client’s legal claims

were settled in two separate cases (the Garrett litigation and the Jones litigation). Id. at

640, 645. Pursuant to the settlement agreement in the Garrett litigation, two insurance

companies of the defendant, Georgia Casualty & Surety Co. (Georgia Casualty) and

Stonewall Insurance Co. (Stonewall), agreed to pay the fees to the plaintiff’s attorneys

over a period of years. Id. at 640-42. The settlement agreement in the Garrett litigation

provided for an assignment of this obligation to First Executive Corp. (First Executive),

without releasing Georgia Casualty or Stonewall from the obligation to pay the fees. Id.

First Executive purchased an annuity to pay the fees from its subsidiary, Executive Life

Insurance Co. (Executive Life). Id. at 641. When Executive Life failed to make all the

required payments, the shortfall was paid by Georgia Casualty and Stonewall. Id. at

644. Pursuant to the settlement agreement in the Jones litigation, the defendant’s

insurance company, Stonewall, was obligated to pay the fees, and it purchased an

annuity from another insurance company, Manulife Service Corp., to pay the fees,

though Stonewall again retained the obligation to pay the fees. Id. at 645-47. First

Executive and Stonewall were the respective owners of the annuities and retained the

power to change the beneficiaries, and the taxpayers’ rights under the annuities were

no greater than those of a general creditor. Id. at 643-47. The Tax Court determined

that (1) the attorneys’ rights to receive payments under the settlement agreements were

not “property” for purposes of section 83, and (2) the doctrine of constructive receipt

was not applicable to the arrangement. Id. at 653-55.

A cash method taxpayer must include amounts in gross income in the year in which

they are actually or constructively received. Treas. Reg. § 1.451-1(a). Broadly speaking,

a compensation arrangement where a cash method taxpayer is owed compensation for

the performance of services and the taxpayer arranges to have the compensation paid

in cash in a year later than the year in which the compensation is earned can be

categorized as either a funded or unfunded arrangement. See, e.g., Rev. Rul. 69-649,

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.

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1969-2 C.B. 106. If an arrangement is unfunded, the compensation is generally included

in gross income in the year in which the taxpayer actually or constructively receives a

cash payment of the compensation. On the other hand, if a compensation arrangement

is funded, the compensation is generally included in the taxpayer’s gross income in the

year in which funding occurs, regardless of when the taxpayer actually or constructively

receives a cash payment.

Taxpayer’s position is that the transaction described in this GLAM constitutes an

unfunded deferred compensation arrangement, and, according to Childs, Taxpayer is

not required to include the compensation in gross income until the year in which

Taxpayer actually or constructively receives a cash payment, which is scheduled to

occur in 2031. This GLAM will explain why Childs does not apply to the transaction and

Taxpayer cannot avoid income inclusion in the year that the funds representing its fee

are transferred to the Third Party. Historically, when compensation earned by a

taxpayer has been paid to a third party, courts have taken various approaches to

determine whether the taxpayer must include the compensation in gross income, even

though the taxpayer did not actually or constructively receive a cash payment of the

compensation. Three of these approaches are discussed in more detail in this GLAM,

each of which can be applied to Taxpayer on these facts: the anticipatory assignment of

income doctrine, the economic benefit doctrine, and section 83. Only one of these

arguments, section 83, was directly addressed in Childs. While we believe that the

arrangement is funded for the reasons discussed in this GLAM, if the arrangement is

not funded, the arrangement must comply with section 409A, which was enacted in

2004, well after Childs was decided in 1994. As explained in more detail below, the

arrangement fails to comply with section 409A, and the compensation is includible in

Taxpayer’s gross income in the year of the section 409A violation.

For the reasons discussed below, Taxpayer must include the fee in gross income in

2021.

LAW AND ANALYSIS

Anticipatory Assignment of Income Doctrine

Taxpayer must recognize the fee income under the anticipatory assignment of income

doctrine in 2021. When the funds were transferred to the Third Party from the Insurer,

the funds represented compensation owed to Taxpayer from the Client under the Fee

Agreement. Taxpayer diverted these amounts to the Third Party in anticipation of

receiving the income and must include the amounts in taxable income as the party who

earned the compensation.

Stated another way, the three “funding” concepts discussed in this GLAM are exceptions to the general

rule that a cash basis taxpayer is not required to include amounts in gross income until the year in which

they are actually or constructively received in cash by the taxpayer. See e.g., Helvering v. Horst, 311 U.S.

112, 116 (1940) (anticipatory assignment of income doctrine); Minor v. United States, 772 F.2d 1472,

1473 (9th Cir. 1985) (economic benefit doctrine); Childs, 103 T.C. at 648 (section 83).

POSTS-101486-22 6

Client’s Compensation Obligation to Taxpayer

Taxpayer represented the Client pursuant to the Fee Agreement in which the Client

agreed to pay Taxpayer a 30% contingency fee out of any money paid by the Defendant

or the Insurer in settlement of the Client’s claims. Taxpayer thus had a contractual right

to compensation from the Client.

In Commissioner v. Banks, 543 U.S. 426 (2005), the Supreme Court held that a client in

a lawsuit recognizes income for the gross amount of the litigation recovery, even though

a portion of the recovery is immediately payable to the attorney in the form of a

contingency fee. In Banks, the Supreme Court reasoned that the client’s cause of action

is an asset owned by the client, and the client “retains dominion over this asset

throughout the litigation.” Id. at 435. The attorney and the client are in a principal-agent

relationship. Id. at 436 (citing Restatement (Second) of Agency § 1, Comment e (1957)).

The “attorney, as an agent, is obligated to act solely on behalf of, and for the exclusive

benefit of, the client-principal, rather than for the benefit of the attorney or any other

party.” Id. When a client relies on the efforts of their attorney to realize an economic

gain (that is, the proceeds from settling the client’s legal claims), the entire economic

gain belongs to the client/principal, even if a portion is payable to the attorney/agent

after the gain is realized. Id. at 437.

Accordingly, consistent with Banks, the entire recovery in the settlement of a lawsuit

(including the contingency fee) initially belongs to the Client. The resulting fee

constitutes compensation from the Client, payable in exchange for Taxpayer’s

representation of, and services performed for, the Client. See Kochansky v.

Commissioner, 92 F.3d 957, 959 (9th Cir. 1996) (contingency fee is “undisputed

compensation for [an attorney’s] personal services”). The Client owned an asset in the

form of the cause of action against the Defendant. When the Client’s legal claim was

settled pursuant to the Settlement Agreement, the asset was converted into the Client’s

right to receive the $1,500,000 settlement, and the entire amount belonged to the Client.

Pursuant to the terms of the Fee Agreement, the Client owed compensation to

Taxpayer based on the Client’s total recovery, payable at the time of the recovery. This

is the case even though the funds representing the fee were paid by the Insurer directly

to the Third Party. Because an attorney is “dutybound to act only in the interests of,” and

works for “exclusive benefit” of, their client, the fee represents compensation from the

Client. See Banks, 543 U.S. at 436.

Compensation Earned by Taxpayer and Paid to the Third Party Represents an

Anticipatory Assignment of Income

The broad definition of “gross income” under section 61(a) includes all economic gains

not otherwise exempted. Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 429-30

(1955). Under the anticipatory assignment of income doctrine, “[a] taxpayer cannot

exclude an economic gain from gross income by assigning the gain in advance to

another party.” Banks, 543 U.S. at 433 (citing Lucas v. Earl, 281 U.S. 111 (1930);

Commissioner v. Sunnen, 333 U.S. 591, 604 (1948); Horst, 311 U.S. at 116-17). The

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rationale for the anticipatory assignment of income doctrine is the principle that gains

should be taxed “to those who earned them,” Lucas, 281 U.S. at 114, a maxim the

Supreme Court calls “the first principle of income taxation.” Commissioner v.

Culbertson, 337 U.S. 733, 739-40 (1949). As explained below, the anticipatory

assignment of income doctrine can apply to a funded compensation arrangement where

the compensation is earned by a taxpayer and paid to a third party.

When a taxpayer attempts to assign income to another party, “the question becomes

whether the assignor retains dominion over the income-generating asset, because the

taxpayer ‘who owns or controls the source of the income, also controls the disposition of

that which he could have received himself and diverts the payment from himself to

others as the means of procuring the satisfaction of his wants.’” Banks, 543 U.S. at 434-

35 (citing Horst). “The crucial question remains whether the assignor retains sufficient

power and control over the … receipt of the income to make it reasonable to treat him

as the recipient of the income for tax purposes.” Sunnen, 333 U.S. at 604. Thus, the

anticipatory assignment of income doctrine applies when a taxpayer retains control over

the disposition of the income in question and diverts the payment of that income to

another person or entity, thereby realizing a benefit by doing so. Banks, 543 U.S. at

435. See also United States v. Basye, 410 U.S. 441, 449 (1973) (“The entity earning the

income … cannot avoid taxation by entering into a contractual arrangement whereby

that income is diverted to some other person or entity.”); Wood Harmon Corp. v. United

States, 311 F.2d 918, 922 (2d Cir. 1963) (“[A] taxpayer who has performed services …

cannot escape the tax on those earnings merely by transferring the right to income to a

third person.”) (emphasis added). The anticipatory assignment of income doctrine

applies here because Taxpayer became entitled to receive income in the form of the

fee, retained control over the disposition of the fee, and diverted payment of the fee to

the Third Party, realizing a benefit by doing so.

First, Taxpayer controlled the disposition of the fee. In the context of anticipatory

assignments of compensation income, the taxpayer providing the services giving rise to

the compensation has the power to dispose of the income, which is equivalent to the

ownership of that income. Duran v. Commissioner, 123 F.2d 324, 326 (10th Cir. 1941)

(citing Horst and Helvering v. Eubank, 311 U.S. 122 (1940)); see also Kochansky, 92

F.3d at 959 (for purposes of the anticipatory assignment of income doctrine, an attorney

controls the services that produce a contingency fee). Because the fee arose out of

services provided by Taxpayer, the fee represented compensation earned by Taxpayer,

and Taxpayer controlled the disposition of that compensation income. Duran, 123 F.2d

at 326; Kochansky, 92 F.3d at 959.

Second, Taxpayer diverted the payment of the fee to another entity (the Third Party).

Banks, 543 U.S. at 434; Basye, 410 U.S. at 451 (“[An] agreement … whereby a portion

of the partnership compensation was deflected to” another entity “is certainly within the

ambit of Lucas v. Earl.”).

Taxpayer realized a benefit when the cash representing the

fee was received by the Third Party. A taxpayer enjoys the benefits of an item of income

when the taxpayer exercises control of the income and causes an amount to be paid to

his assignee to satisfy the taxpayer’s wishes. See Horst, 311 U.S. at 116-17 (“[I]ncome

is ‘realized’ by the assignor because he, who owns or controls the source of the income,

also controls the disposition of that which he could have received himself and diverts

the payment from himself to others as the means of procuring the satisfaction of his

wants.”); Harrison v. Schaffner, 312 U.S. 579, 582 (1941) (“[B]y the exercise of [the

taxpayer’s] power to command the income, [the taxpayer] enjoys the benefit of the

income on which the tax is laid.”); Sunnen, 333 U.S. at 606 ( “[T]he receipt of income by

the assignee” is “the fruition of the assignor’s economic gain.”); Raymond v. United

States, 355 F.3d 107, 114 (2d Cir. 2004) (“[E]xercising the right to ‘control[ ] the

disposition’ of a fund is sufficient for the realization of taxable income.”) (citing Horst);

Duran, 123 F.2d at 326 (“[T]he exercise of [the] power in procuring payment to an

assignee … is the equivalent of the enjoyment of the income.”) (citing Horst and

Eubank). Thus, Taxpayer controlled the disposition of the fee by providing the relevant

services (to the Client), diverted the payment of the fee to another person or entity (the

Third Party), and enjoyed a benefit when the cash was received by the Third Party.

Banks, 543 U.S. at 435.

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Taxpayer may argue that the anticipatory assignment of income doctrine does not apply

where income inclusion is merely deferred to a later year and there is no attempt by

Taxpayer to avoid taxation entirely; in other words, that the doctrine relates to “who”

should be taxed, not “when” that person should be taxed. For example, in Oates v.

Commissioner, 18 T.C. 570, 585 (1952) (Oates I), the Tax Court rejected the

government’s argument that the assignment of income doctrine (specifically Lucas,

Eubank, and Horst) was applicable where the taxpayers entered into binding

agreements to defer compensation before it was payable to them. See also Gann v.

Commissioner, 31 T.C. 211, 218 (1958) (anticipatory assignment of income doctrine did

not apply where the taxpayer “did not sell, assign, or give up their right to receive”

payment and “merely agreed to the postponement of the date of payment”). But the

anticipatory assignment of income doctrine has not been so limited when income is

diverted to a third party. In affirming Oates I, the Seventh Circuit Court of Appeals noted

that each of Lucas, Eubank, and Horst involved an assignment of income to a third

party. Commissioner v. Oates, 207 F.2d 711, 713 (7th Cir. 1953). This was not at issue

in the case before them, as the taxpayers merely instructed their employer to make the

payment at a later date, rather than causing the compensation to be paid immediately to

a third party. Id. at 714. Oates I and Gann do not apply because Taxpayer did more

than “merely agree[] to the postponement of the date of payment” of the fee from the

It is irrelevant that Taxpayer never had a right to receive the fee directly, once the Deferral Agreement

and the Settlement Agreement were effective. In Basye, the Supreme Court ruled that “[t]he Government

need not prove that the taxpayer had complete and unrestricted power to designate the manner and form

in which his income is received.” 410 U.S. at 452. It was sufficient in that case that the taxpayer earned

the income and the parties agreed to divert the income to a third-party trust. Id. at 451; see also

Armantrout v. Commissioner, 67 T.C. 996, 1007 (1977).

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Client. Gann, 31 T.C. at 218. Taxpayer gave up the right to receive the fee from the

Client by diverting the payment to the Third Party.

Here, the anticipatory assignment of income doctrine is being applied to identify “who”

should be taxed: Taxpayer, as the entity that performed the relevant services and

earned the compensation. As for “when” Taxpayer should be taxed, the Supreme Court

has repeatedly ruled that the assignor must recognize income when payments are

made to the assignee. See Lucas, 281 U.S. 111 (assigned salary and fees taxable to

the assignor in the years paid to the assignee); Eubank, 311 U.S. at 125 (“[W]e hold

that the commissions were taxable as income of the assignor in the year when paid.”)

(emphasis added); Horst, 311 U.S. 112 (bond interest was taxable to the assignor in the

years paid to the assignee); Schaffner, 312 U.S. 579 (attempted assignments of trust

income executed in 1929 and 1930 taxable to the assignor in the years of payment,

1930 and 1931); Sol C. Siegel Productions, Inc. v. Commissioner, 46 T.C. 15, 23-24

(1966) (“Ordinarily … a cash basis assignor is accountable for his assigned income in

the year in which it is paid rather than in the year in which he makes the assignment.”)

(emphasis added); Rev. Rul. 74-32, 1974-1 C.B. 22 (“[A] cash-method taxpayer who

contracted to perform services under an arrangement whereby the remuneration for his

services would be paid to a third party must include the compensation in his gross

income […] at the time it is received by the third party.”) (emphasis added).

It is irrelevant whether Taxpayer’s intent in entering into the Deferral Agreement was to

defer, rather than to avoid completely, the inclusion of the fee in income, Basye, 410

U.S. at 452 (“[T]he tax laws permit no such easy road to tax avoidance or deferment.”)

(emphasis added). See also Banks, 543 U.S. at 434 (holding that a “discernible tax

avoidance purpose” is not required for the doctrine to apply). It does not matter whether

Taxpayer assigned its right to the fee before the Client’s case had been settled and the

fee had materialized. See Banks, 543 U.S. at 435 (“[T]he anticipatory assignment

doctrine is not limited to instances when the precise dollar value of the assigned income

is known in advance.”); Kochansky, 92 F.3d at 959 (“That Kochanky’s fee was

contingent … does not change the fact that, when the fee materialized, it was

undisputed compensation for Kochansky’s personal services.”). The doctrine applies

equally to assignments entered into before the performance of services (as in Lucas) or

after all the services have been performed (as in Eubank).

Finally, while the Supreme

Court has frequently applied the anticipatory assignment of income doctrine in the

context of gratuitous transfers to family members (either directly or through a trust or

partnership), for example, in Lucas, Eubank, Horst, and Culbertson, the doctrine is not

limited to intra-family transfers, as illustrated by Basye and Banks.

Under the current facts, the Deferral Agreement was entered into by Taxpayer after the relevant legal

services had been performed. The anticipatory assignment of income doctrine would still apply if

Taxpayer had entered into the Deferral Agreement before the performance of services (for example, at

the same time Taxpayer entered into the Fee Agreement with the Client).

In Basye, the Court specifically noted that the case involved an “assignment arrived at by the

consensual agreement of two parties acting at arm’s length.” Basye, 410 U.S. at 453 n.13.

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In summary, Taxpayer must recognize the fee as income under the anticipatory

assignment of income doctrine. Because the fee was compensation payable in

exchange for services provided by Taxpayer to the Client, Taxpayer controlled the

disposition of that compensation income. Duran, 123 F.2d at 326. Taxpayer diverted

that income by having the fee paid to the Third Party. Banks, 543 U.S. at 434; Basye,

410 U.S. at 451. Taxpayer realized a benefit when the Third Party received the cash

representing the fee at Taxpayer’s direction. Horst, 311 U.S. at 116-17; Schaffner, 312

U.S. at 582; Sunnen, 333 U.S. at 606; Raymond, 355 F.3d at 114; Duran, 123 F.2d at

326. Taxpayer, as the earner and assignor of the income, “retain[ed] sufficient power

and control over the … receipt of the income to make it reasonable to treat him as the

recipient of the income for tax purposes,” even though it was paid to the Third Party.

Sunnen, 333 U.S. at 604.

Taxpayer attempted to avoid taxation of the fee in 2021 by having it paid to the Third

Party, but as the “entity earning the income,” Taxpayer “cannot avoid taxation by

entering into a contractual arrangement whereby that income is diverted to” the Third

Party. Basye, 410 U.S. at 449. Taxpayer must recognize income in 2021 – the year that

the assigned income was actually paid to the assignee. Lucas, 281 U.S. 111; Eubank,

311 U.S. at 125; Horst, 311 U.S. 112; Schaffner, 312 U.S. 579; Sol C. Siegel

Productions, 46 T.C. at 23-24; Rev. Rul. 74-32.

Childs Does Not Apply to Avoid the Assignment of Income Doctrine

Childs does not apply on these facts such that Taxpayer can avoid including the fee in

gross income in 2021 under the anticipatory assignment of income doctrine. The Tax

Court in Childs only addressed whether the taxpayers in that case had income under

section 83 or the doctrine of constructive receipt. Childs did not address the application

of the anticipatory assignment of income doctrine.

Economic Benefit Doctrine

The purported deferral arrangement is also taxable in 2021 under the economic benefit

doctrine when cash was transferred to the Third Party and the Third Party promised to

pay amounts to Taxpayer that were owed to Taxpayer by the Client. Like the

anticipatory assignment of income doctrine, courts have applied the economic benefit

doctrine to funded compensation arrangements where the compensation in question

has been paid to a third party.

Transfer of Funds to the Third Party for the Benefit of Taxpayer and Beyond the

Reach of Creditors of the Client Constitutes a Taxable Economic Benefit

The Client had a contractual obligation to pay a fee of $450,000 to Taxpayer. Under the

economic benefit doctrine, Taxpayer must recognize gross income upon the satisfaction

of this obligation by means of the transfer of funds to the Third Party (a third party to the

transaction) making them beyond the reach of the Client’s creditors. Taxpayer’s

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agreement with the Third Party is ineffective to stop recognition of income in the year

that the funds representing the fee were transferred to the Third Party.

Under the economic benefit doctrine, “the benefit derived from an employer’s

irrevocable set-aside of money or property as compensation for services rendered is

includible in the service provider’s gross income at the time of the set aside, where the

money or property is beyond the reach of the employer’s creditors.” Our Country Home

Enterprises, Inc. v. Commissioner, 145 T.C. 1, 53 (2015).

In United States v. Drescher, 179 F.2d 863 (2d Cir. 1950), cert. denied, 340 U.S. 821

(1950), the Second Circuit Court of Appeals, applying the economic benefit doctrine,

determined that the value of an annuity purchased by an employer for an employee in

connection with the performance of services was includible in the employee’s gross

income at the time of the purchase. In Drescher, the taxpayer provided services as an

officer and director of a corporation, and the corporation purchased nonforfeitable

single-premium annuities from an insurance company, with the taxpayer named as the

annuitant. Id. at 864. Under the annuity contracts, the taxpayer was entitled to fixed

monthly payments for life commencing at age 65 and a death benefit payable to the

taxpayer’s beneficiary if the taxpayer died before age 65. Id.

The court determined that the value of the annuities was includible in the taxpayer’s

gross income in the year of purchase rather than when payments were made, because

the taxpayer “received as compensation for prior services something of economic

benefit” in the form of “the obligation of the insurance company to pay money in the

future to him or his designated beneficiaries on the terms stated in the policy.” Id. at

865. Even though the employer retained ownership of the annuities, and the annuities

could not be assigned by the executive, surrendered for cash, sold, or pledged for a

loan, the court found that the “right to receive income payments” in the future

“represented a present economic benefit” to the employee, and this benefit accrued and

was taxable at the time the annuities were purchased. Id. (emphasis added). The result

in Drescher is consistent with the “well-established principle that a cash basis taxpayer

must include in gross income amounts paid to third parties exclusively for the benefit of

the taxpayer that are not intended to be gifts.” Hyde v. Commissioner, 301 F.2d 279,

282-83 (2d Cir. 1962) (citing, inter alia, Drescher).

In Sproull v. Commissioner, 16 T.C. 244 (1951), aff’d per curiam, 194 F.2d 541 (6th Cir.

1952), an employer transferred $10,500 to a trust for the benefit of an employee (the

taxpayer) in 1945, with payments to be made in 1946 and 1947. The taxpayer was the

“sole beneficiary” of the trust, and “[n]o one else had any interest in or control over the

monies.” Id. at 247-48. The court determined that the entire amount was taxable income

in 1945 (the year the money was placed in trust rather than the years when amounts

were distributed from the trust) because the payment to the trust represented an

“economic or financial benefit conferred on the employee as compensation.” Id. at 247.

When the money was placed in the trust, the “employer’s part of the transaction

terminated” and “the amount of the compensation was fixed at $10,500 and irrevocably

paid out for [the taxpayer’s] sole benefit.” Id. The amount of compensation was not

POSTS-101486-22 12

subject to any contingency, and there was no possibility that it could be returned or

forfeited to the employer. Id.

Rev. Ruls. 69-50, 1969-1 C.B. 140 and 77-420, 1977-2 C.B. 172, apply the result in

Sproull and Drescher to the creation of an account payable with a third party for the

benefit of the party providing services.

In Rev. Rul. 69-50, a doctor provided medical services to a patient who was insured by

a nonprofit corporation. The insurance company did not employ the doctor and was thus

a third party to the transaction. The doctor entered into an agreement with the insurer to

defer a portion of the fees for providing services to the patient. The payments would be

deferred until the doctor’s death, disability, or retirement. Citing Drescher, Sproull, and

other economic benefit doctrine cases, the ruling concluded that the doctor had gross

income once the medical services were performed and amounts were credited to the

doctor’s “account payable on the books of the” insurer. Once the doctor provided

medical services to a patient, the doctor had a right to compensation from the patient,

but instead of being paid directly by the patient, the doctor received a right to deferred

compensation from the insurer, in the form of an account payable. The ruling concludes

that the doctor’s patients “funded their obligation” to the doctor, and “in doing so, they …

conferred an economic or financial benefit” on the doctor.

Rev. Rul. 77-420 amplifies Rev. Rul. 69-50 and provides that the tax result remains the

same even if the doctor’s right to deferred compensation from the insurer is subject to a

substantial forfeiture provision in favor of the insurer, because there is no possibility that

the deferred compensation could be forfeited to any patient (the recipient of the

services).

These cases are applicable to the current facts. In Drescher and Sproull, a fixed amount

of money was placed with a third party (a party other than the party receiving the

services) for the benefit of the taxpayer (the party providing the services), the money

was irrevocably placed with the third party because there was no possibility the money

could be returned to the party receiving the services, and the money was not subject to

the claims of creditors of the party receiving the services. That is, there was an

“irrevocable set-aside of money … as compensation for services rendered … beyond

the reach of the employer’s creditors.” Our Country Home Enterprises, 145 T.C. at 53.

In dicta, one court has read these rulings as only being relevant to the issue of constructive receipt. In

Minor, 772 F.2d at 1474 n.1, the Ninth Circuit Court of Appeals stated that “[t]he essence of [the rulings]

was that the physician had constructively received the income.” Because the government conceded the

issue of constructive receipt, the court found that the rulings were not relevant to the remaining issue,

which was economic benefit. In fact, the rulings involve the application of the economic benefit doctrine,

as they both use the phrase “economic or financial benefit” and Rev. Rul. 69-50 cites Sproull, Drescher,

and other economic benefit doctrine cases. The General Counsel Memorandum supporting the two

rulings (GCM 33918 (August 26, 1968) and GCM 37244 (June 6, 1977), respectively) make this clear.

GCM 33918 notes that the holding in Rev. Rul. 69-50 is based on an example in Rev. Rul. 60-31, 1960-1

C.B. 174, which is based on “the doctrine of ‘economic benefit.’” GCM 37244 includes multiple references

to “economic benefit.” Neither GCM discusses constructive receipt.

POSTS-101486-22 13

In Taxpayer’s case, pursuant to the terms of the Settlement Agreement and the Deferral

Agreement, a fixed amount of money ($450,000) was irrevocably placed with the Third

Party (a third party that did not receive services from Taxpayer) for the benefit of

Taxpayer (the party providing the services) as compensation for services performed by

Taxpayer, there was no possibility that the money could be returned to the Client (the

party receiving the services), and the money was not subject to claims of creditors of

the Client. As in Sproull, the exact amount of compensation was known, that amount

was not subject to any future contingency,

and there was no possibility that the funds

would be returned to the Client. 16 T.C. at 247. Taxpayer was the only beneficiary of the

Third Party’s promise to pay money in the future, and neither the Third Party nor any

other party had any power to change the beneficiary. By the time the money was

transferred to the Third Party, all the relevant services giving rise to the fee had been

performed, and Taxpayer “had to do nothing further to earn it or establish his rights

therein.” Id. at 248. The only condition on Taxpayer’s right to possess the funds was the

passage of time, which is not a condition that prevents the application of the economic

benefit doctrine. Stiles v. Commissioner, 69 T.C. 558, 569 (1978); Thomas v. United

States, 213 F.3d 927, 932 (6th Cir. 2000).

Taxpayer may argue that the economic benefit doctrine does not apply because

Taxpayer’s right to the Deferred Payment under the Deferral Agreement merely

represents a non-negotiable, non-assignable, and non-transferable promise to pay

money in the future that is subject to claims of creditors of the Third Party. The relevant

inquiry, however, is whether the funds are subject to claims of creditors of the party

receiving the services. Our Country Home Enterprises, 145 T.C. at 53 (economic benefit

doctrine applies “where the money or property is beyond the reach of the employer’s

creditors”) (emphasis added). Here, the Deferred Payment is subject to claims of

creditors of the Third Party but not the Client (the party receiving the services). The

facts of Drescher, Sproull, and Rev. Ruls. 69-50 and 77-420, illustrate that the doctrine

applies even if funds are subject to claims of creditors of a third party:

• In Drescher, the insurance company’s promise to pay money to the taxpayer

under the annuities would have been subject to claims of creditors of the insurer,

as an insurer and an annuitant generally have a debtor-creditor relationship. See

Hughes v. Sun Life Assur. Co. of Canada, 159 F.2d 110, 113 (7th Cir. 1946). The

annuities were not subject to claims of creditors of the employer, though,

because the taxpayer was the beneficiary of the annuity, and only the taxpayer

had the right to change the beneficiary. Drescher, 179 F.2d at 864.

• Because the trust in Sproull was irrevocably funded and the employer did not

have “any interest in or control over the monies,” assets in the trust would only

The relevant inquiry is whether the amount of compensation is fixed when the taxpayer receives a

vested interest in the funds, even though the value may change due to investment gains and losses. In

Sproull, the court treated the amount of compensation as “fixed” and irrevocable even though the money

was placed in a trust and invested by the trustee until payment was due. Id. at 247. Likewise, in Rev. Rul.

69-50, the amount payable to the taxpayer in the future was subject to “investment gains and losses.”

In summary, the economic benefit doctrine applies because money was irrevocably set

aside for the benefit of Taxpayer as compensation, beyond the reach of the Client’s

creditors. Our Country Home Enterprises, 145 T.C. at 53. The economic benefit is the

obligation of the Third Party “to pay money in the future” to Taxpayer on the terms

stated in the Deferral Agreement. Drescher, 179 F.2d at 865. The Client “confer[red]

[the] economic or financial benefit” on Taxpayer when cash was transferred to the Third

Party and Taxpayer received a right to receive the Deferred Payment from the Third

Party, as Taxpayer’s right to the Deferred Payment “emanate[d] from the … services

that [were] rendered to” the Client by Taxpayer. Rev. Rul. 77-420 (citing Rev. Rul. 69-

50). Once the fee was transferred to the Third Party, the Client’s part of the transaction

terminated and “the amount of the compensation was fixed,” in our case at $450,000,

and “irrevocably paid out for [the] sole benefit” of Taxpayer. Sproull, 16 T.C. at 247. As

a cash method taxpayer, Taxpayer “must include in gross income amounts paid to third

parties exclusively for the benefit of the taxpayer that are not intended to be gifts.” Hyde,

301 F.2d at 282. Because the amounts paid to the Third Party arose from the services

provided by Taxpayer to the Client, the amounts were not gifts.

POSTS-101486-22 14

have been subject to claims of creditors of the trust and not the employer. 16

T.C. at 247-48.

• In Rev. Rul. 69-50, the taxpayer was entitled to an “account payable on the

books of the corporation,” meaning it was subject to claims of creditors of the

corporation (the third party) but not the patients (the recipients of the services).

Rev. Rul. 77-420 notes that the taxpayer could not forfeit any amounts to any

patient.

For the reasons discussed above, Taxpayer received an economic benefit in 2021 when

cash was transferred to the Third Party beyond the reach of the Client’s creditors and

the Third Party promised to pay compensation to Taxpayer that was owed to Taxpayer

by the Client. This economic benefit was taxable as gross income to Taxpayer in 2021.

Childs Does Not Apply to Avoid the Economic Benefit Doctrine

Childs does not apply on these facts such that Taxpayer can avoid including the fee in

gross income in 2021 under the economic benefit doctrine. The Tax Court in Childs only

addressed whether the taxpayers in that case had income under section 83 or the

doctrine of constructive receipt. Childs did not directly address the application of the

economic benefit doctrine as a basis for income inclusion. While economic benefit

doctrine case law is relevant to section 83, as courts (including the Tax Court in Childs)

have looked to economic benefit doctrine case law to interpret section 83, the economic

benefit doctrine remains an independent basis for income inclusion. Courts have

continued to apply the economic benefit doctrine in the compensation context following

the adoption of section 83 (see, e.g., Wheeler v. United States, 768 F.2d 1333 (Fed. Cir.

1985)).

POSTS-101486-22 15

Section 83

Taxpayer also has gross income in 2021 under section 83. When cash was transferred

to the Third Party and the Third Party promised to pay amounts to Taxpayer that were

owed to Taxpayer by the Client, the transaction constituted a transfer of “property” for

purposes of section 83. As discussed below, the section 83 regulations treat a funded

compensation arrangement as “property” for purposes of the statute.

Under section 83, “[i]f, in connection with the performance of services, property is

transferred to any person other than the person for whom such services are performed,”

the party providing the services must include in gross income the fair market value of

the property less the amount paid for the property.

Section 83(a); Treas. Reg. § 1.83-

1(a)(1). “Property” includes (1) “real and personal property other than either money or

an unfunded and unsecured promise to pay money or property in the future” and (2) “a

beneficial interest in assets (including money) which are transferred or set aside from

the claims of creditors of the transferor, for example, in a trust or escrow account.”

Treas. Reg. § 1.83-3(e).

If section 83 applies to a transfer of property, the party providing services must

recognize income in the first year that the property is either transferable or not subject to

a substantial risk of forfeiture. Section 83(a); Treas. Reg. § 1.83-1(a)(1). Property is

subject to a substantial risk of forfeiture if the taxpayer’s rights to the property are

conditioned upon (1) “the future performance [or refraining from the performance] of

substantial services” or (2) “the occurrence of a condition related to a purpose of the

transfer.” Treas. Reg. § 1.83-3(c)(1). The risk that the property may decline in value is

not a substantial risk of forfeiture. Id.

All the requirements of section 83 were met in 2021 when cash was transferred to the

Third Party in connection with the performance of services by Taxpayer for the Client.

Taxpayer is subject to section 83, as the statute applies to any “person” that receives

property in connection with the performance of services, and a partnership is a “person”

for purposes of the Code. Section 7701(a)(1). Section 83 applies to employees and

independent contractors. See Treas. Reg. § 1.83-1(a)(1); Cohn v. Commissioner, 73

T.C. 443, 446 (1979). Taxpayer performed services for the Client by settling the Client’s

claims against the Defendant. In connection with the performance of those services, the

Client transferred “property” to Taxpayer (as discussed in more detail below) in 2021.

Under section 83, the value of the property is includible in Taxpayer’s income in the

year of transfer because the property was not subject to a substantial risk of forfeiture,

as Taxpayer’s right to receive the property was neither conditioned on the future

The property does not need to be transferred to the party providing the services or transferred by the

party receiving the services, so long as the “property is transferred to any person other than the person

for whom [the] services are performed.” Section 83(a). See also Treas. Reg. § 1.83-1(a)(1) (“This

paragraph applies to a transfer of property in connection with the performance of services even though

the transferor is not the person for whom such services are performed.”).

POSTS-101486-22 16

performance of (or refraining from the performance of) substantial services nor any

condition related to the purpose of the transfer. There was no possibility that the

property could be forfeited to the Client, and the risk that the Deferred Payment could

lose value due to investment losses is not a substantial risk of forfeiture for purposes of

section 83.

Taxpayer Received a Transfer of “Property” in the Form of a Funded Promise to

Pay, as a Well as a Beneficial Interest in Money Set Aside from the Claims of

Creditors of the Client and the Insurer

The term “property” is not defined in section 83. The section 83 regulations provide that

the term “includes real and personal property other than either money or an unfunded

and unsecured promise to pay money or property in the future.” Treas. Reg. § 1.83-3(e)

(first sentence). The term “property” also includes “a beneficial interest in assets

(including money) which are transferred or set aside from the claims of creditors of the

transferor, for example, in a trust or escrow account.” Id. (second sentence). Thus,

under Treas. Reg. § 1.83-3(e), there are three ways in which money or a promise to pay

money can constitute “property”: (1) a promise to pay money is funded, (2) a promise to

pay money is secured,

or (3) the receipt of a beneficial interest in money, when the

money is transferred or set aside from the claims of creditors of the transferor.

As discussed below, Taxpayer received a funded promise to pay money, as well as a

beneficial interest in assets (money) which were transferred or set aside from the claims

of creditors of the transferor.

Funded Promise to Pay

While the Tax Court in Childs did not address the application of the economic benefit

doctrine, it did look to certain economic benefit doctrine cases to determine the meaning

of “funded” in the context of understanding Treas. Reg. § 1.83-3(e) (first sentence),

which provides that “property” does not include an “unfunded and unsecured promise to

pay money or property in the future.”

Based on a review of Sproull, Minor, and Centre v. Commissioner, 55 T.C. 16 (1970),

the Tax Court in Childs determined that:

“funding occurs when no further action is required of the obligor for the trust or

insurance proceeds to be distributed or distributable to the beneficiary. Only at

the time when the beneficiary obtains a nonforfeitable economic or financial

benefit in the trust or insurance policy is the provision for future payments

This GLAM does not address whether the loan obtained by Taxpayer from the Third Party would cause

applicable state law, if Taxpayer obtained a setoff right against the Third Party with respect to the

Deferred Payment to the extent of the loan obtained by Taxpayer, Taxpayer could be treated as a

secured creditor of the Third Party for purposes of Federal bankruptcy law, causing the Third Party’s

promise to pay money to become “secured,” resulting in a transfer of property for purposes of section 83.

a portion of the Deferred Payment to become “secured” for purposes of section 83. Depending on

In applying this test, the Tax Court treated the defendant’s insurance companies as the

“obligors” of the compensation without discussion. Id. at 651. As a result, the Tax Court

determined that the promise to pay the fees in Childs was not “funded” for purposes of

section 83 because the attorneys merely had a promise to pay from the insurers, and

that promise to pay was subject to the rights of general creditors of the insurers. Id.

Further, the purchase of the annuities by the insurance companies did not result in

“funding” under section 83 because the insurers remained the owners of the annuities

and reserved the right to change the beneficiaries, and the taxpayers did not have rights

to payment greater than the rights of a general creditor of the insurers. Id.

POSTS-101486-22 17

secured or funded. However, if the trust or policy is subject to the rights of

general creditors of the obligor, funding has not occurred.”

103 T.C. at 651.

Under the current facts, pursuant to the Settlement Agreement, the Insurer agreed to

pay the entire settlement of $1,500,000, inclusive of Taxpayer’s fee. Treating the Insurer

as the “obligor” of the fee, just as the Tax Court did with the insurers in Childs, the

Deferred Payment became a “funded” promise to pay money for purposes of section 83

when the Third Party agreed to pay the fee on a deferred basis and the Insurer was

released of the obligation to pay the fee under the Settlement Agreement. At that time,

the Tax Court’s conditions for “funding” under Childs were satisfied:

• “[N]o further action [was] required of the obligor” (the Insurer) for the fee to be

“distributed or distributable to the beneficiary” (Taxpayer). Id. at 651. Once the

funds were transferred to the Third Party, the only condition on Taxpayer’s right

to receive the funds was the passage of time. No further action was required of

the Insurer for the fee to be distributable to Taxpayer because the Insurer was

released of any further obligations once the Insurer distributed the settlement

funds. By contrast, in Childs, further action was required by the insurers, because

the insurers at all times remained liable to make periodic payment to the

taxpayers. Id. at 641, 645. The insurers’ purchase of annuities in Childs to make

payments to the taxpayers did not relieve the insurers of the ongoing obligation

to pay the fees – when Executive Life failed to make payments under the

This GLAM does not address whether this aspect of Childs is now incorrect in light of Banks, because

the client should be viewed as the “obligor” of the promise to pay the fees, rather than the insurance

companies. As discussed above under the heading “Client’s Compensation Obligation to Taxpayer,” in a

typical contingency fee arrangement, the client has the sole obligation to pay compensation to the

attorney. If the client had been treated as the “obligor” of the fees, funding would have occurred under the

facts of Childs. Once the insurers agreed to pay the fees pursuant to the settlement agreements, “no

further action [was] required” of the client for the amounts to be “distributed or distributable” to the

taxpayers, the amount of compensation was fixed and nonforfeitable, and the insurers’ promise to pay

was not “subject to the rights of general creditors” of the client. Id. at 651. It is sufficient to conclude, as

we do in this GLAM, that by treating the Insurer as the “obligor” of the fee, in the same way that the Tax

Court treated the insurance companies as the “obligors” in Childs, funding occurred when the Third Party

agreed to pay the fee and the Insurer was discharged of the obligation to pay.

POSTS-101486-22 18

annuities in the Garrett litigation, the shortfall was paid by Georgia Casualty and

Stonewall. Id. at 644.

• Taxpayer “obtain[ed] a nonforfeitable economic or financial benefit” in the

Deferred Payment. Id. at 651. The Third Party’s “obligation… to pay money in the

future to” Taxpayer on the terms stated in the Deferral Agreement represents an

“economic benefit” to Taxpayer. Drescher, 179 F.2d at 865. This economic

benefit was also nonforfeitable. At the time the funds were transferred to the

Third Party, the funds were not “subject to the possibility of return to” the Client.

Sproull, 16 T.C. at 247. Taxpayer had provided all the relevant services to the

Client giving rise to the Deferred Payment and “had to do nothing further to earn

it or establish [its] rights therein.” Id. at 248.

• The Third Party’s promise to pay Taxpayer under the Deferral Agreement was

not “subject to the rights of general creditors of the obligor” (the Insurer). Childs,

103 T.C. at 651. When the settlement funds were transferred by the Insurer to

the Third Party, the Insurer was released of any further obligation to pay the fee,

and the Deferred Payment was only subject to rights of general creditors of the

Third Party, not the Insurer.

Applying Childs, because the Deferred Payment became a “funded” promise to pay

money in the future, the transaction resulted in a transfer of “property” for purposes of

section 83. Treas. Reg. § 1.83-3(e) (first sentence).

Money Set Aside from the Claims of Creditors of the Transferor

Under Treas. Reg. § 1.83-3(e) (second sentence), “a beneficial interest in assets

(including money) which are transferred or set aside from the claims of creditors of the

transferor” can also constitute “property” for purposes of section 83. While the court in

Childs discussed the meaning of the phrase “unfunded and unsecured promise to pay

money” under Treas. Reg. § 1.83-3(e) (first sentence), it did not analyze whether the

attorneys in that case received a beneficial interest in money that was set aside from

the claims of creditors of the transferor.

The regulations do not define the term “transferor.” The plain meaning of the term

“transferor” in the context of Treas. Reg. § 1.83-3(e) (second sentence) is the person

who transfers the “assets (including money).” Here, the “transferor” of the funds

representing the fee for purposes of section 83 is either the Insurer or the Client. The

Insurer is the “transferor” in the sense that the Insurer directly transferred $450,000 to

the Third Party. Alternatively, the Client is the “transferor” in the sense that the

settlement funds (including the fee) belonged to the Client before being transferred to

the Third Party, because the settlement funds represented the total recovery that the

Client received for disposition of the Client’s legal claims against the Defendant, as

discussed above under the heading “Client’s Compensation Obligation to Taxpayer.” In

form, the funds representing the fee were transferred by the Insurer to the Third Party,

but in substance, the funds were transferred by the Client, because only the Client had

the legal authority to direct the funds to another party (that is, the Insurer facilitated the

transfer of funds belonging to the Client to the Third Party for the benefit of Taxpayer).

POSTS-101486-22 19

For purposes of this GLAM, however, it is not necessary to resolve this issue, because

the tax result is the same whether the Insurer or the Client is treated as the “transferor.”

See Treas. Reg. § 1.83-1(a)(1) (section 83 can apply “even though the transferor is not

the person for whom [the] services are performed”). In either case, the transfer of

$450,000 to the Third Party constitutes a transfer of property for purposes of section 83,

because “money” has been “transferred” to the Third Party for the benefit of Taxpayer,

and the money has been “set aside from the claims of creditors of” both the Insurer and

the Client. Treas. Reg. § 1.83-3(e) (second sentence). After the Third Party received the

money, the money was subject to claims of creditors of the Third Party, but it was no

longer subject to claims of creditors of the Insurer or the Client, because neither the

Insurer nor the Client had any right to the money after it was transferred to the Third

Party.

To summarize, the Third Party’s promise to pay the Deferred Payment to Taxpayer in

the future constituted “property” for purposes of section 83 for two reasons. First, the

Third Party’s promise to pay was a funded promise to pay money. Second, Taxpayer

received a beneficial interest in money that had been set aside from the claims of

creditors of the Insurer and the Client. The property was transferred to Taxpayer in

connection with the performance of services by Taxpayer to the Client. The property

was not subject to a substantial risk of forfeiture, as there was no possibility that the

property could be forfeited to the Client. As a result, all the requirements of section 83

were met in 2021 when the money was transferred to Third Party and the Third Party

agreed to pay the Deferred Payment, and the full value of the fee ($450,000) is

includible in Taxpayer’s income at that time.

Section 409A

This GLAM has explained why Taxpayer’s compensation arrangement is funded, and

therefore taxable, in 2021, under the anticipatory assignment of income doctrine, the

economic benefit doctrine, and section 83. Taxpayer’s position, however, is that the

arrangement constitutes unfunded deferred compensation, and the fee is not includible

in gross income until Taxpayer actually or constructively receives a cash payment of the

compensation, which is scheduled to occur in 2031. If the arrangement is viewed as an

unfunded deferred compensation arrangement, the Third Party’s promise to pay

Taxpayer certain amounts in 2031 under the Deferral Agreement constitutes a

“nonqualified deferred compensation plan” that is subject to the requirements of section

409A, and the plan is not exempt from section 409A under the independent contractor

exception in Treas. Reg. § 1.409A-1(f)(2). In 2021, the plan failed to comply with the

initial deferral election requirements of section 409A(a)(4). Additionally, Taxpayer

violated section 409A(a)(3) in 2021 when Taxpayer obtained a loan from the Third Party

that, in the event of default, could be repaid through an offset or reduction of the

Deferred Payment, because the loan was a substitute for an accelerated payment of

deferred compensation. Treas. Reg. § 1.409A-3(f). Because the arrangement violates

section 409A, the entire value of the Deferred Payment as of December 31, 2021, is

POSTS-101486-22 20

subject to income inclusion in 2021, plus an additional 20% tax. Section

409A(a)(1)(A)(i); Section 409A(a)(1)(B)(i)(II).

Nonqualified Deferred Compensation Plan

Section 409A applies to any “nonqualified deferred compensation plan.” Section

409A(a)(1)(A)(i). The term “nonqualified deferred compensation plan” means “any plan

that provides for the deferral of compensation, other than (A) a qualified employer plan,

and (B) any bona fide vacation leave, sick leave, compensatory time, disability pay, or

death benefit plan.” Section 409A(d)(1). The term “plan” includes any “agreement,

method, program, or other arrangement, including an agreement, method, program, or

other arrangement that applies to one person or individual.” Treas. Reg. § 1.409A-

1(c)(1). Taxpayer, a cash method partnership, is subject to section 409A, as section

409A applies to “service providers,” which includes individuals as well as corporations,

partnerships, and other entities that “account[] for gross income from the performance

of services under the cash receipts and disbursements method of accounting.” Treas.

Reg. § 1.409A-1(f)(1).

Unless an exception applies, a plan provides for a deferral of compensation subject to

section 409A “if, under the terms of the plan and the relevant facts and circumstances,

the service provider has a legally binding right during a taxable year to compensation

that, pursuant to the terms of the plan, is or may be payable to (or on behalf of) the

service provider in a later taxable year.” Treas. Reg. § 1.409A-1(b)(1).

On June 30, 2021, Taxpayer acquired a “legally binding right” to “compensation”

payable by the Third Party when the parties entered into a “plan” (the Deferral

Agreement), and compensation under that plan was payable to Taxpayer in a later

taxable year (2031):

• The Deferral Agreement constitutes a “plan,” because the term “plan” includes an

“agreement … that applies to one person or individual.” Treas. Reg. § 1.409A-

1(c)(1). Taxpayer, a partnership, is a “person” for purposes of the Code. Section

7701(a)(1). As a cash method partnership, Taxpayer is a “service provider”

subject to section 409A. Treas. Reg. § 1.409A-1(f)(1).

• Taxpayer had a “legally binding right” to a payment because Taxpayer had a

contractual right in 2021 to a payment in 2031 under the Deferral Agreement. A

“legally binding right includes a contractual right that is enforceable under the

applicable law or laws governing the contract.” Application of Section 409A to

Nonqualified Deferred Compensation Plans, Explanation of Provisions and

Summary of Comments, section III.B, 72 FR 19,234, 19,236.

• The amounts payable under the Deferral Agreement constitute “compensation.” If

the fee had been paid to Taxpayer directly by the Client, the payment would

constitute “compensation for services” for purposes of section 61, because

On April 17, 2007, the Treasury Department and IRS promulgated final regulations under section 409A

(the Final Regulations). 72 FR 19,234.

POSTS-101486-22 21

Taxpayer’s right to the payment derived from the performance of legal services.

Amounts retain their character as compensation for services even if the payor is

a party other than the recipient of the services.in situations in which a right to a

payment constituting compensation is substituted or exchanged for a new

payment. See United States v. Woolsey, 326 F.2d 287, 291 (5th Cir. 1963);

Trantina v. United States, 512 F.3d 567, 571-72 (9th Cir. 2008); Turner v.

Commissioner, 38 T.C. 304, 308 (1962); Flower v. Commissioner, 61 T.C. 140,

149 (1973); Henry v. Commissioner, 62 T.C. 605, 606 (1974); Seserman v.

Commissioner, 21 T.C.M. (CCH) 1042 (1962); Ramella v. Commissioner, 38

T.C.M. (CCH) 747 (1979).

• The amounts payable under the Deferral Agreement were payable in a taxable

year (2031) later than the year in which Taxpayer acquired the legally binding

right to compensation from the Third Party (2021).

Thus, the Deferral Agreement was a “nonqualified deferred compensation plan” subject

to section 409A, because “the service provider,” Taxpayer, had a “legally binding right

during a taxable year [2021] to compensation that, pursuant to the terms of the plan [the

Deferral Agreement], is or may be payable to (or on behalf of) the service provider in a

later taxable year [2031].” Treas. Reg. § 1.409A-1(b)(1).

Independent Contractor Exception

Section 409A does not apply to “an amount deferred under a plan between a service

provider and service recipient with respect to a particular trade or business in which the

service provider participates,” if certain conditions are met. Treas. Reg. § 1.409A-

1(f)(2)(i). This exception only applies to an amount “deferred under a plan between a

service provider and service recipient.” Id. (emphasis added). The fee was “deferred

under a plan between” Taxpayer and the Third Party (rather than Taxpayer and the

Client). The Client’s obligation to pay the fee to Taxpayer was discharged when the

Insurer transferred the funds representing the fee to the Third Party. Taxpayer acquired

a legally binding right to compensation from the Third Party pursuant to the Deferral

Agreement.

For purposes of section 409A, the term “service recipient” means “the person for whom

the services are performed and with respect to whom the legally binding right to

compensation arises.” Treas. Reg. § 1.409A-1(g). While Taxpayer had a legally binding

right to compensation from the Third Party under the Deferral Agreement, Taxpayer did

not provide any services to the Third Party (that is, all the relevant services were

provided to the Client). Because the Third Party is not “the person for whom the

services” giving rise to the fee were performed, the Third Party cannot qualify as a

“service recipient” for purposes of the independent contractor exception to section

409A. Treas. Reg. § 1.409A-1(f)–(g). Section 409A can apply to a plan “even if the

payment of the compensation is not made by the person for whom services are

performed.” Treas. Reg. § 1.409A-1(g). As such, the amounts payable to Taxpayer by

the Third Party under the Deferral Agreement constitute “nonqualified deferred

POSTS-101486-22 22

compensation” subject to section 409A, even though the Third Party is not a “service

recipient.”

This reading of the independent contractor exception is consistent with the statute and

regulations under section 409A. The statute broadly applies to “any plan that provides

for the deferral of compensation.” Section 409A(a)(1)(A)(i). The statute itself does not

include any exception for independent contractors; instead, the independent contractor

exception is a narrow regulatory exception to the broad reach of section 409A. The

independent contractor exception is not intended to provide independent contractors

with a categorical exclusion from section 409A.

In other words, all deferred

compensation arrangements of a service provider are not exempt from section 409A

merely because that service provider can meet the requirements of Treas. Reg. §

1.409A-1(f)(2)(i) with respect to one or more service recipients.

Because the amounts payable under the Deferral Agreement represent deferred

compensation subject to section 409A and the amounts cannot qualify for the

independent contraction exception in the Final Regulations, Taxpayer must comply with

the requirements of the statute, including the requirements of section 409A(a)(4)

regarding election timing and section 409A(a)(3) regarding the accelerated payment of

deferred compensation.

Initial Deferral Election Timing Requirements

A nonqualified deferred compensation plan subject to section 409A must provide, upon

adoption of the plan or when otherwise permitted under the section 409A initial deferral

election requirements, for a deferred amount to be paid at a time and in a form meeting

the section 409A time and form of payment requirements. Treas. Reg. § 1.409A-

1(c)(3)(i).

Under section 409A(a)(4), an irrevocable election as to the time and form of the

payment of the deferred compensation must generally be made in the year before the

taxable year in which the services giving rise to the compensation were performed.

Section 409A(a)(4)(B)(i). However, a special timing rule applies in the first year in which

See Application of Section 409A to Nonqualified Deferred Compensation Plans, Explanation of

Provisions, section I.C. 70 FR 57,930 (“Among the many objectives underlying the enactment of section

409A is to limit the ability of a service provider to retain the benefits of the deferral of compensation while

having excessive control over the timing of the ultimate payment. Where the independent contractor is

managing the service recipient, there is a significant potential for the independent contractor to have such

influence or control over compensation matters so that categorical exclusion from coverage under section

409A is not appropriate.”) (emphasis added).

The Final Regulations include an anti-abuse rule. Treas. Reg. § 1.409A-1(a)(1) provides that “[i]f a

principal purpose of a plan is to achieve a result with respect to a deferral of compensation that is

inconsistent with the purposes of section 409A, the Commissioner may treat the plan as a nonqualified

deferred compensation plan for purposes of section 409A and the regulations thereunder.” This GLAM

does not address whether the Commissioner could apply the anti-abuse rule to determine that the

Deferral Agreement represents a nonqualified deferred compensation plan that must comply with the

requirements of section 409A.

POSTS-101486-22 23

a taxpayer becomes eligible to participate in a plan. In that case, the election can be

made within 30 days after the date Taxpayer becomes eligible to participate in the plan,

but only with respect to services to be performed after the election. Section

409A(a)(4)(B)(ii); Treas. Reg. § 1.409A-2(a)(7)(i).

The Deferral Agreement was entered into in 2021, which was the first year Taxpayer

was eligible to participate in the plan. As a result, to comply with section 409A,

Taxpayer had to make an irrevocable election regarding the timing of payment of the

deferred compensation within 30 days after becoming eligible to participate in the plan,

but only with respect to services to be performed after the election. By the time

Taxpayer entered into the Deferral Agreement on June 30, 2021, and elected to be paid

in 2031, all the services giving rise to the fee had already been performed. The legal

engagement began on March 1, 2017, and was concluded on July 1, 2021, one day

following the execution of the Deferral Agreement. As a result, Taxpayer’s election to

defer compensation was not timely for purposes of section 409A(a)(4) because it only

became irrevocable after all the relevant services had been performed.

Anti-Acceleration Rule and Substituted Payment

In addition to the initial deferral election timing requirements, the plan must also comply

with the requirements of section 409A(a)(3) regarding the acceleration of benefits.

Under section 409A(a)(3), a nonqualified deferred compensation plan subject to section

409A cannot permit the acceleration of the time or schedule of any payment under the

plan. Likewise, Treas. Reg. § 1.409A-3(j)(1) provides as follows:

“Except as provided in paragraph (j)(4) of this section, a nonqualified deferred

compensation plan may not permit the acceleration of the time or schedule of

any payment or amount scheduled to be paid pursuant to the terms of the plan,

and no such accelerated payment may be made whether or not provided for

under the terms of such plan. For purposes of determining whether a payment of

deferred compensation has been made, the rules of paragraph (f) of this section

(substituted payments) apply.”

When amounts were initially deferred pursuant to the Deferral Agreement, Taxpayer

elected to be paid in a lump sum in 2031. The anti-acceleration rule of section

409A(a)(3) was violated in 2021, when Taxpayer obtained a loan against amounts

deferred with the Third Party. The loan was an accelerated payment of deferred

compensation because of the substitution rule in Treas. Reg. § 1.409A-3(f), which

provides that “the payment of an amount as a substitute for a payment of deferred

compensation will be treated as a payment of the deferred compensation.” Whether one

payment is a substitute for the payment of deferred compensation is based on the facts

and circumstances. Id. If a “service provider receives a loan the repayment of which is

secured by or may be accomplished through an offset of or a reduction in an amount

deferred under a nonqualified deferred compensation plan, the payment or loan is a

substitute for the deferred compensation.” Id.

POSTS-101486-22 24

Taxpayer’s loan constitutes a substitution under Treas. Reg. § 1.409A-3(f). Under the

terms of the Note, in the event of Taxpayer’s default, the Third Party has a right to

exercise a setoff right, such that the Third Party can reduce the Deferred Payment by

the amount of loan and accrued interest, to the extent of the default. Under Treas. Reg.

§ 1.409A-3(f), obtaining the loan represents a payment of deferred compensation

because the repayment of the loan “may be accomplished through an offset of or a

reduction in an amount deferred under a nonqualified deferred compensation plan”

(emphasis added).

Section 409A Violations

If at any time during a taxable year a nonqualified deferred compensation plan (1) fails

to meet the requirements of section 409A(a), or (2) is not operated in accordance with

such requirements, all compensation deferred under the plan for the taxable year and

all preceding taxable years shall be includible in gross income for the taxable year to the

extent not subject to a substantial risk of forfeiture and not previously included in gross

income. Section 409A(a)(1)(A)(i). The income tax imposed is increased by an amount

equal to (1) 20% of the compensation that is includible in income, plus (2) the amount of

interest determined under section 409A(a)(1)(B)(ii). Section 409A(a)(1)(B). These

amounts are an additional income tax, subject to the rules governing the assessment,

collection, and payment of income tax, and are neither an excise tax nor a penalty.

Because Taxpayer did not make a timely election to defer compensation under the plan,

the plan failed to comply with the requirements of section 409A(a)(4) in 2021. The plan

also failed to comply with the requirements of section 409A(a)(3) in 2021 when

Taxpayer obtained a loan from the Third Party, the repayment of which may be

accomplished through an offset of or a reduction in the Deferred Payment.

As a result, the value of the Deferred Payment ($470,000) is includible in Taxpayer’s

gross income for 2021, to the extent not subject to a substantial risk of forfeiture and not

previously included in income. Section 409A(a)(1)(A)(i). The Deferred Payment was not

subject to a substantial risk of forfeiture, because Taxpayer’s right to the Deferred

Payment was not “conditioned upon the future performance of substantial services by

any individual.” Section 409A(d)(4). The amounts deferred under the plan have not

previously been included in Taxpayer’s income. As a result, the entire balance of the

plan ($470,000) is includible in Taxpayer’s gross income for 2021. This amount is also

subject to an additional income tax of 20% under section 409A(a)(1)(B)(i)(II).

* * *

This written advice was prepared in conjunction with the Office of Associate Chief

Counsel (Income Tax & Accounting) and coordinated with key stakeholders in Large

Business and International (LB&I). Although this GLAM addresses some of the ways in

which the legal fees constitute gross income to Taxpayer at the time they are paid to the

Third Party, it does not purport to discuss or provide formal legal advice with respect to

all Federal tax issues raised by the facts discussed herein. For example, this GLAM

POSTS-101486-22 25

does not address any self-employment tax issues, constructive receipt issues, or

method of accounting issues, such as whether Taxpayer has adopted a method of

accounting for the purportedly deferred legal fees. This GLAM also does not address

whether the loan Taxpayer obtained from the Third Party is a bona fide loan for Federal

tax purposes.

Please call me or Richard Nettles at (202) 317-5600 if you have any further questions.