Contingency Fee Income Recognition: When the Fee Is Earned, Cash vs. Accrual Timing, and Advance Costs

Contingency fee practices create a timing problem that hourly-billing firms never face. An hourly firm bills monthly and recognizes income as it collects, with a relatively predictable revenue stream. A contingency firm invests months or years of attorney time and tens of thousands of dollars in advance costs, earns nothing until the case resolves, and then receives a large lump sum that may arrive in a different tax year than the one in which the case settled. The question of when that fee becomes taxable income is not as simple as “when the check arrives.” Constructive receipt, the economic performance rules, structured settlement timing, and the assignment-of-income doctrine all create traps for contingency practices that do not plan carefully. A firm that settles a case in late December, structures the payout into January, and deducts advanced litigation costs in the wrong year can end up with income in the wrong period, disallowed deductions, and a tax bill that does not match the cash in the bank.

Why do most law firms use the cash method?

The cash method of accounting recognizes income when cash is received and deductions when cash is paid. Most law firms use the cash method because it aligns taxable income with actual cash flow, avoids the complexity of accrual accounting for receivables and payables, and defers the recognition of income on unbilled work-in-progress. For contingency firms, the cash method is particularly valuable because the firm may invest two to four years of time and costs before receiving any revenue. Under the cash method, the firm pays tax only when the fee arrives, not when the case settles or when the fee is “earned” in an accounting sense.

The cash method is available to any law firm (regardless of entity type) that meets the gross receipts test under IRC 448(c). For tax years beginning in 2026, the threshold is $32 million in average annual gross receipts over the prior three years. Nearly all law firms fall under this threshold. Firms that exceed it must use the accrual method, which creates the timing complications discussed below.

The choice of method is an accounting method election made on the firm’s first tax return. Changing methods requires filing Form 3115 and computing a Section 481(a) adjustment to prevent income from being duplicated or omitted in the transition.

When is a contingency fee “received” for tax purposes?

For a cash-method firm, the fee is income when it is actually or constructively received. Actual receipt is straightforward: the settlement check arrives, is deposited, and the fee portion is income. Constructive receipt is where the complexity starts.

Under Treas. Reg. 1.451-2(a), income is constructively received when it is “credited to [the taxpayer’s] account, set apart for him, or otherwise made available so that he may draw upon it at any time.” The regulation adds a qualifier: income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions.

For contingency firms, these rules create several scenarios worth understanding.

• Settlement signed in December, check arrives in January. If the settlement agreement is signed and the opposing party mails or wires the payment in December, but the check does not arrive at the firm’s trust account until January, the fee is generally income in January (the year of actual receipt) for a cash-method firm. There is no constructive receipt in December because the firm did not have access to the funds. However, if the settlement check was available for pickup in December and the firm chose not to pick it up until January, the IRS could argue constructive receipt in December.

• Settlement proceeds deposited into the trust account. When settlement proceeds arrive, they are deposited into the client trust account, not the firm’s operating account. The fee portion remains in the trust account until the firm issues a final accounting to the client, resolves any outstanding liens (medical providers, litigation funding companies), and disburses the client’s share. The fee income is recognized when the firm transfers its fee portion from the trust account to the operating account, or when it has an unrestricted right to do so (constructive receipt). If the only reason the fee is still in the trust account is the firm’s own administrative delay, the IRS may argue constructive receipt occurred when the settlement proceeds were deposited.

• Disputed fees. If the client disputes the fee amount (challenging the percentage, the cost calculation, or the scope of the fee agreement), the dispute creates a substantial limitation on the firm’s receipt. In that case, the fee is not constructively received until the dispute is resolved. The Tax Court has consistently held that a genuine dispute over the right to receive income prevents constructive receipt.

How does the accrual method change the timing?

An accrual-method firm recognizes income when all events have occurred that fix the right to receive the income and the amount can be determined with reasonable accuracy, regardless of when payment is received. For a contingency fee, the right to the fee is typically fixed when the settlement agreement is executed (or when the court enters judgment). At that point, the amount is determinable (the settlement amount multiplied by the fee percentage, minus costs), and the income is recognized even if the cash has not arrived.

This means an accrual-method contingency firm that settles a case on December 28 recognizes the fee income in that tax year, even if the settlement check does not arrive until February. The cash-method firm in the same situation recognizes the income in the following year. For a firm with several large settlements near year end, the difference can be hundreds of thousands of dollars in shifted income.

The economic performance rules under IRC 461(h) add a further wrinkle on the deduction side. An accrual-method firm cannot deduct a liability until economic performance occurs, even if all events establishing the liability have occurred and the amount is determinable. For most expenses (rent, salaries, supplies), economic performance occurs when the services are provided or the property is used. For tort and breach-of-contract liabilities, economic performance occurs only when payment is made. This means an accrual-method firm that owes a referral fee to another attorney on a settled case cannot deduct the referral fee until it is actually paid, even though the obligation is fixed and determinable at settlement.

How should advance litigation costs be treated?

Contingency firms routinely advance costs on behalf of clients: filing fees, service of process fees, deposition transcripts, court reporters, expert witness fees and expenses, medical record retrieval, investigation costs, trial exhibits, and travel. These costs can total $20,000 to $200,000 or more on a complex personal injury, medical malpractice, or commercial litigation matter. The tax treatment depends on whether the costs are the firm’s expense or a loan to the client.

If the fee agreement provides that the client is ultimately responsible for the costs (win or lose), and the firm is advancing the costs as a loan, the advance is not deductible when paid. It is recorded as an asset (Client Cost Advances Receivable) and recovered from the settlement proceeds or billed to the client. The firm gets no deduction until the cost is written off as uncollectible (if the case is lost and the client cannot pay). This is the most common arrangement and the correct treatment when the client bears the ultimate risk of the costs. For the bookkeeping mechanics, see law firm bookkeeping.

If the fee agreement provides that the firm bears the costs regardless of outcome (the firm eats the costs if the case is lost), the costs may be deductible when paid under IRC 162 as ordinary and necessary business expenses. However, the IRS may argue that costs incurred in developing a contingent asset (the lawsuit) should be capitalized under IRC 263 and recovered only when the case resolves. The courts have not been entirely consistent on this point, but the weight of authority supports current deduction for routine litigation costs (filing fees, discovery costs, travel) and capitalization for costs that create a distinct asset or benefit that extends beyond the current year (such as a large expert report that will be used at trial two years later).

The practical approach: treat advanced costs as an asset when the client bears the cost risk, and deduct costs currently when the firm bears the risk, unless the cost is clearly a capital expenditure.

What’s the assignment-of-income problem?

In Commissioner v. Banks, 543 U.S. 426 (2005), the Supreme Court held that a plaintiff who pays a contingency fee to an attorney must include the full settlement amount (including the fee portion) in gross income. The plaintiff cannot exclude the attorney’s fee from income by arguing that the fee was never the plaintiff’s money. The Court applied the anticipatory assignment-of-income doctrine (from Lucas v. Earl, 281 U.S. 111): a taxpayer cannot avoid tax on income by assigning it to someone else before it is received.

The practical consequence: a client who settles a case for $1,000,000 and pays a $330,000 contingency fee must report $1,000,000 in gross income (to the extent not excluded under IRC 104(a)(2) as damages for physical injuries). The client then deducts the $330,000 fee, but the deduction is subject to limitations. For employment discrimination and certain other claims, IRC 62(a)(20) allows an above-the-line deduction for attorney fees. For other types of claims, the fee deduction was a miscellaneous itemized deduction (subject to the 2% AGI floor) before the Tax Cuts and Jobs Act of 2017 suspended miscellaneous itemized deductions. The One Big Beautiful Bill Act made that suspension permanent, meaning the deduction remains unavailable for many plaintiffs.

For the law firm, Banks means the firm should advise clients about the tax consequences of the contingency fee arrangement at the engagement stage. A client who wins a $5 million verdict on a commercial claim may owe tax on the full $5 million and get no deduction for the $1.65 million contingency fee. This is not the firm’s tax problem (the firm pays tax only on its fee), but it is a client-relations and disclosure issue.

How do structured settlement fees affect timing?

An attorney who receives a contingency fee can structure the fee payments over time using a structured attorney fee arrangement. The attorney assigns the right to the fee to a structured settlement company, which purchases an annuity that pays the attorney in installments over a period of years. If the arrangement is set up before the attorney has a right to receive the fee (before the settlement is finalized), the structured fee payments are taxed as received, spreading the income over the payout period.

The timing is critical. The structured fee arrangement must be in place before the attorney has an unrestricted right to the fee. If the settlement is finalized on December 15 and the attorney does not set up the structured arrangement until December 20, the IRS will argue that the attorney had constructive receipt of the full fee on December 15, and the subsequent assignment to the structured settlement company does not change the timing. The arrangement must be negotiated as part of the settlement, before the attorney’s right to the fee is fixed.

Structured attorney fees are most useful for large verdicts or settlements where the fee is $500,000 or more. The deferral reduces the current-year tax bill and spreads the income over the payout period. The cost is the loss of immediate access to the full fee amount and the credit risk of the annuity issuer.

How do contingency firms manage cash flow and taxes?

The feast-or-famine revenue cycle of a contingency practice makes estimated tax planning difficult. A firm might receive no fee income for six months and then collect $2 million in a single month. The IRS requires quarterly estimated tax payments (April 15, June 15, September 15, January 15), and underpayment penalties apply if the payments are insufficient.

The safe harbor for estimated taxes is the lesser of 90% of the current year’s tax liability or 100% of the prior year’s tax liability (110% if prior-year AGI exceeds $150,000, which it will for any profitable law firm partner). Most contingency-firm partners use the prior-year safe harbor: they pay estimated taxes based on the prior year’s actual tax, regardless of the current year’s income. This avoids underpayment penalties even if the current year’s income is substantially higher.

A partner who owes $300,000 in estimated taxes must make payments of $75,000 per quarter, but fee income may not arrive until Q3 or Q4. Partners in contingency firms typically maintain a cash reserve (or a line of credit) to cover estimated tax payments during dry periods. Some firms structure guaranteed payments at a level that covers each partner’s estimated tax obligations, with contingency-fee income as the upside. See partner compensation for how guaranteed payments interact with the overall compensation structure.

What should I do next?

If your firm operates on the cash method (as most do), confirm that fee income is being recognized when received, not when the settlement is signed. Review year-end settlements to ensure there is no constructive receipt issue (an available check the firm chose not to deposit). Check the treatment of advanced litigation costs: if the client bears the cost risk, the advances should be on the balance sheet as an asset, not deducted as expenses. If the firm bears the cost risk, confirm the costs are deductible and not subject to capitalization.

• Law firm bookkeeping, the chart of accounts and the client cost advance account that tracks advanced litigation costs
• Law firm billing and collections, the AR management and collection process for non-contingency revenue
• Law firm partner compensation, how contingency fee income flows through the K-1 and interacts with guaranteed payments
• IOLTA trust accounting, the trust account where settlement proceeds sit before disbursement
• Law firm client costs and advanced litigation expenses, the detailed treatment of advanced costs, recoverability, and write-off timing
• Law firm work-in-progress and unbilled time, how unbilled time and costs affect the firm’s financial position
• Law firm client trust interest, the interest earned on settlement proceeds held in trust before disbursement

Related guides:

• Law Firm Associate Partner Track Compensation Tax
• Law Firm Billing Collections Accounts Receivable
• Law Firm Bookkeeping Chart Of Accounts Billing
• Law Firm Client Costs Advanced Litigation Expenses
• Law Firm Client Trust Interest Iolta Reporting

Related guides:

• Assignment of Income Doctrine: Why You Cannot Shift Business Income to a Lower-Bracket Family Member

This guide is general information, not tax advice for your specific situation. Which points apply, and how, depends on your facts.