Source: http://archives.cpajournal.com/1997/1097/features/F301097.htm
Timestamp: 2019-04-22 20:11:00+00:00

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Taxpayers have been able to avoid income tax liability by assigning the right to receive contingent payments to another taxpayer. The courts have placed limits on such transactions going back to a Supreme Court decision when it ruled that fruits cannot be attributed to a different tree from which it grew. In another Supreme Court decision, commissions were taxed to the assignor because his rights to receive the payments were not uncertain and the fruit had sufficiently ripened on his tree. However, in one case where the entire business along with the income was transferred, the tree would be deemed transferred with the fruit and the income taxed to the assignee. Other cases have ruled for the taxpayer when the right to future income was sufficiently uncertain.
Under the proper circumstances, this restrictive doctrine does not apply to an assignment of contingent fees to a partnership. This exception allows for some tax planning involving a family limited partnership for which the author provides an example.
In some instances, taxpayers have been able to avoid income tax liability by assigning the right to receive contingent payments to another taxpayer. Nevertheless, taxpayers have discovered that avoiding tax liability on contingent fees only applies in a limited set of circumstances, as Richard Kochansky discovered in a recent decision against him. Although Kochansky was not allowed to assign contingent fees in this case, the IRS did not assess a negligence penalty for relying on a prior case in which the taxpayer successfully assigned contingent fees.
By not imposing the negligence penalty, the IRS implied that it was reasonable for Kochansky to rely on A.R. Jones, a case that allowed a taxpayer to assign contingent fees without incurring any tax liability. This outcome leaves a question as to under what circumstances a taxpayer can assign contingent fees and avoid tax liability for those fees. This question will be answered in three parts. First is a review and summary of the statutory, judicial, and administrative interpretations relating to the assignment of contingent fees. Second is a delineation and analysis of the critical elements in determining when contingent fees can be assigned without incurring tax liability. Finally, there is a suggestion on how to structure transactions to assign contingent income and avoid tax liability.
Under IRC section 61, gross income includes all compensation and commissions, which are includable in income in the year recognized by the taxpayer based on the taxpayer's accounting method. According to Reg. section 1.446-3(c), cash basis taxpayers generally report income in the year received (or constructively received), and accrual basis taxpayers generally report income when the "all events" test is met. Although contingent fees are not includable in income under the cash or accrual accounting methods, it can be inferred that they will be taxed to the one who earned them since these future payments would be compensation for services rendered. Because this is not clearly spelled out in the IRC, however, it has been left to the courts to articulate to whom contingent fees should be taxed.
Lucas v. Earl. The idea of avoiding tax liability by assigning the right to receive income earned by the taxpayer to another is not new. As early as 1930, the Supreme Court of the United States ruled on this issue in Lucas v. Earl. In this landmark ruling, taxpayer and his spouse entered into a valid contract stating that all property and earnings "shall be treated and considered . . . to be . . . owned by us [taxpayer and spouse] as joint tenants . . . with rights of survivorship." The question before the court was to whom should salary and fees earned by taxpayer be taxed. The court ruled that "the statute could tax salaries to those who earned them and provide that the tax could not be escaped by anticipatory arrangements and contracts . . . to prevent the salary when paid from vesting even for a second in the man who earned it." The opinion concluded with the often cited tree-and-fruit metaphor: The fruits cannot be attributed to a different tree from that on which they grew.
Hall. The Seventh Circuit Court of Appeals used the same logic as Eubank when it ruled that future insurance renewal commissions were taxable to the salesperson-assignor even though the assignor (Hall) transferred the agency contracts (which contained the right to receive the renewal commissions) to his spouse. Taxpayer argued that the tree (the agency contracts) was transferred with the fruit (the renewal commissions). Nonetheless, the court felt the commissions were derived from the taxpayer's services and not from the agency contracts. However, if the assignor transferred the entire insurance business along with the insurance contracts to the assignee as in Jones v. Corbyn, the tree would have been deemed transferred with the fruit, and the commission income would be taxable to the assignee. Therefore, in Hall, the fruit ripened on the taxpayer's tree, and assigning the right to receive that income did not relieve the taxpayer of his tax liability regarding that income.
Cold Metal. Within a year after W.B. Hall, the limits of the anticipatory assignment of income doctrine was tested concerning its application to the assignment of truly uncertain future income in Cold Metal Process Co. In this case, taxpayer (a corporation) owned patents, but could not receive claims for patent infringements or royalties relating to the patents until lawsuits brought against the corporation by the U.S. were settled. This situation made the receipt of patent infringement claims and royalties contingent on the outcome of the lawsuits. Before the lawsuits were settled, taxpayer corporation was liquidated and all assets were transferred to a trustee, including the right to receive the claims for patent infringement and royalties pending the outcome of litigation. The court ruled that the anticipatory assignment of income doctrine did not apply because the "absolute and unconditional assignment by it [taxpayer corporation] . . . of the income producing property [the patents] together with a contingent right to income therefrom, payable, if at all, at some indefinite time in the future in an indeterminate amount, with respect to which the assignor [taxpayer corporation] had no voice or control whatsoever, prevents us from treating the case as one involving the anticipatory assignment of income, which when paid becomes taxable to the assignor."
Jones. Subsequent rulings also allowed anticipatory assignments when the right to future income was sufficiently uncertain. For example, taxpayer in A.R. Jones performed $350,000 of services for the U.S. government for which he was not compensated. After nine years of negotiations with the government--including a lawsuit--to collect the $350,000, taxpayer (an individual) transferred the claim to a recently formed corporation (taxpayer owned 67% of the assignee corporation, but possessed only one of four votes on the board of directors) for $10,000 (taxpayer needed the money to pay income taxes). Nine months after the transfer, the court made its final decision in favor of taxpayer. The following tax year, taxpayer received the settlement and promptly remitted the funds to the assignee corporation. The court ruled that "the claim . . . by means of which the funds were realized, was at the time of assignment . . . uncertain, doubtful, and contingent. . . . The assignment in this case was full, complete, final, and definite. When this assignment was made over five months before the court . . . announced its decision, over nine months before the decision became final, and over 14 months before payment was received, the 'tree' appeared to be blighted and almost devoid of life." Thus, the anticipatory assignment of income doctrine did not apply because the fruit did not ripen until the tree was transferred to the assignee corporation.
Dodge. The case of Dodge is another example in which the anticipatory assignment of income doctrine did not apply. Partner A offered to leave one-half of his estate to Partner B's daughter if B performed all of the work for AB partnership (A and B were brothers). Partner A refused to put the agreement in writing. This agreement took place 30 years before A's death. B performed all partnership work. One year before death (1963), A rewrote his will, leaving nothing to B's daughter (A died in 1964). Daughter filed an action in 1965 against A's estate to enforce the oral promise. B died in 1967 and B's daughter won the action in 1968. The IRS contended that the proceeds from A's estate were income in respect of a decedent to B under the anticipatory assignment of income doctrine because B's daughter's inheritance was the compensation for B's work on the partnership. However, the court ruled the anticipatory assignment of doctrine did not apply because the right to that income was doubtful, uncertain, and contingent in view of the facts (the claim had to be litigated). Once again, the fruit had not sufficiently ripened on the tree.
Kochansky. Although W.B. Hall and Dodge allowed taxpayers to avoid taxation on contingent income that was anticipatorily assigned to another, the fact that income is contingent on some future event is only one factor the courts use to determine tax consequences. In Kochansky, the taxpayer assigned to his ex-wife (in a divorce settlement) a portion of legal fees contingent on the outcome of a case he was litigating. Taxpayer won the case and remitted the assigned portion to his ex-wife. The court ruled that even though the taxpayer's fee was contingent on the successful outcome of litigation, the fees were clearly compensation for his legal services. As a result, the anticipatory assignment of income doctrine applies because the fruit had ripened on the taxpayer's tree.
and report partnership income in amounts different from their contributions to the pool.
Taxpayer (an attorney) received referral fees from Old Firm (where he was an associate) while he was a partner in New Firm. Collection of the referral fees was contingent on Old Firm receiving revenue from the referred client. Taxpayer remitted all referral fees received from Old Firm to New Firm in accordance with New Firm's partnership agreement (partnership agreement states that all fees arising from the practice of law be remitted to New Firm). At the end of the year, taxpayer received his distributive share of New Firm's partnership income according to his percentage share of partnership profits. Thus, the promise to remit fees not yet earned to New Firm was an anticipatory assignment of income.
However, the court, citing Rev. Rul. 64-90 (which states that a taxpayer may assign income to a partnership), held this anticipatory assignment of income to be valid because it believed Congress implicitly intended subchapter K to allow the pooling of income and losses of partners--as long as the type of income earned bears sufficient nexus to partnership activities (see for example Leininger.) The court further added that this situation is analogous to attributing income to a personal service corporation when a corporate employee performs labors that give rise to the income (e.g., C. Johnson). Finally, the court concluded that Lucas v. Earl does not apply because there is no assignment of income since it is the partnership that earned the fees.
The analysis of the above case law indicates the taxpayer liable for reporting assigned contingent fees upon realization depends on the facts and circumstances of each case. Specifically, the assignment of income doctrine can be avoided in many instances. However, several factors appear to be paramount in making such a determination.
Assignor's Effort to Generate Income. If the income is realized through only the assignor's efforts (the assignee did not have to expend any effort to realize the income) as was the case in Lucas v. Earl, Eubank, W.B. Hall, and Kochansky, income will be taxable to the assignor when it is realized even if realization is uncertain. However, if the source of the income is transferred along with right to receive future income as in Jones v. Corbyn, then realization of the future income will be taxable to the assignee. Therefore, when contingent fees are realized due to only the assignor's efforts, they will be attributed to the assignor unless other mitigating factors are present (e.g., transferring the source of the income with the right to receive future income).
Likelihood of Income Realization and Assignee Effort. Transferring the source of income (i.e., the business from which the income was derived) is only one way to shift the tax liability for contingent income to another taxpayer. When the taxpayer wants to transfer the tax liability for contingent income without transferring the source of that income, he or she must consider 1) the likelihood that income will be realized solely through his or her efforts and 2) the amount of effort the taxpayer must expend to realize that income. In Dodge, the court deemed that realization of the assigned right to future income was sufficiently doubtful based on the nature of the assigned right (30 years before assignor's death, assignor orally promised to leave one-half of his estate to assignee if assignor's partner [assignee's father] performed all partnership-related work). The judiciary also considered the amount of effort expended by the assignee (assignee realized income only after three years of litigation) to be equally important in determining the likelihood of income realization. Thus, to determine the likelihood of income realization by the assignee, the courts equally weighted the amount of effort expended by the assignee (to realize the income) and the underlying nature of the contingency.
Timing Issue. Another factor the courts used to determine the likelihood contingent income would be realized is the date the assignment was made. In Cold Metal Press Co., and A.R. Jones, the assignors transferred both the income source and the right to receive future income. As noted above in Jones v. Corbyn, income will be attributed to the assignee if the tree is transferred with the fruit. Moreover, in Cold Metal Press Co. and A.R. Jones, the courts had to decide if the fruit had sufficiently ripened on the assignors' trees as of the date of transfer. If the fruit had sufficiently ripened, income would be attributed to the assignor. Unlike Dodge, the date of the assignment in both Cold Metal Press Co. and A.R. Jones was critical to the courts' determination of the likelihood the assignees would realize income (i.e., based on the nature of the contingency and the assignees' efforts). Therefore, even if the tree is transferred with the fruit, realization of future income will accrue to the assignor if the fruit has sufficiently ripened while the assignor still held the tree.
Assignment of Contingent Fees to a Partnership. The overriding question in the cases analyzed thus far was how to apply the anticipatory assignment of income doctrine. However, when contingent fees are assigned to a partnership, the judiciary had to determine if the anticipatory assignment of doctrine applied. Schneer illustrated the court's belief that the entity approach should be applied to a partnership under Subchapter K. This meant a partnership agreement could require the assignment of contingent fees (bearing sufficient nexus to partnership activities) to the partnership--whether or not the partner was acting in his or her capacity as a partner--and allocate partnership income without regard to who actually earned it. As a result, the assignment of income from a partner to a partnership is outside the scope of the assignment of income doctrine provided the income was earned while a partner. For a summary of the critical factors in assignment of income cases, see the Exhibit.
The analysis of case law regarding the assignment of contingent fees to a partnership reveals an opportunity to use such an assignment to shift income to family members with low marginal tax rates by allocating profits to partners whose efforts did not produce the income. If a taxpayer has children who do not work for the partnership, allocating income to them can be accomplished with a family limited partnership, provided certain conditions are met. By making the children limited partners, they are not required (nor are they allowed) to participate in management activities. These rules apply whether the children purchase their partnership interests or acquire them by gift (or use capital from a gift to obtain such interest).
If the partnership interest was acquired by gift, the first requirement that must be met is that the donor must have, in fact, relinquished sufficient control over the gifted property or interest to create a bona fide partnership relationship. Otherwise, the children's partnership interests will be ignored for tax purposes. Therefore, the donor parent must be certain that he or she is willing to give the children an interest in partnership assets and have the other partners acknowledge that the children are partners.
Since the children will have only a capital interest in the partnership, the second condition that must be met is that capital must be a material income-producing factor. Given that the goal of this partnership is to assign contingent fees, the partnership will likely derive most of its income from fees or commissions. Although compensation for personal services is prima facie evidence that capital is not a material income-producing factor, Poggetto indicates that capital is material when it is necessary to meet the business needs of the partnership. Consequently, the parent must show a need for the children's capital, such as the purchase of new equipment, to justify the need for the children's capital contributions.
One more condition must be met regarding ownership of the partnership interest. Where minor children cannot demonstrate that they are competent to manage their own property, the partnership interest should be held in trust. Additionally, the trustee should be unrelated and independent of the parent partner. Therefore, a prudent taxpayer should place children's partnership interests in a trust with an independent trustee to avoid having the partnership interest disregarded for tax purposes.
Complying with the above rules insures the children have a bona fide limited partnership interest in their parent's personal service partnership, but IRC section 704(e)(2) prevents a parent from allocating substantially all partnership income to the children (even assuming the allocation has substantial economic effect). According to Reg. section 1.704-1(e)(3), family partnership income must be distributed proportionate to capital interests after distributing reasonable compensation to the parent partner for his/her services rendered to the partnership.
The following is an example of how this might be done.
Dana operates a successful personal-injury law practice as a sole proprietorship. Her fees are based on a percentage of her clients' judgments. Thus, the income is contingent on the outcome of each case.
Desiring to reduce the family tax liability, she gives $10,000 to each of her two children, Randy (19) and Sonia (21). Dana, Randy, and Sonia subsequently form the DRS limited partnership. The children are not minors, so their interests do not need to be held in trust.
Dana contributes $80,000 of noncash assets (basis and FMV) for an 80% general partnership interest and Randy and Sonia each contribute $10,000 for their 10% limited partnership interests. It is immaterial whether the children acquired their interest by direct gift or purchased an interest with gifted money.
Dana uses the $20,000 cash to upgrade the partnership's computer system and update her law library with CD-ROM and online reference materials. This should satisfy the "income as a material income-producing factor" requirement because the partnership had no other cash.
During the year, DRS had net income of $250,000. If Dana were an associate attorney at another law firm, compensation for her services would be approximately $100,000. This establishes a logical basis to determine reasonable compensation for services rendered.
Therefore, the first $100,000 is allocated to Dana. Reasonable compensation for services rendered must first be allocated to the service-providing partner.
Dana also receives $120,000 [($250,000 ­ $100,000) x 80%] of the remaining profits for a total allocation of $220,000. Randy and Sonia each receive $15,000 [($250,000 ­ $100,000) x 10%]. The remaining profits are allocated proportionate to partners' capital interests.
Richard I. Newmark, PhD, CPA, is an assistant professor and Ted D. Englebrecht, PhD, CPA, a professor and Eminent Scholar, both at Old Dominion University, Norfolk, VA.

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