Frank C. Kilcoyne, CSSC

Well-Thought-Out Attorney Fees

This is the time of year when plaintiffs’ attorneys get to do something their hourly-rate opponents never get to do: manage their income tax bills by deferring fee income into future years. Many of you are familiar with the concept of “structured attorney fees” but have either never done one or never really focused on why they represent such a remarkable value.

If you have a basic understanding of tax accounting, you’ll know that fee income becomes taxable income when it is considered “received” by the attorney, typically when the cash portion of a settlement arrives for deposit in their client trust account.

Checks in hand are usually great news because revenues are so famously uneven in a trial practice. Maintaining adequate cash flow is critical but the plain truth is: some years are great, others lousy. The great years help make up for the lousy ones, but there is actually such a thing as a year being too good. After doing year-end planning with one’s accountant, more than one attorney has walked out confused (and a little bewildered) by having been told that they had earned “too much income.”

Sounds like a nice problem to have – but not if it means paying substantially more taxes than necessary. Attorneys in the significant earning years of their careers also tend to have families or aging parents or other financial obligations. There can be a real squeeze play going on and overpaying taxes is just a silly waste of hard-earned dollars.

Fortunately there is a solution to this problem and it is both simple and easy. The simple part is just paying attention to when a good year is about to become a great year and then starting to consider deferring fees on the remaining cases due to close that year.

I say it is also “easy” because the options available to an attorney are the same available to clients when they want to structure: in other words, an attorney can craft future cash flows just about any way they want to: guaranteed payment for “X” number of years, lifetime income to the practitioner (joint to spouse), a series of lump sums, or combinations of the above. The start dates for such payments can be immediate or they can be programmed to start “Y” years in the future. The fees can be paid to individual attorneys or back to the practice itself, whichever is best in a given situation.

For your tax preparer’s reference, the leading tax case on structured attorney fees was Childs v. Commissioner, 103 T.C. 634 (1994). In this case, the tax court and the 11th U.S. Circuit Court of Appeals ruled that settlement documents in this case did indeed control the timing of income received by an attorney and that the doctrine of constructive receipt did not apply.

Note the date of that decision: 1994. It has been perfectly legal to defer attorney fees for over 20 years! The IRS has accepted this decision and the matter is no longer in dispute.

Now why would the IRS be so kind to trial attorneys? Why should they be allowed to defer income when other lawyers cannot? Well, they are not doling out any kind of favors to trial attorneys, they are simply interpreting and applying tax law the same to the attorney as they do to the attorney’s client: as long as payment over time is a material term of settlement and properly crafted into the settlement documents that way, then the tax is not due for the attorney until they year they actually receive payment.

Oh, and the second-best thing about structuring attorney’s fees is this: there are no artificial dollar limits on the amount being deferred. Unlike complicated retail retirement plans which impose hard-dollar limits on the amounts deferred (and further complicated tests like the one for ‘top-heaviness’), an attorney can defer fees of $50,000 or $5 million.

Yes, you read that right: you can create a future income stream for yourself in small amounts as cases come in, or fully-fund a retirement on the strength of one monster case. All same tax rules; all same mechanics.

Lastly, when deferring significant sums like these the question arises as to what kind of investment vehicle will the funds be invested in and what kind of pre-tax returns might be expected. This will again be up to the attorney.

The simplest and more traditional route has been to simply create a fully-guaranteed income stream backed by a highly-rated domestic life insurance company. That is the only choice where lifetime income is desired because only life insurance companies can issue guarantees of lifetime payment.

But an attorney may also fund future payments using a portfolio comprised solely of U. S. Treasury securities.

For those with longer time horizons and greater risk tolerances, there are even new programs available which permit future payments to be tied to the performance of investment markets. One is offered in the form of a rider attached to a traditional settlement annuity-type policy and backed by that issuing life insurance company. And there are even options which can be funded using funds issued by Vanguard®(1) and other well-established investment companies.

Bear in mind that market-related options will involve additional discussions with properly licensed individuals and entities and may not suitable for all situations. But know that this strategy exists, other attorneys are now making it a routine element of their practice, and new and valuable options are now available.

Would you like to have a more comprehensive discussion regarding this technique? Call Frank C. Kilcoyne, CSSC, at frank.kilcoyne@jmwsettlements.com or call 800.544.5533. I am here to help.


(1) Copyright The Vanguard Group, Inc.