Category: Corporations
Subject: S Corporations, Built-In Gains Tax
Title: Attorney's Contingent-Fee Case Inventory Present at Election of S Status
IRC Sections: 1374
Filename: 1145.html
Date Produced: 3/96

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Background
Taxpayer (TP) is a law firm organized as a C corporation. TP does contingency fee lawsuits and at any given time has cases in progress that may ultimately be won or settled thereby producing fee income. TP is contemplating an S election. The issue is whether the contingency fees realized after the election related to cases in progress at the time of the election are subject to the built-in gains tax under Section 1374.

Comments
1374 applies to net recognized BIG.

Recognized BIG means any gain recognized during the recognition period on the disposition of any asset in existence at the time of conversion. 1374(d)(3).

Regs at Section 1.1374-4(b) say income items recognized post conversion attributable to pre-conversion activity are not BIG items unless the income would have been recognized pre-conversion under the accrual method of accounting. Given the "all-events" test, it seems clear that in general contingent fee cases would not give rise to income to an accrual basis taxpayer. It seems to me that in most cases, neither prong of the all events test is met: A) the attorney's right to the income is not fixed, and B) the amount of the income is not determinable with reasonable accuracy.

Unfortunately, I do not feel that the income item rule set forth at Regulation Section 1.1374-4(b) and the general asset recognition rule set forth in the statute are mutually exclusive. The statute and the regulation are sufficiently broad to support the argument that the cases in progress are assets, some of which are recognized after the conversion.

I think there is exposure here. I think the regulations were intended to deal with the situation we have, but both the statute and the regulations are sufficiently loose to allow an alternative interpretation. I think despite the best of intentions on the part of the drafters of the regulations, the amount of dollars involved here could invite an agent to take a position contrary to the client's interest in this matter.

I feel that we need to quantify and minimize the risk by attempting to value the taxpayer's case inventory at the date of conversion.

Go through the taxpayer's case inventory at 12/31/95. Categorize the cases as 1) pre-judgment or settlement, 2) cases in which a judgment has been entered but the case may go on appeal, and 3) cases in which a judgment has been entered and either the time for appeals has expired or appeals have been lost and the attorney is simply waiting to get paid.

Let's look at the standard agreement between attorney and client as to fees. Please get the specific contractual language. Exactly when and how does the attorneys right to income become fixed?

What happens if an attorney dies or becomes incapacitated in the middle of a case? Obviously the case inventory has value. What is it? Is there a provision in a partnership agreement, a buy-sell agreement, or anything else to deal with this question? Is there are rule of thumb common in the industry? Obviously, I am getting at trying to cap the value of the case inventory at the date of conversion.